Taking Human Capital Theory Seriously: Simkovic on “The Knowledge Tax”

Graduate professional education in the US is facing a financing squeeze. Some argue that those learning to become doctors, nurses, engineers, lawyers, and the like should get no help from the federal government, because they tend to earn higher incomes than average. Others question that premise, arguing that past results of grad degrees are no guarantee of future performance. They believe that an impending wave of defaults on federal student loans will raise the cost of federal credit programs.

Nevertheless, each side argues for policy with convergent outcomes. The “grad students will be rich” camp argues for curtailing federal loans, since they believe professionals can handle the higher interest rates on the private market. The “grad students will be poor” camp wants to raise the rates on federal student loans, to build up the already hefty surpluses the government is now making, to prepare for the putative future defaults. In the eyes of both, graduate students are the undeserving recipients of government largesse.

I’m not convinced by either: the “too rich” camp fails to value professional services properly, and the “too poor” camp is relying on controversial accounting techniques. But until I read Mike Simkovic’s recent paper “The Knowledge Tax,” I’d never thought of an even more fundamental distortion at work here: tax policy. Simkovic lays out the problem with characteristic clarity, considering a hypothetical college graduate deciding on (1) attending medical school and practicing medicine; or (2) purchasing a small vacant building and converting it into rental apartments:

Either option will require an initial investment of $300,000 and several years of hard work before reaching profitability. Each (but not both) can be financed with a combination of family money and external loans. The medical degree can be expected to produce higher returns before taxes in the form of a large boost to earnings, because of strong demand for health services and relatively low supplies of qualified physicians. The apartments will likely produce more modest returns before taxes because of an adequate supply of housing. However, assume the apartment complex can be expected to produce higher returns after taxes because of more generous tax treatment of real estate. If our college graduate buys the building, he can

1) recover the cost of the building and improvements through depreciation deductions

2) fully deduct interest expenses

3) deduct any state or local property taxes from his income for federal taxes

4) ultimately benefit from relatively low capital gains rates on eventual sale of the building, potentially converting his labor converting the building into capital gains.

By contrast, if he pursues the medical degree, he will be unable to recover the cost of tuition through amortization, only a fraction of the student loan interest (if any) will be deductible, his additional earnings attributable to the medical degree will be subject to both federal income and payroll taxes, he will not receive a deduction on his federal income taxes for the employee-paid half of payroll taxes, and he will have few opportunities to convert his labor income into capital gains.

Of course, the federal government also helps higher education in various ways, which Simkovic carefully notes in an appendix to the article. As the Higher Education Act moves toward reauthorization in this or coming years, we’ll be hearing plenty about every subsidy out there. But the tax disadvantage against human capital could easily wipe all those out. As investors and governments decide whether to invest more in persons or machines, Simkovic’s perspective is a crucial corrective to the current, one-sided debate.

There are outsized economic gains accruing to nations that educate their citizens well. But so much dialogue about education today is negative. I recently suffered through a speech by a technocrat on the “negative productivity” of primary school teachers. Foundations fund think tanks to declare that masters’ programs are worthless, and then fund magazines to publicize that “finding.” Professional education, too, is under attack. From this perspective, it’s not hard to see why a state like Wisconsin appears set to cut $300 million from universities, while investing $500 million in pro basketball arena. For its top leaders, spectacle has real economic value, while schooling’s benefits are not worthy of government support beyond what was provided in 1998.

Simkovic suggests that the education sector is, in fact, overperforming, given the tax burden now imposed on it. His work also shows how established labor economics complements the message of more heterodox thinkers like Mariana Mazzucato and Robert Kuttner (who emphasize the importance of policy to the shape of future innovation). I hope that open-minded journalists like David Leonhardt will give it a look, to help inform debate over public priorities.

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