(Reprinted from HKCER Letters, Vol. 24, January 1994) 

 

The Role of the Government
in Human Capital Investment

William Chan

 

Perhaps more than at any other time, the economy of Hong Kong is in a state of flux. The opening up of China has ushered in more than a decade of changes that are still ongoing. The fundamental changes in the very structure of the economy have resulted in a corresponding shift in the demand for workers away from the manufacturing and towards the service industries, and with it, a mismatch in job requirements and skills accumulated by workers, leaving some industries drastically short of labor and others, stuck with redundant ones. At the administrative and professional levels, the brain drain in the wake of the June 4th tragedy has shown signs of slowing down in recent years, partly as a result of continuing sluggishness in the North American and Australian economies which reduces the attractiveness of emigration. But while the hemorrhaging has slowed and some emigrants have returned, the cumulative effect of earlier and continuing emigration has taken its toll on the stock of professional and managerial talents. Together with a robust economy that has benefited from being the gateway to China in general and the Pearl River Delta in particular, these factors have resulted in persistent tightness in the overall labor market.

In a broader perspective, there has always been concern that, given the non-interventionist policies of the government, the quality of workers in Hong Kong may fall behind those of the other "little dragons," which may threaten the long-run competitiveness of our industries. This is particularly disturbing as the labor force, perhaps the largest asset of our economy, has shown only modest growth over the past decade due to below-replacement fertility and decreasing labor force participation. Given the lack of flexibility in our immigration policy, investment in its quality appears to be the only viable solution to augmenting our labor force.

In the face of these internal and external challenges, there has been no lack of calls for almost everyone's favorite solution: government intervention. While expanding the government's role in education and training of workers comes with the attractive name of investing in human capital, and apparently is welcomed by most if not all, the fact that resources for these investments are not free means that these popular initiatives must be evaluated by the same standards as for any other government project. It is therefore only appropriate that we should take stock of the situation and assess the rationale for government intervention before deciding whether such intervention is justified, and if so, what form it should take.

Tertiary and Continuing Education

Given the substantial loss of professional and managerial workers to emigration, the government's ambitious policy of expanding tertiary education may go some way towards alleviating any shortage higher up in the occupational hierarchy. From 1991 to 1995, degree-level places are projected to increase by 42.7 percent, to 15,000, offering tertiary education for more than 18 percent of the 17-to-20 age group. The policy, however, has not been met with universal approval. The tertiary institutions have complained that there has not been a commensurate increase in resources to cover the expansion and they are worried about falling academic standards, while many educators are dissatisfied with what they see as an imbalance in growth at different levels of education. Even if we are to focus on the initiative as an investment in our depreciating human capital stock, I am not convinced that it is an efficient solution. With 1997 fast approaching and the public still jittery about the future of the territory, and with the U.S. economy finally showing some sign of recovery, emigration may pick up again at any hint of political crisis. Increasing public funding for full-time tertiary education at the projected scale would probably just be paving the way for more to leave, compliments of the Hong Kong taxpayers. To make sure that Hong Kong can benefit from the investment, we need a more focused effort with lower liabilities.

To be sure, Hong Kong needs a sizable population of educated workers for continued social and economic growth, and since there are external benefits involved, the market cannot be trusted to provide the socially efficient solution; the government is right to subsidize tertiary education. But given that it takes time to expand facilities in our tertiary institutions, arbitrarily increasing the degree-level places beyond the growth capacity of existing resources may result in substantial diminishing returns that compromise the efficiency of the investment. Together with the very real possibility of continued brain drain, the government should probably consider lower-cost alternatives to expanding full-time places, at least as a short-run measure. Indeed, part-time and extramural programs and distance learning seem to be more cost effective as they allow more intensive use of existing resources, particularly in the evenings and over weekends. This would allow production of education at a lower marginal cost than if capacities have to be expanded to accomodate more full-time students.

The financial burden on the government of these alternative continuing education programs can also be lower for another reason. The public has shown a very large demand for these courses, even if they have to pay for most of the costs. And they probably should, since most of these courses are for self-enrichment or self-advancement, with the students reaping most of the benefits. For example, of the degrees conferred in the first convocation of the Open Learning Institution, 152 out of a total of 161 are in applied computing, clearly suggesting that more "practical" programs which enhance marketable skills are far more popular, with career advancement being a, if not the, major motive among those seeking continuing education. The more a program of study emphasizes professional, technical, or applied training, the smaller are the external benefits not captured by the student; therefore, government subsidy for this education should be smaller. But to the extent that Hong Kong as a whole still benefits from a more educated population, apart from the increase in productivity reflected in higher income for the graduates, and to the extent that individual students may face liquidity constraints which limit their ability to pay for education even if it is worthwhile in the long run, some form of government financing is still warranted, and can be in the form of grants or loans to either the institutions or the students. Direct assistance to the latter is probably preferable as this would allow the government's resources to be allocated by market forces: Institutions offering programs which cater to the needs of the students would get more subsidies from the government through higher enrollment and revenue from tuition. This would provide greater incentive for the institutions to design and offer programs that satisfy the needs of the market. To further control cost and target assistance to students who are committed, the government can disburse the grant or give tax credit only upon successful completion of various stages of a program of study.

