Higher education is an important part of the economy, but the increasingly exorbitant cost of higher education in the United States is leading to an untenable situation for students, institutions, and taxpayers alike. We should be aware of how the sources and structure of revenues influence the behavior and spending decisions of our colleges and universities. When colleges and universities receive funding directly from the state through lump-sum subsidies, as is the current method in most states, it creates perverse incentives that run contrary to the interests of affordable, quality education.
By simply reallocating the funds currently used to subsidize colleges and universities away from the institutions and into the hands of student, the state would still be promoting higher education, but would be removing the perverse incentives of institutional subsidies. Thus, the question is not, “Should we support higher education?” but rather, “How can we continue to support higher education while simultaneously promoting affordability and productivity?” Instead of giving subsidies directly to a college or university, states could follow the lead of the federal government and give the money directly to the students in the form of an educational stipend, voucher or grant. This would lead to beneficial competitive pressure and would incentivize universities to meet their students’ needs rather than the desires of legislators.
The Current System and Why it Matters
Universities and colleges receive funding from a variety of sources, including tuition and fees, research grants, private gifts and endowments, and state appropriations (i.e. direct government subsidies to colleges and universities. State appropriations represent the single largest source of revenue for public degree-granting institutions in the Unites States. As Figure 24.1 indicates, in the 2005-2006 school year, colleges and universities received more than $58 billion in revenues from state appropriations, which was nearly a quarter of total revenues. The second largest revenue source, tuition and fees, was just under $42 billion, or 17 percent of total revenues.
While each state has a unique system of appropriating money for higher education, these subsidies play a very important role in the finances of public colleges and universities and it is therefore reasonable to conclude that the structure of these payments has an effect on their incentives and therefore their actions.
Of the many ways the current system of direct subsidization of public universities under legislative discretion affects the incentives of colleges and universities, there are two that stand out as being particularly perverse in view of declining college affordability: it provides a disincentive to decrease spending and it incentivizes increased spending on lobbying and other non-academic pursuits.
A Disincentive to Decrease Spending
Direct subsidization gives colleges a disincentive to decrease spending. Consider two campuses, both alike in dignity. The first school behaves with a cavalier disregard for costs, spending all of their revenues engaging in high cost activities with little or no value to students. The second school behaves prudently by cutting costs, innovating, and keeping expenditures to a minimum, which results in surplus revenues. Under the current system, colleges like the first one will likely successfully petition the legislature for additional funding, citing their high operating costs and the economic importance of an educated workforce. However, colleges like the second one - those that strived to keep operating costs low, spent wisely, and generated a surplus - cannot claim that they were underfunded. In fact, it will appear that they have been overfunded and will likely have their subsidies reduced. Thus, wasteful spending is likely to be rewarded in the form of higher state appropriations, while prudent cost saving measures are likely to be punished in by lower state appropriations.
This perverse incentive system gives colleges a strong incentive to spend everything they are given, which, when combined with the fact that many prominent rankings of colleges and universities equate spending with quality makes it easy to see why costs rarely fall without some external shock.
An Incentive to Increase Spending on Lobbying and Other Non-Academic Pursuits
The second perverse effect of the current system is that it gives colleges an incentive to increase spending on lobbying efforts and other non-academic pursuits. The reason for this is simple: when most of their money comes directly from the state, it is much more effective for colleges to focus on winning over and satisfying legislators by spending time and money on lobbying and public relations than it is to focus on winning over and satisfying students and parents by spending time and money on academic matters.
It is too often the case that behavior that would likely increase state appropriations also increases costs, generally without increasing educational quality. Take for example, expenditures on lobbying. While figures spent lobbying state governments are not available, in 2006, the education industry spent $85.7 million lobbying the federal government, an activity that offers no direct educational benefit for students.
