Optimal Education Policy, R&D Productivity, and Endogenous Growth with Heterogeneous Individuals

Palokangas, T. (2026). Optimal Education Policy, R&D Productivity, and Endogenous Growth with Heterogeneous Individuals. Helsinki GSE Discussion Papers 55/2026

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Abstract

This study characterizes optimal policy in an endogenous growth model where heterogeneous individuals choose between entering the workforce as unskilled labor or pursuing education to become skilled. In the decentralized economy, monopolists produce goods using both labor types. They purchase innovations from R&D firms, which employ skilled labor whose productivity increases with education duration. We identify two fundamental market distortions: the extensive margin (the decision to acquire skills) and the intensive margin (the duration of schooling). The social planner corrects these distortions through two primary instruments. A student grant is employed to internalize the positive externalities of education. Conversely, a targeted income tax on skilled labor corrects the intensive margin; by reducing the marginal benefit of prolonged schooling, the tax mitigates over-education and ensures a timely transition into the productive workforce. The government budget is balanced via a consumption tax, while government-backed loans relax liquidity constraints for heterogeneous students. The justification for these interventions vanishes when economic growth is absent or R&D productivity is independent of education duration. In these limiting cases, a laissez-faire approach is socially optimal, underscoring that education policy must be dynamically linked to the broader macroeconomic innovation environment.

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