Abstract

Since World War II, the United States government has made improved access to higher education a priority. This effort has substantially increased the number of people who complete college - generally thought to be a good thing. We show, however, that such policies can actually increase income inequality. The mechanism that drives our results is the "signaling" role of education first explored by Spence (1973). We focus on government policies that reduce the effective interest rate on borrowing for education. When borrowing for education is difficult, lack of a college education could mean that one is either of low ability or high ability but has low financial resources. Wages and income reflect the presence of high ability individuals in the uneducated pool. When government programs make borrowing easier, high ability types get educated and leave the uneducated pool. We demonstrate our argument by solving for the relationship between the effective interest rate and income inequality in the steady state of a dynamic asymmetric information model.