Yet another example concerns intercollegiate sports. While only 19 of the 119 Football Bowl Series schools generate positive net revenues from their intercollegiate athletics programs, the evidence shows that participation in NCAA Division I-A football increases state appropriations. In other words, state legislatures are encouraging colleges and universities to engage in money losing non-academic enterprises - in this case, athletics. State funding has also been linked to other non-instructional spending such as research spending, public service spending and even some non-spending variables, such as net tuition.
It is apparent that schools have a big incentive to respond to the state legislature, often at the expense of the students. Since state appropriations represent a plurality of revenues at public schools (even surpassing tuition and fee revenue), it comes as no surprise that colleges and universities respond more to the demands of state legislators than they do to the demands of those they are educating. Incurring these extraneous costs are students, parents and taxpayers.
The Benefits of Funding Students Instead of Institutions
The beauty of switching from funding institutions to funding students is that states can maintain their current level of funding, while simultaneously unleashing a slew of beneficial outcomes, described below.
Less Wasteful Spending
Funding students instead of institutions can be expected to lead to lower costs in higher education because legislatures would no longer punish colleges for cutting costs. When funding is funneled directly to institutions, there is little incentive to find ways to cut costs. In fact, there is a disincentive, because if you succeed in cutting costs, thus generating a surplus, legislators are likely to conclude that they are providing too much funding and cut the budget the following year. This is no longer the case when funding is given directly to students. A school that succeeds in cutting costs will no longer be punished with a smaller budget.
Students are Empowered and Competition is Increased
Another benefit of a student grant system is that it offers students more choice by broadening the number and types of institutions at which they can pursue their postsecondary education Such a system would empower students, allowing them to vote with their feet, which would increase competition among colleges. The empowerment and accompanying increase in competition comes in two forms.
First, there is an increase in competition among existing colleges. By allowing students to take their grants to a wider variety of institutions, colleges would be encouraged to become more focused on their students. This new “customer focus can help build a student-centric higher education system that delivers quality, flexible learning experiences.” For example, many nontraditional students are currently ill-served by institutions that have little incentive to adapt to their needs, since students often have no other options to choose from. A student grant system would change this, since students would have the option of taking their subsidies elsewhere. This would provide an incentive for colleges to tailor their services to students that are currently marginalized.
The second way in which a student grant system would empower students and increase competition is by providing an incentive for new and innovate colleges to enter the market. Under the current system, potential new colleges face the prospect of competing against incumbent colleges whose costs are massively subsidized, up to 70 percent in some cases. This acts as a huge barrier to entry, which artificially reduces competition within higher education. As a result, colleges are much more monopolistic than is desirable. The more monopolistic they are, the more they exhibit the traditional weaknesses of monopolies, such as the tendency to be inefficient, unresponsive to customer needs, resistant to innovation, and preoccupied with preventing competition. If competition among colleges were to be increased, then these undesirable tendencies would be curtailed.
By allowing new and innovative colleges to compete with existing ones on an equal footing, we can expect for the higher education sphere to become much less resistant to both technological and pedagogical innovation. Those institutions that do not adopt appropriate practices and technologies will lose market share to those that do. Many of these practices will lead to lower costs, which can be passed on to students in the form of lower tuition.
Better and More Flexible Targeting of Subsidies
One major problem with funding institutions directly was pointed out a half century ago by Milton Friedman:
“The subsidization of institutions rather than of people has led to an indiscriminate subsidization of whatever activities it is appropriate for such institutions to undertake, rather than of the activities it is appropriate for the state to subsidize. Even cursory examination suggests that while the two classes of activities over lap, they are far from identical.”
There are many activities and operations that are perfectly legitimate for an institution to be involved in, such as recruiting and athletics, which provide little to no benefit for the public, and should therefore not be subsidized by taxpayers. But when funding is given to institutions rather than students, it is difficult and costly to ensure that money is not spent on such activities. This problem is avoided under the student grant approach, since colleges that excessively cross-subsidize non-academic activities will have less money available for educational spending, and will therefore be at a disadvantage when it comes to attracting students.