One area of particular potential that has yet to be incorporated into the government's overall tertiary education strategy is distance-learning programs offered by many overseas institutions. To tap into the booming local market for continuing education, many foreign institutions have aggressively marketed their correspondence programs for local students. Since the government has yet to develop regulations and standards for such programs, the products in the market are understandably heterogeneous in quality, with potential students often having difficulty in making an informed choice. One possible approach to co-opting these resources is the Consortium Model in which local tertiary institutions are encouraged to link up with foreign universities in offering distance learning programs of tertiary education. Since local institutions are in a better position to assess the quality of potential overseas partners and have the incentive to choose only those which can offer the highest value added, information can be more efficiently acquired and students can be more confident of the quality of the products offered. The overseas institution also benefits from an established local agent which has expertise in developing and marketing products in the local market. The local institution can also profit from the joint venture if the foreign institution can offer teaching expertise not available locally, and particularly if the program is accredited overseas and procedures are set up to allow for transfer of credits and furthering of study abroad. Such foreign connections can prove very attractive for many people who are leaving open the option of emigrating and would not like to see their human capital wiped out in that event. These programs in turn represent a lucrative source of revenue for the local institution, which can be used with greater autonomy than government funds. Thus, all can potentially gain from such an arrangement. That the idea has not yet really caught on may be partly a result of a lack of clear guidelines from the government on such joint ventures, but it may also be that the financial incentives are not strong enough for the local institutions. These institutions are currently enjoying relatively large local market power, and gains from the partnership may not justify the transaction costs involved in setting up the consortium and sharing the revenue. There may also be difficulties in attracting first-rate overseas institutions which are concerned that such programs will dilute the value of their full-time degrees at home. In any case, it is an option well worth trying, and the government should expedite the development of regulations that can give sufficient flexibility and autonomy for the institutions to explore such opportunities.

To summarize, there is no substitute for the extension of full-time tertiary education that provides more than pre-professional training to more secondary school graduates in an increasingly egalitarian society, and the government should continue to pursue this goal, devoting resources for growth at a steady rate. But the constraint of resources and the socio-political circumstances today call for a more cost-effective approach in the short run. Expanding continuing education, with an emphasis on more marketable and professionally-oriented programs of study and greater financial contributions from the students, involves more intensive use of existing resources and offers a more socially efficient way of satisfying the aspirations of people for self-improvement. It will also help replenish our stock of managerial and professional workers without first taking many out of the labor force, as well as reduce the social cost of the government making a bad social investment if some of the graduates are subsequently lost to emigration.

Investment in Training and Upgrading of Skills

The continuing labor shortage and high turnover among workers in many sectors have raised the concern that the employers' incentive to train workers would be impaired, thereby lowering productivity in the short run and slowing economic growth in the long run. The implicit argument is for some form of government intervention, perhaps in the form of government investment in training.

While training is widely recognized as a form of investment in human capital, it is often less understood that search also is. When both jobs and workers are heterogeneous, and information is imperfect, it takes time for workers to find the job in which they excel. Labor turnover and mobility is a necessary process through which workers are allocated to jobs where their abilities can be best utilized. The subsequent improvement in resource allocation enhances the performance of the economy. In a structurally transforming economy, there is bound to be a lot of rematching of workers and jobs, often leading to a transitional increase in unemployment and turnovers. With a tight labor market, Hong Kong has been able to avoid the former but not the latter. But this is inevitable, indeed indispensable, in a normally functioning labor market; to artificially reduce mobility or subsidize training would be counterproductive and defeat the objective of improving economic efficiency.

