The paper analyzes the impacts of an individual’s unobserved ability on schooling and wages in the context of a developing country using rich data from the Cebu (Philippines) Longitudinal Health and Nutrition Survey. Unlike any previous study, my model allows for grade repetition and school reentry after dropping out of school. Both phenomena are common in developing countries in general, and in the Philippines in particular. Semi parametric approach is used to control for an individual’s unobserved ability. The results strongly indicate that children with lower innate ability enter school at a later age and complete fewer years of school. They are also more likely to drop out of school at all levels of education, but the effect of lower ability diminishes at higher levels of education. While a standard Mincer equation yields a 4.5 percentage point return to an additional year of schooling, my model estimates this return to be only 2.7 percentage points. An omitted ability bias appears substantial. While completing additional years of schooling can compensate for lower innate ability, such substitution would be costly. It would take about three additional years of education to compensate for one standard deviation lower innate ability in terms of labor market returns. Improving school quality appears to increase achievement test scores only a bit, and lower pupil-teacher ratios yield only slightly higher rates of elementary school completion. Higher family income appears to benefit both attendance and completion of elementary school, but these effects are quite small despite being very precisely estimated.
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