Human Capital Formation and Economic Growth in India : A CGE Analysis 1

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1 Human Captal Formaton and Economc Growth n Inda : A CGE Analyss 1 V. P. Ojha 2 B.K. Pradhan 3 Abstract In ths study, a multsectoral neo-classcal type prce drven CGE model, wth the addtonal feature that t ncludes a mechansm by whch publc educaton expendture to buld human captal augments the supply of educated/sklled labour, s used to analyse the mpact of an ncrease n the former, fnanced by an ncrease n drect tax rates, on economc growth and ncome dstrbuton n the Indan economy. The smulaton results suggest that t s possble to ncrease nvestment n human captal n the resource constraned fscal envronment of the Indan economy, and reap the benefts n terms of a faster economc growth and a better ncome dstrbuton. The results also suggest that secondary educaton needs to be accorded hgher prorty, though, not necessarly, at the cost of hgher educaton. Fnally, to maxmse the benefts n terms of economc growth t s desrable that nvestment n physcal captal be ncreased smultaneously wth nvestment n human captal. JEL Classfcaton : D58, H5, I2 Keywords : CGE model, Publc Expendture, Human Captal, Sklled Labour, Educated Labour, Educaton, Economc Growth, Income Dstrbuton, Inda. 1 Ths study was undertaken at the Natonal Councl of Appled Economc Research (NCAER), New Delh and sponsored by the South Asa Network of Economc Research Insttutes (SANEI). 2 V P Ojha s a Senor Consultant at NCAER, New Delh. E-mal : [email protected] 3 B K Pradhan s Chef Economst at NCAER, New Delh. E-mal : [email protected] 1

2 Human Captal and Economc Growth n Inda - A CGE Analyss 1. INTRODUCTION Studes on human captal formaton Educaton and economc growth n Inda CGE analyss of the lnkage between publc expendture on educaton and economc growth The present study MODEL STRUCTURE Sectoral dsaggregaton The producton structure Investment Factor markets Household ncome and consumpton demand Prvate corporate and publc sector ncome Household savngs Government savngs Foregn savngs Market equlbrum and macroeconomc closure Intertemporal adjustments THE BASE-LINE SCENARIO Benchmark parameters Labour supply and wage levels GDP and household ncome THE POLICY SIMULATIONS Polcy Smulaton Polcy smulaton Polcy Smulaton Polcy smulatons : caveats CONCLUSIONS AND POLICY IMPLICATIONS 37 REFERENCES 39 APPENDIX 1 (SAM) 43 APPENDIX 2 (Model Equatons) 48 2

3 Human Captal Formaton and Economc Growth n Inda : A CGE Analyss 4 V. P. Ojha 5 B.K. Pradhan 6 1. Introducton It s well known that Inda s transton to an outward-lookng strategy s a delayed one. Compared to, say, Chna, Inda s almost a decade behnd n launchng ts economc reforms program, whch t dd n 1991 as a response to the economc crses created by the chronc fscal and trade mbalances of the eghtes, rather than as a planned shft to outward orentaton. Lttle wonder then, that Inda, agan unlke Chna, was unprepared for the greater openness of the outward-orented strategy. It had not gone through the nternal adjustments and transformatons whch must deally precede trade lberalzaton. In fact, Inda s stll strugglng to undergo the varety of nternal economc reforms that are requred to be able to face the challenges of globalzaton. Among these reforms are () de-bureaucratzaton and deregulaton of the ndustral envronment, () restructurng of the publc sector, () developng the agrcultural and ndustral nfrastructure and (v) promotng human development. It s not a matter of chance that the last one s not an ntegral component of the reform package of the government, but only a sort of add-on to the polcy package. The underlyng vew s that polces for human development or socal sector development, as t s referred to n the polcy-makng crcles, are supplementary measures requred to translate economc growth nto an equvalent ncrease n human well beng. Whle ths vew s not contestable, t s clearly nsuffcent. More specfcally, t does not take nto account the obvous lessons from the experence of hgh performance east Asan and the Chnese economes n the last two decades. The polcy makers n these economes clearly regarded the causaton between human development and economc growth as b-drectonal. And n operatonal terms, they conscously developed the human resources to acheve hgher economc growth. The present study s motvated by a vew smlar to the one, whch underlay the strategc plannng of the East Asan Economes. It may also be mentoned here that, though human captal n 4 Ths study was undertaken at the Natonal Councl of Appled Economc Research (NCAER), New Delh and sponsored by the South Asa Network of Economc Research Insttutes (SANEI). 5 V P Ojha s a Senor Consultant at NCAER, New Delh. E-mal : [email protected] 6 B K Pradhan s Chef Economst at NCAER, New Delh. E-mal : [email protected] 3

4 an economy ncludes both the state of health and the educatonal levels of the the people, n ths study the focus s exclusvely on educatonal captal. In sub-sectons that follow, we dscuss the exstng lterature on human captal formaton and economc growth. Fnally, n sub-secton 1.4 we outlne the man objectves of the present study. The rest of the paper s organsed as follows. Secton 2 presents the overall structure of the CGE model used n the present study, wth specal emphass on the ntertemporal dynamcs whch ncludes a mechansm through whch publc educaton expendture augments the stock of human captal. Secton 3 presents the man features, such as, GDP growth and growth of household ncomes, of the base-lne or the busness-as-usual (BAU) scenaro. In secton 4, we report the smulaton results of the three polcy scenaros n comparson wth the BAU scenaro. Secton 5 concludes and suggests polcy mplcatons of our results. In Appendx 1 we present the Socal Accountng Matrx (SAM) whch provdes the benchmark equlbrum data set for the model. Appendx 2 gves the detaled set of equatons of the model. 1.1 Studes on human captal formaton The lterature on human captal formaton s abound wth partal equlbrum analyses of producton and cost functons of educaton (see Shr Prakash and Chowdhury (1994), Tlak (1985) and Tlak (1988), as well as of determnants of household expendture on educaton (see Tlak (2001a), Tlak (2001b)), Tlak (2001c), Tlak (2002), and Shr Prakash and Chowdhury (1994) ). The studes dealng wth the producton functon of educaton (say, for example, Shr Prakash and Chowdhury (1994)) measure output n terms of enrolments and nputs n terms of number of teachers employed and value of non-teachng nputs. Such producton functons are obvously useful n determnng whether the producton of educaton s subject to ncreasng, constant or dmnshng returns and the relatonshps between the margnal productvtes of the teachng and non-teachng nputs. (The cost functons of educaton are essentally a dual of the producton functon and serve the purpose of merely confrmng the results obtaned from the producton functons). However, from these essentally techncal descrptons of the producton of educaton no polcy concluson of consequence s dervable. In other words, n so far as these studes determne nether the prvate nor socal returns to educaton, ther polcy sgnfcance s lmted. The studes concerned wth the determnants of household expendture on educaton (for example, Tlak (2002) also treat educaton as an end n tself and fall short of explanng expendture on educaton n terms of the expected prvate returns on educaton. Usng state-wse cross-sectonal state level data for hs regressons, 4

5 Tlak (2002) explans household expendture on educaton n terms of household ncomes, and other household characterstcs such as educatonal level of the head of the household, occupaton, caste, relgon. The general equlbrum studes on educatonal captal formaton have a broader objectve, namely, assessng the mpact of nvestment on educaton on productvty (growth) and/or equty (wage-nequalty). All these studes are based on the underlyng assumpton that publc nvestment n educaton s a powerful polcy nstrument for nducng faster economc growth wth an mproved or a worsenng ncome dstrbuton. It needs to be stressed that a pror t cannot be known whether nvestment n educaton leads to growth wth more or less wage nequalty. Not surprsngly then, most of these studes are concerned wth the mpact of nvestment n educaton on changes n wage nequalty over tme. In a general equlbrum framework, there s mult-drectonal causaton between nvestment n educaton and changes n the relatve wages of sklled labor. On one hand, the ncreased nvestments n educaton lead to an ncrease n the relatve supply of sklled labor, whch n turn exerts a downward pressure on the relatve wages of sklled labor. On the other hand, the technologcal changes and the changes n nternatonal terms of trade n favor of skll ntensve goods, that necessarly accompany the growth process, push upwards the sklled wage rate relatve to the unsklled wage rate by creatng more demand for sklled labor. In short, relatve factor supply and relatve product prce changes are both mportant n explanng the change n the relatve return to sklled labor, and a general equlbrum model effectvely captures the net mpact of these factors on the relatve wages. Pradhan (2002) fnds an nterestng paradox n the growth process of the Indan economy, namely, that there s not much change n ncome nequalty even though there are large changes n the educatonal levels of the populaton over tme. He tres to resolve ths paradox by usng an appled general equlbrum model to smulate the mpact of large changes n access to educaton on wage nequalty. The model results clearly show that even for very large ncreases n access to educaton the wage nequalty remans unchanged. Apparently, the domnant effect on the sklled labor wage rate s that of the changes n the relatve product prces n the world market (.e., the trade effect), rather than that of ncreased relatve supply of educated labor ensung from enhanced access to educaton. The trade effect on the relatve demand for sklled labor has been shown to be very mportant for Inda by Wood and Calandrno (2000) also n a SAM (Socal Accountng Matrx) based comparatve analyss of the mpact of trade lberalzaton on human resources n Inda and Chna. Gdlng and Robbns (2001) analyze the patterns and sources of changng wage nequalty n Chle and Costa Rca durng structural adjustment, usng an econometrc decomposton technque whch splts the effects of enhancement of human captal nto the 5

