This Thanksgiving, when my cousin raised the subject of gigantic college endowments, my mind went straight to tax (as it does). Coincidentally, I had just read an essay by Professors Melanie McCoskey and Doron Narotzki about recent tax law changes affecting higher education. So, about those college endowments.
The Tax Cuts and Jobs Act introduced a new excise tax on private colleges with large endowments (I.R.C. § 4968). The tax, which applies to colleges with endowments of at least half a million dollars per student, equals 1.4% of their net investment income. Relatively few colleges are hit by the tax, and the authors include a list of the 25 that were. There aren’t many shockers on the list, but some may be surprised to learn which schools are not listed. The bottom line: to get hit by this tax, a school’s endowment not only needs to be gigantic, but it needs to be really gigantic.
Nevertheless, Professors McCoskey and Narotzki make a compelling case that the new tax is bad news for economic diversity at these elite universities. Affected schools will be forced to make cuts in their discretionary spending in order to pay the excise tax, and an easy way to make those cuts is by scaling back on scholarships. Since virtually all of the scholarships these schools provide are need-based, any scaling back of scholarship payments could severely limit access for low- and middle- income students. If the authors are right, then the excise tax may be another example of a tax law that fails to advance its policy goals.
But what exactly are the goals of this tax? To shed light on what may have motivated the excise tax, the authors review the legislative history, beginning with a predecessor: excise taxes on private foundations. Private foundations have been subject to excise taxes since 1969. The taxes were defended as necessary to curb abuse and compensate the government for the cost of monitoring them. However, the authors seem unconvinced by this account, suggesting that the tax on private foundations was penal.
Moreover, they observe that “a tax on private schools with high levels of endowments per student could also be viewed as punishment by the current administration.” Here, they hold up law professors as evidence. According to the authors, law faculty at the affected universities give disproportionately to Democrats, providing a reason for the conservative administration to target them. Then again, the same can be said about many other law faculties, so that explanation seems partial at best.
Next, the authors turn to more innocent explanations. They recall a 2008 quote by Iowa Senator Chuck Grassley asserting that “[i]t’s fair to ask whether a college kid should have to wash dishes in the dining hall to pay his tuition when his college has a billion dollars in the bank.” Though Grassley sounded the alarm, the issue was dropped when the Great Recession began. Endowments, like the rest of the market, took a hit in the recession. But by 2015, it was reported that college endowments had averaged a 15.5% return in 2014, and they only paid out 4.4%. That report caught the attention of Congress.
It is possible, then, that the excise tax was born from the sentiment that colleges’ failure to spend enough from their endowments is unfair to students, many of whom incur significant student debt to attend. Then again, the authors point out that “the average three-year return is 4.2%, the five-year return is 7.9% and the ten-year return is 4.6%.” This makes the 4.4% payout rate seem much more defensible. Besides, if the goal is to encourage payouts, then an imposition of payout requirements would seem like a better approach.
Another possibility is that Congress worried about the concentration of wealth at a handful of elite universities. According to a Congressional Research Service report, “11% of institutions [hold] 74% of all endowment assets in 2014. Institutions with the largest endowments (Yale, Princeton, Harvard, and Stanford) each hold more than 4% of total endowment assets.” But it is very hard to see how the excise tax would address problems associated with concentrations of wealth.
First, the tax itself is based on the size of investment returns, not the value of endowment assets—it is too small to break up the concentration of wealth. Second, there are no signs that the tax is part of a broader redistributive policy. The amount of money the tax will raise is only a “drop in the bucket,” according to the authors’ calculations, and there is no immediate plan to redistribute that revenue to students. Plus, if the authors’ predictions about scholarships are right, the tax may target the “rich” but actually burden the poor.
Ultimately, the authors shy away from providing their takes on what is really driving the excise tax, perhaps because the policy rationale is so hopelessly muddled. But one thing seems clear: the new excise tax on endowments is unlikely to result in larger payouts to students. As a result, it is unlikely to increase economic diversity in higher ed, and it may well hinder it.
This essay provides a concise overview of the excise tax on endowments, as well as changes to qualified tuition programs, the repeal of the higher-education deduction, the taxation of student loan discharge, and various other changes that have not been enacted. I recommend this essay to any tax scholar who is interested in education or inequality.