The graduate tax when education is a signal

•The graduate tax is a policy option for recovering higher education costs.•Wealth determines participation because of imperfect capital markets and uncertainty.•An inefficiently high number of high-wealth, low-ability students are educated.•Implementing a graduate tax deters low-wealth students and worsens this inefficiency.

This paper investigates the effects of a graduate tax when the return to education is uncertain and wages are determined through equilibrium in a labor market with signalling. The consequence of uncertainty is that both ability and initial wealth matter for educational choice. Compared to a constrained first-best the market outcome with uncertainty and signalling results in an inefficiently high number of people entering higher education. Due to the positive wealth effect over-entry is proportionately greater for high-wealth individuals. The graduate tax reduces entry into education so enhances efficiency. However, it has undesirable distributional consequences: low-wealth individuals are deterred from entering education but high-wealth are encouraged. In this respect, the graduate tax has clear failings as a method of financing higher education.