The graduate tax when education is a signal Russayani Ismail a , Gareth D. Myles b,c,n a Department of Economics, Universiti Utara Malaysia, Malaysia b Department of Economics, University of Exeter, Exeter EX4 4PU, UK c Institute for Fiscal Studies, UK article info Article history: Received 6 July 2015 Accepted 29 July 2015 Available online 14 August 2015 Keywords: Higher education Uncertainty Signalling Graduate tax abstract This paper investigates the effects of a graduate tax when the return to education is uncertain and wages are determined through equilibrium in a labor market with signalling. The consequence of uncertainty is that both ability and initial wealth matter for educational choice. Compared to a constrained first-best the market outcome with uncertainty and signalling results in an inefficiently high number of people entering higher education. Due to the positive wealth effect over-entry is proportionately greater for high-wealth individuals. The graduate tax reduces entry into education so enhances efficiency. However, it has undesirable distributional consequences: low-wealth indivi- duals are deterred from entering education but high-wealth are encouraged. In this respect, the graduate tax has clear failings as a method of financing higher education. & 2015 University of Venice. Published by Elsevier Ltd. All rights reserved. 1. Introduction The idea of introducing a tax on graduates has often been proposed as an alternative way of recovering the costs of education. 1 The basic concept of a graduate tax is that students would not have to pay the up-front cost of their education. Instead, the costs would initially be borne by the government with repayment by graduates through a tax premium during their working lives. If the tax is progressive with the rate linked to income, under such a scheme successful graduates will subsidize the less successful. Proponents of the graduate tax argue that it is a fairer method of financing higher education since graduates obtain significant private benefit from education in terms of future higher earnings. It is also regarded as a good method of widening access for those from less privileged backgrounds since it avoids the need to pay up-front fees and provides a degree of insurance against future income uncertainty. If the returns to education were purely private and certain, and the capital market were perfect, then each individual would assess whether the net benefit of education was positive and the perfect capital market would make the timing of repayment of costs immaterial. In these circumstances there is no need for a policy to assist the less privileged since initial wealth would not be a determinant of educational choice. It is unlikely that the market for education conforms to this description. In practice, the return to education is uncertain since individuals cannot perfectly predict the outcome when making educational choices and imperfect capital markets will impose borrowing restrictions. When education involves the Contents lists available at ScienceDirect journal homepage: www.elsevier.com/locate/rie Research in Economics http://dx.doi.org/10.1016/j.rie.2015.07.008 1090-9443/& 2015 University of Venice. Published by Elsevier Ltd. All rights reserved. n Corresponding author at: Department of Economics, University of Exeter, Exeter EX4 4PU, UK. E-mail address: gdmyles@ex.ac.uk (G.D. Myles). 1 It has also been the subject of much discussion in the UK. See, for example, the Financial Times editorial on 9 August 2010 (available at www.ft.com/ cms/s/0/e4bcba5a-a3e2-11df-9e3a-00144feabdc0.html) and the Browne Review of higher education funding in the UK (https://www.gov.uk/government/ uploads/system/uploads/attachment_data/file/422565/bis-10-1208-securing-sustainable-higher-education-browne-report.pdf). Research in Economics 70 (2016) 24–37