Moreover, a student grant program would be much more flexible when it comes to targeting specific desired outcomes. The current block grants are effectively spread out equally over the entire student body, which is typically undesirable from an economic efficiency perspective. For instance, there are differences in both the societal benefits and the costs to provide an undergraduate versus a graduate education, or between classes in chemistry and classes in English, but all essentially get the same subsidy.
While there is no easy way around these issues when funding institutions, the solution is quite simple when money is given directly to students – just alter the size of the stipend based on the circumstances. If some courses are more costly to provide, or we want to enhance equality of opportunity, or encourage more students to major in Science, Technology, Engineering and Math (STEM) fields, then we can simply adjust the size of the grants to match the specific policy goals.
Since the case for subsidizing higher education typically rests on its value to society, it stands to reason that it would be more efficient to target programs with the greatest impact on overall welfare (assuming, perhaps unrealistically, that the political process can distinguish between the welfare implications of various programs). This could be as broad as limiting funding to certain departments or majors, or as specific as limiting the funding to certain courses. Such a scheme would be nearly impossible under the current system, but would be relatively straightforward under a student grant system.
Changes in Political Activities
Another set of advantages of moving toward a student funded system can be thought of as a reordering of priorities. The first of these is a shift in emphasis for colleges from needing to please governments to needing to please students. With the current system providing subsidies directly to the public colleges and universities, they have stronger incentives to satisfy the demands of lawmakers and politicians than to satisfy the demands of their students. Colleges that depend upon the state government for their biggest share of revenue are quite focused on keeping the state government happy, and employ an army of lobbyists and public relations specialists to manage public opinion and ensure that the money continues to flow.
Just as colleges have adopted lobbying practices when much of their funds come from the state legislature, they will increase their efforts to ensure student satisfaction when more of their funds come from students. Subsidizing students directly will make them the source of a much greater percentage of the schools’ revenues than is currently the case. If all state subsidies are converted to student grants and become tuition revenue for the colleges, the students would be the source of roughly 40 percent of revenues at public degree-granting institutions. This will make students’ tuition by far the largest source of revenue for colleges, which will help to refocus colleges’ efforts towards ensuring that they are providing what students need.
The second main shift in priorities under a student funding system concerns legislators, and will ultimately result in less political interference in the operations of colleges. Direct state appropriations are a Faustian bargain for state colleges in the sense that it ensures their continued existence but also opens them up to undesirable meddling by politicians. As Armen Alchian noted, “Having accepted almost exclusive dependence on financing directly from the political and legislative processes, they should not complain of ‘political interference’ when that same political process examines more intently the budget and the operations of the university."
Colleges have been relatively unmolested by politicians compared to what will happen in the near future as the public tires of paying ever more tuition and ever more taxes. Unless current trends reverse, a backlash is coming and colleges will be on the receiving end of it. Fortunately for colleges, funding students instead of institutions can drastically reduce their vulnerability to political interference while maintaining their revenue (in the aggregate). By switching from an institutional to a student funding model, the primary public policy question becomes “how many and which students do we want to encourage to attend college, and what do we want them to do while there” instead of “how should colleges spend the money we give them.” Moreover, from the institutional point of view, it will be much easier to maintain spending on programs that give money directly to voters than to continue to rely on the state appropriations process, as many colleges are seen as elitist and inefficient.
The Big Three Questions
Switching from funding institutions to funding students will raise a number of new issues that are largely avoided under the current system. The answers to these three questions will largely determine the effects of the new system.
Question 1: Who Is Eligible for the Grants?
The first big question that needs to be answered is who is eligible for the grants. With direct state appropriations to colleges, this issue is largely outsourced to the admissions offices of the colleges. Under a student funding system, this question would need to be addressed directly.
The easiest allocation scheme would probably be to continue to rely on colleges’ admissions offices, and only make grants available to those that have been accepted to a college. However, many different schemes are possible. For example, if a more egalitarian outcome is desired, grants could be given to every high school graduate, or all students that meet a minimum score on entrance examinations.