6 educaton prce and educaton quantty effects. Ther exercse shows that the educaton prce effects vared across sectors on account of the varaton n the sectoral rates of growth n the demand for educated workers, and ths lead to an ncrease n nequalty n Chle despte a large equalzng educaton quantty effect. Duflo (2002) n hs paper on the effects of educatonal expanson n Indonesa shows a dfferent mpact on the relatve wages of sklled labor. Usng a two sector - formal and nformal econometrc model, he shows that the sklled labor, employed exclusvely n the formal sector, suffers a downward revson of relatve wages, because the faster ncrease n human captal s not matched by a correspondng ncrease n physcal captal n ths sector. Interestngly, ths paper ndcates the possblty of there beng competng demands of physcal and human captal on the nvestble resources of the government for a mxed economy lke Inda. That s to say, the publc sector, whch bases ts nvestment decsons on long-term growth rather than on short-term proftablty consderatons, needs to defne a trade-off between augmentng physcal and human captal. Most other general equlbrum studes on the shfts n the relatve wages pertan to the U.S.A. Goldn and Katz (1999), Francos and Nelson (1998), Harrgan and Balaban (1999) and Baldwn and Can (1997) are all concerned wth explanng the paradoxcal effect of educatonal expanson on the wage nequalty.e., ncreased avalablty of educaton ncreases rather than decrease the relatve wages for sklled labor. And, n fact, the paradox s resolved n almost all the cases by ncorporatng the effects of trade and technologcal changes on the relatve demand for sklled labor. 1.2 Educaton and economc growth n Inda The lnk between publc spendng on educaton and economc growth s by now well-establshed n the lterature. Starng wth the work of Schultz (1961) educaton has been vewed as nvestment n human captal rather than consdered to be a consumpton good under Keynes nfluence. Subsequently, Blaug et al (1969), Tlak (1987) and Psacharopoulos (1993) show that nvestment n educaton yelds a hgher rate of return than nvestment n physcal captal. Romer (1986) and Lucas (1988) have propounded the new growth theores n whch sustaned long-run growth of per capta ncome s explaned by the lkelhood of nvestment n human captal generatng constant or ncreasng returns. Emprcal studes n the lterature on educaton and economc growth also fnd compellng evdence for the hypothess that a substantal proporton of the growth of the economes s attrbutable to the rse n the educatonal levels of the workforce. Lau et al (1993) attrbute almost 25 percent of the economc growth n Brazl to the ncrease n the average educaton of the 6

7 workforce. The success stores of the East Asan mracle economes are also replete wth references to mass prmary educaton programmes pursued by ther governments (World Bank, 1993). In Inda, Mathur (1993) has shown that a postve assocaton exsts between stocks of human captal and economc development and that the assocaton becomes stronger at hgher levels of educaton. Mathur and Mamgan (2002) fnd the nfluence of both techncal and general educaton on per capta ncome to be postve wth that of the former beng more powerful. In agrculture, Chaudhr (1979) fnds that prmary schoolng affects productvty postvely, partcularly n tmes of rapd technologcal change. Whle the lnk between the spread of educaton and economc growth s regarded as undsputable, the precedng lnk between publc educaton expendture and the spreadng of educaton has become a bt of a controversal area, especally n Inda. Emprcal evdence n Inda n ths regard s dverse dfferng hugely across the states and does not seem to corroborate the assumed postve lnkage between publc spendng on educaton and the spread of educaton (Pradhan, Trpathy and Rajan (2000)). Varous explanatons are offered for the absence of a strong postve assocaton between publc educaton expendture and educatonal outcome leakages from the amount spent due to corrupton, teacher absenteesm, non-motvated and dscouragng teachers, ll-equpped schools and unwllngness of parents to send ther chldren to schools due to economc or non-economc constrants. The concluson sometmes drawn from all ths s that publc spendng s not really nstrumental n promotng educaton, and therefore should not be overdone. Ths s unfortunate especally because the dverse emprcal evdence does not warrant ths rather straghtforward concluson. A detaled examnaton of the queston of the mpact of publc educaton expendture on the qualty of educaton and educatonal outcome, partcularly enrolment, has been done by Pradhan and Sngh (2004). Pradhan and Sngh (2004) also do not fnd a strong nfluence of pubc expendture per chld and the rate of growth of expendture on the enrolment rate for 16 major states of Inda. However, ths s because the varyng degrees of effcency of expendture across states are not taken nto account. The effcency of expendture s defned as the techncal effcency of the nputs the number of schools and the number of teachers n generatng educatonal output, such as enrolment. Usng Data Envelopment analyss (DEA), they rank the states by ther levels of techncal effcency. Havng thus ranked the states by ther levels of techncal effcency, they a fnd stronger postve assocaton between publc educaton expendture and enrolment for the relatvely effcent states as compared to the relatvely neffcent states. In other words, once the effcency of expendture s taken nto account, the effect of publc educaton expendture on enrolment s seen to be stronger. In general, t s arguable that states whch employ better educatonal processes also demonstrate a stronger lnk between educaton 7

8 expendture and educatonal outcome. By mplcaton, the states n whch the lnk between educaton expendture and educatonal outcome s weak have to fnd ways and means to strengthen ths lnk.e., control the leakage from the educaton expendture, prevent teacher absenteesm mprove nfrastrucutre n schools, and, above all, take care of the economc and non-economc factors whch are responsble for the lack of nterest shown by households n provdng educaton to ther chldren. In short, the pcture whch emerges from the analyss of Pradhan and Sngh (2004) s hardly the one whch would undermne the mportance of ncreasng publc spendng on educaton n Inda. The share of expendture on educaton n GDP n Inda has been contnuously ncreasng from 1.19 percent n 1951 (not shown n table 1) to 3.98 percent n , after whch t suffered a declne tll In t was restored to 3.90 percent, and n t crossed the 4.0 percent mark. However, t may be noted that although educaton has always been gven hgh prorty by the government of Inda snce ndependence, the publc expendture target of 6 percent of GDP s stll nowhere n sght. Not surprsngly, even after 50 years of ndependence, the enrolment rates reman low n ths country, partcularly n case of poor and the nhabtants of rural areas. It follows that the role of publc spendng on educaton, though not complete per se, remans mportant n acceleratng the growth n school enrolment. Besdes, an expanson of publc educaton expendture s all the more desrable because of the externaltes assocated wth educaton, such as, reduced populaton growth and better health care. The sources of fnance for educaton Inda are the central and the state governments, local bodes, consumers of educaton (fees etc.) and foregn ad. Prmary among these are the state governments. However, as argued by Mehrotra (2004), gven the serous fscal defcts of the poorest states and the lmted scope of nter-sectoral reallocaton of expendture towards educaton from other sectors and of ntra-sectoral allocaton wthn the educaton sector (from hgher levels of educaton to lower levels), the only remanng opton for fnancng further ncreases n publc educaton expendture s earmarked taxes for educaton, a source employed effectvely by many countres, such as, Korea, Chna, Botswana and Brazl. Mehrotra (2004) also fnds the successful example of Brazl, worth emulatng for Inda. In Brazl, an educaton fund, FUNDEF, created by federal taxaton, helps n the equalsaton of expendture capacty n educaton between poorer and rcher states. He further recommends that n Inda, much lke n Brazl, the central government, and not the state governments, should levy addtonal taxes and dedcate the revenue thus rased to the cause of educaton. The dedcated fund for educaton could then allocate resources to the states that are n greatest need and those that show the best performance. The ntatve for addtonal taxaton and the subsequent creaton of the dedcated fund needs to be taken by the central government 8

9 because many of the state governments have been seen to be lackng n ther commtment to elemenatry educaton. Table 1 : Trends n Publc Educaton Expendture Ed. Exp./ GDPMP (n %) Ed. Exp./ Total Govt. Exp. (n %) Source : Educaton expendture : Analyss of Budget Expendture n Educaton (varous years). New Delh,MHRD Total government expendture : Indan Publc Fnance Statstcs, Government of Inda GDP at market prces : Natonal Accounts Statstcs (varous ssues), CSO, Government of Inda Table 2 : Enrolment rates by place of resdence and poverty category Place of Resdence Enrolment rate (n %) All-Inda 76.2 BPL 65.6 APL 84.8 Rural-Inda 73.2 BPL 63.8 APL 81.1 Urban-Inda 86.7 BPL 72.4 APL 96.4 Note : APL : Above Poverty Lne BPL : Below Poverty Lne. Source : Pradhan and Roy (2003) 9

10 1.3 CGE analyss of the lnkage between publc expendture on educaton and economc growth The overall goal of ths study s to nvestgate the lnkage between human captal and economc growth. However, as mentoned before, n ths study our focus s concentrated on only the educatonal aspect of human captal. Secondly, though the household expedture on educaton s by no means small (see Tlak (2002)), we are not treatng t as a polcy varable. It s nfact largely dependent, among other thngs, on the government expendture on educaton as shown by Tlak (2002). Havng made these two assumptons, we narrow down the goal of the study to an nvestgaton of the lnkage between publc nvestment n educaton and economc growth. In a pror hypotheszng about the lnkage between educatonal captal nvestment and economc growth, one tends to argue that nvestment n educaton ncreases the supply of educated (sklled) labour, whch, on account of ts hgher productvty relatve to non-educated (unsklled) labour leads to hgher economc growth wth lower relatve wage for sklled labour. Ths s nothng but the standard one-sector endogenous growth theory lne of reasonng, and need not hold n a mult-sector, mult-factor general equlbrum framework. What ths lne of reasonng overlooks s the fact that educatonal captal accumulaton wll n all lkelhood be accompaned by a changes n demand pattern n favour of skll ntensve goods. The (exogenous) nternatonal terms of trade wll also most lkely shft n favour of the skll ntensve goods. All ths wll ncrease the relatve demand for sklled labour exertng thereby an upward pressure on ts relatve wage. On the producton sde, there wll not only be a restructurng of the composton of goods produced n favour of skll ntensve goods, but also some resubsttutng n favour of unsklled labour n the producton processes. In short, changes n both the relatve factor returns and the relatve product prces play a role n determnng the quantam of growth. It follows then that, how much the resultant growth wll be s an emprcal queston best answered by a computable general equlbrum model. A CGE analyss of the lnkage between publc expendture on educaton and economc growth s conspcuous by absence n the scanty lterature on human captal formaton n Inda. For other countres also, CGE studes on the mpact of publc educaton expendture on human captal formaton are sparse. Suwa-Esenmann, Zonzlos and Bourgugnon (1995) assess the programs mplemented n Greece under the Europeon Communty Support Framework ( ), for promotng growth through nvestments n nfrastructure and human captal. The model used n ths study s an extended verson of the standard CGE model descrbed n Dervs, de Melo and Robnson (1982) whch ncorporates a sem-keynesan closure approprate for the Greek economy. 10

