Tax Reform Will Be A Boon to Colleges

The Tax Cuts & Jobs Act of 2017 will benefit colleges that disproportionately serve less-wealthy students.

(The below is adapted from FREOPP’s new monograph, Tax Reform: A Boon to Colleges: How the Tax Cuts & Jobs Act of 2017 Improves the Economics of Postsecondary Education. The complete PDF version can be found here. Versions originally appeared at Forbes.)

Donald Trump has signed into law the most comprehensive reform of U.S. tax code in 31 years: the Tax Cuts and Jobs Act of 2017.

Among its sweeping effects on the economy, the legislation is likely to have significant effects on the economics of higher education, and particularly on colleges’ budgets. The Act will have the effect of constraining several of colleges’ biggest sources of revenue, while expanding other sources. The overall impact on the rapid growth of tuition will vary broadly between states and types of colleges, but the preponderance of the legislation’s immediate adverse effects are concentrated among wealthy colleges that primarily serve wealthy students.

A time of soaring tuition

College tuition continues to soar to record highs, having grown 5% annually for the past ten years, as in Figure 1, and has more than doubled in the last 30 years, after accounting for inflation. Today a four-year degree from a public college costs approximately $65,000, and costs $150,000 at a private one, according to the Department of Education. Students borrow increasing amounts in to afford skyrocketing tuition, as shown in Figure 2.

Just 21% of Americans believe that college is affordable, according to Gallup. That’s a serious threat to Americans’ economic welfare considering that 65% of all jobs in the U.S. economy can be expected to require some college or a degree by 2020, according to the Georgetown Public Policy Institute. Employment rates for Americans with college degrees continues to reach new highs, while employment for those with only high school degrees has largely not recovered to levels before the 2008 Financial Crisis, as illustrated in Figure 3.

A college education is already a major economic differentiator: the median income of Americans who haven’t gone to college is $36,000, while that of those with a degree is approximately $60,000: 67% higher, according to the Bureau of Labor Statistics’ Current Population Survey. Yet 52% of employers report they are unable to find the employees they need according to ManpowerGroup’s annual survey.

College is not for everyone, but it is important that every American that wants to get a college education can afford to.

Tax overhaul’s biggest economic effects on higher education

The Act is a sweeping overhaul of federal tax code. It lowers most individual tax rates and adjusts the income levels to which they apply; roughly doubles the standard income tax deduction; limits state and local income tax deductions to $10,000; lowers the effective tax rate for most pass-through filers; permanently reduce corporate tax rates to 21%; allows full expensing of equipment purchases for the next five years; doubles the child tax credit; implements a territorial tax on multinationals that taxes only income earned in the U.S.; doubles the amount excludable from estate tax; allows 529 educational savings plan funds to be used for K-12 and homeschooling; repeals the Affordable Care Act’s individual mandate; and raises the alternative minimum tax exemption for individual and married filers.

Just 21% of college students believe that college is affordable.

“It was a fantastic evening last night,” said Trump reflecting on the Senate’s 51–49 vote approving its original version of the bill. College administrators have generally expressed a less favorable view on the tax reform than the president. “They’re willing to throw higher education and our students under the bus to get a win on tax reform,” said F. King Alexander, president of Louisiana State University, in a statement generally reflective of sentiments expressed by many college leaders.

Discussion of the tax plan’s effect on colleges has generally focused on two topics of only moderate aggregate economic significance: eliminating tax waivers for graduate students and expanding college savings plans. The House version of the tax bill proposed to eliminate graduate students’ ability to exclude tuition waivers — grants covering tuition — from their taxable income. This didn’t survive in the final legislation. The final legislation increased the uses of tax-advantaged 529 college savings plans; now they can be spent on private elementary and high school tuition, and on homeschooling, without penalty.

But the economic effects of these two popular topics on higher education are not nearly as large as other effects of the tax bill, such as limiting state and local tax deductions, doubling the standard income-tax deduction, and — to a lesser extent — introducing an excise tax on wealthy colleges endowments. For example, the controversial and now-abandoned proposal to eliminate of the graduate tuition waiver is a significant concern for the roughly 145,000 graduate students who use it. But by comparison, roughly 16,000,000 college students attend public and private nonprofit colleges, according to the Department of Education’s 2017 Back To School Statistics, and doubling the standard income-tax deduction is expected to reduce charitable donations to such colleges by around $13 billion annually.

