How Important Is Human Capital? A Quantitative Theory Assessment of World Income Inequality

We build a model of heterogeneous individuals—who make investments in schooling quantity and quality—to quantify the importance of differences in human capital vs. total factor productivity (TFP) in explaining the variation in <it>per capita</it> income across countries. The production of human capital requires expenditures and time inputs; the relative importance of these inputs determines the predictions of the theory for inequality both within and across countries. We discipline our quantitative assessment with a calibration firmly grounded on US micro evidence. Since in our calibrated model economy human capital production requires a significant amount of expenditures, TFP changes affect disproportionately the benefits and costs of human capital accumulation. Our main finding is that human capital accumulation strongly amplifies TFP differences across countries: to explain a 20-fold difference in the output per worker, the model requires a 5-fold difference in the TFP of the tradable sector, vs. an 18-fold difference if human capital is fixed across countries.