11 However, the accumulaton of human captal s treated n an exogenous manner. It s assumed that the expendture on tranng programs has a drect postve effect on labour partcpaton, thereby, ncreasng the absolute number of sklled workers, wthout changng that of the other (unsklled) types of labour. There s no transformaton of unsklled labour nto sklled labour envsaged n the model. More closely related to the goal of ths study s the paper by Jung and Thorbecke (2003). In ths paper the mpact of publc educaton expendture on human captal, the supply of dfferent labour sklls, and ts macroeconomc consequences are analysed usng a recursvely dynamc multsectoral CGE model for two heavly ndebted poor countres (HIPCs), Tanzana and Zamba. The CGE model used here s the standard neo-classcal type descrbed n Dervs, de Melo and Robnson (1982), Thorbecke (1992) and Robnson et al (1999), wth the addtonal feature that three dfferent types of labour - non-educated, prmary-educated, and hgher-educated labour - are combned n two stages n the producton structure of the model, to reflect dfferent levels of substtutablty. The non-educated and the prmary educated labour are combned wthn a Cobb- Douglas type Armngton aggregaton to produce an aggregate of unsklled labour. Ths unsklledlabour-aggregate s then combned wth hgher-educated labour wthn a CES type Armngton aggregaton to yeld a composte labour measure. Proft maxmzng frms employ the optmal amount of each type of labour gven wage rates and the techncal and budget constrants. Another novel feature of the Jung and Thorbecke (2003) model s that ts ntertemporal dynamcs ncludes a specfc mechansm through whch publc educaton expendture augments the stock of human captal. In other words, educaton expendture provdes addtonal educatonal captal to those who are n the educatonal ppelne. As these ndvduals come out of the educatonal ppelne, they acqure mproved labour sklls and, thereby, add to the stock of human captal. The busness-as-usual scenaro or the base run of the Jung and Thorbecke (2003) model s generated under the assumpton that each of the three types of labour grows at the gven populaton growth rate. Subsequently, three alternatve polcy scenaros, each envsagng a 15 percent ncrease n real publc expendture on educaton over the base-run level under three dfferent assumptons, are smulated. In the frst scenaro the supply of prmary-educated and hgher-educated labour are determned frst n the model, and the supply of non-educated labour s determned resdually, n such a manner that the total work force grows at the gven populaton growth rate. The underlyng assumpton n ths smulaton beng that the non-educated labour supply s not responsve to the wage rate. In the second smulaton, the more realstc assumpton of elastc labour supply s made. In ths case, a rse n the wage rate results n a flow of the prevously unemployed non-educated 11

12 workers nto the labour market, wth the flow ceasng when the wage rate of non-educated labour equals that n the base run. In the thrd smulaton, the addtonal assumpton made s that the ncrease n real educaton expendture s drected exclusvely to the poor household groups, so that the ncrease n the educated labour supply over that n the base-run comes entrely from the poor groups. In other words, ths smulaton provdes for an ncrease n the endowment of human captal of the poor groups relatve to that of the non-poor groups. The hgher educaton expendture ncreases the labour supply growth rates for prmary educated and hgher educated labour to the same extent (0.4 percentage ponts) n all the three smulatons 7. However, n case of non-educated labour, the labour supply growth rate ncreases by 0.2 percentage pont n smulatons 2 and 3, but decreases by 2.1 percentage ponts n smulaton 1, where labour supply of non-educated labour s determned resdually. The growth rates of the wages for both hgher educated and prmary educated labour declne by 0.3 percentage ponts n smulatons 2 and 3, whle n smulaton 1, the wage growth rates for hgher and prmary educated labour decrease respectvely by 0.6 and 0.3 percentage ponts. For the non-educated labour, the growth n wage level remans unchanged (at the base-run level) n smulaton 2 and 3 by assumpton, but ncreases by 2.3 percentage ponts n smulaton 1. The average wage grows at the same rate n smulaton 1 as n the base run. But the growth rate of the average wage declnes by 0.3 percentage ponts for Tanzana and 1.1 percentage ponts for Zamba n case of smulatons 2 and 3. The extent of physcal captal accumulaton n Zamba s much lower than Tanzana, on account of a lower savng rato n the former country. Hence, the ncrease n the number of sklled workers s not complemented by an adequate ncrease n physcal captal lmtng the growth n labour productvty and consequently n wages. Wth 15 percent ncrease n real publc expendture on educaton, GDP growth rate under smulatons 2 and 3 ncreases by 0.2 and 0.1 percentage ponts respectvely for Tanzana and Zamba. In smulaton 1, however, GDP growth rate mproves by only 0.1 percentage pont for Tanzana and remans the same as n the base run n for Zamba. Moreover, n all the smulatons for both the countres the captal ncome grows faster than the wage ncome. Ths s expected, as the supply of educated labour ncreases as a result of the expanson n publc educatonal expendture, and captal consequently becomes relatvely more scarce. Income dstrbuton changes are not unform ether across the smulatons or for the two countres. Under scenaro 1, the growth rate of household ncomes of the urban poor mproves by 7 In the summary of results presented here, we mostly refer to the fgures for Tanzana. Unless otherwse mentoned, the broad orders of magntudes of the changes n the varables for the twocountes are the same. 12

13 percentage pont, and declnes by 0.1 percentage pont for the urban non-poor n case of Tanzana. However, t s the other way round for Zamba, where the growth rate of household ncomes of the urban poor declnes by 0.1 percentage pont, and mproves by 0.1 percentage pont for the urban non-poor. Ths happens because the urban poor household group s heavly dependent upon ncome from educated labour. Hence, an ncrease n publc spendng on educaton makes ths group worse off by ncreasng the supply of educated labour. The rural household ncomes grow relatvely faster for the poor vs-a-vs the non poor n Tanzana, but not so n Zamba. Unlke n Tanzana, n Zamba, the educated workers are not concentrated wthn the non poor household groups, but dspersed among non poor and poor household groups. Under scenaro 2, n Tanzana, the growth rates of ncomes of both the urban and rural poor mprove by 0.3 percentage pont, whle those of urban and rural non-poor ncrease by only 0.1 percentage pont. That s, the poor gan more than the non poor from the ncrease n publc educatonal expendture n Tanzana, but the opposte s true for Zamba. In Zamba, the mprovement n the growth rates of ncomes of the urban and rural non poor s greater than that for the urban and rural poor. Evdently, Zamba, as compared to Tanzana, has a larger proporton of educated workers wthn the poor households. In smulaton 3, the growth rates of ncomes of the poor household groups mprove sgnfcantly more than those of the non poor household groups resultng n a more equal dstrbuton of ncome n Tanzana. However, n Zamba the ncome dstrbuton does not mprove. Here, both the poor and non poor groups mprove ther ncome growth rates relatvely equally among the rural households, and, among the urban households the non poor groups, n fact, mprove ther ncome growth rates relatvely more than the poor groups. Clearly, the dfference n the endowment of human captal of poor households between Zamba and Tanzana matters n determnng the mpact of an ncrease n educaton expendture on the ncome dstrbuton n the two countres. In short, the man concluson that emerges from the counterfactual polcy smulatons of the Jung and Thorbecke (2003) model s that an ncrease n publc educaton expendture per se can contrbute postvely to GDP growth. Improved labour market flexblty wll enhance the postve mpact of an expanson n publc educatonal expendture on GDP growth. Furthermore, the rse n publc expendture on educaton should deally be complemented wth an ncrease n publc nvestment on physcal captal. And, fnally, the ncrease n educatonal expendture must be better targeted to poor households f any mprovement n the ncome dstrbuton s to be expected. A crucal queston on whch the Jung and Thorbecke (2003) paper s slent s the followng : how s the ncrease n publc educaton expendture to be fnanced or, to put t another way, what 13

14 wll be the preferred mode of fnancng an expanded publc educaton expendture programme. In fact, the suggeston that the rse n publc expendture on educaton be matched wth an ncrease n publc nvestment on physcal captal begs ths queston. If publc nvestment cannot be curtaled (t mght have to ncrease!), then some other adjustment has to be made n a resource constraned fscal envronment - ether government expendture n other sectors wll have to be reduced or, f that s not feasble, taxaton wll have to be ncreased as suggested by Mehrotra (2004). We have consdered the latter opton n the present study. 1.4 The present study In the present study, we have used a recursvely dynamc multsectoral CGE model for the Indan economy. Our model has been formulated on the lnes of the Jung and Thorbecke (2003) model to capture the mpact of an ncrease n publc educaton expendture on GDP growth and ncome dstrbuton across four rural and fve urban household groups As s usually done n a CGE modelng analyss, we frst generate a base-lne (busness-asusual) scenaro, and then smulate alternatve polcy scenaros for assessng the consequences for growth and ncome dstrbuton n Inda of an expanson n publc educaton expendture. The specfc polcy questons to whch the polcy scenaros are addressed are the followng : () What s the mpact of an ncrease n publc educaton expendture fnanced by an ncrease n drect taxes on GDP growth and ncome dstrbuton? () What s the mpact of an ncrease n publc educaton expendture concentrated n the secondary educaton sector fnanced by an ncrease n drect taxes on GDP growth and dstrbuton? () What s the mpact of an ncrease n publc educaton expendture concentrated n the secondary educaton sector complemeted wth an ncrease n publc nvestment fnanced by an ncrease n drect taxes on GDP growth and dstrbuton? 14

15 2. Model Structure Our model s a multsectoral, neo-classcal type prce drven CGE model, wth the addtonal feature that t ncludes a mechansm through whch publc expendture on educaton augments the supply of human captal (.e., educated / sklled labour). The overall structure of our model s smlar to the one presented n Jung and Thorbecke (2003). However, n formulatng the detals of the model, we follow an eclectc approach keepng n mnd the nsttutonal features pecular to the Indan economy. The model has 10 producton sectors and three factors of producton - land, captal and composte labour, whch n turn, s a nested CES aggregaton of non-educated, secondary-educated and hgher-educated labour 8. At the begnnng of a perod, the economy s endowed wth a certan level of physcal captal and human captal, n the form of stocks of dfferent types of labour. In any gven perod the allocaton of captal across producton sectors s fxed, but labour s ntersectorally moble. Producers act as proft maxmsers n perfectly compettve markets,.e., they take factor and output prces (nclusve of any taxes) as gven and generate demands for factors so as to mnmse unt costs of output. The factors of producton nclude ntermedates and the prmary nputs captal, land and dfferent types of labour. For households, the ntal factor endowments are fxed. They, therefore, supply factors nelastcally. Ther commodty-wse demands are expressed, for gven ncome and market prces, through the Stone-Geary lnear expendture system (LES). Also households save and pay taxes to the government. Furthermore, households are classfed nto four rural and fve urban categores. The government s not asssumed to be an optmsng agent. Instead, goverment consumpton, transfers and tax rates are exogenous polcy nstruments. The rest of the world supples goods to the economy whch are mperfect substtutes for domestc output, makes transfer payments and demands exports. The standard small-country assumpton s made, whch mples that, Inda s a prce-taker n mport markets and can mport as much as t wants. However, because the mported goods are dfferentated from the domestcally produced goods, the two varetes are aggregated usng a constant elastcty of substtuton (CES) functon, based on the Armngton assumpton. As a result, the mports of a gven good depends on the relaton between the prces of the mported and the domestcally produced varetes of that good. For exports, a downward slopng world demand curve s assumed. Furthermore, a constant elastcty of transformaton (CET) functon s used to defne the output of a gven sector as a 15