Doubling the standard deduction will almost certainly have a greater aggregate impact on the economics of higher education than the much-discussed elimination of the graduate student tuition waiver would have had. The elimination of the tax waiver would have to make a $90,000 adverse impact per-year on each graduate student for the effects of the waiver’s elimination and the doubling of the standard deduction to be remotely comparable in aggregate, and that is unlikely given the graduate student pay less than $4,000 in taxes. (Graduate students earn $29,964 on average according to Glassdoor, and face an average tax rate of under 14%.)

In this paper, we will focus on three of the tax overhaul’s biggest and broadest likely effects of on colleges’ budgets. Specifically, the legislation:

• Limits the exemption for state and local taxes, giving wealthy Americans a new incentive to pressure state and local lawmakers to rein in subsidies for public colleges;
• Doubles the standard income-tax deduction, making donations to public and private nonprofit colleges less rewarding on an after-tax basis for an estimated 40 million Americans who will no longer itemize deductions; and
• Introduces a new excise tax on the investment income of very wealthy universities’ endowments, while potentially boosting those endowments’ returns on equity assets by cutting corporate tax rates

We will examine the merit and impact of these three reforms as they relate to higher education, with particular emphasis on the endowment tax, because for the first time in the republic’s history the federal government is reducing the tax-exempt status of nonprofit colleges.

Limitation of state and local deduction likely to increase scrutiny of college appropriations

The legislation places a limit on individuals’ ability to deduct state and local tax payments from their federally taxable income. Filers will now be able to deduct up to a total of $10,000 of state and local income, property and sales taxes paid.

Capping the state and local deduction — known as the SALT deduction — is a progressive shift in the country’s tax burden, in that it raises taxes on high-income taxpayers. 88% of the soon-to-be reduced deduction’s benefit flows to Americans with income above $100,000, according to the Tax Foundation.

High-income taxpayers in states with high taxes will be the most adversely affected, because they will no longer be able to deduct the highest state and local taxes. Wealthy California and New York taxpayers will suffer the most because of those states’ tax rates; they are expected to pay 30% of the nation’s total additional tax revenues resulting from the deductions’ elimination, according to the Tax Policy Center.

Residents of low- and no-tax states such as Florida and Texas stand to benefit from the deduction’s elimination: they will now pay a reduced proportion of the nation’s federal tax revenue.

Because residents of high-tax states will lose some their ability to avoid paying federal taxes without the SALT deduction, the proportion of federal revenue shouldered by the 72% of taxpayers who don’t take that deduction will decrease.

The SALT deduction’s elimination is causing alarm among college leaders in high-tax states. Wealthy taxpayers will now have an added financial incentive to monitor spending; to pressure lawmakers to lower appropriations, including those to public colleges; and to leave high-tax states.

Randi Weingarten, president of the American Federation of Teachers, which represents colleges’ faculty and professional staff and has 1.7 million members, predicted that removing the deduction will “devastate funding for public schools, infrastructure, law enforcement and other vital services.”

Many states with high individual tax rates maintain large appropriations for colleges. For example, California spends 6% of its state budget supporting public colleges — $13 billion annually — which is roughly $4 billion more than any other state, and 23% more than America’s per-capita average, according to the 2016 report of the State Higher Education Officers Association (the most recent published). California’s large per-capita spending on higher education has not translated into affordable tuition, as in Figure 4.

Chris Hoene, executive director of the California Budget and Policy Center, which has published analyses on the effects of removing the deduction summarized the rationale for concern: “people’s appetites for paying taxes aren’t endless … Certainly, it will have a significant impact on funding education in the future, because the taxes people are paying that are already supporting education will go up.”

Historically it has been easier for lawmakers to cut public college appropriations than to cut those for Medicaid. Medicaid is generally a mandatory appropriation in state budgets, meaning that Medicaid is funded automatically, outside of the normal discretionary appropriations process; whereas public college funding is set by annual appropriations acts. A panel-data analysis of changes to state appropriations over time by Brookings found that 6% of reductions in public college appropriations are associated with increases in Medicaid funding, controlling for other changes to state budgets.

Given that the 50 states are expected to have spent a combined $227 billion on Medicaid in 2017, as compared to $65 billion on public colleges, according to the latest estimates from Statista and the DOE, small percentage increases in Medicaid funding can be expected to have significant adverse effects on college funding.

The second biggest spender on public colleges — after California — is Texas, which has no state income tax and appropriates roughly $8.5 billion annually for colleges. That’s roughly the same amount spent on public colleges per-capita as California.

