Tag Archives: College endowments

The College Endowment Tax: A Good Idea, Sort of…

Starting next January, some 35 very wealthy private colleges and universities will start paying an annual 1.4 percent college endowment tax under the new tax reform law. That’s very few of the nation’s institutions of higher learning, and the tax will not apply to assets that directly contribute to an educational purpose. When you hear wisecracks such as “Harvard is a hedge fund with a university attached,” you are listening to one reason for the tax. Other reasons include resentment toward elite universities for allowing leftwing domination of modern faculties and rising campus disrespect for free speech and intellectual diversity.

Related: The Case for Taxing Endowments

The precedent to exempt colleges from taxation emerged during the colonial era when newly established colleges were subsidized, in part, by exempting them from property taxes. Given their mission to educate young men for civic leadership and the clergy, the employment of an infant industry policy to exempt colleges from taxation to encourage their growth and sustainability seemed reasonable. Colleges, however, are increasingly astray from the mission of creating and disseminating knowledge, which serves a useful social function that arguably merits subsidization. They are increasingly engaged in revenue-generating activities that resemble those pursued by taxpaying commercial enterprises.

This includes endowment investment portfolios at some universities that look like highfalutin hedge funds. The commercial interests of universities should be taxed in the same manner as taxpaying enterprises and individuals, not granted the special privilege. The endowment tax moves us closer to this ideal.

The endowment tax mainly applies to wealthy universities such as Harvard, MIT, Princeton, and Yale. These four institutions collectively control about a quarter of the $500 billion assets held by college endowment funds, providing them an unprecedented advantage in attracting top students and faculty. The tax may reduce endowment inequality and improve the competitiveness of higher education. Some donors may redirect their philanthropy from the wealthy institutions to less well-endowed ones where their gift will have a higher long-term impact because it will grow tax-free. This would improve the financial position of institutions benefiting from such reallocation of gifts, allowing them to invest in strategic areas to better compete for top students and faculty.

Finally, the endowment tax may send a symbolic message to colleges that the public is increasingly dissatisfied with their behavior. Lawmakers with the ability to subsidize colleges also have the option of taxing them. This could serve as an impetus for university leaders to control profligate spending, improve affordability, enhance learning, and promote intellectual diversity.

Will It Reduce Financial Aid?

Some college officials have suggested that the endowment tax will reduce access among talented low-income students because a portion of their endowments is earmarked for financial aid. Returns attributable to such funds may end up exempt as an argument could be made that scholarships directly contribute to an institution’s educational mission.

While the endowment tax will nonetheless result in a modest revenue loss for wealthy institutions, most of these schools have what economists refer to as highly inelastic demand curves. This means they could raise tuition without significantly reducing the number of qualified students willing and capable of paying sticker price. The loss in revenue from the endowment tax could be made up by charging full price payers more, without adversely impacting access to low-income students. Proponents of redistribution should favor this. But then again, affected colleges might respond by reducing the number of low-income students admitted or the aid packages offered to them.

The endowment tax of 1.4 percent is lower than the 2 percent rate imposed on net investment income of private foundations. Meanwhile, individual investment income is taxed at the marginal rate (up to 37 percent post-reform) and long-term capital gains up to a 20 percent tax rate, plus any state levies. The net investment income and capitals gains of corporations are taxed at the corporate rate (21 percent post-reform). Why should wealthy universities such as Harvard, whose $37 billion endowment exceeds the GDP of countries such as Bahrain and Latvia, pay a lower tax rate than a middle-class family or small business for performing the same economic activity?

In addition to the direct revenue loss from the endowment tax, the new policy will also impose indirect costs. The higher education community is likely to increase its lobbying efforts to try and shape the final details of the policy in their favor to minimize losses. The policy will likely be complex, imposing new compliance costs. Lobbying and regulatory compliance are costly and will divert resources from more productive uses.

A Small Tax Needn’t Stay Small

Though the new tax is small, we should learn from history. The Revenue Act of 1913 imposed a very modest 1 percent federal income tax but has evolved into the federal government’s largest revenue stream, propagating a Leviathan central government.

While the endowment tax is likely to have a modest impact, it is a slippery slope for further federal meddling in and politicization of higher education. Faced with a rapidly expanding national debt and unfunded liabilities, lawmakers may view universities resources, including their endowments, like a pot of gold at the end of an ivory tower. They may also increasingly use the power of the purse to coerce university conformity to whatever ideology is in vogue, further reducing intellectual diversity.