16 revenue-maxmsng aggregate of goods for the domestc market and goods for the foregn markets. Ths mples that the response of the domestc supply of goods n favour or aganst exports depends upon the prce of those goods n the foregn markets vs-à-vs ther prces n the domestc markets, gven the elastcty of transformaton between goods for the two types of markets. The model s Walrasan n character. Markets for all commodtes and non-fxed factors - captal stocks are fxed and ntersectorally mmoble - clear through adjustment n prces. However, thanks to the Walras' law, the model determnes only relatve prces. The exchange rate s chosen as the numerare and s, therefore, normalsed to unty. The model determnes endogenously the foregn savngs n the external closure. Fnally, because the aggregate nvestment s exogenously fxed, the model follows an nvestment-drven macro closure, n whch the aggregate savngs -.e., the sum of household, government and foregn savngs - adjusts, to satsfy the savng-nvestment balance. Intertemporally, the model adjusts through changes n the stock of physcal captal and the stock of human captal. Physcal captal s ncreased by nvestment, whch s exogenously gven. Human captal s augmented by the new supply of educated labour, whch n turn s a functon of publc educaton expendture. 2.1 Sectoral dsaggregaton Our model s based on the followng ten sector dsaggregaton of the Indan economy : 1. Agrculture ( 1 to 7 ), 2. Mnng ( 8 to 11 ), 3. Manufacturng-1 (12 to 24), 4. Manufacturng-2 (25 to 44), 5. Constructon (45), 6. Electrcty, gas and water supply, (46 to 47) 7. Transport, storage etc., (48 to 51) 8. Wholesale and retal trade etc, (52 to 53) 9. Fnance, nsurance, real estate etc., (54 to 56) 10. Communty, socal and personal servces, (57 to 60) Note that for each sector the consttuents n terms of the 60-sector Central Statstcal Organsaton Input-Output Transacton Table (CSO-IOTT) s ndcated n the parenthess. Note also that each 8 In our classfcaton of 3 types of labour n Inda, secondary educated ncludes all those from 1 st pass to 12 th pass.e., elementary + secondary + hgher secondary educated, and hgher educated ncludes 16

17 sector has 3 types of labour nputs unsklled or non-educated labour, sem-sklled or secondary educated labour and sklled or hgher educated labour whch sum up to what s called composte labour. 2.2 The producton structure Producton technologes for all sectors are defned usng nested CES functons as shown below : Domestc Sectoral Gross Output Intermedate Input Bundle Value Added (VA) Composte Labour (CL) Captal (K) Sklled Labour Composte (SLC) Non-educated Labour (LL1) (.e., Unsklled Labour) Secondary-educated Labour (LL2) Hgher-educated Labour (LL3) (.e,.sem-sklled Labour ) (.e,.sklled Labour ) Note that vertcal lnes n the nestng dagram represent leontef combnatons, whle the slantng lnes represent CES combnatons of the nputs nvolved. For agrculture there s an addtonal branch n the nestng structure. In the agrcultural sector, a cobb-douglas aggregaton of land and captal produces composte captal whch n turn s combned wth composte labour to produce value added. At each level of the nested producton functon, the assumpton of constant elastcty of substtuton (CES) and constant returns to scale (CRS) s made. For every level, the producer s problem s to mnmse cost (or maxmse proft) gven the factor and output prces and express graduates + hgher-than-graduates. 17

18 demands for nputs. It follows that for every level, the followng three relatonshps hold : the CES functon relatng output to nputs, the frst order condtons, and the product exhausaton theorem. For all the levels taken together, the producton system thus determnes the gross domestc output, the nput demands, value-added as well as the demands for the varous types of labour. (The captal stock n a partcular perod s gven, so the frst-order condton effectvely determnes the sectoral return on captal.) 2.3 Investment Publc and prvate nvestment are fed nto the model as two dstnct consttuents of the total nvestment. There are fxed share parameters for dstrbutng the aggregate nvestment across sectors of orgn. However, the allocaton mechansms for sectors of destnaton are dfferent n the two cases of publc and prvate nvestment. For publc nvestment there s dscretonary allocaton, and the allocaton ratos are therefore set exogenously n the model n each perod. On the other hand, for prvate nvestment the allocaton ratos are gven n a partcular perod, but are revsed from perod to perod on the bass of the sectoral relatve return on captal. The relatve return on captal n any sector s gven by the normalsaton of the mplct prce of captal n that sector to the economy-wde returns. Note that ths rule does not mply full factor prce equalsaton, but only a sluggsh reallocaton of nvestment from sectors where rate of return s low to ones havng hgher rates of return. Needless to say, all ths bfurcaton of total nvestment nto ts publc and prvate components wth ther dfferng allocaton mechansms s an attempt to approxmate the way nvestments are actually made n the Indan economy. Incdentally, t also allows for publc nvestments to be drected towards strategc sectors dsregardng short-run consderatons of proft maxmsaton. 2.4 Factor markets Labour s ntersectorally moble. Wages are flexble and adjust to equlbrate the demand and supply for each of the three types of labour non-educated labour, secondary-educated labour and hgher educated labour. There s no unemployment for any of the three types of labour. Croppng land n the agrcultural sector s also fully utlsed at the equlbrum rent. However, captal stocks are fxed sectorwse. The optmsng behavour of producers therefore determnes sector specfc return on captal. 18

19 2.5 Household Income and consumpton demand There are nne household groups n the model - rural cultvator (RC), rural artsan (RATN), rural agrcultural labour (RAL), rural others (RO), urban farmer (UF), urban non-agrcultural selfemployed, (UNASE), urban salared (US), urban casual labourer (UCL), urban others (UO). The factor endowments for each household group are gven. Households derve ther ncome by sellng the factors they own land, labour (of 3 types) and captal. From these ncomes, taxes are netted out and transfer payments by government and rest of the world are added to arrve at the household dsposable ncomes. The households are assumed to save a fxed fracton of ther dsposable ncomes. The rest of t s spent on the consumpton of goods. The consumpton functons of the households are estmated by the most sutable Stone and Geary lnear expendture system (LES), whch s wdely used n Inda. Prvate corporate and publc sectors do not have any consumpton expendture. They receve ncome from the rental values of non-land captal. Prvate corporate sector gets addtonal ncome from rental value of land and government transfer payments ncludng nterest payments. 2.6 Prvate corporate and publc sector ncome Prvate corporate sector ncome conssts of ts earnng from factor ncomes and transfers from government, whch s equal to ts savngs. On the other hand, publc sector ncome s defned as ncome from enterpreneurshp (factor ncome from captal) that goes as transfers to government. 2.7 Household savngs The average propensty to save out of ther dsposable ncomes s exogenously gven for each of the four rural and fve urban households. Households thus save a fxed part of ther ncomes. Total household savngs n the economy s obtaned by summng up the savngs of all the nne household groups. 2.8 Government Savngs Government revenue orgnates from the followng fve sources : excse tax on producton, sales tax on goods, mport dutes from mported goods and ncome tax from households. All the tax rates are exogenously gven. Government ncome also ncludes the captal ncome and land rent from ownershp of these factors, factor ncome from abroad and publc sector ncome. Government expendture takes place on account of government consumpton and transfers to households and 19

20 frms, and publc sector nvestment, all of whch are exogenously fxed. Government savngs s obtaned as the dfference between government ncome and expendture. 2.9 Foregn Savngs Foregn savngs n dollar terms s expressed n the model as the excess of payments for total mports over the sum of export earnngs, net curent transfers and factor ncome from abroad. The latter two, t may be noted., are exogenously gven values n the model Market equlbrum and macroeconomc closure Market clearng equlbrum n the commodty markets s ensured by the condton that sectoral domestc supply must equal demand faced by that sector. The sectoral domestc supply, (.e., domestc gross output) of a commodty s determned through the nested CES functon n the producton structure of the model. On the other hand, sectoral demand s a combnaton of domestc demand and export demand, based on a CET transformaton functon. In turn, the aggregate demand for a commodty.e., the sum of consumpton, nvestment and government and ntermedate demands - s equated to the demand for a composte commodty defned as an Armngton type CES aggregaton of domestc demand and mports. The model s Walrasan n sprt wth the sectoral prces beng the equlbratng varables for the market-clearng equatons. The Walras' law holds and the model s, therefore, homogeneous of degree zero n prces determnng only relatve prces. The exchange rate serves as the numerare, and s, therefore, fxed at one. Fnally, note that although the model s neoclasscal n nature, t follows nvestment-drven macro closure n whch aggregate nvestment s fxed and the components of savngs - household savngs, government savngs and foregn savngs - are endogenous varables and adjust to equalze savng and nvestment Intertemporal adjustments In the nterm-perod sub-model, the physcal and human captal stocks are updated. Sectoral captal stocks are exogenously gven at the begnnng of a partcular perod. However, our model s recursvely dynamc, whch means that t s run for many perods as a sequence of equlbra. Between two perods there wll be addtons to captal stocks n each sector because of the nvestment undertaken n that sector n the prevous perod. More precsely, sectoral captal stocks 20

21 for any year t+1 are arrved at by addng the nvestments by sectors of destnaton, net of deprecaton, n year t to the sectoral captal stocks at the begnnng of the year t. Between two perods there wll be addtons to human captal stocks also because of the publc educaton expendture undertaken n the prevous perod. More specfcally, the output flow of labour of educaton level 'm', MS m, s an addtve functon of the educaton expendture and the lfetme wage dfferental between wages at educatonal level 'm' and the next lower level 'l' 9. The functon s specfed as follows : ρ t = β 1 x GED + β 2 x W MS edl m t m ( lt Wl (t 1) 1) 1+ g 1+ r t 1 t 1 where MS m : output flow of labour of educaton level m GED l : government educaton expendture at level l, W m g r : Wage rate for labour of educaton level m : growth rate of the economy as a proxy for the growth rate of the wages. : dscount rate β 1, β 2, ρ edl : postve constants 10 ML m : new labour supply of educaton level m The flows of labour of dfferent educatonal levels are nterlnked wth each other. From the pool of populaton growth (MS 1 ), some proceed to secondary school (MS 2 ), whle others reman non-educated (ML 1 ), and from secondary school, some advance to hgher educaton (MS 3 ), whle others drectly enter the labour market as secondary educated (ML 2 ). Fnally, hgher-educated workers are produced and suppled (ML 3 ). Wth the total ncrease of the labour force constraned to a fxed populaton growth rate, the new supply of non-educated labour (ML 1 ) s determned resdually. The labour flows are explaned n the fgure below : 9 For a detaled dervaton of the functon of the output flow of educated labour, see pages of Jung and Thorbecke (2003). 10 For β 1 and β 2 we have used the same values as Jung and Thorbecke (2003), whch s 0.5 for each, and for ρ ed l we have used the values 0.44 and for secondary and hgher educaton respectvely. 21

