Higher Education Subsidization: Part 2 – Subsidy Design

Editor’s Note: This series is adapted from the new paper, Higher Education Subsidization: Why and How Should We Subsidize Higher Education? Part 1 explored the justifications and rationales that have been used to subsidize higher education. This part explores subsidy design considerations.

There have been seven main justifications for subsidizing higher education: Promoting favored religions, reducing labor force size, strengthening national defense, paternalis­m, redistribution, generating positive externalities, and boosting economic growth.

Assuming that a subsidy program is sufficiently justified, the next question is how it should be designed. Four key considerations are targeting, distribution, size, and unintended consequences.


One of the first questions to answer when providing a college subsidy is whether it should be universally available or selectively targeted to a subset of students. Universally available subsidies would provide the same subsidy to each student, whereas selective targeting provides different students with different subsidies.



There are essentially two methods of providing college subsidies: Subsidies can be provided directly to institutions through payments to colleges and universities, often called appropriations, or to students in the form of financial aid. Appropriations are sometimes the better choice, such as when there are agglomeration economies or economies of scale. Generally, however, the financial aid approach is better.



Another consideration for subsidy implementation is the size of the subsidy. Subsidies could be too large or too small. A $1 per student subsidy will not address any meaningful justification for subsidization, while a $1,000,000 per student subsidy would be excessive.


Unintended Consequences

No matter how well-designed a subsidy may be, it can be rendered ineffective by unintended consequences. For college subsidies, these usually take the form of colleges responding strategically to the subsidy, thereby partially or fully offsetting the intended effect of the subsidy. For example, there is very convincing evidence that colleges raise their prices when more financial aid is available to students, a phenomenon called the Bennett Hypothesis.

These design considerations are not entirely independent of each other. For example, if the subsidy should be selectively targeted, then it should also generally be distributed as financial aid to students since giving the subsidy to the college as an appropriation would allow for, and arguably guarantee, mistargeting of the subsidy.

By combining the subsidy justifications with the design considerations, we can determine the general approach that subsidy programs should take. While the paper covers all seven justifications, I’ll highlight three here.



Subsidies justified on redistributive grounds should use selective rather than universal targeting since the whole point of the subsidy is to provide additional funding for specific categories of people. A universal subsidy would simply not meet the goal of redistribution. This, in turn, means that redistributive subsidies should utilize the student aid distribution method rather than institutional funding.


Generating Positive Externalities

Since there is little reason to assume that all college majors generate the same externalities, and there is some evidence that externalities, in fact, vary by academic field, the financial aid design is a superior approach because it allows for more precise targeting of subsidies to fields that generate positive externalities. Moreover, colleges do many things besides teaching, including conducting research, providing public service, housing students in dorms, and feeding students in dining halls. Not all of these have the potential to generate positive externalities, so not all have plausible claims for subsidization. Accordingly, a blanket subsidy for college expenses in general is not justified by citing positive externalities.


Boosting Economic Growth

Not all types of education will have the same effect on growth. For example, scholars have found “a positive effect of engineers on growth, and a large direct negative effect of lawyers on growth.” Since universal subsidies would provide the same subsidy to both fields, while selective targeting would allow for subsidizing engineering while taxing law, selective targeting is better.

The superiority of selective subsidies in relation to boosting economic growth also means that the financial aid design is superior to the institutional appropriations approach. The design of financial assistance allows for more precise targeting of students in fields most likely to boost economic growth.

In Part 3, we’ll examine whether federal subsidies are sufficiently justified and how well they are designed.

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