In addition to having a number of options for determining initial eligibility, continuing eligibility could also be modified substantially. Currently, as long as the student is enrolled at a college, they receive an implicit subsidy. Under a student grant system, a time or credit limit could be placed on the awards, encouraging students to graduate in a timely manner. Another option would be to enact a minimum GPA or class rank requirement to incentivize and reward hard work.
Question #2: How much do they get?
The next question that needs to be addressed is how the amount of the grants will be determined. Under the current system of institutional subsidies, public colleges and universities effectively distribute the subsidies equally across all students. While this amount depends on the college attended (and there are large differences between colleges), at a particular college, we currently give everyone essentially the same subsidy.
This distribution could be replicated under the grant system by giving every student at a particular college the same amount, but allowing this amount to vary by college so as to reproduce the current distribution of state appropriations. However, it is clear that merely reproducing the existing distribution of aid is not ideal since it will not change the behavior of colleges.
Specifically, the two main rationales for public subsidies for higher education are to enhance equality of opportunity and to internalize positive externalities (when social rates of return are larger than private rates of return). Giving each student at a school the same implicit subsidy is a very costly method of achieving these goals, since much of the money will go to students who are likely to attend college anyway, or to students that are unlikely to graduate (and therefore don’t shower others with positive externalities).
Thus, if we wanted to do more to equalize opportunities, the grant amounts could vary based on parental socioeconomic status, with those from disadvantaged backgrounds receiving larger grants. This is just one example of a scheme that would make student specific characteristics the determining factor for aid as opposed to the current system where aid is based on the institution attended. Another would be to establish minimum requirements or a sliding scale of funding based on an objective performance measure such as GPA. This would help increase student effort and performance, though it would likely lead to grade inflation as well.
Any attempt to use individual subsidies as a specialized policy instrument should be approached with caution. Introducing excessive political intervention and exposing funding decisions to the whims of politicians could ultimately lead to lower academic quality and wasteful allocations of money and talent. With the possible exception of the two just mentioned, governments should probably not make too many adjustments based on student specific characteristics.
One possible exception would be encouraging students to select fields that have the largest externalities by offering them larger subsidies. Currently, we basically provide the same subsidy to those majoring in fields where we have a shortage as we do to those where there is a surplus. This is an inefficient use of public money, since the marginal externalities in the fields with a shortage are likely to be much higher than the marginal externalities in fields with a surplus. A better use of money would be to provide larger grants to students pursuing an education in high need areas such as nursing and the STEM fields. However, such a scheme should only be pursued if differential funding is determined by objective criteria, such as Labor Department projections, or prevailing market wages, since any subjective criteria would likely be mangled by the political system, and would not likely be an improvement over a flat rate grant.
Question #3: Where can they spend it?
A related issue is institutional eligibility. It must be determined what restrictions, if any, should be placed on where students will be allowed to spend their grants. Some restrictions are desirable to avoid subsidizing diploma mills, though there are several routes that could be taken.
The most conservative option would be to restrict grant use to public universities. However, this obscures one of the major features of a student grant program, which is that without state appropriations being made directly to universities, there really isn't that much of a difference between public and private universities. While it may be desirable to restrict grant use to formerly public colleges during a transition phase, over time, the grants should be able to be spent at any accredited college. While this would certainly open up public universities to more competition from private ones, it would also free them from onerous regulations and political meddling that often prevent them from acting in their own best interests.
A great deal can be learned by looking at some real world examples of reforms in the spirit of those outlined above. We'll review a brief background on several of these efforts.
The Pell Grant Program is a federal program that has provided students from low income families with grants to help pay the cost of college since the mid 1970’s. The grants are awarded to students from low income backgrounds, with the size of the award depending on the cost of attendance and the students expected family contribution, though in practice, the latter is all that matters for most students. The grants can be used at any institution eligible for Title IV funding, which includes most public, private non-profit, and private for profit schools.