How can Texas afford such large overall and per-capita spending on higher education without state income taxes? Part of the explanation is that California spends roughly $15 billion more (of state funds) on Medicaid annually according to the Medicaid and CHIP Payment and Access Commission. That is to say: California’s tax burden isn’t being predominantly driven by spending on public universities, but by spending on health care entitlement programs.

Not only will wealthy taxpayers in high-tax states have an added incentive to demand reduced state appropriations and taxes, they will also have a stronger incentive to move their residences and businesses to lower-tax states once the SALT deduction is repealed. The SALT’s repeal “will push the rich toward states with lower levies, like Florida, Texas, Nevada, Washington and Arizona,” wrote Ray Dalio, who runs Bridgewater Associates, a large investment firm and taxpayer in Connecticut, which has the second highest tax burden in the country, according to the Tax Foundation.

Eliminating the SALT deduction will also create an added incentive for wealthy residents of high-tax states to demand greater transparency with regard to how college appropriations are spent and the outcomes they generate.

States’ tax burden isn’t being predominantly driven by spending on public universities, but by spending on health care entitlement programs.

Until now, there has been comparably little interest in closely examining state government expenditures, even though roughly 87 college administrators are hired every day — 517,636 from 1987 to 2012 — far exceeding growth in enrollment, according to the American Institute for Research. There are now two non-academic employees at public colleges for every tenure-track faculty member.

Less than half of the 76% of adults who use the internet to search of for data about the government every year ever search for information about state governments, according to the Pew Research Center. But interest in transparency initiatives like Reclaim New York, which collects, organizes and publishes checkbooks of state and local government, may increase as a consequence of the SALT deduction’s elimination.

State, local appropriations pay one-quarter of public colleges’ costs

State and local appropriations are a major source of funding for public colleges, comprising 23% of the $336 billion those colleges spend every year, according to the National Center for Education Statistics’ 2016 Digest of Education Statistics. State governments spent more than $65 billion on public, degree-granting colleges in the 2014–2015 academic year, the most recent year for which data are available from the Department of Education. Local governments spent an additional $11 billion.

That state and local total of $76 is significant in the context of government support for higher education. To put it in perspective, the federal government spent a total of $27 billion awarding Pell grants to 7.1 million students for the 2016–2017 academic year, according to The College Board’s 2016 Trends in Student Aid. (Spending on federal loans is a less straightforward comparison due to differing methods for estimating the timing and magnitude of student’s repayment.)

Reducing taxpayer funding for colleges increases out-of-pocket spending by college students

When states reduce the growth of appropriations to public colleges, those colleges generally tend to raise tuition to replace that lost revenue, rather than reduce costs.

One fact is generally not in dispute: most of the explanation for tuition increases at public colleges is unrelated to appropriations cuts. Research on the causes of tuition inflation consistently supports the conclusion that cuts in appropriations explain less than half of the total increases in public college tuition since 2000.

On average, every dollar states have cut in appropriations for public colleges since January 2000 has been associated with a 31-cent increase in tuition, according to a study by Douglas Webber in this October’s Economics of Education Review. Webber’s estimate is especially convincing because he has repeatedly revised his methodology, incorporating additional explanatory variables that together make one of the most comprehensive and convincing cases for explaining causality.

Since 2008, the average annual tuition at public colleges and universities has increased 33%, or $2,333. Public tuition has increased in all 50 states, while 46 states are spending less per-student than before the recession, according to the Center on Budget and Policy Priorities. (That analysis accounts for both consumer price inflation and the roughly 12 percent increase in enrollment during the same period.)

The 2008 crisis was followed by significant reductions in state spending, but following 2008, funding cuts were not been the majority explanation of tuition increases. In the five years following the crisis, tuition increased at a similar rate to appropriations cuts: states reduced spending per-student 28%, while tuition increased 27% at four-year public colleges, nationwide, on-average, according to tabulation by the CBPP.

But still, most of the that tuition increase was not caused by appropriations cuts. Webber estimates that since the 2008 recession, on average, every dollar of appropriations cut resulted in a 41-cent tuition increase, a reminder that there are substantial drivers of post-2008 tuition inflation that are unrelated to funding cuts. Other studies put that estimate as low as 5-cents, which would enhance the conclusion that colleges were raising tuition for other reasons, but Webber’s methodology is the most convincing for the reasons above.

In cases where college students are significantly wealthier than the taxpayers funding their education, it is only right to shift the burden of paying for a public college education onto those wealthier students.

This is not the case with low-income students, but it is the case with the majority of students.

