Paul L. Caron
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Wednesday, February 27, 2008

Becker & Posner Debate Desirability of Forcing Colleges to Spend 5% of Their Endowments Annually to Curb Rising Tuition

Gary Becker and Richard Posner debate Senator Grassley's concerns about the rising college tuition in the face of burgeoning college and university endowments:

Becker:

I do not deny that colleges invite criticism when they increase tuition while their endowments are increasing by a lot. Although it seems much more natural and appropriate for colleges to lower tuition when their endowments grow, there is a powerful reason why endowment growth is often accompanied by a growth in tuition. A rapid increase in endowments, even by schools that spend a small fraction of their endowments, enable schools to spend more resources on increasing the quality of the college education they offer. They would tend to attract better teachers and researchers, provide smaller classes, enlarge their libraries and other information storage and dissemination facilities, and provide better athletic facilities and other amenities. These improvements in what a college offers in turn helps attract students who are willing to pay higher tuitions. Since American colleges are in a highly competitive environment, they tend to raise tuition when they can attract good students who are willing to pay more.

Although I disagree with Senator Grassley and other Congressmen about whether we should be concerned by the sharp increases in tuition, I do agree with him and other critics that colleges should spend a larger fraction of their endowments. However, my reasons are very different from theirs, and I certainly do not believe that schools should be required by law to spend a larger fraction of endowments. The problem I believe with the governance of many schools is that their boards of directors believe they are managing financial assets that should be maintained, and preferably increased, in perpetuity. In my judgment the major goal of presidents and boards should be to improve teaching and research, and that may well mean spending much more than the income from endowments.

Of course, the persons in charge of a college's governance should be concerned about the effects of spending down endowment on the college's future financial strength. However, colleges that compete well against their peer schools generally attract more generous private and public contributions. As a result, schools that spend wisely higher percentages of their endowments may well increase, not decrease, future endowments. Likewise, schools that refuse to spend more than a rigidly fixed percent of their endowments may experience a decline in their competitive position that will tend to reduce their ability to attract contributions in the future. Therefore, boards of directors that do not allow greater spending because they want to maintain, or increase, their schools' endowments could be responsible for reductions in future endowments.

In arguing this I am partly influenced by the experience of the Olin Foundation. This was a large foundation that explicitly decided to spend down its endowment in order to better accomplish its goals. The Olin Foundation did spend all its endowment on law and economics and other programs, and has essentially now closed its doors. During the relatively short time of its existence the Olin Foundation accomplished far more than most other large foundations do over many more years. I am not suggesting that all colleges follow Olin's example and plan to go out of business- some of them should, however. Rather, I suggest that they should copy Olin's example of trying to be successful now, even if that means spending more than their incomes on attracting and teaching good students, and in producing path-breaking research.

Posner:

The 5 percent rule makes less sense for universities than for foundations. Foundations normally derive all or most of their income from investing their original endowment, and so they are not in competition with each other. Nor have they the spur of profit maximization. They are governed by self-perpetuating boards of trustees; so there is no democratic check either. The idea behind the 5 percent rule is to prevent the hoarding of endowment income, perhaps to provide high salaries and generous perks to staff and to prod the trustees to seek additional grants and thus compete with other foundations. But the prod is slight so long as the average return on investing the endowment is at least 5 percent a year. With inflation currently running at 4 percent, a 5 percent return is easily achieved.

Higher education, in contrast to the foundation sector, is a highly competitive industry, even though most universities are nonprofit. They compete vigorously for students, faculty, and grants, which include alumni donations, foundation and other third-party donations, and government grants; state universities also receive money appropriated by the state legislature, but this is a diminishing source of the revenue of major state universities such as Berkeley, UCLA, Michigan, and Virginia. The different sources of income are complementary: good students attract good faculty and vice versa, and a university's academic standing attracts donations and grants. The universities' principal income consists of tuition plus donations and grants plus endowment income, but some universities have income from television contracts for their athletic teams, and others have income from patents developed by members of their faculty. The major universities not only have large endowments but also receive large annual gifts from alumni and others. Generally, wealthier universities are better, or at least more prestigious, than poorer ones, and so they can and do charge very high tuition even though they could "afford" to charge lower, or even zero, tuition; but that would not make economic sense for them.

Given the competitive structure of higher education, it is hard to see why government should step in and try to limit tuition. The universities have a competitive incentive to provide financial aid to highly promising applicants who cannot afford full tuition; why those who can afford to pay for it should not be asked to pay for it escapes me. Forcing abolition of tuition would be a subsidy for rich kids. If universities were somehow prevented from charging tuition, moreover, applicants and their families would not have to think carefully about educational options. A free university education would be attractive to many people for whom it would be a poor investment if they had to pay stiff tuition, though it would not be completely free in an economic sense because they would have to forgo income from working. And a 5-percent-fits-all solution would make no sense for universities that had very small endowments and good reasons for wanting them to be larger.

The difficult question involves the federal income tax exemption for donations to universities. It is a legitimate question why the federal taxpayer should be subsidizing Harvard, with its $35 billion endowment. The only justification would be if the type of research and teaching that goes on at Harvard or the other major universities generates external benefits that, were it not for the subsidy, would be smaller by more than the subsidy. This seems unlikely. The cost of the scientific research and graduate scientific training conducted in these universities is already heavily subsidized by federal and corporate grants and contracts; and increasingly the scientific research done by universities is applied rather than basic and so is eligible for patent protection. The contribution of nonscientific fields to welfare is not negligible, but one does have a sense that in many of them the marginal product is slight or even negative--is there really social value in having 400 English-language philosophy journals (the approximate number today) rather than 50? Because universities, though competitive, are not profit maximizers, because of age-old uncertainty concerning the effectiveness of various methods of teaching and the value of various forms of scholarship, and because of a tradition of faculty autonomy reinforced by the tenure system, universities have much the character of workers' cooperatives, which are not notably efficient enterprises.

https://taxprof.typepad.com/taxprof_blog/2008/02/becker-posner-d.html

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