Reform Financial Aid

The goals of our financial aid system are certainly admirable. Providing assistance to the less fortunate is a crucial tool to help achieve equality of opportunity. However, the system could be reformed to achieve these goals much more efficiently. As Sandy Baum, an economist with the College Board notes, our current financial aid system is “like the tax system… Each piece gets piled on another piece. And the way they fit together is generally not something people would design by purpose.” Unfortunately, a consequence of this maze of overlapping and sometimes contradictory programs is that our financial aid system actually leads to higher college costs.

The first way in which our aid system leads to higher costs is by limiting competition. The cost of going to college for potential students is obscured because information is withheld, and hugely important decisions are skewed by perverse incentives. This translates into a competitive environment among colleges that is not as vigorous as it would otherwise be, which implies less market discipline for the colleges.

Secondly, our system encourages price discrimination. This increases the revenues of the colleges, which in turn increases their spending. This leads to higher costs and typically, higher tuition, which offsets some of the benefits of the aid.

To remedy these problems, the aid system should be reformed to alter the awarding of aid, increase the information given to students about their aid, and limit colleges’ access to student financial information. These reforms will enhance competition by providing more information and discouraging price discrimination.

 

How the Current System Discourages Competition

To understand how the financial aid process discourages competition, it will be helpful to be familiar with a timeline of some key steps college applicants must take if they want financial aid, outlined below.

Step 1 (December – January): Apply to colleges While the specific application deadline varies by school, it is typically between December and January of the student’s senior year.

Step 2 (January): Fill out the FAFSA Applicants are told that they should fill out the Free Application for Federal Student Aid (FAFSA) as soon as possible after January 1st in the year in which they are seeking aid.

Step 3 (February): Receive the SAR About a month after submitting the FAFSA, a student will receive a Student Aid Report (SAR). The SAR summarizes the information submitted on the FAFSA, and reports a figure called the Expected Family Contribution (EFC). The EFC is the amount that the government has determined that the student and their family are capable of paying. The SAR is also sent to all the colleges that the student indicated they would like to apply for financial aid for on the FAFSA.

Step 4 (starting in April): Receive acceptance and aid award letters from colleges. Around April, the schools to which the student has been accepted will begin to mail out acceptance letters, which typically include a financial aid award letter. This letter informs students of the estimated cost of attendance as well as the aid that has been made available to them by both the school and the government.

This peculiar arrangement gives rise to a number of problems that have the effect of reducing competition among colleges and increasing their costs.

The Current System Obscures Costs in the Planning Stages

The first way in which the financial aid system discourages competition is by neglecting to inform applicants of what aid is being made available for them in a timely manner. Please note the incongruity in timing above. Students apply to colleges in step 1, but do not find out if they can afford them until step 4.

This is not due to a lack of effort on the students’ part. It is estimated that the average family spends 10 hours gathering the required documents and filling out the FAFSA, but “Completing the FAFSA yields absolutely no information about aid eligibility. In fact, definitive information about aid eligibility does not arrive until months after the FAFSA is submitted.” Even when the form is filled out online, the student receives no immediate information after this rather large investment of time, and must wait about a month before getting the SAR. Recall, however, that the SAR does not tell them how much aid they’ll receive either, but rather how much the government thinks they can afford to pay. To finally find out how much aid they will get, the student must wait another month or two; until they receive aid award letters from the schools that have accepted them.

The sticker price of college is typically much higher than the net price that the student will need to pay. But the fact that they will not know what their net price is prior to applying makes it very difficult to plan. As Bowen, Chingos, and McPherson put it in Crossing the Finish Line, “this is a significant impediment to planning from the standpoint of deciding both whether and where to attend college.” While almost six out of ten students intend to apply to 4 or more colleges, a majority actually applies to less than three, and 22 percent end up applying to just one college. Given the lack of information, it is likely that one or more of these colleges will be beyond their financial reach. Combined with the fact that they may not get accepted to all the schools they apply to, this implies that by the time they make a final decision on where to attend, many students will have even fewer choices available, greatly diminishing their ability to “shop around.” As a consequence, the potential of consumer shopping around to act as a disciplining mechanism is greatly diminished.