In considering whether high turnover actually discourages training, it is useful to distinguish between general and specific training. The latter enhances a worker's productivity only within the firm providing the training, while the former is not likewise constrained. If a training is general, the employer will not have the incentive to pay for it, but the worker will, either through enrollment in a formal training program offered in the market or through on-the-job learning at a reduced wage, because the returns to such investment would also accrue almost entirely to the worker in the form of higher subsequent wages, whichever firm he works for. For example, perhaps no firm will hire and train a worker as a typist if he/she does not already possess typing skills, but that does not mean that the failure of the employer to provide training will result in a shortage of typists, at least not for that reason. Workers who believe typing skills will enhance their future income will invest their own time and money in aquiring them. Existence of an active market in which courses for this and other marketable skills are offered on a proprietary or non-proprietary basis indicates that the incentive of workers to invest in themselves is alive and well. Training and probational periods during which workers are paid relatively low wages are examples of the alternative arrangement. Thus, investment in general skills will not be adversely affected by high turnovers. With most discussions of the incentive-to-invest issue centering around free-riding of training by employers who raid other firms for trained workers, the concern is with human capital of this more or less general nature. But since the employers did not pay for such investment in the first place, they should have no complaints when the workers leave for better opportunities.

But very often, employment brings with it some form of firm-specific investment on the worker. At the very least, putting up a newspaper advertisement and screening the applicants represent resources spent on locating the right candidate, and this investment is lost when the worker leaves the firm. Since firm-specific investment usually involves joint financing and sharing of returns by both the employer and the employee, high turnover rates do reduce the incentive to invest by both parties. But that should perhaps be interpreted as the correct incentive: When workers are unsure about alternative opportunities, and firms about the long-term commitments of the workers, it is both socially and privately efficient for the parties to be more cautious in making such investments. For the government to subsidize specific training would reduce mobility of workers and efficiency in allocation of labor resources, as well as result in overinvestment in risky projects, with the taxpayers paying for too much training that, in the end, brings little or no returns. Also, any benefits of such government subsidy would be captured mostly, if not entirely, by the firm or the worker, a rather arbitrary redistribution of resources that has to be justified.

Another, related argument for intervention is that vacancies at strategic positions impose external costs on other firms and industries, so that government assistance in filling such vacancies can, by removing bottlenecks in the economy, bring social benefits that are larger than those accrued directly to the firms and workers involved. This idea of an externality is misplaced, since the significance of these strategic positions, if they exist, will be fully internalized in their remunerations. As long as the market wage can adjust, workers will be attracted to these positions. Persistent vacancies in these positions merely reflect that they are not "strategic" enough, or that the employers are not paying enough. In either case, there is no cause for government subsidy in training.

The efficiency of the market solution depends, of course, on the ability of wages to adjust in response to supply and demand conditions and serve as signals in directing the allocation of resources. Where wages are rigid, the market mechanism breaks down, and unemployment/shortage will occur. Advocates of government intervention sometimes suggest lags in inflationary expectations; the reluctance of employers to increase wages for particular grades of workers for fear of upsetting the existing hierarchy; and their tendency to adjust fringe benefits instead, in order to attract workers, as reasons for real wage rigidity. As the story goes, since real wages do not adjust fast enough to reflect market conditions, they fail to provide sufficient incentive for workers to invest in training even when it is socially optimum to do so, so that government subsidy is necessary. In support of this hypothesis, slow growth in the real wage in not only the manufacturing but also the rapidly expanding service sectors has been cited as evidence: From 1987 to 92, real wage grew at an annual rate of 0.43 percent in manufacturing; 1.64 percent in wholesale; 5.38 in retail; 3.26 in hotels; 4.51 in transport, storage, and communication; 4.45 percent in finance, insurance, real estate, and business services; 4.58 percent in community, social, and personal services; and 4.85 percent in construction.

While an annual rate of growth of more than 4 percent in real wage in many of the expanding sectors cannot exactly be considered sluggish, that they did not grow faster is also consistent with high intersectoral mobility of workers, which tends to equalize real wages and earnings at the margin. In any case, the arguments for wage rigidity paint a picture of a very static economy in which agents are slow in adjusting expectations, information is inefficiently disseminated, and workers are not sophisticated enough to look beyond the wage rate in considering job remunerations -- all of which bears little resemblance to the dynamic market in Hong Kong. Indeed, the high worker turnover rates in the expanding sectors are indications that market forces are working and that wages are converging to the market clearing levels despite some stickiness that might have been introduced by the prospect of labor importation. Where the wages fail to adjust because of constraints imposed by international competition, the inefficiency and inequity of intervention are obvious: The government should not be in the business of subsidizing the training of workers in order to maintain the profit margin of industries which have lost their competitiveness.

Even if we were to accept the very implausible scenario of a very rigid labor market that cannot function efficiently without government guidance, the appropriate role for the government appears to be one of facilitating the flow of information so as to reduce friction in the market. To efficiently compensate for wage rigidity by training requires that the government know which types of jobs are "underpaid" and by how much, and that government decisions are made and implemented faster than the market can adjust. Such faith in governmental wisdom is not likely to be vindicated.