The majority of students attending public colleges have higher income families than the average taxpayer subsidizing their college education. The median parental income of incoming college freshmen is generally much higher than the average taxpayer’s median income — roughly 60% higher, according a landmark panel-data study by the Higher Education Research Institute that drew attention to this disparity 10 years ago.

Low-income students are not only less well-off than most taxpayers, but also for them the cost of attending college is disproportionately unaffordable.

A 2013 study by The Pell Institute for the Study of Opportunity in Higher Education indicates that for students whose families were in the second-lowest income quartile, the net price of attending college consumed 35% percent of the family’s income, on average. But for students whose families were in the lowest income quartile — the least wealthy Americans — the net price of attending college consumed 84% of the families’ income, on average. College is patently unaffordable for low-income Americans.

Shifting the burden of paying for college from taxpayers onto low-income students — such as in the case of rising tuition — is a regressive and significantly adverse social outcome.

It is regressive because these students have lower incomes than most taxpayers; and it is socially adverse because, for these students, college is highly unaffordable, especially in families with siblings wishing to attend college, or if students are guardians with childcare expenses.

Shifting the burden of funding college education onto students themselves is more reasonable for wealthier students, though unacceptable for lower-income students.

Public college subsidies may constrain low-income Americans’ opportunities

Subsidies made directly to colleges are not the best way to make college affordable and accessible. State governments generally choose which colleges will receive taxpayer dollars, and how much support each of those college will receive.

But states don’t do a very good job at allocating funding to the colleges that will provide students with the educational opportunities they want. Bridget Terry-Long, professor at the Harvard Graduate School of Education, conducted a landmark study measuring the effectiveness of states’ allocation of public college funding.

Subsidizing colleges instead of college students holds lower-income Americans back from getting the college education that best suits them.

Terry-Long measured a vast array of attributes of students at 2,700 U.S. colleges to learn about why students choose to attend their particular colleges. The measured attributes included everything from students’ chosen colleges’ distance from their home, to individuals’ standardized test scores, to intended majors, to their program’s graduation rate. Her findings published in The Review Economics and Statistics, show, perhaps unsurprisingly, that affordability is a key decision-making factor for students who choose to attend a public college. But she also found that the colleges which states subsidize and make more affordable are often not the colleges their residents want to attend. Terry-Long calculates that if states’ subsidies were given to students to spend at any public or private accredited college of their choice — instead of given directly to colleges — 29% of students who attend public colleges would choose to attend a private non-profit or for-profit college.

Subsidizing colleges instead of college students holds lower-income Americans back from getting the college education that best suits them. Giving subsidies to colleges instead of to students does not seem to be the best way to expand educational opportunities and access. This same problem manifests itself in Bernie Sanders’ well-known “free” community college proposal. Making only community colleges affordable — or other public colleges — steers lower-income Americans towards these particular colleges, when this may not be the best fit for them. Terry-Long’s research is evidence of this phenomenon.

While public college appropriations are likely to become subject to increased scrutiny, appropriations directly to students may increase. Earlier this month, Rep. Virginia Foxx (R., N.C.), chairwoman of the House Education and Workforce Committee, introduced a landmark proposal to overhaul the way the federal government funds and oversees higher education. Among that legislation’s many reforms, it expands the Pell Grant program, which makes grants directly to students in financial need that they can spend at any accredited college. (I discuss the Pell expansion in another article, here.)

Supporting students directly with programs like the Pell Grant and the Subsidized Stafford Loan seems to be a more effective way to expand educational opportunities and access.

Doubling standard deduction threatens financial incentive for donations to colleges

The tax overhaul diminishes the influence of a key financial incentive for taxpayers to donate to nonprofit colleges: their ability to deduct it from taxable income.

The Tax Cuts and Jobs Act roughly doubles the dollar amount of the standard tax deduction. Raising the standard tax deduction means that fewer taxpayers are likely to have an incentive to choose to itemize deductions.

Taxpayers can only deduct charitable contributions if they choose to itemize deductions (listing eligible expenses) on their tax returns. If taxpayers instead choose to take the standard deduction, they don’t get a tax benefit from making charitable contributions (with rare exceptions, such as avoiding capital gains tax when donating appreciated stock).

The higher standard deduction is expected to reduce the number of Americans who itemize their federal tax deductions by approximately 38 million or 16% — from 45 million persons to only 7 million — according to the Tax Policy Center.