The Current System Skews Decisions

Another problem with the current system is that decisions are skewed. For example, students’ decisions of whether or not to work are distorted. “The current formula absorbs student earnings from work very quickly (especially for independent students), taxing them (above a low-income protection allowance of $2,500) at a very high rate of 50 percent.” So, for every $100 dollars a student earns over the summer, they can expect to see their aid reduced by $50.

Perhaps the most important decision that is skewed is that of which school to attend. The government routinely makes more aid available to those that attend more expensive schools.

Case Study 22.1: The New GI Bill

A glaring example of the problems with financial aid varying based on the school attended is the new GI Bill. Effective as of August 2009, the GI Bill offers financial aid to qualified servicemen and women to cover educational costs, including housing.

The maximum benefit amount was originally set to cover the highest in-state, public, undergraduate tuition and fees. While this formula initially appeared to promote fairness by taking into account the different costs of attending school in different states, it was quickly realized that the enormous variation among states gave rise to fairness issues of a different nature. The maximum award per term ranges from $523 in Delaware to $63,576 in Utah. Expensive flight training as well as lab heavy courses, which often have additional fees, account for much of the difference. The maximum payout for tuition alone varied greatly as well, ranging from $93.40 per credit hour in South Dakota to $1,471 per credit hour in Texas.

The criteria laid out by the bill negatively effects higher education in two key ways. First, it encourages students to attend the most resource intensive colleges by making them less price conscious. Many students are already under the mistaken impression that they will get the best value if they attend the most expensive school since it is common to use price as a proxy for quality. However, we should not encourage students to attend the most resource intensive institutions without evidence that such institutions are providing a better education. By setting the award levels high enough to cover the most expensive public school, the bill will further reduce price consciousness. Second, it encourages colleges that currently charge less than the maximum to increase tuition, since they can do so without making the students any worse off. Since such a small minority of students will be veterans, this will be a relatively minor problem in this case (unless schools find a way to raise tuition just for veterans), but if the program covered a larger percentage of the students, this could be extremely problematic.

As the discussion of the GI Bill illustrates, it is often the case that aid is higher where tuition is higher. While the grant programs are generally able to avoid this problem (due to the fact that they max out at relatively low levels), the loan programs are quite guilty in this regard. While there are yearly and cumulative loan limits, within those limits, the Government Accountability Office reports that “the maximum unsubsidized Stafford loan amount is calculated without direct consideration of financial need: students may borrow up to their cost of attendance, minus the estimated financial assistance they will receive.” In other words, students that attend schools with higher costs of attendance (i.e., more expensive schools) will be eligible for more aid in the form of loans. This not only gives the subtle message that the government values graduates from expensive colleges more than graduates from less expensive ones, but more importantly, it greatly diminishes the extent to which price sensitivity can act as a constraint on tuition increases. If increases in tuition were not accompanied by higher loan eligibility, then tuition hikes would be a more costly decision to make, and we would see less of them.

The Current System Encourages Price Discrimination

The current system also discourages competition by encouraging price discrimination. Recall that the SAR summarizes the information on the FAFSA about student and parental income and assets as well as determines the EFC (how much the government thinks they can afford to pay). Incredibly, this information is then sent to the colleges to which the student has applied. In effect, the government is telling the colleges precisely what they think the student and their family can afford. This enables and encourages colleges to practice price discrimination - charging different students different amounts for essentially the same service. This would be similar to going to a movie theater where the ticket clerk knows exactly how much money each customer is willing to pay, and prices tickets accordingly.

Colleges engage in price discrimination by offering students tuition discounts, or scholarships. By setting a higher tuition than they otherwise would and varying the amount of the discount/scholarship, the college can increase the revenue it brings in from tuition. This helps explain why the Delta Cost Project has found that a “prominent trend in the past two decades has been growing use of ‘tuition discounting’ as a recruitment tool and as a mechanism for generating funds for student aid.”

By giving each college an applicant’s financial information, the current system makes it likely that the schools will end up charging similar amounts. Remarkably, a group of Ivy League colleges even used to meet to discuss and standardize aid awards to individual students, so as to avoid getting into a bidding war.

Case Study 22.2: United States v. Brown University et al.