22 MS3 ML3 Hgher-educated Labour (level 3) Hgher Educaton MS2 ML2 Secondary-educated Labour (level 2) Prmary Educaton MS1 ML1 Non-educated Labour (level 1) Populaton Growth Fgure 1 : The labour flows Note that the followng relatonshps between the flows of labour types of dfferent educatonal levels hold. ML 3 t = MS 3 t ; ML 2 t = MS 2 t MS 3 t ML 1 t = n x P t + ( 3 l = 1 dhl LS l t ) - ( ML 2 t + ML 3 t ) LS l (t+1) = LS l t ( 1- dh l ) + ML l t ; for l = 1,2,3. where P = populaton n = labour partcpaton rate dh l = deprecaton rate (retrees) of labour stock of educatonal level l LS l = labour stock of educatonal level l 22

23 3. The Base-Lne Scenaro Our CGE model has been calbrated to the benchmark equlbrum data set represented n a SAM for the Indan economy for the year The SAM used for the present study s based on Pradhan, Sahoo and Saluja (1999). The SAM gven here has been re-aggregated and modfed to conform to the classfcaton scheme of the producton sectors, labour categores and the household groups, adopted n the model. The reaggregated and modfed SAM s presented n Appendx 1. Usng the benchamark data set for the year , we solve the CGE model frst for the base-year, and, subsequently, usng a tme seres of the exogenous varables of the model, we generate a sequence of equlbra for the perod from to From the sequence of equlbra, the growth paths of selected (macro) varables of the economy are outlned to descrbe the base-lne scenaro. 3.1 Benchmark parameters After havng obtaned the basc data set from the SAM, the CGE model s subjected to benchmark calbraton. Calbraton nvolves a determnstc approach to specfyng parameter values n such a manner that the model soluton replcates the base-year data (Shoven and Whalley (1992)). Calbraton of the shft and share parameters of the producton functons, CES aggregaton functon for mports and CET functon for mports, however, requre the elastcty parameters of these functons to be gven. The elastcty parameters have been taken from dfferent sources and are gven below n table 3. Note that dfferent types of labour are combned n two stages n the producton structure to reflect dfferent degrees of substtuablty. The sklled labour composte and non-educated labour are combned wthn a CES type Armngton aggregaton that has a small elastcty of substtuton equal to 0.5 to yeld composte labour. In turn, sklled labour composte s a CES Armngton aggregaton of secondary-educated and hgher-educated labour based on a larger elastcty of substtuton equal to 0.8. Through ths labour aggregaton scheme, the model s able to capture productvty growth caused by educaton. Note also that the hgher wage ncome for the educated labourers results n hgher share parameters for such workers n the calbraton. Educated workers thereby contrbute more to the composte labour. It follows that an ncrease n the supply of educated labour leads to a hgher value for composte labour, resultng n hgher producton. In table 4 we present the endowmnents of human captal across the nne household groups. It s nterestng to note that most of the secondary and hgher educated belong to the urban salared 23

24 and urban non-agrcultural self-employed groups. Almost 85 percent of hgher-educated and 42 percent of secondary-educated workers come from these two groups. However, secondary-educated workers are more evenly spread over the urban and rural groups. Urban groups have 48.5 percent of the secondary-educated workers and rural groups have 52.5 percent of the educated workers. (It may be noted that, n our classfcaton of educated workers, secondary-educated ncludes elementary, secondary and hgher- secondary educated. The dstrbuton of workers wthn these three levels of educaton s not shown n the table.) Table 3 : Elastcty Parameters ρ 1 ρ 2 ρ 3 ρ a ρ c ε ex s1 Agrculture s2 Mnng s3 Manufacturng s4 Manufacturng s5 Constructon s6 Elec. Gas & W.S s7 Trans. & Stor s8 Whole & Ret.Trade s9 Fn., Ins. & Real Es Comm.,Soc.& Per. Servs Note : ρ 1 : elastcty of substtuton between composte labour and captal. ρ 2 : elastcty of substtuton between sklled labour composte labour and uneducted labour. ρ 3 : elastcty of substtuton between secondary-educated labour and hgher-educated labour. ρ a : elastcty of substtuton between domestc demand and mports. ρ a : elastcty of substtuton between domestc sales and exports. ε ex : export demand elastcty Source : Jung and Thorbecke (2003) and Chadha et al (1999). 24

25 Table 4 : Resource endowment shares n percentages Non-educated labour Secondaryeducated labour Hghereducated labour Physcal Captal RC RATN RAL RO UF UNASE US UCL UO Note : RC : Rural Cultvator ; RATN : Rural Artsan ; RAL : Rural Agrcultural Labourer ; RO : Rural Others ; UF : Urban farmer ; UNASE : Urban Non-agrcultural Self-employed ; US : Urban Salared ; UCL : Urban Casual Labouer ; UO : Urban Others. Physcal captal endowment ncludes that of land. Captal column sums upto only 66.86% because the remanng 33.14% accrues to prvate enterprse, publc enterprse, government and the rest of world. Source : Calculatons from MIMAP Inda Survey, 1996, NCAER. 3.2 Labour supply and wage levels In the base-lne scenaro, labour supply grows annually at the rate of 1.84 percent (table 5). Among the three types of labour, the supply of hgher educated workers grows fastest at the rate of 4.94 percent, followed by secondary-educated workers supply whch ncrease at the rate 3.66 percent. The supply of non-educated labour, whch s determned resdually, grows by only 1.04 percent annually. It would seem that the 8.31 percent and 9.34 percent annual growth n real publc expendture on secondary and hgher educaton respectvely s makng a postve mpact on the supply of educated workers. Regardng wage levels, there s maxmum mprovement n the non-educated workers wage rate whch ncreases by 3.86 percent annually. Educaton expendture benfts the non-educated labour ndrectly, by nducng a relatve decrease n ts supply. Secondary-educated workers wage rate also grows fast at 3.57 percent. The wage rate of hgher-educated workers ncreases at only 3.07 percent per annum. The wage rates of secondary and hgher educated workers rse despte the ncrease n ther supples because the technques of producton become more skll ntensve as the economy grows over tme (table 5). 25

26 Table 5 : Baselne : Labour supply, wage rates and publc educaton expendture Average annual growth rates for to n percent Labour Supply 1.84 Non-educated labour 1.04 Secondary-educated labour 3.66 Hgher-educated labour 4.94 Wage rate (real) 4.55 Non-educated labour 3.86 Secondary-educated labour 3.57 Hgher-educated labour 3.07 Publc educaton expendture (real) 8.47 Secondary educaton 8.31 Hgher educaton 9.34 Table 6 : Baselne : Wage rate ndexes Wage rate as a multple of non-educated worker s wage rate Wage rate (real) Non-educated labour Secondary-educated labour Hgher-educated labour The hgher rate of growth of the non-educated worker s wage notwthstandng, the wage nequalty across the three types of labour partcularly between non-educated and hgher-educated labour - remans acute at the end of the seven-year perod (see table 6). Ths s manly due to the extreme nequalty of wages of the three types of labour prevalng at the begnnng of the perod. 3.3 GDP and household ncome Real GDP n the base-run grows at 5.99 percent per annum, wth nvestment n physcal captal beng on an average percent of GDP. The rate of growth of wage ncome s 2.45 percent hgher than that of the captal ncome (table 7). Household ncome as a whole grows at 5.64 percent per annum. But the rates of growth of ncomes vary wdely across the varous household groups. The rate of growth of ncomes of the urban salared class s, expectedly, the hghest.e., 7.35 percent. Urban salared households are 26

27 the greatest benefcares from the spread of educaton. These households account for percent of the hgher-educated and percent of the secondary-educated labour (see table 4). Urban non-agrcultural self-employed mprove ther ncomes at the rate of 5.17 percent per annum. Ths class also depends largely for ts ncome on secondary and hgher educated labour. Another group, not so expected, whch benefts from the spread of educaton s rural others. Ths group s endowed wth percent of the secondary educated workforce and 9.45 percent of hgher-educated workforce. However, the non-benefcares of educaton.e., those havng manly non-educated labour as a source of ther ncome are also sgnfcantly better-off, thanks to the rse n the wage rate of non-educated labour. For example, household ncomes of the rural agrcultural labourers grow at 5.28 percent per annum. Urban casual labourers, who are to a large extent though not manly dependent on non-educated labour, also ncrease ther ncomes by 5.49 percent per annum 11. Table 7 : Baselne : GDP and household ncome Average annual growth rates for to (n percent) GDP (real) 5.99 Investment (% of GDP) Wage Income (real) 6.57 Captal Income (real) 4.12 Household Income (real) 5.64 Rural Cultvator 4.70 Rural Artsan 4.71 Rural Agrcultural Labour 5.28 Rural Others 6.07 Urban Farmers 4.66 Urban Non-ag. Self-Employed 5.17 Urban Salared 7.35 Urban Casual Labourer 5.49 Urban Others Note that wage ncome s allocated to each household group on the bass of the base-year endowment shares for all the years. That s, the flow of new labour types s dstrbuted across household groups n the same way as the whole labour stock. 27

