Labor Market Liberalization, Human Capital Investment, and Inequality

Professor Zhang, Lichen   (Principal Investigator (PI))

Dr Gu Shijun   (Co-Investigator)

Dr Heathcote Jonathan   (Co-Investigator)

36

2022-01-01

399993

Labor Market Liberalization, Human Capital Investment, and Inequality

economic growth, heterogeneous agent model, human capital investment, inequality, intergenerational mobility

Economics

Business Studies (B)

17502721

General Research Fund (GRF)

2021

On-going

1 Over the past three decades, the Chinese economy has been characterized by rapid GDP and productivity growth, widening income inequality (Ding and He (2018)), and lower social mobility (Fan, Yi, and Zhang (forthcoming)). Investment in human capital is believed to play a key role in determining aggregate productivity growth, inequality, and social mobility. However, in China, the less market-oriented labor market and greater difficulties in gaining access to higher education can distort human capital investment choices. For example, performance-linked compensation schemes are much rarer in state-owned enterprises (SOEs) than in privately-owned enterprises (POEs) (Ge and Yang (2014); Liu and Otsuka (2004)), which may imply that salaries earned by SOE-workers are less dependent on their human capital. Hence, in an economy that is dominated by SOEs, such as China in the early 1990s, since the reward to skills was small, people may have had weak incentive to invest human capital. Similarly, limited opportunity to access higher education could substantially discourage parental investment in children’s human capital. 2 Two reforms took place in China almost simultaneously in the 1990s and have gradually liberalized the country's labor market — a market-oriented reform that led to the rise of the private sector and increased job mobility, as well as a large-scale public college expansion program. Both reforms can potentially increase investment in human capital by incentivizing parents to invest more in their children’s skills. 3 Using household-level data on China, we show that the returns to human capital are higher for individuals working in the private sector than in the state-owned sector, and also increase with education levels. This suggests that an economic reform that leads to the expansion of the private sector would increase human capital investment by incentivizing parents to invest more in their children’s human capital. More importantly, we find that the increase in the returns to human capital with higher levels of education is greater for individuals working in the private sector than in the state-owned sector. This implies a potential complementarity between the two reforms. The market-oriented reform that led to the rise of POEs and provided people with more opportunities to work in POEs can incentivize individuals to attend college. Similarly, those with a college degree would consider working for POEs more attractive, which means that the college-expansion scheme would lead to more people working in the private sector. The joint effect of the two reforms is likely to be greater on labor reallocation and human capital investment, compared with the sum of the separate effects. 4 Motivated by these novel empirical findings, we extend an otherwise standard heterogenous-agent overlapping-generations general equilibrium model to incorporate two margins: (1) altruistic parents who invest in their children’s human capital through multiple stages of childhood development, which determines children’s chance to be admitted by colleges as well as life-time earnings; and (2) multi-sectors: each individual can endogenously choose to work between the state-owned sector and the private sector based on her human capital and education level. 5 After estimating the model using Simulated Method of Moments, we plan to use this model to quantify both the macroeconomic and distributional consequences of the market-oriented reform and the college expansion program as well as the effects of the complementarity between the two on labor reallocation, human capital investment, economic growth, inequality, and intergenerational mobility. 6 The economic growth in the model results from an increase in the aggregate human capital, an input of firms’ production, driven by both reforms, together with the labor (human capital) reallocation from the less productive state-owned sector toward more productive private sector. The main channel through which the reforms lead to rising income inequality and intergenerational persistence works through the uneven distribution of the increase in the aggregate human capital investment across households. College-educated parents with high human capital level have greater resources to spend on their children, so they and their off-springs benefit disproportionally from the reforms. Consequently, parents with high levels of human capital and education are more likely to transmit their socioeconomic status to their children, compared with prior to the reforms. 7 There are three major contributions of this project. First, we contribute to the literature that studies China’s rapid economic growth by exploiting the channel through how labor market liberalization reforms affect parents’ incentive to invest in their children’s human capital, thus impacting labor (human capital) reallocation. Second, this project will be the first paper that provides a theory and a quantitative general equilibrium model to explain why economic reforms lead to the rise of inequality and the decline of intergenerational mobility jointly. Third, we extend a heterogeneous-agent life-cycle model with endogenous human capital formation à la Lee and Seshadri (2019) into the context of developing economies like China by incorporating two new elements: (1) multi-sectors; and (2) a human-capital-based selection mechanism that determines individuals’ college attendance probability.