Federal Student Aid Drives Up Tuition

Too often, the progressive response to an ever-increasing student loan burden on today’s young graduates is to make federal student aid easier to use, usually in the form of lower interest rates or more debt forgiveness. A new report from the Federal Reserve Bank of New York, by economists David Lucca, Taylor Nadauld, and Karen Shen, disputes this prescription. Rather than lightening the load on students, federal student aid programs actually increase tuition at America’s colleges and universities.

The paper concludes that each additional dollar of Pell Grants, awards given to low-income students to help them pay for college, increases tuition by 55 cents. Each dollar of Direct Subsidized Loans, or need-based loans for which the government pays the interest while students are in school, increases tuition by 65 cents. These effects vary by type of school, with the largest tuition increases found in private four-year institutions.

Importantly, the paper also finds that the “sticker price” of tuition translates at a high rate to how much students and their families end up paying. This rate ranges from 37 percent in the lowest quartile to 94 percent in the highest quartile—meaning students in the highest quartile will end up paying 94 cents on every dollar of tuition increases that are due to federal student aid. Federal student aid not only increases the price tag of a college education, but students actually have to pay for it, too.

The authors make a point of comparing the education market of today to the housing market in the run-up to the financial crisis of 2008. Both are heavily financed by loans—student loans for education, mortgages for housing—and both lines of credit are heavily subsidized by the government. As we know, the housing market experienced a bubble that nearly brought down the global financial system when it popped. With just shy of $1.4 trillion in outstanding student loans and a 41 percent increase in tuition at private four-year schools since 2000, a similar bubble in higher education spending is looking like more and more of a reality.

Most credit markets have safeguards to ensure that borrowers use funds properly and that lenders are usually able to recover the money. If you take out a mortgage to buy a home, you must put up the house as collateral. In corporate finance, the owners of a company (stockholders) must absorb losses before creditors part with a single penny.

Few such safeguards exist for federal student loans. As a result, colleges are not exposed to risk should students default on their loans. Colleges are thus free to raise tuition with wild abandon, knowing that the financial burden will fall on students (or the government, should the students default). Generous student aid programs only accelerate this trend.

Solutions exist. Currently the federal Department of Education controls the accreditation process that determines which schools are eligible for federal student aid. Senator Marco Rubio (R-FL) called Tuesday for revamping the accreditation process to make it more friendly to “innovative, low-cost” providers of education, forcing expensive colleges to compete with other institutions for students. The result would be lower tuition and a higher-education system that better caters to students’ needs.

Another idea is to force colleges to cover a certain percentage of any student loan defaults. Such a policy would incentivize colleges to equip students with the skills they need to find well-paying jobs that will enable them to pay back their loans in full. If education is an investment, then colleges should have a stake in how that investment pays off.

A better, but less politically feasible, solution is to privatize the student loan industry entirely. Our current student loan program treats students as welfare beneficiaries rather than assets to be developed. Private investors would have a full stake in the outcome of a student’s education. As a result, they would have an interest in facilitating students’ academic and professional development, by helping to identify promising fields of study and career paths. Rather than writing a check and setting students loose into the world, as the government currently does, independent investors would share with the students a strong interest in their success.

Education is an important investment, and the current system does not have safeguards in place to ensure that the costs of that investment do not grow to outweigh the benefits. The recent paper from the New York Fed makes clear that reform is necessary to prevent the price tag of higher education from further spiraling out of control.