Journal of Economic Dynamics & Control 27 (2003) 1459–1502 www.elsevier.com/locate/econbase Higher education subsidies and heterogeneity: a dynamic analysis Elizabeth M. Caucutt a , Krishna B. Kumar b; * a Department of Economics, University of Rochester, Rochester, NY 14627, USA b Finance and Business Economics, Marshall School of Business, HOH 701, University of Southern California, Los Angeles, CA 90089-1427, USA Abstract In this paper, we develop a simple dynamic general equilibrium framework to address the eects of increasing higher education subsidies in the US, from their already substantial lev- els, on inequality, welfare, and eciency. We focus on three policies. The rst is a tax and subsidy scheme that ensures that the parental decision to send a child to college is inde- pendent of income. Such a policy decreases the eciency of the utilization of education re- sources, while the welfare gain is minimal. The second policy maximizes the fraction of college educated labor. This results in a large drop in the above-mentioned eciency with little or no welfare gain. The third is the provision of merit-based aid to the poor as op- posed to purely need-based aid. This policy can increase education eciency with little decrease in welfare. Based on these experiments, we conclude that the case for further increases in higher education subsidies might have been overstated. ? 2002 Elsevier Science B.V. All rights reserved. JEL classication: E60; I22 Keywords: Dynamic heterogeneous-agent models; Welfare analysis ∗ Corresponding author Tel: 213-740-6533; Fax: 213-740-6650. E-mail addresses: ecau@troi.cc.rochester.edu (E.M. Caucutt), kbkumar@usc.edu (K.B. Kumar). 0165-1889/02/$ - see front matter ? 2002 Elsevier Science B.V. All rights reserved. PII:S0165-1889(02)00067-2