28 4. The Polcy Smulatons We develop three alternatve polcy scenaros for an expanson n the publc educaton expendture. In all the the three smulatons, the ncrease n publc educaton expendture s fnanced by an ncrease n the drect taxes.e., ncome and corporate tax. In fact, the ncrease n publc educaton expendture s mplemented n a manner suggested by Mehrotra (2004). That s, we ncrease the ncome and corporate taxes by a specfed percentage and dedcate the resultng addtonal revenue to publc spendng on educaton. The mode of fnancng remans the same n all the three smulatons, but the mode of expendture vares across them. In the frst smulaton, the addtonal expendture on educaton s dstrbuted between secondary and hgher educaton n the same proportons as n the total expendture of the base-lne scenaro. In the second scenaro, the extra expendture s drected exclusvely towards secondary educaton. In the thrd polcy scenaro, the addtonal revenue from the specfed ncrease n tax rates s shared equally between nvestment n physcal captal and educaton expendture concentrated n the secondary educaton sector. 4.1 Polcy smulaton 1 In ths smulaton, we ncrease the rates of ncome tax and corporate tax by 10 percent and use the addtonal revenue for ncreased publc spendng on secondary and hgher educaton n the same proportons as n total publc educaton expendture of the base-run. By ths mechansm, the 10 percent ncrease n the two drect tax rates, results n a percent ncrease n real publc educaton expendture over the base-run. And publc educaton expendture as a percentage of GDP, ncreases by 0.43 percentage pont compared to the base-run. 28

29 Table 8 : Smulaton 1 : Labour supply and wage rates Average annual growth rates for to (n percent) Dff.from base-lne n %age ponts Smulaton 1 Baselne Smulaton 1 Labour Supply Non-educated labour Secondary-educated labour Hgher-educated labour Wage rate (real) Non-educated labour Secondary-educated labour Hgher-educated labour In polcy scenaro 1, the growth rate of secondary and hgher educated labour supply goes up by 0.35 and 0.32 percentage ponts respectvely, but that of the non-educated labour supply goes down by 0.43 percentage pont, snce t s determned resdually. As a result non-educated workers become relatvely more scarce and mprove the growth rate of ther wage rate by 1.27 percentage ponts. The secondary and hgher educated workers are suppled more abundantly and, therefore, suffer a declne n the growth rates of ther wage rates by 0.55 and 0.50 percentage ponts respectvely (table 8). The nequalty n the wages also narrows down a lttle, wth the hgher and secondary educated workers recevng wages whch are respectvely 6.35 tmes and 1.73 tmes the wage of the non-educated workers (table 9). Table 9 : Smulaton 1 : Wage rate ndexes Wage rate as a multple of non-educated worker s wage rate n Smulaton 1 Baselne Wage rate (real) Non-educated labour Secondary-educated labour Hgher-educated labour Wth a percent ncrease n publc educaton expendture, GDP growth rate mproves by 0.17 percentage pont. Investment as a percentage of GDP declnes margnally, snce ts level s fxed exogeously and remans the same as n the base-run. As a result, captal, n comparson to educated labour whose supply ncreases, becomes more scarce. Hence, captal ncome growth rate ncreases by twce as many percentage ponts as the ncrease n the wage ncome growth rate (table 29

30 10). Household ncome also grows faster by 0.13 percentage ponts. An nter-group comparson of the household ncome growth rates reveals that all groups experence a faster growth n ther ncomes except, the urban salared and the rural others, who suffer a declne n ther ncome growth rates as a consequence of the fall n the growth rates of the wages of secondary-educated and hgher-educated workers. It may be noted that these two groups are the ones experencng the hghest growth rates n ther ncomes n the busness-as-usual scenaro. Hence, a declne n ther ncome growth rates n the face of a rse n the ncome growth rates of the remanng groups represents a dstnct change towards greater equalsaton of ncomes. Table 10 : Smulaton 1 : GDP and household ncome Average annual growth rates for to (n percent) Dff.from base-lne n %age ponts Smulaton 1 Baselne Smulaton 1 GDP (real) Investment (% of GDP) Wage Income (real) Captal Income (real) Household Income (real) Rural Cultvator Rural Artsan Rural Agrcultural Labour Rural Others Urban Farmers Urban Non-ag. Self-Employed Urban Salared Urban Casual Labourer Urban Others Note : The fast movers.e., those household groups havng ncome growth rates hgher than 6% n the base-lne - are shown n talcs. 30

31 4.2 Polcy smulaton 2 In ths smulaton, we ncrease the rates of ncome tax and corporate tax by 10 percent and use the addtonal revenue for ncreased publc spendng exclusvely on secondary educaton. By ths mechansm, the 10 percent ncrease n the two drect tax rates, results n a percent ncrease n real publc expendture on secondary educaton over the base-run. For publc expendture on educaton as whole the ncrease s of percent. As a percentage of GDP, the ncrease n expendture on elementary educaton s by 0.41 percentage pont. In polcy scenaro 2, supply of secondary-educated labour goes up whle that of noneducated labour goes down lke n smulaton 1. But the order of magntudes nvolved are hgher n case of ths smulaton. In comparson to the base-run, the rate of growth of supply of secondaryeducated labour ncreases by 0.52 percentage pont, whle that of non-educated labour declnes by 0.48 percentage pont. The growth rate of hgher-educated workers also declnes margnally. The mprovement n the wages of the non-educated labour s, as compared to the base-run, much faster. That s, the rate of growth n ther wages s 5.18 percent, whereas t was only 3.86 percent n the base-run. For secondary-educated labour, whch s now more abundantly suppled, there s a fall n the growth rate of wages. It may be noted that n ths scenaro, there s a sgnfcant substtuton n producton n favour of secondary-educated labour vs-à-vs hgher-educated labour. And ths explans why there s a margnal declne n the growth rate of the hgher-educated worker s wage even as hgher-educated labour becomes relatvely more scarce. The wage rate nequalty shows some mprovement as the rate of growth of non-educated labour rses and that of the secondaryeducated labour falls, but the hgher-educated labour stll earns a wage whch s more than 6.5 tmes that of non-educated labour (table 12). Table 11 : Smulaton 2 : Labour supply and wage rates Average annual growth rates for to (n percent) Dff.from base-lne n %age ponts Smulaton 2 Baselne Smulaton 2 Labour Supply Non-educated labour Secondary-educated labour Hgher-educated labour Wage rate (real) Non-educated labour Secondary-educated labour Hgher-educated labour

32 Table 12 : Smulaton 2 : Wage rate ndexes Wage rate as a multple of non-educated worker s wage rate n Smulaton 2 Baselne Wage rate (real) Non-educated labour Secondary-educated labour Hgher-educated labour Table 13 : Smulaton 2 : GDP and household ncome Average annual growth rates for to (n percent) Dff.from base-lne n %age ponts Smulaton 2 Baselne Smulaton 2 GDP (real) Investment (% of GDP) Wage Income (real) Captal Income (real) Household Income (real) Rural Cultvator Rural Artsan Rural Agrcultural Labour Rural Others Urban Farmers Urban Non-ag. Self-Employed Urban Salared Urban Casual Labourer Urban Others Note : The fast movers.e., those household groups havng ncome growth rates hgher than 6% n the base-lne - are shown n talcs. Wth a percent ncrease n publc expendture on secondary educaton, GDP growth rate mproves by 0.23 percentage pont. An ncrease n the supply of secondary-educated labour (notwthstandng the margnal declne n the supply of hgher educated labour), n our labour aggregaton scheme, leads to a hgher value for composte labour, resultng n hgher value-added and, thus, hgher GDP. Note that n ths smulaton, as compared to smulaton 1, the GDP growth rate s hgher, whch suggests that the negatve mpact on productvty due to the declne n the growth rate of hgher-educated workers s more than compensated by the postve mpact on productvty on account of the rse n the growth of secondary-educated workers. However, ths by 32

33 no means ndcates the relatve unmportance of hgher educaton. On the contrary, a large-scale substtuton of secondary-educated workers for hgher-educated workers wll, n all lkelhood, result n a net loss of productvty for the economy. Hence, promotng secondary-educaton at the cost of hgher educaton beyond a pont may well be detrmental to GDP. In fact, the result of ths smulaton can easly reverse n a longer tme frame or for a larger dverson of resources from hgher to secondary educaton wthn the same tme frame. Household ncome as a whole grows at 5.83 percent per annum whch s faster than ts rate of growth n the base-run by 0.19 percentage pont. Except for the urban salared households, all households beneft from the faster spread of educaton under scenaro 2. For the urban salared and urban farmers groups, the ncome growth rates margnally declne ; for all other groups the growth rates of ncome are hgher (table 13). Urban salared group s hugely dependent upon hgher and secondary labour for ts ncomes (see table 4). For hgher-educated workers the growth rates of the wage rate as well as the labour supply declne n ths smulaton, whle, for, secondary-educated workers the faster growth n labour supply s more than compensated by the slower growth n ther wage rate. Hence, a declne n the ncome growth rate of the urban salared households. But the declne n the ncome growth rate of ths group s only margnal by 0.04 percentage pont, and even after the declne ts ncome growth rate s 7.31 percent. All other household groups mprove ther postons. Especally those groups whch had ncome growth rates of less than 5 percent, such as, rural cultvator and rural artsan, have moved up to ncome growth rates near 5 percent. In short, the fast movers are slowng down and the slow movers are catchng up. Income dstrbuton thus changes for the better when the growth of secondary educaton s speeded up. 4.3 Polcy smulaton 3 In ths smulaton, we ncrease the rates of ncome tax and corporate tax by 10 percent, and the addtonal revenue s shared equally between nvestment n physcal captal and educaton expendture concentrated n the secondary educaton sector. Ths results n a 8.55 percent ncrease n real publc expendture on secondary educaton over the base-run. For publc expendture on educaton as whole the ncrease s of 7.25 percent. As a percentage of GDP, the ncrease n expendture on secondary educaton s by 0.22 percentage pont. On the other hand, the addtonal nvestment n physcal captal rases the nvestment-gdp rato from percent to percent. Under ths scenaro, the ncrease n expendture on secondary educaton s smaller n comparson wth that n the prevous smulaton. Hence, the growth n the supply of secondary- 33

34 educated workers ncreases by only 0.20 percentage pont (table 14). The decrease n the growth of resdually determned non-educated labour supply s also of a lower order. The growth rate of hgher-educated labour supply, however, pcks up n ths smulaton, even though the expendture on hgher educaton does not ncrease. The growth n hgher-educated labour supply s stmulated by the rse n the wages of ths type of labour 12. The growth n wage rates, n ths smulaton, ncreases not only for non-educated labour but for secondary and hgher-educated workers as well. The reason for ths s that the producton technques under ths scenaro become more skll ntensve ntensve, thus ncreasng the demand for sklled labour.e., secondary and hgher educated labour. It may be noted that the wage rates for secondary and hgher educated labour grow faster n ths smulaton vs-à-vs the prevous sumlaton. Fnally, the wage-rate nequalty n ths smulaton s the same as that n the base run. And n comparson to the prevous smulaton the wage nequalty has worsened. Table 14 : Smulaton 3 : Labour supply and wage rates Average annual growth rates for to (n percent) Dff.from base-lne n %age ponts Smulaton 3 Baselne Smulaton 3 Smulaton 2 Labour Supply Non-educated labour Secondary-educated labour Hgher-educated labour Wage rate (real) Non-educated labour Secondary-educated labour Hgher-educated labour Note that the new labour supply at any level s nfluenced not only by the government expendture on that level of educaton but also by the wage dfferental between the gven level and the precedng level. 34