The GI Bill
Numerous GI Bills have been enacted over the years in the hopes of encouraging veterans returning from war to continue their education. The basic structure of the bills has been broadly the same, with students receiving a certain amount (depending on their contract with the various services) for use at most accredited colleges. One interesting variation on the latest GI Bill, which became effective in 2009, is that the amount of the award now varies geographically. The portion of the award used to pay tuition is set to cover costs at the highest in-state tuition at a public college in the state where the institution is located. In other words, the amount received varies based on the state the veteran goes to school, with the highest award in Texas, which pays up to $1,471 per credit hour, and the lowest in Puerto Rico, paying $90 per credit hour.
Georgia’s HOPE Scholarships
The Georgia HOPE Scholarship Program (Helping Outstanding Pupils Educationally) was established in 1993 as a merit-based scholarship funded exclusively by revenue from the Georgia Lottery. In order to be eligible for the program, high school students must be Georgia residents with a 3.0 grade point average at a college preparatory school, or maintain a 3.2 grade point average for other diploma types. Eligible students are awarded full tuition at public institutions, whether attending full or part-time, in addition to a book allowance and other HOPE-approved fees. Recipients attending private institutions currently receive $1,750 per semester ($1,666 per quarter) attending full-time, and $875 per semester ($583 per quarter) when attending part-time. The HOPE Scholarship is available to students attending an eligible public or private college, university or technical college in the state of Georgia.
Florida’s Bright Futures
Created in 1997, the Bright Futures Scholarship Program grants academic aid to students based on merit. The program is similar to the Georgia HOPE Scholarship in that it is wholly funded by the Florida Lottery. The Bright Futures Program is divided into several tiered requirement levels, with accompanying reward levels. Students must graduate from a Florida high school with a 3.0 grade point average and earn a minimum score on either the CPT, SAT or ACT. While the amount of the award is commensurate with academic achievement, the average cost per award for the 2008-2009 school year was $2,533604. The award can be used at public or private schools within the state.
Colorado’s College Opportunity Fund
In 2004, Colorado created the College Opportunity Fund (COF), which initiated a system of individual subsidies called stipends. These stipends were available to all in-state undergraduate students enrolled at any of Colorado’s state colleges and universities. They carried a limit of 145 credit hours, and once exceeded, the student was generally no longer eligible for the stipend. The legislation also created a program of “fee-for-service” and performance contracts, which have been used to “hold institution harmless.” These features were enacted to ensure that institutions did not lose revenues under the new scheme.
The previous attempts at instituting student grant systems have provided a number of lessons that should guide future reform efforts.
Lesson number 1: Student grant systems can increase access to college.
The lesson that is perhaps the most important to many people is that a student grant system can increase access. This is not much of a surprise, since it would be truly odd if giving people money to go to college discouraged them from going to college. But it is nevertheless reassuring that the empirical evidence from a variety of the programs above are consistent with increased access. Pell grants are widely cited as enabling low income students to attend college, and previous G.I. bills have been effective at increasing years of schooling and the college completion rates for veterans. In addition, is has been estimated that Georgia’s HOPE scholarship increased college attendance by 8 percent, and Florida’s Bright futures scholarship program has been linked to increased college preparation and attendance.
Lesson Number 2: Student grant systems can be designed so that they do not lead to higher tuition.
One concern among many scholars is the potential impact that aid programs can have on the tuition charged by colleges and universities. For instance, the Bennett Hypothesis holds that the money provided by aid programs will simply be harvested by colleges in the form of higher tuition, leaving students to pay the same amount they would have without the aid. Prior research has been unable to either confirm or deny the validity of the Bennett Hypothesis for aid in the aggregate. While it is possible that a student grant system could be structured and funded in such a way that the Bennett Hypothesis would hold, our own research has indicated that this is not a concern for current student grant systems that are means tested and modest in size, such as the Pell grant.
Lesson Number 3: Do not confuse changes in the structure of funding with changes in the level of funding.
It is important to make a distinction between the structure of the funding and the level of the funding. The structure of funding refers to who gets the check from the government, institutions or students. This is the focus of this chapter. But there are also questions about the level of funding - how much money is disbursed. While this is not a focus here, these two concepts are often mashed together when moving from one structure to the other, potentially leading to confusion.