The wealthiest Americans will likely still itemize, but many of those 38 million Americans who will no longer itemize are likely to be wealthy and donors. A study by the Indiana University Lilly Family School of Philanthropy estimates that approximately $13 billion less in charitable gifts will be made annually because of the elevated standard deduction — that is roughly 3.3% of the $390 billion given by Americans every year.

Policymakers should make tax policy better for charities and lower-income Americans

A reduction of billions of dollars of income for charities is a potentially terrible social consequence. The tax treatment of charitable deductions warrants lawmakers’ attention: it has long been distorted by unrelated changes in the tax code.

When U.S. tax-exemption of charities was first codified in the Tariff Act of 1894, income taxes were flat at 2%. That means that if an American donated $100, they would get a $2 tax benefit (2% of $100), whether they were rich or poor.

Today the situation is different: if successful New York hedge fund managers donate $100 to the Ivy League college they attended, they may get around a $50 tax benefit. But minimum wage earners might not get any financial benefit at all for having donated the same amount. (Note, the highest marginal tax rate for a New York City resident is around 50%.)

Colleges have a lot to lose from the doubling of the standard deduction. They raised $40 billion in charitable contributions during 2015, according to the Council for Aid to Education’s 2016 Voluntary Support of Education report.

It is unclear what proportion of total reduced charitable contributions would be contributions made to colleges. If contributions to colleges were reduced by the same percent as overall reductions in charitable contributions, that they would decrease approximately 3.3% — $1.3 billion — from $40 billion annually to $38.7 billion annually. To the extent that most dollars donated to colleges are from high-income persons, the reduction in giving is likely to be smaller. That’s because high-income persons will continue itemize deductions under the nearly doubled standard deduction. Data on contributions to colleges give the contribution amount, which is a very rough proxy for the donor’s income, but the large size of many contributions indicates that the average contributed dollar is given by a wealthy donor.

Data on contributions indicates that any adverse effect on charitable contributions is likely to be concentrated among colleges that are already well-off. Charitable contributions are highly concentrated among a few wealthy colleges, an added reason for policymakers to re-think today’s vastly disproportionate tax rewards for wealthy donors. The Council for Aid to Education’s analysis of 2015 contributions indicates that roughly 30% of dollars donated to all colleges — roughly $12 billion — was received by just 20 colleges, which include all of the Ivy League. Eight contributions were for $100 million or more, and were received by just four of those 20 colleges.

The wealthiest donors will continue to have the tax incentive to donate. If those eight $100 million-plus donations were from U.S. taxpayers, those individuals would likely have high enough incomes to itemize and get a tax deduction even under the new, higher standard deduction. Low- or no-cost donor advised funds are a popular way for wealthier donors to concentrate their charitable contributions made over several years into one year for tax purposes, allowing them to more easily and efficiently benefit the itemization deduction.

Overall, the tax legislation is a coup for college endowments

The tax legislation is generally good news for college endowments of all sizes, not to mention pensions and other investment accounts maintained by colleges. Endowments can reasonably expect substantial one-time gains in their equity and alternative investment holdings on account of the reduction of the top corporate tax rate to 21%. Even under substantially pessimistic assumptions about endowments’ ability to benefit from asset price increases, those wealthy endowments affected by the new tax on investment income will likely recoup the cost of the new tax several times over. In this section, I’ll walk through the logic and math behind endowments’ net benefit from the legislation.

The tax-bill’s reduction of the top federal corporate tax rate to 21% should have a substantial positive impact on the two biggest types of assets endowments invest in: equities (stocks) and alternative investments. Alternative investments are assets other than stocks, bonds and cash. Common examples of alternative investments are hedge funds, private equity partnerships, commodities and real estate. Together equities and alternative investments comprised a total of 87% of all U.S. colleges’ endowments, by value in 2015 according to the NACUBO.

Stocks increase in value when corporate taxes are cut because the reduction in future tax liabilities leaves more value in the hands of stockowners as opposed to the government. Goldman Sachs’ David Kostin estimates that the corporate tax cut will deliver around a 11.5% earnings gain for S&P 500 companies, equivalent to $1 in increased earnings per share of the index, per 1% reduction in the top C Corporation tax rate. Kostin’s estimate is in line with other estimates by Wall Street analysts.

Endowments can reasonably expect substantial one-time gains in their equity and alternative investment holdings on account of the reduction of the top corporate tax rate to 21%.