35 Table 15 : Smulaton 3 : Wage rate ndexes Wage rate as a multple of non-educated worker s wage rate n Smulaton 3 Baselne Smulaton 2 Wage rate (real) Non-educated labour Secondary-educated labour Hgher-educated labour Table 16 : Smulaton 3 : GDP and household ncome Average annual growth rates for to (n percent) Dff.from base-lne n %age ponts Smulaton 3 Baselne Smulaton 3 Smulaton 2 GDP (real) Investment (% of GDP) Wage Income (real) Captal Income (real) Household Income (real) Rural Cultvator Rural Artsan Rural Agrcultural Labour Rural Others Urban Farmers Urban Non-ag. Self-Employed Urban Salared Urban Casual Labourer Urban Others Note : The fast movers.e., those household groups havng ncome growth rates hgher than 6% n the base-lne - are shown n talcs. Under scenaro 3, n whch there s a smultaneous ncrease n nvestment n physcal captal and expendture on secondary educaton, the GDP growth rate goes up by 0.37 percentage ponts - whch s 0.14 percentage pont more than the ncrement n GDP growth rate under scenaro 2. (Recall that n scenaro 2, the addtonal resources rased from the ncrease n the ncome and corporate tax rates s spent completely and exclusvely on secondary educaton). It follows that when an ncrease n expendture on secondary educaton s matched wth an ncrease n nvestment n physcal captal, the growth n labour productvty and thus GDP s enhanced. Household ncome as a whole s also growng faster n ths smulaton as compared to smulaton 2. However, an ntergroup comparson of the houshold ncome growth rates of ths smulaton vs-à-vs the prevous 35

36 smulaton shows that the ncome dstrbuton s tendng to become more unequal. That s, the fast movers among the household groups, such as, urban salared and rural others are movng up the ncome ladder faster, whle, the slow movers rural cultvator, rural artsan, rural agrcultural labour and urban casual labourer - are nchng up even more slowly. 4.4 Polcy smulatons caveats In the nterpretaton of the smulaton results, the assumptons on whch our model s based must be borne n mnd. Frst, we assume that ncreased publc educaton expendture wll translate nto mproved educatonal outcomes. We have already dscussed n secton 1.1 how the effcency of publc educaton expendture vares across states. The low effcency of publc educaton expendture n many states wll brng down the average effcency of such expendture, whch we have tred to capture n the model by assgnng low values for the elastctes of the output flow of educated labour wth respect to publc educaton expendture. Second, we assume that the technology and the resource endowment shares of dfferent household groups are fxed durng the tme span of our model. Ths s justfable for the relatvely moderate polcy changes consdered n our smulatons.thrd, we assume that the labour markets for the three types of labour are segmented. In the real world, t may be possble that hgher-educated workers enter the market for secondary-educated workers and secondary-educated workers enter the market for non-educated workers, f they are unsuccessful n fndng a job of ther respectve skll (educatonal) level. However, the magntudes of these reverse flows of educated labour are not lkely to be large especally because the ntal wage rates of the three types of labour are far apart from each other and do not converge very much n the tme frame of our model. In other words, ths assumpton s not as restrctve as t seems 36

37 5. Conclusons and Polcy Implcatons We conclude by hghlghtng the man polcy lessons from our smulaton exercses. The polcy lessons that emanate from our polcy scenaros are manly three. In polcy scenaro 1 we saw that a 14 percent ncrease n real publc expendture on secondary and hgher educaton, fnanced through a 10 percent ncrease n the ncome and corporate tax rates, helps n achevng hgher economc growth as well as an mproved ncome dstrbuton. However, t may be noted that the mprovement n both GDP growth and ncome dstrbuton s a moderate one. An nterestng aspect of the result s that the non-educated workers also beneft from the spread of educaton. There s a marked rse n the wage rate of these workers, whch s nstrumental n reducng the wage nequalty. The polcy concluson whch emerges from ths scenaro s that t s possble to augment nvestment n human captal n the resource constraned fscal envronment of the Indan economy and reap the benefts n terms of a faster economc growth and a better ncome dstrbuton. In polcy scenaro 2, there s 17.5 percent ncrease n real publc expendture on secondary educaton (fnanced n the same way as n scenaro 1) and the base run level mantaned for publc expendture on hgher educaton. As a result, both the GDP growth and the mprovement n ncome dstrbuton s enhanced. Ths scenaro does ndcate that, from a polcy pont of vew, secondary educaton needs to be accorded hgher prorty. However, t does not follow that secondary educaton should be promoted at the cost of hgher educaton. Lmtng the growth of hgher educated labour would amount to lmtng the growth of labour productvty and thus of GDP. On balance the concluson seems to be that efforts need to be drected and ntensfed towards fndng alternatve means of fnancng hgher educaton so that more resources are avalable for expandng secondary educaton. In polcy scenaro 3, there s a judcous mx of nvestment n physcal captal and nvestment human captal. The moblsaton of resources s done smlarly, but the spendng of the addtonal resources s spread equally over nvestment n physcal captal and expendture on secondary educaton. The productvty gans are larger n ths scenaro, and GDP growth s further enhanced. But the wage nequalty and the household ncome dstrbuton clearly worsen (n comparson to scenaro 2). Ths result n combnaton wth the result of the prevous smulaton ndcates, on one hand, that nvestment n physcal captal s essental for easng the constrants on productvty growth, and, on the other hand, that nvestment n human captal plays a crucal role n spreadng the benefts of economc growth more evenly across the varous sectons of the 37

38 populaton. The polcy lesson that we would lke to draw from ths s that government should preoccupy tself wth the task of expandng the human captal base, and, at the same tme, encourage the prvate sector to accelerate nvestment n physcal captal. Ths s now a wdely accepted vew. It s also endorsed by our smulaton results. 38

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40 Mathur, A (1993), The Human captal Stock and Regonal Economc Development n Inda n Nuna, S C (ed.) Regonal Dspartes n Educatonal Development, South Asa Publshers, New Delh. Mathur, A and R P Mamgan (2002), Techncal Sklls, Educaton and Economc Development n Inda, The Indan Journal of Labour Economcs, vol. 45, no. 4. Mehrotra, S (2004), Reformng Publc Spendng on Educaton and Moblsng Resources : Lessons from Internatonal Experence, Economc and Poltcal Weekly, February 28, 2004 Pradhan, B.K (2002) Role of Educaton n Wage Inequalty Change n Inda: , Natonal Councl of Appled Economc Research, New Delh. Pradhan, B.K, A. Sahoo and M. R. Saluja (1999): A Socal Accountng Matrx for Inda, , Economc and Poltcal Weekly, November, Vol. 27: Pradhan, B K and Shalabh Sngh (2004), Polcy Reforms and Fnancng of Elementary Educaton n Inda : A Study of Qualty of Servce and Outcome, Workng Paper - 93, March 2004, Natonal Councl of Appled Economc Research, New Delh. Pradhan, B K, K K Trpathy and Raj Rajan (2000), Publc Spendng and Outcome of Socal Servces n Inda : A Revew durng the Regme of Polcy Reforms, Dscusson Paper Seres No.15., September 2000, Natonal Councl of Appled Economc Research, New Delh. Pradhan, B K and P K Roy (2003), The Well-Beng of Indan Households : MIMAP Inda Survey Report, Tata-McGraw Hll, New Delh. Psacharopoulos, G (1993), Returns to Investment n Educaton : A Global Update, PPR Workng Paper No. WPS 1067, World Bank, Washngton, D.C. Robnson S, A Yunez-Nauda, R Hnojasa-Ojeda, J D Lews, S Devarajan (1999), From Stylzed to Appled Models : Buldng Multsector CGE Models for Polcy analyss, North Amercan Journal of Economc and Fnance, vol. 10, Romer. P M (1986), Increasng Returns to Long-Run Growth, Journal of Poltcal Economy, vol. 94, Shr Prakash and S. Choudhary (1994), Expendture on Educaton: Theory, Models and Growth, New Delh, Natonal Insttute of Educatonal Plannng and Admnstraton. Suwa-Esenmann, Zonzlos and Bourgugnon (1995), Evaluatng the CSF wth an Extended Computable General Equlbrum Model : The Case of Greece ( ), Journal of Polcy Modelng, vol. 17, No. 2, Shoven and Whalley (1992), Applyng General Equlbrum, Cambrdge Unversty Press. Thorbecke, E and the Centre for World Food Studes (1992), Adjustment and equty n Indonesa, Pars, Development Centre of the Organsaton for Economc Cooperaton and Development. 40

41 Tlak, J.B.G. (1985), Analyss of Costs of Educaton, Occasonal Paper No. 10, New Delh, Natonal Insttute of Educatonal Plannng and Admnstraton. Tlak, J.B.G. (1987), Economcs of Inequlty n Educaton, Sage Publcatons/Insttute of Economc Growth, New Delh. Tlak, J.B.G. (1988), Cost of Educaton n Inda, Internatonal Journal of Educatonal Development, Vol. 8(1) : Tlak, J.B.G. (2000), Household Expendture on Educaton In Inda: A Prelmnary Examnaton of the 52nd Round of the Natonal Sample Survey, New Delh: Natonal Insttute of Educatonal Plannng and Admnstraton. Tlak, J.B.G. (2001b), Household Expendture on Educaton In Inda:, Busness Perspectves, Vol. 3(2) (July-December): Tlak, J.B.G. (2001c), Determnants of Household Expendture on Educaton n Inda, Internatonal Journal of Development Plannng Lterature, Vol.16. Tlak, J.B.G. (2002), Determnants of Household Expendture on Educaton n Rural Inda, Workng Paper Seres No.88, Natonal Councl of Appled Economc Research. New Delh. Wood, A. M. Calandrno (2000), When Other Gant Awakens: Trade and Human Resources n Inda, Economc and Poltcal Weekly, Dec. 30, Wood. A. (1998), Globalzaton and Rse n the Labor Market Inequaltes, Economc Journal, Vol.108: World Bank (1993), The East Asan Mracle, Oxford Unversty Press, New York. 41