Some people look at the Colorado COF program and conclude that student grant systems are a failure since the cost of college continued to increase. However, this is largely an instance of confusing the structure of funding with the level of funding. A Blue Ribbon Panel that was created prior to the adoption of the COF recommended that the stipend be $4,000 annually for a full-time student,609 which would align the stipend with the overall level of state appropriations at the time. Instead, the stipend was set at $80 per credit hour, or about $2,400 a year for a full time student. This amount was “roughly equivalent to the level of state appropriations per FTE … [of] the lowest-cost public institutions in the state.” In other words, the stipend revenue essentially replaced state appropriations at the level of the lowest cost institutions. This low stipend was then supplemented at higher spending colleges with fee for service and performance contracts. Thus, with few new incentives to cut costs and tuition, it is unremarkable that net-tuition rates would rise, as they did throughout the country.
Lesson Number 4: Do not vary the award based on the institution attended.
Another lesson is that the grant amount per student should not vary based on the institution attended. To begin with, giving larger grants to those that attend certain colleges will reintroduce incentives for lobbying and political interference. In addition, it can lead to inequitable situations. One recent example of this is the newest GI Bill, which was designed to cover the cost of the most expensive program at a public university in each state. While this sounds quite reasonable at first, various quirks quickly revealed how misguided the idea was. The presence of a small but expensive program, such as a flight school, in one state would lead to a dramatically different award amount than in a state that kept tuition down through very generous state appropriations. Thus, in South Dakota, the maximum award per credit hour was less than $100, while in Texas, it was over $1,400.
Lesson Number 5: “Hold the institution harmless” clauses undermine some of the main benefits of switching systems.
While perhaps necessary during a transition phase, arrangements that seek to preserve the existing distribution of funding among institutions largely castrate some of the main benefits of switching to a student grant system. This is most clearly illustrated examining the Colorado COF. Recall that the legislation establishing the stipends also provided fee for service and performance contracts. These were designed to ensure that individual colleges and universities did not lose revenue under the new system. When this occurs, not only is the competitive enhancement of a student grant system lost, but the colleges will also still have a strong incentive to continue lobbying the state government to maintain their privileged position.
Lesson Number 6: Awareness and predictability are important to ensure that disadvantaged populations participate.
If the system is too complicated or intimidating, it is likely to result in low participation rates among already disadvantaged students, who may not possess the skills, confidence, or knowledge to complete an intimidating and complicated application process. This lesson is most clearly demonstrated by the Colorado COF and the Pell grant. With the COF, minority students and students at community colleges were much less likely than their peers to authorize their COF-stipend initially. However, the differences in participation between community colleges and four-year institutions fell dramatically over time, and became completely insignificant by the third year of the program. This suggests that the problems were largely eliminated as students became more familiar with, and institutions became more adept at assisting students with the program. It is possible that a more aggressive, coordinated, and consistent awareness campaign could have eliminated the initial discrepancies.
Pell grants suffer from this problem as well, though the problem may have more to do with a burdensome and uncertain aid application process than a lack of awareness about the program and its benefits. Either way, there are a “large and growing number of lower income college students who do not apply for aid, even though they are likely eligible for a Pell grant: an estimated 1.5 million in 2004.
U.S. higher education has seen a remarkable increase in costs over the past few decades. While there are many different factors that affect the cost of a college education, the current structure of subsidization fuels, at least in part, these increases. The system of subsidizing colleges and universities directly creates perverse incentives for colleges and universities to increase spending. Shifting away from the current system of providing large subsidies directly to the institutions, and towards a new system that provides educational subsidies directly to individual students would help mitigate the recent cost increases by forcing institutions to compete for subsidy revenues by demonstrating the beneficial outcomes for students rather than currying favor with legislatures. While simply changing the funding structure will not be a panacea for all the current woes, it is a step in the right direction.