Capital market failure, adverse selection and optimal financing of higher education

We apply theories of capital market failure to analyze
optimal financing of risky higher education. In the market solution,
students can only finance their education through debt. There is
underinvestment in human capital, because some students with socially
profitable investments in human capital will not invest in education
due to adverse selection problems in debt markets and because
insurance markets for human capital related risk are absent. Legal
limitations on the use of human capital in financial contracts cause this
underinvestment; without them private markets would optimally
finance these risky investments through equity rather than debt and
supply income insurance. The government, however, can circumvent
this problem and implement equity and insurance contracts through the
tax system using a graduate tax. This paper shows that public equity
financing of education coupled to provision of some income insurance
is the optimal way to finance education when private markets fail due
to adverse selection. We show that education subsidies to restore
market inefficiencies are sub-optimal.