Analysing the Need to Spend on Education

Author(s): David Mayston and Peter Smith

Source: The Journal of the Operational Research Society, Vol. 41, No. 2 (Feb., 1990), pp. 125-
131
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J. OpI Res. Soc. Vol. 41, No. 2, pp. 125-131, 1990 0160-5682/90 $3.50 + 0.00
Printed in Great Britain. All rights reserved Copyright (Cy1990 Operational Research Society Ltd

Analysing the Need to Spend on Education

DAVID MAYSTON and PETER SMITH
Department of Economics and Related Studies, University of York

An earlier paper has put forward a methodology for measuring the 'need to spend' on education by local
authorities. This paper examines the economic principles underlying the measurement of the need to
spend, and finds some problems inherent in the earlier work. The measurement of spending need would
nevertheless seem an essential step in the pursuit of territorial equity, particularly in the light of policy
developments in the United Kingdom concerning local management of schools. The paper therefore
identifies the areas where furtherclarification of key issues is required.

Key words: economics, education, government, public expenditure, resource allocation

INTRODUCTION
A paper by Steven Taylor' has drawn attention to one aspect of a much neglected area of public
policy-making in the United Kingdom-the distribution of revenue support grants to local
authorities. Some ?8.8 billion of Government expenditure is distributed in England alone in the
form of what is known as block grant. The purpose of the grant is ostensibly to equalize simulta-
neously for differences in tax bases and differences in expenditure needs between localities, and the
grant is not conditional on any specific forms of expenditure.
Taylor describes the grant-related expenditure assessment (GRE) which is estimated by central
Government as the amount an authority should spend if it wishes to deliver 'a common standard
of service'. Central Government grant is then determined such that, when spending at their GRE,
all authorities are able to levy the same rate of local taxation. Thus the GRE is designed to enable
the Government, using the grant system, to compensate for differences in need between different
authorities. Authorities are, of course, free (within limits) to spend at levels other than their GRE.
The grant-allocation mechanism simultaneously secures resource equalization by adjusting grant
so that, for equal per capita variations in expenditure from GRE, different authorities experience
equal changes in local rates of taxation, regardless of their local tax base. The Society of County
Treasurers2gives full details of the grant mechanism.
The first purpose of this paper is to bring to bear the principles of economic analysis in order to
examine what such a grant system is trying to achieve. We then critically examine the study on
which Taylor bases his recommendations, and express some reservations concerning its validity.
Scrutiny of these issues has become particularly urgent in the light of recent policy developments
in the United Kingdom. The Government is in the process of implementing a system of devolved
budgeting in schools,3 which will entail every local education authority specifying a spending-
needs formula for its schools. More generally, the proposed reform of local government finance4
involves a major overhaul of needs-assessment formulae, and many of the issues raised here are
germane to services other than education.

ECONOMIC PRINCIPLES AND BLOCK GRANTS

As Taylor notes, the precise purpose of the GRE is open to debate. Bramley' gives a full
discussion of the issues involved. The Government's own definition is that 'the GRE for a particu-
lar authority is an assessment of how much it would cost that authority to provide a common
standard of service, having regard to its general circumstances and responsibilities'.' For the pur-
poses of this discussion we shall assume that the aim of GRE is to give each authority the
opportunity to attain the same level of educational achievement. Under this interpretation,
authorities with different social and economic endowments should therefore be able to secure the
same quality of educational attainment if they all spend on educational provision at the level of
their educational GREs. An assumption that the Government might wish to add to this interpre-
tation is that the services are delivered with maximum efficiency.
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 Journal of the Operational Research Society Vol. 41, No. 2

In order to examine the role of GRE assessments, and shortcomings in empirical work, it is
instructive to examine the economic determinants of the provision of educational services. For the
sake of this exposition it is presumed that the quality of the local education can be represented by
a scalar qi. This is related to pupil numbers ni, to expenditure on education Ei and, to some
extent, also to local socioeconomic circumstances, represented by a vector si. That is, there exists
an implicit productionfunction for educational output of the form

fi(qj, ni, Ei, si) =0 (1)

(see Henderson and Quandt,' pp. 92-93). (We shall assume that all authorities face the same factor
prices for the same inputs, such as teachers under nationally negotiated wage scales, since to do
otherwise would raise excessive complications here.)
Under the assumption that more grant income is desirable for the education service, the quality
of educational attainment is taken to be a strictly increasing function of expenditure. If this is the
case, for a desired level of quality of provision qi,, it is then possible to identify a cost or expendi-
ture function,
Ei = gi(qi, ni, sj), (2)
describing the minimum level of expenditure that is needed to attain each target level of average
educational attainment, qi, for ni pupils, when facing socioeconomic circumstances si. Under our
assumptions, gi increases with the quality of educational output required, qi, and can also be
expected to increase with pupil numbers ni. Moreover, adverse socioeconomic circumstances s
are likely to increase expenditure requirements at all levels of output.
It is usual to express costs in terms of cost per pupil, and if we assume, for the sake of simplicity,
that there are no economies or diseconomies of scale, this implies that we can write

Pi. = E/ni = gi(qi, ni, si)/ni _ hi(qi, si), (3)

where Pi is expenditure need per pupil.