42

43 Appendx I : SAM agrculture mnng manuf. 1 manuf. 2 constructon elec.gas & water supply transport & storage wholesale & retal trade fn.,ns. & real estate agrculture mnng manufacturng manufacturng constructon elec., gas and w.s trans.& stor whol.& ret. trade fn., ns. & real est comm., soc. & per. servs Unsklled labour ncome Sem-sklled labour ncome Sklled labour ncome Captal ncome RC RATN 0.00 RAL RO 0.00 UF 0.00 UNASE US UCL UO Prvate enterprse Publc enterprse Government net. Ind. tax Captal Account 0.00 Rest of World Account Total

44 comm.,soc.& per. servces Unsklled labour ncome Sem-sklled labour ncome Sklled labour ncome Captal ncome RC RATN RAL RO agrculture mnng manufacturng manufacturng constructon elec., gas and w.s trans.& stor whol.& ret. trade fn., ns. & real est comm., soc. & per. servs Unsklled labour ncome Sem-sklled labour ncome Sklled labour ncome Captal ncome RC RATN RAL RO UF UNASE US UCL UO Prvate enterprse Publc enterprse Government net. Ind. tax Captal Account Rest of World Account Total

45 UF UNASE US UCL UO agrculture mnng manufacturng manufacturng constructon elec., gas and w.s trans.& stor whol.& ret. trade fn., ns. & real est comm., soc. & per. servs Unsklled labour ncome Sem-sklled labour ncome Sklled labour ncome Captal ncome RC RATN RAL RO UF UNASE US UCL UO Prvate enterprse Publc enterprse Government net. Ind. tax Captal Account Rest of World Account Total

46 Prvate enterprse Publc enterprse Government net. nd. tax Captal account Rest Of World Account agrculture mnng manufacturng manufacturng constructon elec., gas and w.s trans.& stor whol.& ret. trade fn., ns. & real est comm., soc. & per. servs Unsklled labour ncome Sem-sklled labour ncome Sklled labour ncome Captal ncome RC RATN RAL RO UF UNASE US UCL UO Prvate enterprse Publc enterprse Government net. Ind. Tax Captal Account Rest of World Account Total Total 46

47 Source : Pradhan, B K, Amarendra Sahoo & M R Saluja, Economc and Poltcal Weekly, November 27, 1999, Pages

48 Appendx 2 Equatons of the Model Producton structure X = as [ λ CL ρ 1 + )K 1/ ρ ρ 1 1 ] (1) 1/(1- ρ 1 ) WK λ CL = K WCL 1 λ (2) PX * X * (1-exct ) = WLL1 * LL1 + WLL2 * LL2 + WLL3 * LL3 + WK * K + PC j j * a j * X (3) ρ (1- λ CL = as2 [ λ2 LL1 2 (1- λ2 )SLC 2] 1/ ρ ρ 2 + (4) WSLC LL1 = SLC WLL1 2 λ 1 λ 2 1/(1- ρ 2 ) (5) WCL * CL = WLL1 * LL1 + WSL C * SLC (6) ρ 1/ ρ ρ 3 + (7) (8) WSLC * SLC = WLL2 * LL2 + WLL3 * LL3 I (9) XD = cet [ λc EXP ρc ] ρ c SLC = as3 [ λ3 LL2 3 (1- λ3 )LL3 3] 1/(1- ρ3 ) WLL3 λ3 LL2 = LL3 WLL2 1 λ 3 1/ ρc + (1- λc )ADD (10) 48

49 PEX EXP = ADD PD λ c 1 λ c 1/(1- ρ c ) (11) PX * XD = PEX * EXP + PD * ADD I (12) PEX = PWE * ER (13) EXP = exs * ( pwes / PWE ) ε I (14) ρa 1/ ρa ρa + (15) AD = arm [ λa IMP (1- λa )ADD ] 1/(1- ρa ) PM λ IMP = ADD a PD (1 salt ) 1 λ + a (16) PC * AD = PM * IMP + PD * (1+ salt ) * ADD I (17) PM = pwm * ( 1 + tarf ) * ER (18) Labour Markets LL1 = LS1 (19) LL2 = LS 2 (20) LL3 = LS 3 (21) Commodty Markets XD = X I (22) Incomes Y h = WLL3 * end h,ll3 + WLL2 * end h,ll2 + WLL2 * end h,ll2 + WLND * end h,lnd fk h * ( WK * K ) (23) YD h = Y h - nct h * ( Y h - WLND * end h,lnd ) + fg h * trnfg * PINDEX + trnfw h * ER (24) 49

50 HS h = sav h * YD h (25) CORPDI = (1- corpt) * [ WLND * end corp,lnd + fk corp * + fg corp * trnfg * PINDEX ( WK * K ) ] (26) CORPSAV = CORPDI (27) PUBDI = fk pub * ( WK * K ) (28) TAXREV = nct h * ( Y h - WLND * end h,lnd ) + corpt * [ WLND * end corp,lnd + fk corp * ( WK * K ) ] (29) + PX * X * exct + PD * ADD * salt + IMP * pwm * ER * tarf GREV = TAXREV + WLND * end gov, LND + fk gov * ( WK * K ) + trnfw gov * ER (30) Expendtures C h, = mnc h, + ( γ h, / PC ) * [ ( YD h - HS h ) ( PC * mnc h, ) ] (31) INVDT = pukv * pubnv + prkv * prnv (32) ID = ad * ( pubnv + prnv ) ; (33) AD = Ch, + ID + cg + aj * X j (34) h j GEXP = trnfg * PINDEX + PC * cg I (35) Savngs and Investment GS = GREV + PUBDI GEXP (36) FSD = ( pwm * IMP ) + [ fk row * ( WK * K ) ] / ER - ( pwe * EXP ) 50

51 - trnfwh + trnfw gov (37) h TS = h HSh + CORPSAV + GS + FSD * ER (38) TS = PC * ID I (39) PVA = PX * (1-exct ) - PCj * a j (40) j PINDEX = α * PC (41) RGDP = [ PVA * X ] / PINDEX (42) Intertemporal Adjustments K,(t+1) = K,t * (1-dp ) + INVDT I (43) MSmt ρedl 1+ g t = β 1 x GED l t + β 2 x W m ( t 1) 1 (44) 1+ rt 1 Wl (t 1) ML 3 t = MS 3 t ; ML 2 t = MS 2 t MS 3 t (45) ML 1 t = n x P t + ( 3 l = 1 dhl LS l t ) - ( ML 2 t + ML 3 t ) (46) LS l (t+1) = LS l t ( 1- dh l ) + ML l t ; for l = 1,2,3. (47) Notatons: Endogenous varables AD ADD C h, CORPDI CORPSAV aggregate demand aggregate domestc demand consumpton demand of commodty by household group h prvate corporate sector dsposable ncome prvate corporate sector savngs 51

52 CL composte labour EXP exports ER exchange rate FSD foregn savngs n dollars GED l government educaton expendture at educaton level l GREV government (total) revenue GEXP government (total) expendture GS government savngs G growth rate of the economy (GDP) HS h household savngs by household group h ID real nvestment demand by sector of orgn INVDT real nvestment by sector of destnaton IMP mports LL1 demand for lablour level 1 (non-educated labour) LL2 demand for lablour level 1 (secondary-educated labour) LL1 demand for lablour level 1 (hgher-educated labour) LS l labour supply of educatonal level l, l = 1,2,3. MS m output flow of labour of educatonal level m, m= 1,2,3. ML m new labour supply of educatonal level m, m= 1,2,3. PC prce of composte good for domestc demand PD prce of domestc sales PEX export prce n rupees PWE export prce n dollars PM mport prce n rupees (nclusve of tarffs) PX producer s prce PINDEX overall prce ndex PVA value-added prce PUBDI publc sector dsposable ncome RGDP real GDP SLC sklled labour composte TAXREV tax revenue of the government WLL1 wage for labour of educatonal level 1 (non-educated labour) WLL2 wage for labour of educatonal level 2 (secondary-educated labour) WLL3 wage for labour of educatonal level 3 (hgher-educated labour) WSLC wage for sklled labour composte WCL wage for composte labour WLND prce of land WK prce of captal X domestc output XD demand for domestc output Y h ncome of household group h YD h dsposable ncome of household group h Exogenous varables and parameters as as2 as3 shft parameter n producton functon for domestc output shft parameter n aggregaton functon for composte labour shft parameter n aggregaton functon for sklled labour composte 52

53 arm shft parameter n Armngton functon for mports and domestc demand a j nput-output coeffcent α weght n the prce ndex (share of value added of product ) cet shft parameter n CET functon for export demand and domestc demand cg real government consumpton corpt corporate tax rate ad share of nvestment by sector of orgn dh deprecaton rate of human captal dp deprecaton rate of physcal captal end h,lll household h endowment of labour level l, l = 1,2,3 end h,lnd household h endowment of land end gov,lnd government s endowment of land end corp,lnd corporate sector s endowment of land exct excse tax rate exs scale factor n the export demand functon ε export demand elastcty fg h share of government transfer to household group h fg corp share of government transfer to the corporate sector fk h share of captal ncome to household group h fk corp share of captal ncome to corporate sector fk pub share of captal ncome to publc sector fk gov share of captal ncome to government fk row share of captal ncome to rest of world (row) γ h, margnal budget share of good for household group h nct h ncome tax rate for household group h λ factor share parameter n producton functon for domestc output λ2 factor share parameter n n aggregaton functon for composte labour λ3 factor share parameter n n aggregaton functon for sklled labour composte λa share parameter n Armngton functon for mports and domestc demand λc share parameter n CET functon for export demand and domestc demand mnc h, mnmum real consumpton parameter for household group h n labour partcpaton rate P populaton pwm world prce of mports n dollars pwes world prce of export substtutes (n dollars) prnv total prvate real nvestment pubnv total publc real nvestment prkv share of prvate nvestment by sector of destnaton pukv share of publc nvestment by sector of destnaton r dscount rate ρ 1 substtutablty parameter n producton functon for domestc output ρ 2 substtutablty parameter n aggregaton functon for composte labour substtutablty parameter n aggregaton functon for sklled labour composte ρ 3 ρ a substtutablty parameter n Armngton functon for mports and domestc demand ρ c substtutablty parameter n CET functon for export demand and domestc demand salt sales tax rate sav h savngs-ncome rato of household group h tarf mport tarff rate 53

54 trnfg trnfw h trnfw gov real transfer from government transfer from rest of the world to household group h n dollars transfer from rest of the world to government n dollars 54