Sorting out the sorting vs. human capital debate

TLDR: In this paper, the authors use data from Finnish polytechnic reform to distinguish between human capital and signaling theories of the value of education, and conclude that education has both human and signaling value.

Abstract: We use data from Finnish polytechnic reform to distinguish between human capital and signaling theories of the value of education. The polytechnic reform took place gradually over the 1990s eventually upgrading all vocational colleges to polytechnics. The reform extended the length of education and created a completely new set of degree titles distinguishing the polytechnic graduates from the earlier graduates from the same schools. While both human capital and signaling theories predict that earnings are higher for those with higher level of education, their predictions differ in respect to what happens to those who graduate from schools that still are vocational colleges after polytechnics graduates start entering the labor market. We find that the reform decreased the relative earnings of vocational college graduates as predicted by the signaling model. We also reject the predictions of “pure” signaling model, and conclude that education has both human capital and signaling value. According to our best estimates, approximately 56 percent of the return to additional education due to the polytechnic reform reflects the effect of education on productivity and the remaining 44 percent its signaling value.