A Smarter Way to Regulate Colleges

Colleges are cashing in credential inflation. In a recent essay for The Chronicle of Higher Education, Kevin Carey notes that many “not-for-profit” colleges operate highly profitable terminal master’s programs in fields such as business administration, education, and public administration that are indistinguishable from the two-year vocational offerings of most “for-profit” colleges. He therefore argues that profitable non-profit programs that offer insignificant financial aid should face the same set of regulatory and tax rules as profit-seeking colleges. Carey is correct that schools create professional programs largely to make money. However, only regulating those programs that provide insufficient resources to their students is a band aid for a problem that requires major reconstructive surgery.

Unintended Consequences

Given the Department of Education’s recent record of crafting poorly written regulations based on arbitrary metrics, Carey’s proposed policy would likely be easily circumvented and result in unintended consequences. Given that the quality of data on higher education finance is somewhat of a black box, I can easily imagine a rule that is based on a set of program profitability metrics.  Savvy college officials would likely respond to the policy in ways that make the programs appear less profitable on paper by artificially inflating the costs associated with the targeted programs in an effort to avoid the rules, resulting in undesirable outcomes.

This could be achieved in a number of ways. Colleges could increase tuition discounts for students in the targeted programs by an amount that allows them to remain profitable and avoid subjection to the new rules. They could also raise costs of the program doing things such as: hiring additional staff; increasing staff compensation; adding or raising administrative overhead charges; or “investing” in extravagant classroom and office buildings and décor.

Any combination of these actions would make the program appear less profitable on paper, but as Vance Fried indicates in a study for the Cato Institute, this is analogous to an accounting gimmick that records profits as expenses. The profits, rather than being returned to investors or reinvested as is the case for private enterprises, are instead dispersed to special interest groups on campus in the form of economic rents and subsidies for other missions. If colleges respond to Carey’s policy in the manner outlined above, it would do little more than serve as a catalyst for a redistribution of the current allocation of economic rents being captured by these programs. This would lead to at least two unintended consequences.

First, the rule change would unleash an unproductive competition for the economic rents that currently are used to cross-subsidize unprofitable campus ventures. Administrators, faculty, and students would compete for the rents, diverting resources from productive activities such as fund-raising, research, teaching preparation, and studying.  Those affiliated with activities that are currently cross-subsidized would be the clear losers of the competition, while those affiliated with the profitable programs would be the winners. Student enrolled in the affected programs, who currently demonstrate a willingness to pay the market price, would likely receive a tuition discount. Faculty and administrative staff affiliated with the program would likely benefit from reduced workloads and/or an increase in compensation. Of course, the net economic profit for each of the beneficiary groups would be the value of the rent minus the resources used to seek it. Meanwhile, the net loss for the losers would be the sum of the values of the lost rent and resources devoted to defending it.  Overall the college would experience a net economic loss equivalent to the combined resources wasted in the rent competition, in additional to regulatory compliance costs associated with the policy.

Because Carey’s rule would likely lead to the reallocation of profits as described above, less revenue would be available to cross-subsidize unprofitable activities and programs.  Given that colleges are organized much like governments in that they are plagued by special interest groups that tirelessly fight to protect their own interests, it is extremely difficult politically to downsize or eliminate activities and programs for which the costs exceed the benefits. The revenue loss from a reduction in cross-subsidization would likely be offset by an attempt to increase revenues from alternative sources such as undergraduate tuition or government subsidies. Given that state and federal government budgets are already stretched thin, tuition hikes would be the most likely source of revenue to compensate for the loss of income attributable to the imposition of new rules on profitable vocationally-oriented programs. This would result in college becoming less affordable.

A Better Solution

In addition to potentially creating perverse incentives, Carey’s idea to treat “profitable” master’s programs as for-profit entities does not go far enough to create a level playing field in either the higher education industry or the number of other private sector markets for which colleges compete. A better policy prescription would involve two broad reforms.

First is adoption of a uniform regulatory environment that does not discriminate based on a college’s tax status. Not only do colleges in the “for-profit” sector pay taxes, they also face stricter regulations than colleges with a tax-exempt status, giving the latter group a politically-achieved competitive advantage relative to the former. Students overwhelmingly attend college for career preparation, as indicated by a 2012 UCLA survey in which nearly 88 percent of college freshman indicated a desire to “to be able to get a better job” as one of the primary reasons influencing their decision to attend college.  All college degree programs provide career training to some extent, even if it is not for a specific career field.  That some colleges reinvest their profits or return them to investors should not put them at a competitive disadvantage relative to colleges that disperse their profits among various campus groups. All colleges should face the same regulatory environment as a means to promote healthy competition and satisfy the diverse educational needs of individual student decision makers.

Next, colleges should be subject to the same accounting standards and taxation on income earned from all activities and enterprises that are regularly taxed in the private sector. According to data reported to the Department of Education for 2,261 four-year public and non-profit colleges, the operation of auxiliary enterprises such as entertainment, food, health, and housing services provided these institutions with an average of $16.7 million in revenues in 2012. This amounts to a $37.8 billion industry that is not subject to taxation. These same colleges also realized an average investment return of $3.2 million in 2012, with thirty-nine institutions generating investment income of $50 million or more. This amounts to $7.25 billion in tax-free investment income. Colleges shouldn’t receive preferential tax treatment for income that is taxable for private sector firms and individuals.





  • Daniel Bennett

    Daniel L. Bennett is a Research Professor at the Baugh Center for Entrepreneurship and Free Enterprise at Baylor University.

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