This cost curve is illustrated diagrammatically in Figure 1. The curve C1 C1 describes the cost
function (3) for authority 1. Authority 2 is assumed to possess less adverse socio-economic circum-
stances than authority 1, and so its cost curve C2 C2 lies below that of authority 1 at all levels of
output.

P C

Equalizing C
grant per 2

q q
FiG. 1. The cost curvefor educational output, and the role of grant-relatedexpenditureassessments.

Within this context, the needs-equalization role of block grant is clear. Suppose the standard
level of quality implicit in the GRE process is q*. Then the difference in the grant allocations per
pupil to the two authorities in Figure 1 should be the vertical distance between the cost curves
at output level q*. In this way, the grant mechanism should allow authorities with different socio-
economic circumstances to face the same effective price for the standard level of educational
output. (In addition, of course, the grant mechanism attempts to secure resource equalization for
variations in expenditure from this standard level. This complication is not considered further
here.)
In order, however, to model the actual choice of expenditure level in an authority, it is necessary
to include considerations relating to both the cost of and the demand for education. Demand
126
 D. Mayston and P. Smith-Educational Needs Assessments

responses are important because an authority may choose to spend more of its block grant on
outputs other than educational attainment (as measured, for example, by public examination
successes) if the cost of achieving additional examination passes becomes too high.
The quality demanded in locality i might then be considered dependent on the local cost of
educational attainment and on the socioeconomic characteristics of its local electorate. Assuming
that the unit cost per pupil per unit of qi (say pi = Pi/qi) is an increasing function of the level of
educational attainment qi, we can write the equation of the supply curve as
qi = ri(pi, si). (4)
We make the assumption that the quality demanded is an inverse function of price, so that
authority 1 in Figure 2 faces the usual downward-sloping demand curve of the form D1 D1. We

D,
p 0S2

l l2

ql q2 q

FIG.2. Effect offavourable .socic-economiccircumstanceson supply of and demandfor educational output.

further assume that the more favourable socio-economic circumstances in authority 2 are associ-
ated with more middle class aspirations of its electorate and parent body, which are manifested
here in increased demand for educational attainment (as measured by public examination
successes). This gives rise to a demand curve D2 D2 to the right of that of authority 1.

PRACTICAL CONSIDERATIONS
The problems of specifying and estimating education production functions are legion. Work by
Bramley8 illustrates the complexities involved in modelling educational outcome at local authority
level. In practice it is usual to assume that examination results offer some measure of the quality of
the education service. Clearly there are many outputs of the education service that are not cap-
tured by such a measure. However, as Taylor argues, they do appear to represent an important if
imperfect yardstick of educational output, and in this paper we do not challenge the use of exami-
nation results as a proxy for q,.
Examination of the GRE methodology6 reveals three key assumptions relevant to the current
discussion. (Throughout the discussion we ignore the special arrangements required to allow for
additional costs in Greater London.) The first assumption is that there exist constant returns to
scale with respect to pupil numbers: in fact, 86%Sof the school GRE total is distributed on the
basis of pupil numbers alone.
The second assumption is that the expenditure function h() )= h( ) independently of i. The
1980 Local Government, Planning and Land Act explicitly instructs the Secretary of State to
distribute grant on the basis of a needs-assessment methodology common to all authorities. This
implies that one should be able to obtain a 'need to spend' formula that is independent of the
particular authority concerned. Such an assumption is implicit in any attempt to secure resource
allocation by formula that seeks to be neutral between authorities in identical circumstances. So
long as one includes all socio-economic circumstances that are relevant to an authority's pro-
duction function (1), this assumption may be deemed reasonable. However, we shall note below
certain econometric difficulties in ensuring this inclusion inherent in the methodology used by
Taylor.
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 Journal of the Operational Research Society Vol. 41, No. 2

