The Federal Role in Pricing

Persistently rising college tuitions, high spending per student, and mounting student debt burdens have re-emerged as key issues in Washington. Secretary Arne Duncan has called on college and university officials to show more urgency in keeping down their prices and spending, the House subcommittee on postsecondary education has held another hearing to wring its hands about college unaffordability, and President Obama has now summoned a select group of college presidents and higher education thought leaders to consider what can be done. 

Federal efforts in the past have focused on shining a spotlight on institutions with the highest rates of tuition growth and exhorting college officials to do more to restrain their spending growth and rein in their price increases.  Recent news stories indicate that these largely symbolic approaches will continue to dominate the debate as the focus seems to be on extolling the virtues of those schools or states that freeze or reduce their tuition levels, move to three-year degrees, measure learning outcomes, or find ways to use technology to lower their costs per student and hopefully their prices

But these efforts are unlikely to yield satisfactory results, just as previous efforts have failed to slow cost and price growth or to reduce the amount students must borrow to pay for their education and related expenses.  They will continue to fail unless the aim is to reshape the relationship between governments and institutions and the rules that determine how much students can and do borrow.  Federal and state officials must recognize that the signals embedded in a number of policies have contributed to the past growth in costs, prices and student debt -- and then do something about it. 

A good place to start this effort would be to get the facts straight.  The higher education debate in recent years has been littered with many misstatements that make it difficult to have an honest discussion about what needs to be done.  It is asserted that many potential students are being scared away from higher education by the higher prices, that attainment -- the percentage of adults with degrees -- has been flat for decades, and that federal and state funding of higher education is dwindling.

The facts, though, are that enrollments are at an all-time high of 20 million students annually, degree attainment rates for all age groups have risen consistently and sometimes very rapidly for more than half a century, and public funding of higher education has increased at an explosive clip over the past decade.  Pell Grant spending and tuition tax credits more than tripled in real terms from 2000 to 2010, while federal funding of university-based research and federal student loan costs for interest subsidies and defaults grew by at least 50 percent in constant dollars during the past decade.  Even state and local funding of higher education grew by 10 percent in real terms during the 2000s; it’s only when the rapid increase in enrollments over the past decade is factored into the equation that state and local support on a per-student basis shows a significant decline in constant dollars.

Two of the statistics that have been accurately portrayed in recent debates are that college charges have increased at more than twice the rate of inflation over the past several decades and that student loan debt burdens have grown enormously, both in terms of the number of students who borrow and in how much they borrow.  These are the troubling statistics that need to be addressed.     

In trying to figure out what might be done to lower the rate of college tuition increases and reduce student debt burdens, it is worth first considering the following economic proposition:  In the absence of federal, state, and local government financing of higher education, the sector would produce far fewer students and graduates, at much higher prices than is currently the case.  In this model, government financial support flows from the belief that higher education is a public good that requires it be offered to a larger share of the population and at more reasonable prices than what the private sector would provide on its own.

At the state and local level, this public intervention in higher education occurs principally in the form of operating support that allows public institutions to charge much less than what it costs per student to provide that education and a financial capital commitment to build enough seats at public institutions to ensure that many more students are able to attend than what private entities would offer.  States and local governments now spend roughly $80 billion annually to support current operations, and despite recent slowdowns in funding and large increases in tuition and fees over time, they still provide far more than half of what public institutions spend on instruction and administration.

Another key aspect of state policy is that most states limit how many students can enroll at their best public institutions below what would typically be demanded at those subsidized prices. The unintended consequences of the combination of these longstanding policies may be that public institutions typically spend much more per student than they would if they were strictly private entities.

One principal federal intervention in the higher education market stemming back more than a half century is the provision of student financial aid in the form of grants, loans and work-study funds, as well as service-related benefits such as the GI Bill and a range of tax-related benefits that help students pay the prices charged by a wide array of public, nonprofit, and, increasingly, for-profit institutions. 