Small and large endowments should have comparable exposure to the price gains associated with the corporate tax reduction. On average, a majority of all endowments assets are in equities and alternative investments combined. Colleges with smaller endowments have a strong tendency to hold a greater proportion of equity investments than colleges with larger endowments, which gravitate overwhelmingly towards alternative investments. A working paper by Jacob Moore at Ohio University organizes National Association of College and University Business Officers (NACUBO) endowment data by endowment size and finds that the proportion of endowments’ assets invested in equities decreases monotonically with endowment size. At the extremes, endowments with assets valued under $25 million hold 42% in domestic equities and 11% in alternative investments; and with assets valued over $1 billion hold 13% in domestic equities and 57% in alternative investments, on average.

Both equities and alternative investments are likely to benefit from the corporate tax cut, though alternative investments are likely to benefit slightly more for technical reasons: they generally contain more debt and have more operating risk (because alternative asset funds typically must sell assets before specified dates, such as the closing of a private equity fund). Alternative assets debt and operating risk magnify events such as the benefit from a corporate tax cut, so wealthier colleges’ endowments, which generally hold a higher proportion of alternative assets, could be expected to benefit more from the corporate tax cuts.

Some basic arithmetic, using conservative assumptions, makes it clear that college endowments of all sizes are likely to benefit from the tax bill, and that those affected by the new tax on investment income should easily recoup the burden. Let’s start with broadly conservative assumptions: that colleges have 50% and no more of their assets in equities and alternative assets combined, far below the actual value; that the total value of all colleges’ endowments’ assets are currently $500 billion, which is below their 2014 level; that there is no greater benefit from the tax cut for alternative investments, beyond that for equities; and that the tax reduction will translate to a one-time increase of 10% in equity prices, below most Wall Street estimates. Under those assumptions, the value of the tax cuts to U.S. colleges endowments would be $25 billion: $500 billion in assets × 10% in price improvement × 50% in equities and alternative assets. Given that 74% of that gain — worth $18.5 billion ($25 billion × 74%) — would go to the wealthiest 11% of colleges, and that the endowment tax is expected to cost colleges a total of $180 million annually, then the endowment tax would be offset by more than five times, whether you assumed a cost of capital of 5%, 10% or 15%. It is also worth noting that substantial equity gains related to the cut in the corporate tax rate occurred in 2017, before they would be subject to the endowment tax, with the effect of amplifying the net benefit to colleges affected by the tax.

Tax exemption reduced for returns on wealthy colleges’ endowments

The tax overhaul directly impacts certain colleges’ revenues by introducing a new tax on income from wealthy colleges’ endowments. The new tax is important to consider, because it is permanent, and because for the first time it reduces the tax-exempt status of nonprofit colleges.

U.S college endowments totaled over half a trillion dollars in 2015, the most recent year for which comprehensive data are available, according to the NACUBO. But endowment wealth his highly concentrated: the Congressional Research Service tabulated that 11% of institutions held 74% of the $516.0 billion across all university endowments.

The Tax Cuts and Jobs Act applies a 1.4% excise tax on investment income earned by private colleges that have enrollments greater than 500 students, and endowments valued at more than $500,000 per full-time student. The $500,000 per-student cutoff means that the tax would only apply to 27 — or 0.6% — of the nation’s 4,583 colleges and universities, according to data from the Chronicle of Higher Education. (The National Association of Independent Colleges and Universities estimates the tax will affect 35 colleges — 0.8% of the nation’s 4,583 colleges.)

The Joint Committee on Taxation estimates that the tax on wealthy colleges will raise approximately $180 million per year.

The endowment tax is economically significant

Wealthy colleges already receive significant sums from the federal government. Ivy League colleges received roughly $24 billion in federal grants between 2010 and 2015, according to a tabulation by Open the Books, a transparency-focused nonprofit.

But the new endowment tax is likely to be economically significant for wealthy universities due to the generally-high growth rates of their endowments. From 2001 to 2016, the 10 largest college endowments collectively grew 80% on average, according to a study by the National Association of College and University Business Officers.

Wealthy universities argue endowment tax will reduce their spending on key items

Leaders of universities affected by the proposed endowment tax have criticized it on the basis that doing so will their ability to fund important programs such as financial aid and research, and that taxing charitable activities in general is unjust. First, I’ll examine the argument that the endowment tax is likely to necessitate reduced spending; then that it is unjust. “University endowments pay for student financial aid; faculty salaries and benefits; much of the research, teaching and learning they all do; and the infrastructure that makes it all possible, including libraries, computers, museums, and lab equipment,” posited a Harvard spokesperson.