The third key assumption is that of linearity of all relationships. Specifically, as described by
Taylor, additional educational needs (AEN) are computed by summing six indicators of socio-
economic circumstances and distributing the AEN GRE total in accordance with this index. This
methodology assumes that
(a) quality of output is a linear function of socio-economic characteristics;
(b) adverse socio-economic circumstances can be compensated by expenditure in some linear
fashion.
These three assumptions together mean that the GRE methodology results in a cost function of
the form
Pi = a + psi + yqi, (5)
where a, P, y are coefficients which are constant across all authorities. The parameter y is the price
of a unit of enhanced educational quality.
The 'standard' level of quality q*, the cornerstone of the GRE philosophy, can be represented
by the relationship
P*= a + * si + yq*, (6)
where P* is expenditure per pupil (equal to GRE/pupil numbers) necessary for authority i to
achieve the standard quality q*. Although using different components for si and different param-
eter estimates, the methodology used by Taylor does not challenge these GRE principles.
In practice, of course, the relationship between expenditure and the quality of education pro-
duced is unlikely to be linear. It might therefore be more realistic to use a more general functional
form. For example, suppose that the relationship between socio-economic circumstances and per-
formance exhibits some degree of diminishing returns. In these circumstances, authorities with
particularly adverse socio-economic circumstances may face a higher marginal cost of achieving
enhanced local education quality than that for less disadvantaged authorities.
In order to illustrate these possibilities, we have tested the implications of relaxing Taylor's
linearity assumptions by repeating the linear regression for AEN used in his paper, but replacing
the explanatory variables with their natural logarithms. The consequent model is as follows:
AEN = 20.83 + 7.35 In(XI) + 9.71 In(X2) - 6.95 In(X3) + 2.32 In(X4)
-2.63 ln(X5) - 13.24 In(X6) + 5.70 In(X7), (7)
where XI to X7 are defined as in the Appendix to Taylor's paper, representing various com-
ponents of the vector si of socioeconomic circumstances, and In denotes the natural logarithm.
The quality of fit is improved slightly (R2 increases from 0.760 to 0.774) by changing to
logarithms. However, much more importantly, use of this non-linear model results in substantial
changes to the estimation of the AEN component of GRE. At the extremes, Solihull would be
entitled to 14.5% less AEN GRE than Taylor's calculations suggest, while Barnet's AEN GRE
entitlement would increase by 26.2%.
Of course, these figures have to be seen within the context of the overall education GRE of
?13.4 billion, of which only about 9% is allocated on the basis of the AEN index. However, they
do illustrate that, even if we accept Taylor's methodology for the present, just a modest move
towards non-linearity can result in large changes in needs assessments. We do not suggest that our
results are any more 'correct' than those presented by Taylor. However, they do illustrate the need
to examine a wide range of alternatives, and to develop a methodology for selecting the most
appropriate model.

ECONOMETRIC ISSUES
The GRE system is designed to distribute grant to authorities so that they all have the
opportunity to purchase the same level of educational quality for the same local price. In doing so,
it is concerned only with the supply side of educational provision. In practice, as we have shown in
Figure 2, local demand will also determine the level of education provision chosen by a locality.
This leads to further important estimation problems noted below.
The study used by Taylor to produce his revised GRE methodology was undertaken by the
Department of Education and Science (DES) to determine the relative importance of socio-
128
 D. Mayston and P. Smith-Educational Needs Assessments

economic circumstances and expenditure in determining examination results.9 Detailed criticism