With recent large increases in Pell Grants and tax provisions, the federal government now spends roughly $100 billion annually in support of students in the form of non-repayable aid, tax breaks for students, and loan subsidies and default costs. This demand-driven strategy has certainly worked in stimulating enrollments far, far beyond what the private sector would have provided on its own.  The unintended consequence of these federal policies, though, may be that prices and possibly the spending per student are far higher than they would have been in the absence of federal aid.

The other major federal role in higher education is support for university-based research, which now amounts to more than $50 billion annually and represents well more than half of what universities spend for research.  The volume and variety of the theories, patents and discoveries produced with federal support of research conducted on campus make this undoubtedly one of the great public policy initiatives of the past half century.  But there is also little doubt that the amount spent by universities on research-related activities is much more than what would have been spent if the federal government had not been involved, and has contributed to overall increases over time in spending per student, at least when it comes to the many universities whose faculties conduct that research.  One culprit here is that the federal government, through the indirect cost system that governs federal research grants, reimburses universities for what they actually spend to administer research programs.

The synopsis above suggests that federal policies have contributed to rising prices, spending per student and debt burdens, and that it is thus appropriate for federal policy makers to consider how they might reduce the inflationary forces at work in the current system.

What to Do (and Not)

So what should federal officials do to address these very legitimate concerns?  One answer to avoid is a heavy reliance on regulatory efforts such as price controls in higher education – they will not work in the long run and they will no doubt ultimately lead to a misallocation of resources.  There also is little reason to believe the federal government has the capability of figuring out what the nation’s 4,000 institutions of higher learning should charge to make the system work better.

There is also reason to be concerned about the shift toward much greater federal regulation of the academic functions of institutions that began in the George W. Bush administration and has continued in the Obama administration, in the form of the federal government getting more involved in the accreditation process, defining credit hours, and other intrusions into academic matters.  This flies in the face of what has made American higher education the envy of the world -- a wonderfully diverse system of institutions that blossomed without government controls but rather through a reliance on self-regulation and professional judgment to help assure quality in academic matters.

A much better place for federal officials to address the very legitimate and pressing concerns about ever-growing college prices and wrenching student debt burdens would be to change the signals that institutional officials receive from federal policies for student aid and university research that lead to price and cost escalation rather than moderation.  In addition, federal officials might consider how they could encourage states to change their funding formulas in ways that slow cost and price growth.

In terms of federal aid and its effect on prices, I argue that Pell Grants have not had much of an effect on the prices that institutions charge in part because the size of the grant a student receives is not tied to the price of the college he or she attends. I think the bigger concern for Pell Grants is a possible substitution effect whereby their growing availability may have been an important factor in the documented shift over time of institutional aid funds and discounts away from the poor and toward middle class students. In this regard, a big unanswered research question is whether the recent huge increases in Pell Grant funding in the past several years have further increased the degree to which institutional aid is being shifted up the income scale. Stay tuned.

But student loans are the bigger concern when it comes to the possible effect of federal policies on pricing. Although there is no definitive causal evidence, there is a strong correlation over time between student and parent loan availability and rapidly rising tuitions. Common sense suggests that growing availability of student loans at reasonable rates has made it easier for many institutions to raise their prices, just as the mortgage interest deduction contributes to higher housing prices.

It is also the case because of student loan program design that the only students who now pay full price are those from wealthier families and many of the students who borrow because sticker prices are used to determine student loan eligibility. It is this feature of the student loan structure than needs to change if the pattern of ever-mounting student debts is to be reversed.

Skin in the Game

In short, institutions must have skin in the game if we are to put a dent in the size of student debt burdens.  Currently, colleges can just maintain or raise their prices and shift the cost-sharing to loans for a broad range of their students. This needs to change. One way to accomplish this would be to require that needy students not receive all their aid in the form of loans.  In effect, this would mean that institutions must offer discounts to their needy students who borrow, thereby reducing their debts.