United States v. Brown University et al. was a landmark 1991 case initiated in order to determine the legality of collusive price setting behavior in higher education. The case took the form of a complaint against eight Ivy League universities and MIT, all accused of illegally collaborating to fix prices. As Rupert Wilkinson’s reports in Aiding Students, Buying Students: 

“Agreeing to ban all merit scholarships, they sent their financial aid officers to big working conferences, meeting twice a year from 1958. Sitting at long tables, first at Harvard, then usually at the Wellesley faculty club, the college officers would try to agree on a basic price… The Ivy-MIT group, in particular, tried not only to agree on the [expected family contribution] for each shared “admit” but to narrow their differences in the amount of “self help” (borrowing and campus-job earnings) expected from most of their aided students.”

MIT and the Ivies believed they were exempt from the 1890 Sherman Antitrust Act, which would normally prohibit such arrangements, because they saw themselves as benevolent institutions pursuing the best interests of society. They viewed their actions as designed to ensure that any available financial aid money was used for truly needy students instead of frittered away in wasteful bidding wars for the top students. There is some evidence that this was a valid concern.

However, a district court found that the group was indeed in violation of the law. While an appeal was filed, a settlement was reached before the appeals court could make a ruling. Under the settlement, the schools would no longer be allowed to discuss individual students, though they were permitted to “agree with one another to give aid only on the basis of financial need and agree on common principles of how to assess that need, provided that they admitted students without regard to what they could pay (“need blind” admissions) and then met all “demonstrated” need.” It was a strange settlement, with the schools essentially allowed to act like a cartel in theory, just not in practice.

While United States v. Brown University et al. is one of the more blatant examples of price discrimination, it shows the opportunity that exists for tuition manipulation as long as institutions receive financial data from students before deciding on financial aid packages. Even in the absence of such cartel-like activity, the harmonization of prices will artificially reduce the variation of these prices among colleges. This greatly reduces the extent to which price can function as a competitive dimension.

 

The Three Goals of Reform

While the current financial aid system discourages competition to the detriment of students, a few relatively simple reforms could remedy this. The reforms should aim to do three things:

Make aid awards from the federal government tailored to each student regardless of the school attended. The amount of aid will vary by student, but more aid should not be given just because a student chooses to attend a more expensive college. Inform students of the amount of aid they will receive (instead of their EFC) as soon possible. Federal aid is predominantly need based, which will allow for accurate estimates of aid to be provided to most potential college students as early as middle school. Cease giving colleges their applicants’ SARs. The problems associated with giving schools detailed financial information on their applicants in terms of reduced competitive pressure are simply too great.

In light of the findings by scholars that “financial aid programs function best when they are based on transparent policies, administered with direct and simple processes, and based on national standards,” these reforms should ideally be accomplished with a simultaneous simplification of the aid system.

 

Advantages of Reform

The main advantage of reform is that it will increase competitive pressure on colleges to provide a cost effective education.

A shopping around mentality is fostered

The first reason why reform would increase competitive pressure is that it would encourage students to consider a wider variety of educational options. This shopping around mentality would be accomplished by fixing the size of each student’s individual award, regardless of the school attended, and informing students of the amount well in advance of application deadlines. Students would then know the total available aid from family and government sources will lead students to approach their college decisions from a more realistic financial standpoint. Armed with a more complete understanding of out-of-pocket prices, students would be better informed to make a wise selection. Potential students will naturally be asking, “Where can I get the most for my $8,000?” The answer to that question could be very different from the currently predominant, “Where would I go if money were not an issue (I’ll worry about paying for it later, perhaps after graduation by which time I’ve accumulated a crushing amount of debt).”

In addition, many students from disadvantaged backgrounds are scared away from attending college by the perceived financial obstacles in their way. If they were informed of the net tuition they were expected to pay, which is often manageable, they would be much more likely to enroll.

More time to think about important decisions

Another factor that will increase competition is that by informing students of aid availability earlier, they will have more time to consider the consequences of their decisions. Deciding whether they should attend college (and if so which one) is the first big financial decision many high school aged students make. The gravity of this decision can have personal ramifications for years to come, and thus should be considered carefully. Unfortunately, the current system withholds information from prospective students until the last minute, and then requires them to make a decision quickly when they are the most emotionally unsuited to do so.

