All posts by Richard Vedder and Justin Strehle

Richard Vedder directed the Center for College Affordability and Productivity and teaches at Ohio University where Justin Strehle is completing a master’s degree in financial economics.

The Case for Taxing College Endowments

Republicans inserted many provisions in their House and Senate tax reform bills that have inflamed the higher education establishment, including a proposed excise tax on endowments exceeding $250,000 per student at private schools. Although only about 70 schools are affected that collectively enroll under 10 percent of the students attending four-year American universities, from some rhetoric of university leaders you would think that the very foundation of American higher education has been dramatically impaired.

Now Universities Have Detractors

There are two good reasons why the endowment tax makes sense to some politicians. First, public attitudes toward universities have distinctly soured in recent years. What the public perceives as outrageous student behavior, feckless university leadership, and excessive tuition fees has combined with a growing hostility by Republican lawmakers angered over the large political donations and public criticism that academics have made attempting to oust them from office. Lawmakers are growing tired of feeding the mouths that bite them. Revenues raised by taxing colleges can modestly help fund other tax reductions that lawmakers want to make, which are probably economically beneficial to the well over 90 percent of the population living outside the Ivory Towers of Academia.

Second, our econometric examination of college endowments suggests a large portion of endowment income is dissipated in relatively unproductive fashions, financing a growing army of relatively well-paid university administrators and giving influential faculty low teaching loads and high salaries. We estimate that roughly only about 15 cents out of each additional dollar of endowment income goes to lower net tuition fees (published tuition fees—sticker prices– are much higher at highly endowed schools, but those schools also give more scholarship aid). When a newly endowed scholarship is created, schools typically either reduce their student aid support from other funds or raise sticker prices to capture some of the newly funded endowment resources for other purposes.

Academic Gated Communities

The late Henry Manne once suggested that so-called “not-for-profit” universities actually are “owned” in reality, if not legally, by powerful faculty and administrators. These schools generate financial surpluses that, while not legally profits, are viewed by powerful university constituencies that consider themselves the true “owners” of the university as the equivalent of profits, a large portion of which are then distributed as “dividends.”

A healthy portion of these dividends are used to provide higher salaries or other perks such as hiring lots of new administrative assistants such as more assistant deans, “sustainability coordinators” or “diversity officers” to perform irksome jobs or meet politically correct objectives such as fighting global warming or achieving the optimal skin colorization of the students and faculty. As endowments rise, so do full professor salaries and the numbers of professors serving a given number of students. To a considerable extent, endowments are a successful rent-seeking scam of the power brokers within universities

At public universities, subsidies are provided by state governments that usually are less than $1,000 a student but are occasionally higher. The five highest state appropriation levels per student among the 13 public Big Ten universities range between $10,000 and $15,000, equal to the amount that would be provided by an endowment of $250,000 per student where the annual spending rate is four to six percent of the endowment principal. Thus, the GOP excise tax on endowments takes effect only at institutions where endowment spending is generally well above the public subsidies provided at state universities.

At Princeton, the endowment per student far exceeds $2 million, providing probably at least $100,000 in university spending per student. Despite these extraordinary resources, the school still has published tuition and fees for next year of $66,510 –and, if the Princeton website is to be believed, 40 percent of students pay the full price. Why should governments subsidize gifts to increase even further the extraordinary amount of spending that goes on at academic gated communities like Princeton?

Moreover, the proposed endowment tax is actually relatively modest. Suppose a school with a $10 billion endowment (about the size of that at Northwestern or Columbia universities) had a pretty good year, making $1 billion from dividends, interest, rents, and unrealized capital gains. As I understand the proposed legislation, it would pay less than $15 million in federal excise taxes.

We usually subsidize universities because they have what economists call “positive externalities” –good spillover effects that benefit all of society. But campus riots and other campus pathologies can lead to negative externalities –bad societal spillover effects. The GOP excise tax proposal reminds me of an email written me in 2002 by Milton Friedman, in which he suggested “a full analysis…might lead you to conclude that higher education should be taxed to offset its negative externalities.”

Alerting Clueless Administrators

An endowment tax would typically raise only a few hundred million dollars annually. Why bother? It likely will not dramatically alter behavior. Still, the proposal has considerable symbolic and informational value. It does send a warning to politically relatively clueless college administrators that their special privileges as institutions should not be taken for granted, and, indeed, are under intense scrutiny.

The call for an endowment tax also receives some modest support from the fact that very large endowments have sometimes eschewed the conventional belief that these investments should be made conservatively, emphasizing publicly traded stocks and bonds. The traditional view is that investments supporting public institutions should emphasize risk minimization more than wealth maximization. Exotic hedge fund investments in the Cayman Islands and the annual payment of tens of millions of dollars to endowment managers strike many as inappropriate for universities or at least something that should not be subsidized through special tax preferences.