Therefore, in the absence of any compelling reasons for believing that the market mechanism has failed in providing the right incentives for investment in training, government intervention is not called for. While the ongoing structural transformation may increase uncertainty for workers and employers, and therefore tends to reduce certain types of human capital investment, the effect is likely to be transitory and entirely efficient. As far as subsidization of training is concerned, contrary to popular misconception, government sponsorship in the present situtation represents inefficient investment and will not enhance economic growth in the long run.

Retraining for the Displaced and Older Workers

Most of the arguments against government involvement in the training of workers apply equally well to the retraining of displaced and other disadvantaged workers by the government. The specific implications have been discussed in some detail in an earlier article in the March 1993 issue of the HKCER Letters, to which interested readers are referred. As pointed out in that article, talks of productivity gains from retraining, while politically necessary, are logically unsound, so that government financing of retraining efforts must stand on its merit as a redistributive instrument. In fact, if considered in conjunction with the government's labor-importation scheme, retraining can be an integral part of an efficient short-run remedy for labor shortage: If the importation of labor benefits the economy as a whole by reducing prices, but hurts a certain segment of the labor force whose wages and opportunities are reduced by the new supply of foreign workers, then redistribution of the social gains is the key to achieving an outcome in which everyone can be potentially better off without anyone being worse off. However, from the way the two schemes are structured, it is not clear how much overlap there is between those who will be receiving retraining and those adversly affected by labor importation. The progressive expansion of the target retraining population to cover the elderly and the handicapped only makes such an efficiency justification more untenable, and we are back to retraining as a means of pure transfer for the disadvantaged, with efficiency being traded off for equity.

Even if we accept such a premise for the initiative, we must still make sure that public funds are well spent for the purpose. In an earlier paper, I warned against over-centralization of the process for developing courses. When training bodies sell their programs to the government rather than to the end-users (the employers), incentives are inevitably distorted, which can result in the squandering of resources. Already, with the scheme gaining publicity and momentum, and more and more agencies applying for government funds for their programs, we are seeing such adverse effects. In one case, an agency proposed a course for training elderly semi-active workers on the use of computers, which, thankfully, was rejected. But that serves to illustrate the difference between the needs perceived by the training agencies and the market value of the training they provide. Since government bureaucrats and committees are not always the best judges of market demands, a more decentralized approach that encourages greater employer participation and guidance by market forces is necessary in order to make sure that resources are spent on improving the welfare of the target population rather than raising the income of training professionals or expanding the operation of the training agencies.

One lesson from foreign experiences is that retraining programs are often nothing more than a pretext for making unemployment benefits more palatable to taxpayers. Unemployed individuals are required to enroll in retraining courses to qualify for unemployment benefits which are made to be perceived as allowances for the "trainees" during their training. Such programs distort work incentives and virtually generate a training industry offering courses of dubious market value to an unmotivated clientele whose major incentive for participation is the "allowance" that comes with retraining. It came as no surprise that, more often than not, these programs proved useless in enhancing the income of the graduates. Hong Kong is still far from the welfare states where generous unemployment benefits are as much a protection against economic hardship as an incentive for unemployment, but in order to avoid the pitfall, enrollment in part-time programs should be encouraged where possible, so that the trainees can remain economically active during training. If intensive, full-time training is necessary, then allowances for trainees in such programs should be kept at a low level. There should be no mistake that retraining is the primary objective, and that redistribution should be in the form of acquisition of skills that will increase future productivity rather than as a current subsidy for unemployment.

Conclusion

With the democratization of the political system and increasing government accountability, what used to be the enshrined principle of active non-intervention seems to be terribly out of vogue these days. It is far more fashionable to preach government involvement and leadership in many facets of life, and in this period of transition, the government is under particular pressure and temptation to oblige. Yet, more often than not, justifications for government intervention lack economic sense even when they are packaged in economic terminologies. The advocation for government subsidization for training of the labor force in the name of investment in human capital is but one example of such folly. Where no obvious market failure exists, it is still best to leave it to the market for the efficient allocation of our resources. And even when labor policies, such as the retraining initiative, can be justified on other than efficiency grounds, it is often true that, with a little imagination in program design, the Invisible Hand can be counted on for some good results where government discretion seems, at first blush, the only possible solution.

Dr. William Chan is a lecturer in the Department of Economics at The Chinese University of Hong Kong. An earlier version of this article was presented at the Academic Forum on "Hong Kong's Labour Market" co-sponsored by the Department of Economics at the Chinese University of Hong Kong, and the Central Policy Unit of the Hong Kong Government on December 9, 1993.

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