Consider the following hypothetical example: Amy comes from a middle class family and has good grades. She falls in love with Ivy U after visiting the campus. She applies to Ivy U knowing that it is very difficult gain admission, and she also applies to a school she is confident she can get into, Safe U. Suppose that she gets into both of the schools, but that the financial aid package for Ivy U is tiny, so to attend Ivy U she would need to take out so much debt that it would impose a severe burden on her for years to come.

Under our current system, Amy is informed that she was accepted into the colleges in mid-April and has to make an enrollment decision by early May. For such an important decision, this seems much too quick. Amy is likely to be so overjoyed about getting into the school of her dreams that she may not have time to think about all the consequences of enrolling there. Under the reformed system, Amy would know what aid the government was providing much sooner, which would allow her to come to grips with the burden the debt would place on her. Given the enormity of such decisions, the new system would be better. She may still decide to go to Ivy U - it is up to her. But there is little lost and much to be gained by giving her more time to weigh the trade-offs between going to the school of her dreams and the impact that would have on her post-college dreams.

Ending price discrimination would lead to lower costs and would refocus competitive effort

Providing colleges with detailed information on students’ finances facilitates price discrimination, a phenomenon also evident in some contexts (movie theaters and airlines, for instance) other than just higher education. In addition, it makes sense that students should pay different amounts to the extent that they are inputs into the educational process. We should not expect for those that have more to offer - be it from their intellectual abilities, leadership on the athletic field, or the diversity they bring to campus - would pay the same price as those that offer less. But that is very different from saying that it should be the policy of the federal government to make it as easy as possible for colleges to price discriminate based on something as arbitrary as parental income, as is currently the case.

By refusing to continue to give colleges information on the finances of their students, price discrimination will be curtailed, which will have two main effects.

First, to the extent that Bowen’s law is true, it will reduce costs. To see why, it is helpful to understand what price discrimination implies for revenues, and then what that impact on revenues implies for costs. Price discrimination is popular among colleges because it increases revenue, as explained earlier. A former university president has said that “student aid has become little more than a clever marketing mechanism that permits colleges to maximize tuition dollars through rampant price discrimination.”

Unfortunately, this increase in revenue often leads to higher costs. Many scholars believe that expenditures in higher education are determined by revenues, meaning that if revenues increase, expenditures will increase as well. Higher expenditures generally lead to higher tuition, which of course has an adverse impact on access. This helps explain the disappointing results of high-tuition/high-aid models, which are supposed to use high tuition and price discrimination to raise money to provide large amounts of aid to low income students. “The appeal of the high-tuition/high-aid model is the claim that it maintains access for low-income students. Unfortunately, evidence from schools operating under this model reveals a different picture.”

The second benefit of limiting price discrimination is that it would shift competitive efforts away from the poaching of talent, and towards the creation of it. Currently, “price discrimination, effectuated through financial aid, is a widely used competitive instrument.” And as the United States v. Brown University et al. case demonstrated, if given the opportunity, colleges will expend enormous resources poaching (or trying to avoid the poaching of) desirable students. From a societal point of view, this is a hugely wasteful use of resources since virtually all of those students will end up going to college anyway. While the urge and incentives for colleges to continue such wasteful practices will remain, by withholding the financial information they use, the ability of colleges to successfully engage in such wasteful activity will be greatly reduced, as they will no longer be starting from a common ground. With the diminished prospects of the success of such methods, at least some colleges will devote that energy and effort toward the improvement of their educational experience

Eliminate need-aware admissions

While increasing competition and reducing costs among colleges is certainly a huge benefit of the reforms suggested above, there are others as well. One of biggest is that by no longer giving the colleges students’ financial information, one of the vilest practices in higher education will cease: “need-aware” admissions. This practice deliberately restricts the number of needy students admitted by using the information provided by the SARs when deciding which applicants to accept. Poorer students who would be accepted on merit are rejected because they would require more aid. Many, including us, view it as “deceitful and wounding to reject a student without saying that the reason was financial rather than academic.” For many schools, the alternative is “admit-deny”, where students are admitted on a need blind basis, but there is no guarantee that enough aid will be available to enable low-income students to attend. While this is also unfortunate, at least it is not deceitful, gives the student the final choice, and frames the decision in a familiar “can you afford to enroll here?” rather than the deceitful “you’re not good enough to enroll here.”

Disadvantages of Reform

There are also some potential disadvantages to reform, against which the benefits must be weighed.