But colleges generally choose to spend far less of their endowments on education than those endowments earn. That surplus raises questions about whether taxing endowments — whether right or wrong — would restrict colleges’ ability to continue funding not just essential expenses, but whether it would restrict their ability to continue funding any of their expenses.

Colleges with endowments valued at over $1B distributed, on average, 4.4% of their assets in 2016, after earning 5- and 10-year annualized returns of 6.1% and 5.7% respectively (net of fees and expenses), according to the National Association of College and University Business Officers. The full set of all U.S. colleges’ endowments distributed an average of 4.3% of their assets in 2016, after experiencing 5- and 10-year annualized returns of 5.4% and 5.0%. (Median values were within 0.3% of average values stated here.)

Given the excess of endowments’ income over their distributions, it appears that they generally have the financial capacity to increase critical programs like financial aid, even with the endowment tax and accounting for inflation. Given the low absolute proportion of wealthy colleges’ endowments spent on education every year — their distributions relative to their total assets — it is worth considering whether giving them so many taxpayer subsidies, in the form of broad tax exemption, is appropriate or wise. I consider this next.

The origins and importance colleges’ tax-exemption

Tax-exempt organizations predate the formation of our republic. Early settlers would work together to create and run orphanages, fire departments, clinics and other charitable organizations to provide services that the government didn’t. The services of these charities continued to be popular during the early nineteenth century when state and federal governments expanded. This suggests that charities addressed needs not met by the government.

The first statutory reference to tax-exemption for charities was in the Tariff Act of 1894, which codified the first principle of tax exemption: that an organization operate for charitable purposes. The 1894 act established a flat, 2% income tax rate, and specifically identified corporations operating for “educational purposes” as being charitable for the purposes of tax exemption.

Exemptions of colleges from tax are — economically — government subsidies.

In 1909 and 1917, federal law statutes codified the other two enduring principles of charitable tax exemption, which remain today: charities need to benefit the public more than they benefit the people who run the charity (no “private inurement”); and donations to charity are deductible from the donor’s income taxes.

Federal law’s explicit identification of education as being eligible for tax exemption continued from the Tariff Act of 1894 through today and can be found in section 501(c)(3) of the IRS Code.

Exemptions of colleges from tax are — economically — government subsidies. That’s because the magnitude and timing of the value of colleges’ tax exemptions are the same regardless of whether the exemption’s value is transferred as a subsidy check, or as tax credit. (The distinction between a conventional subsidy and a tax credit is the mode of delivery, but that doesn’t have an effect on the economics of college’s tax exemption. For a full discussion of how tax exemptions are subsidies in the context of colleges, see Henry Hansmann’s explanation.)

While nonprofit colleges are still exempt from federal income tax today, they are also exempt from a wide variety of other taxes. Colleges are generally exempt from state and local income tax; from state and local property tax; from items and services they buy, sell or license; from long- and short-term capital gains tax; from federal, state and local tax on the income of debentures they issue to private lenders or to the public; and from business activities that have nothing to do with education, so long as the proceeds will be used for education.

Tax-exempt endowments are regressive

The tax exemption of college endowments distributes government support in a manner that subsidizes the education of students at wealthy colleges more, on a per-student basis, than it does for students at poor ones. The tax subsidy, in the form of taxes not collected on endowment income, is larger for colleges earning more endowment income than it is at colleges with little or no endowment income.

Under the new endowment tax Harvard would have had to pay $20 million — a 1.4% tax — on the $1.4 billion it earned in income from investments in fiscal 2017, as compared to the $1 million Middlebury would have to pay on the $74 it earned the same year.

As wealthy colleges’ endowments continue to experience compound growth — 6.1% over the last 5 years — they likely to receive a greater and greater portion of higher education tax benefits.

Subsidizing wealthy colleges leaves behind low-income students at less-wealthy colleges

Leaders of wealthy colleges not only have warned that the endowment tax may restrict programs, but they have also have specifically cautioned that low-income students and applicants could suffer. “Amherst’s endowment allows the college to avoid a heavy reliance on tuition revenue and therefore to admit the most promising students regardless of financial considerations,” said the college’s president Biddy Martin. Martin may have a valid point, but it is worth noting that Amherst has a lot more income available to spend on financial support for students which it doesn’t: in fiscal 2016 Amherst elected to distribute 4.5% of its endowment, which has gained 6.9%, 6.7% and 10.7% over the last 5, 10, and 20 years respectively.

