Federal politicians tinker with the Internal Revenue Code frequently, but the rules regarding donations to colleges and universities, as well as the rules regarding the money earned by endowments have remained unchanged for many decades. It’s all tax-exempt and our institutions of higher education like it that way.
Some people have begun asking whether those rules still make sense. What is the justification for the tax-exempt status of non-profit colleges and universities? In a recent paper published by the Center for College Affordability and Productivity, economics professor Richard Vedder scrutinized the case for our “hands off” policy.
Vedder is a free-thinking scholar and arrives at some conclusions the higher education establishment won’t like.
To begin with, Vedder notes that there are two principal reasons why favorable tax treatment of colleges and universities might seem to make sense – first, that higher education helps to promote equal economic opportunity and intergenerational economic mobility, and second that higher education has various favorable social spillover effects (“positive externalities” in the lingo of economists). Therefore, if higher education indeed has such beneficial effects, we might want to write the tax laws so as to encourage schools to exist and grow.
Regarding the egalitarian argument that getting a college education contributes to social leveling, Vedder observes that the data don’t bear this out at all. The great increase in the percentage of the population going to college occurred in the years after World War II. So you’d expect income inequality to have decreased – but it hasn’t. In fact, Vedder writes, “measured income inequality has actually grown at the same time that college participation has risen.”
It might be that income inequality would have risen even more if it hadn’t been for the increasing rate of college participation, but we don’t know. It certainly doesn’t appear that the favorable tax treatment of colleges and universities – not to mention the great amount of government financial aid to students – has done anything to decrease the degree of income inequality in the United States.
Vedder has a good explanation why not. For one thing, college attrition is quite high, especially at the mid- and lower-tier institutions. More than 40 percent of students who enroll fail to graduate within six years. Also, the better colleges have kept their student bodies at roughly the same size even as demand for their services has skyrocketed. Many of America’s elite schools now accept only around 10 percent of their applicants, or less, as we read in this New York Times story.
Here I must quibble a bit with Professor Vedder. In my view, it’s not very important that the top institutions haven’t expanded to meet rising demand. That’s because there really isn’t much difference between studying at one of them and studying at a non-prestige school. An engineering education at, say, North Carolina State is not inferior to an engineering education at Harvard.
The crucial point Vedder misses here is that many college students, including some from top schools, graduate with weak basic skills and therefore enter the job market with little to show for their college “investment.” That’s the main reason why the “income gap” isn’t shrinking – many students simply don’t bother to learn much, as I argue in this paper.
What about the “positive externalities” that colleges allegedly confer upon society? The College Board puts out an annual report entitled Education Pays, which goes through pages of charts and tables to show that college graduates smoke less, commit fewer crimes, are less likely to be unemployed, devote more time to volunteer activities, among other social benefits.
That’s another superficially appealing argument, but Vedder quickly eviscerates it: “Showing association is not the same thing as showing causation. I would hypothesize that at age eighteen, before entering college, the college bound students tend to have positive social attributes relative to the high school graduates who do not continue on.” We simply don’t know how much marginal benefit college education has, so it’s not convincing to argue that favorable tax treatment of college is warranted because of these positive externalities.
Suppose that we started to tax the income from college endowments? Vedder shows that such a tax could raise around $6 billion per year. That amount would allow for a Pell Grant increase of roughly 40 percent. He isn’t advocating such taxation. In fact, he writes that he could make a good argument against it, but merely wants to demonstrate that “the potential impacts on college access of changing federal tax laws can be important and substantial.”
Another contentious tax-related issue Vedder takes up is whether colleges and universities should be compelled to spend at least a certain percentage of their endowment income. Unlike other private foundations that are required by law to spend at least 5 percent of their endowment each year, colleges and universities don’t have any spending minimum.
Several members of Congress have said that they think there should be a minimum spending requirement. Vedder states one argument in favor of changing the law this way: “The purpose of the tax exemption is to fulfill the mission of the university, but the institution, at least in the short run, is doing nothing with the funds that would help it achieve that mission.”
The word “nothing” overstates the matter, but it’s true that some of the nation’s top universities spend a remarkably small percentage of their endowments, and much of what they spend money on is of questionable relevance to education. Some schools lavish money on very swanky dorms and amenities for the students, faculty, and administrators. With endowment growth at many of the top universities dramatically outpacing the rate of inflation, why not replace the old rule – no rule at all – with a requirement that the school spend at least a certain percentage?
Vedder contends that it would be a good rule of thumb for universities to spend whatever amount annually that is consistent with maintaining the real value of the endowment in the long run. He is not, however, sold on the idea of having a federal mandate, arguing that if the wealthy universities are compelled to increase spending from their endowments, the unintended consequence could be an acceleration of “the academic arms race” – that is, spending not to bring the cost of attendance down for many students, but rather to create still more pleasant campus amenities.
(The idea of having a federal mandate on college endowment spending is quite contentious and was the subject of this Pope Center pro and con.)
Taxation is always an important topic, whether we’re talking about things that are already heavily taxed or things that so far have not been taxed, such as universities. Vedder’s paper on the latter is sure to figure in future debates about the advisability of taxing our institutions of higher education.
George C. Leef is the vice president for research at the John William Pope Center for Higher Education Policy in Raleigh.