Reform May Further Commercialize and Commodify Higher Education

Many people are already worried about the extent to which higher education is succumbing to commercialization and commoditization. Increasing competition among colleges, and encouraging students to ask where they can get the most for their (and the government’s) money could be seen as exacerbating these trends. Our emphasis has been on costs in terms of time and money; however, it is difficult to place such economic values on certain aspects of a well-rounded education, such as civic mindedness and being exposed to a diversity of ideas and people. If commoditization is actually occurring, it is possible (though far from certain) that our proposed reforms could have a negative effect on these less tangible aspects of an education.

Reform May Lead to Lower Revenue for Some Colleges

We noted above that according to some, the curtailment of price discrimination would lead to lower revenue, which will lead to lower expenditures, which will in turn lead to lower tuition. However, others argue that expenditures are not determined by revenues. If they are correct, then restraining revenue growth by inhibiting price discrimination will not have any beneficial consequences for spending or tuition, and could even lead to higher tuition as colleges try to make up for the extra revenue they used to collect through price discrimination.

Reform May Have Collateral Damage

It should be kept in mind that there is considerable cross-subsidization in higher education, and that many of the activities that are cross-subsidized, such as research and public service, are viewed as beneficial by most people. If the reforms upset the status quo by altering the finances or priorities of colleges, then it is possible that there will be less support for some of these activities, as more resources are devoted to educational functions. This could also lead to the starving of departments that don’t have enough student demand to cover their costs, whether that is because of low interest (such as Latin) or high costs (lab sciences).

Obstacles to Reform

The main obstacle to reform is resistance by those institutions that have an advantaged position under the current system. They quite naturally are going to fight anything that endangers their advantaged position.

The Perkins loan program is an illustrative example of this. Perkins loans are made to low income students directly by the school using funding that was provided by the federal government. As graduates at any particular college repay their loans, the money is recycled and loaned out to new students at that college. Since the initial endowment was fixed, some schools are much better off than others under this arrangement. In particular, colleges that received a disproportionately large amount and those that have subsequently enrolled fewer low income students have more money per eligible student. It is now the case that the same student could get a Perkins loan at one college, but not at another. Numerous attempts have been made to fix this inconsistency, but all “previous attempts to reform the Perkins loan program have met with failure because of opposition from colleges that would suffer under any equitable reallocation of Perkins loan program funding.”

So which schools would stand to lose under these reforms? The main losers would be expensive colleges (since their students would no longer get more aid) and colleges that currently price discriminate (since they will no long receive student financial information). These schools have set high tuitions and offer lots of discounts (institutional aid) so as to milk their students for more money. On the other hand, virtually all two-year schools, and many low-cost public schools do not have tuition levels high enough to make price discrimination worthwhile. They do not use the information that is given to them on the SAR for the simple reason that their students generally qualify for enough aid to enable them to pay the full tuition charge. Thus, they would not lose out under the reforms.

Conclusion

Former university president Robert Ronstadt put it bluntly when he said, the “American student-aid system… has failed.” To begin with, the costs of college are obscured. Students must currently apply to colleges long before they know if they can afford to attend. In fact, the flow of information is almost exclusively from the students to the colleges, with the government acting as a mere collection point, in spite of the fact that it is the government that is providing much of the money. Even after divulging intimate details about their finances, students must wait around three months before the colleges inform them of the aid that the government is providing.

Decisions are skewed by the fact that students qualify for more aid if they go to a more expensive college. This encourages students to attend higher tuition colleges, even though there is virtually no evidence that more expensive colleges do a better job of providing an education.

The aid system also encourages price discrimination by sharing the financial information of applicants with colleges, who are then (mostly) free to set their price accordingly. Not only does this lead to higher costs, but it also leads to the rejection of students on purely financial grounds, a practice known as need-aware admissions.

It would be difficult to devise an aid system where more information is given to colleges, and less information is given to students. However, our aid system does not have to be this dysfunctional. Making the aid award independent of the college attended, actually telling the student what aid they will receive in a timely manner, and withholding the financial information of students from the colleges they apply to would all be highly beneficial. By making these relatively simple reforms, competition among colleges could be enhanced and price discrimination could be curtailed, both of which would benefit students in the form of lower costs.