But the bigger problem with Martin’s argument is that wealthy colleges are primarily concerned about the ability to provide financial assistance to low-income students who have the opportunity to attend those wealthy colleges.

Only 24.4% of Amherst College’s students are from households in the bottom 60% of national income, according to data from the Equality of Opportunity Project. Only 17.5% of the average Ivy League college’s class are from households in the bottom 60% of national income. And just 9% of Ivy students are from the families with income in the bottom 40% of the nation.

Put another way: these colleges largely serve the wealthy and the upper middle class, as illustrated in Figure 5. 38 colleges, including five of the Ivy League, had more students from the top 1% of household income, than from the bottom 60%, according to the EOP.

The paucity of low-income students admitted by wealthy colleges suggests that the tax-exemption of endowments may not as effective a use of taxpayer dollars for the purposes of making higher education accessible to students from low-income backgrounds.

College endowments are essentially private, nonprofit foundations

Endowments use their assets and income — including government subsidies in the form of tax exemption — overwhelmingly to invest in financial assets, as opposed to spending them on charitable activity. On average, they allocate only 4% of their assets annually towards colleges’ operating budgets, according to the National Association of College and University Business Officers.

For 48 years, U.S. tax law has reflected the belief that the government should not consider financial investing as fully charitable, even its proceeds are used solely for charitable purposes. The tax treatment of private, nonprofit, non-operating foundations — I’ll just say “foundations” — makes this apparent.

Foundations are corporations that are self-controlled; and that invest and distribute money for charitable purposes. College endowments are foundations that happen to be subsidiaries of colleges.

There are three important ways foundations are treated differently than other nonprofits, all of which were codified in the Tax Reform Act of 1969 (TRA69). Foundations must distribute a certain minimum proportion of their assets every year to be used for charitable purposes. Failure to meet this minimum, meant the foundation was no longer a tax-exempt charity.

Today this distribution requirement is 5% and can be found in Section 4942 of the Internal Revenue Code. That’s more than 4% the average college endowment with over $1 billion distributes.

The TRA69 also taxed foundation’s investment income “to share some of the cost of running the government.” Today foundations’ income is taxed at 2%. The current tax overhaul proposes to tax endowments’ income at 1.4%, and proposes to apply that tax to roughly the wealthiest 1% of colleges.

The TRA69 also established that charitable contributions to foundations were tax-deductible only up to a certain percentage of a taxpayer’s income. This deduction limit has historically ranged from twenty to thirty percent of taxable income. No such limit applies to contributions to universities operating large endowments.

The tax code should continue to support the important work of endowed institutions, but should also not continue steer a disproportionate amount of government benefits and subsidies to colleges that are already wealthy, and that generally enroll students from wealthy backgrounds.

It is hard to justify why wealthy colleges’ endowments should be treated differently than those of charitable foundations. It would be both fairer and distributionally more progressive to treat them consistently.

The tax bill is largely a challenge to wealthy colleges that serve wealthy students

Economically, the tax overhaul is largely a challenge to wealthy colleges. The most immediate, negative, economically significant effects on colleges single out campuses that are wealthy; specifically, a likely reduction on charitable contributions and a new endowment tax.

Given that these wealthy colleges overwhelmingly serve wealthy students, generally have a surfeit of resources that are still unemployed in making their programs broadly affordable, and continue to aggressively raise tuition; it is hard to argue that the federal government should not redirect its subsidies and tax benefits away from these colleges, towards programs like the Pell Grant that help all students in need, not just those at wealthy colleges.

In the medium term, public colleges in high-tax states will likely have their appropriations subjected to added scrutiny, due to the near elimination of the state and local tax deduction. It is generally easier for states to cut discretionary funding for public colleges than mandatory funding for other costly programs such as Medicaid. It is hard to forecast how individuals’ charitable donations to colleges will change, or the future course of various states’ appropriations, but one thing is certain: the gains on investments associated with corporate tax cuts should benefit nearly all colleges, given the ubiquity of investment accounts such as pensions. In the narrow case of the endowment tax, the investment gains can be expected to offset the new tax more than five times over.

Overall, the tax overhaul has large and diverse implications for colleges’ budgets. But the worst effects are largely concentrated among wealthy colleges: they face effects that are simultaneously large, near-term, largely permanent and negative. But overall the legislation is likely to be a boon for many colleges. The Tax Cuts and Jobs Act cuts corporate tax rates, and the consequential gains on colleges’ and college systems’ investments can reasonably be expected to offset some of the challenges the Act brings to colleges’ budgets.