Federal intrusion into higher education has been a root cause of many of the issues fueling growing public resentment towards it. Calling upon the government to fix problems that it helped create may prove to be foolish and perpetuate them indefinitely. As Milton Friedman once said, “there is nothing so permanent as a temporary government program.” His wisdom suggests that we ought to move in the direction of reducing government involvement in higher education, not increasing it.

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.

Top College Endowments Are Political Targets Now

One of the pillars of our education establishment, The Education Trust, recently published a report meant to pressure colleges and universities with large endowments into spending more of their earnings on one of its pet causes – very low or even free tuition for students from poorer families. The study, “A Glimpse Inside the Coffers: Endowment Spending at Wealthy Colleges and Universities,” claims to show that these institutions “aren’t doing nearly enough” to help such students.

To cite just one example from the report, suppose that the University of Pennsylvania were to raise its endowment spending up to Education Trust’s recommended five percent level – and spent all of the additional money on reducing tuition for poor students. By doing that, Penn could double the number of low-income students entering the school, from 109 per year to 218 per year.

Now, I am no fan of the way our colleges and universities that have gigantic endowments choose to spend their money. I think that too much goes toward the student amenities arms race, toward the hiring of unnecessary administrators who have to pretend to be busy at jobs such as “Vice President for Diversity and Inclusion,” and toward luring “star” faculty members who don’t teach much, away from other schools. But just because they waste a lot of money already is no reason to favor Education Trust’s plan.

Related: Another Bad Idea—Mandatory Endowment Spending

Here is the fatal flaw. Going to an elite, high-cost college is little or no better than going to a lower-cost, non-elite one. Sometimes, in fact, students (no matter their family’s finances) get a superior education at a non-prestige school where there are fewer distractions and where the faculty pays more attention to the undergraduates.

Is Prestige Worth the Cost

Sticking with Penn, let’s suppose that the university decided to follow Education Trust’s advice and succeeded in enrolling an addition 109 students from low-income families with very low tuition and other fees. Penn is indeed a very famous school, but where would those 109 students have gone otherwise?

Perhaps some would have gone to a private liberal arts college in the state or region. Grove City College is a possibility. For decades, the administration at the school has kept costs to the lowest possible level (although certain it isn’t free) and, even more important, students get lots of direct attention from the faculty. Courses are taught by experienced professors, not by grad students. The curriculum remains solid, not full of trendy, narrow, politicized classes.

Yes, a degree from Penn is regarded as prestigious – far more so than a degree from Grove City or most other schools, public or private, in the state. The question, however, is whether that prestige is worth the trade-offs to get it.

Evidently, the people at the Education Trust (along with a majority of America, I’d guess) think so. That is because they have bought into “the Chivas Regal effect” – namely the notion that something must be better in quality simply because it costs more.

Leaders at our high-cost colleges have been promoting that idea (and cashing in on it) for years. It just isn’t true, however. Going to a high-cost, elitist school is neither necessary nor sufficient for students to get a good college education and get on track for a successful career.

I don’t often agree with New York Times writer Frank Bruni, but his book Where You Go Is Not Who You’ll Be nailed an important truth. (My review of the book is available here.) Students often do very well at colleges that almost no one has ever heard of; conversely, the environment of big, famous schools can be damaging to some students.

I will add one further objection to Education Trust’s “More Free College!” idea. To the extent that Penn or any other wealthy university enrolls more students who are from relatively poor families, it will also have to reject an equal number of other students who aren’t from low-income households. Some and probably most of those students will be very highly qualified students who were eager to go to Penn despite the cost.

Those students will most likely be ones who don’t check off any “diversity” box and are therefore expendable in the school’s enrollment management calculus – in other words, sharp Asian kids. They will have to settle for one of their backup schools.

I’m not saying that is a national disaster, but it does mean shuffling some of our best students away from colleges where they’d have been challenged and into ones where they’ll do fine but perhaps not their very best.

For all the lip service they pay to various “social justice” ideas, college leaders, are pretty steadfast in protecting their freedom to use their wealth as they think best. I hope they live up to that and ignore the Education Trust.