of this study can be found elsewhere.10,11Equations of the following form were estimated by the
DES, using ordinary least-squares regression techniques:
qi = a + b * si + cPi + 6i, (8)
where a, b and c are constants to be estimated, Ei is the usual error term, and qj, the dependent
variable, is some measure of examination results in authority i.
At first glance, equation (8) looks like an empirical representation of (5), and so would appear to
offer some prospect of providing an operational means of estimating individual GREs. However,
an immediate contradiction presents itself. In three of the six equations estimated by the DES, the
expenditure coefficient c on Pi is insignificant, and in the remaining three it accounts for only a
small proportion of the variance. That is, expenditure appears to have little or no effect on many
measures of education output! So the empirical results appear to contradict the GRE philosophy
of 'compensatory education', and our apparently reasonable assumption of strictly positive returns
from education expenditure.
There are many possible reasons for this phenomenon, other than the obvious, though perhaps
unpalatable, conclusion that expenditure has no impact on educational outcome. In practice, the
budget constraints faced by local authorities have hitherto been kinked, in an attempt to dis-
courage high spending. This, together with other aspects of the block grant system, has the effect
that different authorities face different marginal prices for educational (and other) inputs, such as
teachers (see Gibson and Watt12 and Barnett et al."3 for details). Of course, more generally, the
equations might be misspecified. The variables used as proxies for social circumstances and
outcome might be inadequate. And there might be systematic differences in costs and efficiency
between authorities, which were not accounted for by the DES methodology. Many of these
possibilities have been examined exhaustively by Bramley.8
However, we suggest that a further, possibly very important reason for this apparent paradox is
that the achievement of examination results on which (8) is based is itself the result of an inter-
action between the supply and demand side considerations in the provision of education services.
Returning to Figure 2, recall that the favourable socioeconomic circumstances in authority 2
allow it to attain a particular level of examination achievement for relatively low cost, thereby
shifting down the marginal cost (or supply) curve when compared with the less favored authority
1. However, these favourable socioeconomic circumstances are also likely to be associated with
more middle class aspirations and higher mean parental income, which shift the 'willingness to
pay' (or demand) curve for examination performance to D2 D2, compared to the demand curve
D1 D1 for the less favoured authority.
It is then perfectly possible for the equilibrium points Q1 and Q2, for the less and more favoured
authority respectively, to involve different levels of examination performance q, and q2, but the
same level of the expenditure variable. A regression equation fitted through the observedpoints Q1
and Q2 will then show observed examination performance to be independentof the observed level
of the expenditure variable pi. However, such a regression will completely fail to estimate correctly
the underlying supply side relationship indicated by SI SI and S2 S2 in Figure 2 and by equation
(5) above. The regression will in general misestimate both the effect of increased expenditure per
pupil along a given supply curve SS, and the influence of individual socioeconomic circumstances,
si, in shifting the supply curve from SI SI to S2 S2
If we are interested in the additional block grant necessary to compensate an authority for
adverse socioeconomic circumstances and give it the additional resources needed to achieve a
target level of educational performance (however it subsequently chooses to use those resources),
then it is the expenditure function (2) and cost relationship (5) which we are interested in estimat-
ing. The DES regression for (8) will be inappropriate for this purpose, and typically will fail
completely to estimate the cost function (5) in an unbiased way. Rather we need a means of
separately identifying the supply and demand relationships.

CONCLUSION
The construction of indices of need to spend in local authorities has exercised central Govern-
ment for many years. Until block grant was introduced in 1981/82, such indices were based on
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 Journal of the Operational Research Society Vol. 41, No. 2

regressions of actual expenditure on numerous indicators of need. The reason this approach was
abandoned was because there was a danger that groups of authorities might be able to bias the
regressions in their favour by suitable manipulation of expenditure.'4 Specifically, the then Con-
servative Government suspected that high-needs authorities could attract to themselves more
grant-in-aid by maintaining high spending levels.
One of the principal purposes of the GRE system was to break the link between actual spending
and needs assessment. In particular, the AEN indicator used since 1981/82 was designed to secure
consistency from year to year, and to be independent of spending decisions. The revised method-
ology suggested by Taylor would mark a return to the old methods, albeit in an indirect way. He
claims that the regression he uses to construct an AEN index is independent of expenditure. On
the contrary, we suggest that the underlying supply relationship is likely to be profoundly influ-
enced by expenditure, even though that variable does not appear to be significant in the regres-
sion. Indeed, we suggest that the use of examination results as indices of the education output
produced by education expenditure would be highly questionable if expenditure did not affect
them in some way.
Notwithstanding these criticisms, we share, however, Taylor's concern that indices of need
should be based on sound analysis and empirical evidence, rather than upon arbitrary judgement.
In the National Health Service, the methods recommended by the Resource Allocation Working
Party (RAWP) have been used to secure substantial movements in resources between health
regions,'5 although the principles underlying the method have recently been diluted, and are
threatened still further by the recent review of the NHS.'6
However, in local government, the Government's research in this area has been reprehensibly
minimal. Only social services have received anything like the attention required. Our discussion
above suggests the need for more, rather than less, consideration of these issues, particularly in the
light of recent policy developments towards devolved responsibility in local government. In the
state education sector, for example, local management of schools requires the specification of a
resource-allocation formula by each local education authority, whereby revenues will be distrib-
uted to schools. Assessment of needs will perforce play a crucial role in such formulae.
Similarly, the introduction of the poll tax, or community charge, requires that all variations in
expenditure from the Government needs assessment must be financed entirely by the local domes-
tic sector. In these circumstances, the needs-assessment procedure is crucial to securing equity
between localities. However, the Government's current determination to make indices of need 'less
complex and more stable"' does not appear to offer much prospect of immediate improvements
in needs-assessment methodology. Moreover, all the available evidence suggests that the Govern-
ment is returning to regression-based techniques for the new needs assessments."8 The need for
more research in this area is palpable.

Acknowledgement-We should like to thank Steven Taylor and an anonymous referee for their comments.

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