Moreover, something has to be done about how much students can borrow for living expenses.  Now, community college students who face $2,000 or $3,000 in tuition and fees are eligible to borrow $10,000 or more to cover their total expenses.  This applies at all institutions for students who live at home or off campus.  This provision should be changed so that reasonable limits are placed on how much these students can borrow.  Ditto for students living in dorms or on meal plans – they should not be allowed to borrow excessively large sums for this form of consumption.  Such a change would likely have the beneficial effect of reducing how much institutions charge for these non-education services.

We must also change the borrowing policy for students taking remedial courses.  Currently, because federal student grants do not cover the full cost of remedial coursework, most students who require remedial work are forced to borrow large sums to pay for courses that do not provide college credit.  We should move instead to a performance-based system in which students would not be charged tuition for remedial courses and the providers of remediation would be  paid a fee by governments for doing so, with the providers who do the best job of increasing the competencies of these students getting the most reimbursement and the most business.

Another necessary student loan reform is to reduce federal student loan subsidies while the borrower is in school.  Under the current rules, students with family incomes well in excess of $100,000 attending higher-priced institutions qualify for federal payment of interest while they are in school (including while they attend graduate school).  This provision should be eliminated or at least limited to Pell Grant recipients. This may seem harsh medicine, but the benefit is very expensive, not well-targeted to those most in need, and serves as an incentive for students to borrow more than they otherwise would.   Maybe this is one area where bipartisan agreement could occur, as the House of Representatives has made such a proposed this year.

The proper way to deal with the issue of reducing heavy repayment burdens is to allow students to repay based on their post-college income, as the Obama administration, to its credit, has recognized.  What administration officials don’t seem to have recognized, however, is that ameliorating the adverse effects of high debt levels through income-contingent repayment serves as a further encouragement to institutions to keep their prices high and let the loan system deal with the consequences.

In the case of federal support for university research, we should move to a system of uniform indirect costs in which all universities are reimbursed the same amount for their administrative costs regardless of whether they rent or own their facilities and buy or lease their equipment.  And we need to eliminate or sharply reduce earmarks for university research facilities, as Congress somewhat reluctantly has done in the last year. The earmarks lead to higher costs just as in other cases when politicians decide who gets public funds, costs tend to rise.

At the State Level

For state governments, the biggest cause for concern is when the state funding formula is based on how much each institution spends per student. This is an invitation for cost creep -- when institutions are paid of the basis of how much they spend, they are likely to spend more. This problem could be addressed if states developed formulas that paid institutions on the basis of normative costs -- what it ought to cost to educate a student in a given field of study rather than what it does cost.

Another needed area of reform in state financing is to get out of the mindset that the only way public institutions can react to cutbacks in state funding is to increase tuition for existing students. For a given level of state funding, cost recovery rates can also be increased by increasing the number of students paying current prices. One reason this politically popular solution is not being used more often is that institutional officials – encouraged by their faculty members -- tend to worry more about quality being diminished by having more students than the consequences of limiting access.

One possible solution is for states, rather than capping enrollments, to build enrollment floors that are based on the number of students funded by the state.  Under this arrangement, public institutions would be allowed to decide how many additional students to enroll in various fields of study based on faculty workloads and capacity utilization and whether the marginal costs of enrolling additional students were less or more than the tuition and fees collected from those students.

While the federal government does not and should not have a direct role in decisions about what and how costs are reimbursed or how many students enroll at public institutions, one could imagine the benefits of a federal incentive approach that provided funds to states that adopted these kinds of rules for normative costs and enrollment floors.

So the answer to the question about what federal officials should do is not to rely on spotlights and megaphones to change institutional behavior.  The federal government could take several steps that would help move us in the direction of lower costs and prices and less money borrowed by students. 

But to be successful such an effort requires recognizing that it is never a good idea to pay organizations or people based on what they actually spend because inevitably they will spend more to get more. And it is always a good idea to keep politicians away from how public funds are allocated because that will inevitably result in more money being spent.  If the president’s discussion with the college presidents were to recognize these two principles, we could be well on our way to a more sensible set of federal policies that would limit the growth in college costs and reduce student debt burdens in the future.