An excise tax on large endowments is unlikely to alter collegiate investment behavior dramatically, nor is it going to be a large revenue raiser at the proposed rate. However, neither is it likely to do much harm and it has some positive symbolic value.

Why Not Use Endowments to Lower Tuition Costs?

Connecticut is going through the motions of trying to tax Yale’s $25.6 billion endowment to help relieve the state’s $266 million shortfall. That effort will fail, but public opinion is starting to question the appropriateness of government-conferred tax benefits for university endowment funds. At Harvard, alumni as politically diverse as conservative Ron Unz and progressive Ralph Nader are running for the Board of Overseers on a “make tuition free” platform.

What legitimate public purpose do endowments serve? The co-authors of this article spent several months exploring this question, looking at roughly 800 university endowment funds on which good data are available and concluding that, with some exceptions, endowments do little to make colleges cheaper and more accessible to students.  Suppose a wealthy donor gives a school funds to endow $100,000 annually in scholarships. Our research shows that probably on net $100,000 in endowment income leads to a student tuition fee decline of only about $13,000. As more endowed scholarship money flows in, universities typically either raise tuition fees more aggressively, or allocate less of their own resources to scholarships.

Related: Endowments Are Still Massive, So Spend

Princeton University had more than $2.8 million in endowment per student as of last June 30-enough to generate $112,000 in spending per student if four percent of the endowment were spent annually.  Princeton’s tuition fee for this year is $43,450. More typical schools have modest endowments generating at most $1,000 in per-student annual revenues.

Yet the more typical school likely has a sticker price at least $25,000 a year less than the highly endowed institutions. The average amount students actually pay after taking account of scholarships is only $3000 lower at the 20 highest endowment schools, compared with schools with more typical modest endowments. That is despite the fact that the high endowment schools have over $20,000 more endowment income per student.

If endowments only modestly make college more affordable, where does endowment income go? A goodly portion (we estimate about 37 percent) goes to support instruction, both by hiring lots more professors and by paying them a lot more. While there are about 12 professors for every 100 students at highly endowed schools, there are only half as many (6) at more typically endowed institutions. Similarly, while full professors at the poorer school average about $90,000 a year in salary, at the highly endowed schools, the figure is more than $155,000.

Related: Is an Endowment a Nest Egg or a Gambler’s Stake?

Some of this increased instructional money probably leads to smaller classes and more contact between students and professors, some of whom are both well-known scholars and fine teachers. Yet as any keen observer of higher education knows (one of us has been a professor for more than 50 years), the highly endowed school faculty mostly have very low teaching loads so they can write papers on often obscure academic specialties, and the more highly paid teachers not only live quite well (particularly when consulting and other income is considered), but often avoid undergraduate students like the plague. As Adam Smith said of professors 240 years ago after Oxford started paying them from endowments, they had “given up altogether the pretense of teaching.” Additionally, the statistical evidence also says about 25 percent of endowment income goes directly for research.

Not all schools behave the same way. Berea College, in relatively poor Appalachian Kentucky, uses its endowment to essentially make college free, foregoing high salaries and extremely low teaching loads to promote student access. A few other schools (College of the Ozarks in Missouri, and, historically, Cooper Union in New York City (now charging tuition) have done the same.

Do big endowments promote prestige and perceptions of high quality? Looking at the relationship between endowment size and rankings on the Forbes Best College list (which we help compile), we find some positive relationship between endowment size and rank, but it is not the dominant determinant.

Still, the five schools with the highest per student endowments (Princeton, Yale, Stanford, Pomona College and Harvard) are all very highly ranked.

Related: Another Bad Idea-Mandatory Endowment Spending

Universities argue endowment allocations are determined by the intent of thousands of donors, many of whom wish to promote things other than low tuition. Yet the Berea example demonstrates that colleges poorer than the Ivy League schools can use alumni support to make college free. Why hasn’t Harvard, Yale or Princeton ever mounted a capital campaign with a-goal of providing no-cost undergraduate education? A no-cost Harvard would set a powerful example and encourage other schools to forego the expensive university arms race in order to reduce financial burdens of attending college.

As tuition fees and student debt loads soar, and as doubts grow about the true return to students of a college education (total enrollments have actually fallen over the past four years), scrutiny of endowments is likely to grow. Pell Grant data reveals that highly endowed schools typically have a much smaller proportion of low-income students. Should they continue to be incentivized to strengthen their academic gated communities for the affluent by accumulating ever larger endowments, largely financed through special tax breaks to donors and capital gains tax exclusions? There are arguments for doing so, but our research suggests that if special tax privileges for endowments are curtailed by Washington policymakers, the colleges have only themselves to blame.