• August 28, 2014

Why Does Tuition Go Up? Because Taxpayer Support Goes Down

In a speech at the University of Michigan at Ann Arbor in January, President Obama called on public colleges that benefit from subsidies, grants, and government loans to rein in the tuition increases that have characterized higher education for well over a decade. "We can't just keep on subsidizing skyrocketing tuition," he said.

The president's plea for moderation was supported by a threat to directly intervene to reduce or even eliminate expanded federal programs to colleges that fail to comply. The presentation was greeted enthusiastically by students, politely received by some university administrators, and criticized as being interventionist by some legislators.

Is the assessment that federal programs "subsidize" higher tuition correct? There are two rather different points of view used to account for rising tuition in public higher education. One is the "market power model," presumably accepted by the president. It asserts that subsidies and grants to students increase demand, which gives colleges more ability to raise tuition. The second is the "spending constraint model," which argues that rising tuition is the obvious consequence of declining state appropriations.

According to the market-power view, grants, aid, and subsidized loans will boost student demand and lead to higher "sticker prices." Under this explanation, colleges do not pass on to students all the revenue generated from Pell Grants and the Stafford Loan Program by offering lower net tuitions. At its extreme, this point of view has been labeled the "Bennett hypothesis," after former Secretary of Education William J. Bennett, who formulated it. The theory's main idea is that federal grants increase revenue but do little to increase enrollment.

If the market-power model is the best explanation for rising tuition, what are its implications? In theory, if there were a monopoly provider of education services, it could respond to a government grant per student by increasing the sticker price, reducing the net tuition that students pay, and thereby accommodating some increase in enrollment. A working rule of thumb for this case is that listed tuition will rise by 50 cents and net tuition will drop by 50 cents for every dollar increase in the subsidy.

Public universities, while possessing some pricing discretion, are not monopolies. When the education market contains numerous providers that offer similar products, the subsidy-induced increases in sticker prices will be smaller and the enrollments will rise more than under the monopoly case. Competition defeats the Bennett hypothesis by reducing a university's ability to raise tuition in response to increases in federal grants.

It is challenging to use the market-power formulation to explain the facts. The primary inconsistency is that the average subsidy per enrollment in the United States is declining, while the average sticker price is rising. This pattern is contrary to the market-power formulation's main prediction.

The spending-constraint explanation, however, does match the facts. It predicts that tuition will increase as taxpayer support falls. Since public universities are constrained by their governing boards to break even, tuition revenue must rise in response to a reduction in taxpayer support to sustain base-level expenditures.

This explanation is consistent with the fact that state support for higher education has declined and tuition has gone up for more than a decade. The higher-education systems in California and Pennsylvania provide prominent recent examples. In both states, public higher education was once heavily subsidized but is now much less so; this has led to unprecedented increases in tuition.

Of course, both pricing formulations can correctly describe the behavior of different types of providers and their responses to different income-level students. Some for-profit colleges and open-access universities, which receive the bulk of federal grant support, may adopt the market-power model and react to higher federal financing by raising their sticker prices. With profit-constrained public universities, though, federal backing can act to mitigate the pressure on budgets associated with cuts in state appropriations and, thereby, make possible more modest tuition increases than would otherwise be the case.

At public universities, tuition revenue has begun to represent a higher percentage of the total cost of educating students, and the share of costs covered by state subsidies has declined. Importantly, some of this revenue increase is from enrollment expansion, which is driven by a variety of demographic and economic factors other than tuition. Today, for public universities, tuition revenues cover, on average, about 50 percent of expenditures, up from about 40 percent a decade ago. The annual increases in expenditures over this period, according to the College Board, have run only about 1.5 percent a year.

So tuition increases have occurred in part because of rather modest upticks in educational spending, but mostly they have occurred to cover the sharp declines in taxpayer support. The spending-constraint model offers a more consistent explanation for the facts than does the market-power formulation. Students are required to pay more because taxpayers are paying less—it's that simple.

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Gary Fethke is professor of management science and economics at the University of Iowa. He is co-author, with Andrew J. Policano, of the forthcoming book Public No More: A New Path to Excellence for America's Public Universities (Stanford University Press, 2012).

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