The Joy of Economics:  Making Sense out of Life
 Robert J. Stonebraker, Winthrop University
 

Education Funding Options

            There is something noble about giving money to talented young people who could not pursue their education without it.
                                                       ...former Major League Baseball Commissioner Fay Vincent

            Because college educations create external or spillover benefits, free markets will produce inefficiently small amounts.  You might want to review the reading on external effects to refresh your memory about the concept and graph.  Governments routinely provide subsidies to increase the number students attending, but the types of funding remain controversial.

Public colleges and universities

            Most government funding comes through annual budget grants to state colleges and universities.  These state subsidies drive down the prices charged and, consequently, increase the quantity of students willing to attend.  In 2005-2006 tuition and fees at a public four-year college or university averaged $5,491 (Tuition and fees at my own institution Winthrop University were $8,776).  Tuition and fees at private colleges and universities that received no annual grants averaged $21,235.¹  Quite a difference.

            Though state subsidies certainly increase the number of students in public colleges and universities, their impact of overall attendance is less clear.  To some extent, the subsidies simply shift which schools students attend.  Students who otherwise might have attended a private school enroll in a public university instead. 

Private schools might be out of the financial reach of low-income students, but relatively few students are truly “low-income.”  College students in general are drawn from families in the top half of the income distribution.  Think back to your high-school classmates.  Which were more likely to continue on to college: those from well-to-do families or those from the poorest families?  Correct.  Financially-challenged students are more apt to enroll in subsidized public colleges than in private ones, but the same holds for students from richer families.  Bargain prices attract the rich and poor alike. 

Unfortunately, if large chunks of the state subsidy go to students who might have attended college anyway, taxpayers get less bang for their bucks.  Middle class taxpayers end up subsidizing children of upper middle-class families to help purchase college educations they would have purchased anyway.

Need-based aid

            An alternative approach would plow more funds into need-based aid.  Grants to public colleges lower tuition for students of all income levels, whether they need it or not.  Need-based aid goes only to low-income students who otherwise might not attend.  It allows taxpayers to get the same boost in overall enrollment at less cost.

            States do provide need-based aid, and the federal government tosses in more, but the amounts are relatively small compared to general state subsidies to public colleges and universities.  Increased reliance on need-based aid does have advantages, but there is a drawback as well.  How do we measure “need?” 

            Government officials currently collect data provided on the Free Application for Federal Student Aid (FAFSA) and, using a complex formula, calculate the amount a family should be expected to contribute to a college education.  Schools then use this value to compute “need” and, in turn, eligibility for need-based aid.  Because two families with similar income may have very different abilities to pay, the formula takes into account more than a family’s current income.  It also considers family size and the number of other children in college as well as the amount of home equity and financial assets such as stocks, bonds, and savings accounts. 

            The approach seems reasonable, and many economists do favor a significant funding shift that would substantially increase need-based aid and decrease the annual grants that lower tuition to all.  However, need-based aid suffers one glaring economic flaw.  It changes incentives.  Families quickly learn that if they diligently save money to finance their children’s education, their children will qualify for less financial aid.  The more assets the family builds through saving, the less financial need their children will demonstrate.  Compare two families with $50,000 annual income.  The one that scrimps and saves for years to help finance its children’s education will qualify for little, if any financial aid.  The one that fritters away its income on fancy cars, country club memberships, and extravagant vacations will have no assets to report and, consequently, will be rewarded with government assistance.  Since assets count against them in the need-based aid game, families have an incentive to spend rather than to save. 

            You’re trying to imagine how to picture this in a graph, aren’t you?  Let me help. Families would normally consider both the marginal benefit (MB) of saving and the marginal cost (MC).   The MC can be thought of as the value of goods and services you can no longer buy.  The efficient family would save as long as the MB covers the MC.  Since each dollar a family saves will result in it receiving less need-based aid, the system effectively lowers the MB of saving.  Check out the graph below.

Merit-based aid

            My own state of South Carolina has shifted funds into merit-based aid.  Modeled after a system instituted in Georgia in 1993, South Carolina has poured tax dollars raised through its state lottery into an expanded LIFE scholarship program.  To be eligible for a LIFE grant, South Carolina high school students must achieve two of the following:  a 3.00 high-school GPA, a ranking in the top 30% of the graduating class, 1100 on the SAT (or 24 on the ACT). 

LIFE recipients currently receive grants of $5,000 per year that may be used at any accredited college or university in the state.  LIFE scholarships can be renewed up to four years if the student maintains a 3.00 college GPA and completes 30 semester hours per year.  Most first-year students entering my own institution (Winthrop) enjoy either LIFE assistance.

These grants presumably serve two purposes.  First, they keep top high school graduates in the state.  Because South Carolina colleges and universities, on average, enjoy less academic prestige than those in other parts of the country, many of our strongest students have chosen to attend out-of-state schools.  Since LIFE grants can only be used within South Carolina, the out-of-state exodus should slow. Second, the grants are designed to increase student incentives to succeed.  The lure of scholarships is supposed to encourage high-school students to earn higher grades, and the need to maintain a 3.00 college GPA should do the same for undergraduates.

            Does the system work as advertised?  Yes and no.  The first goal certainly is being achieved.  Student demand for South Carolina colleges and universities rose significantly right away.  Applications to attend Winthrop and other in-state schools quickly soared to record levels.  Georgia’s experience was similar.  Formerly known to many primarily as a party school, the University of Georgia quickly found the academic quality of its applicants rising to new levels.

            So what?  Remember that the reason for government subsidies is to expand enrollment.  There is considerable evidence that merit-based aid reallocates enrollment, but none that it increases it.  First, most of the merit aid is going to students from upper income families who would have attended college anyway.  South Carolina schools, like those in Georgia, will enjoy increased enrollments, but they will come at the expense of lower enrollments in out-of-state schools. South Carolina’s gain might simply be North Carolina’s loss.  If so, there is no benefit to society as a whole.

            More importantly, the jump in merit-based aid has given the state legislature an excuse to cut the annual grants to public schools such as Winthrop.  Faced with less state funding, Winthrop (like other schools in the state) has increased tuition to compensate.  As a result, tuition increases have eaten away a significant part of the gains LIFE recipients would otherwise have enjoyed.  Students who receive and renew their grants still will be in good financial shape, but others will not.  Low-income students without access to merit-based aid will find even public colleges increasingly out of their financial league.  If so, the net effect could be for overall college enrollment to fall.

            What about student incentives to succeed?  The evidence seems mixed.  High-school and college grades in Georgia did rise after implementing its merit-based plan.  Proponents claim this supports their contention that students are working harder and learning more. However, critics contend that grades rose for other reasons.  Knowing that students cannot get needed scholarships without high grades, teachers might become more lenient and relax their standards.  Pressure from students and parents could easily accentuate such grade inflation.  Shifts in student course schedules also might account for the higher grades.  Research on Georgia's program shows that the scholarships made students less likely to enroll in demanding majors such as math and science that typically award low grades and more likely to enroll in majors such as education that often award higher grades.  Students also reduced course loads to maintain higher grades and shifted credits toward summer classes that often enroll weaker students with less competitive records.² All of these views are plausible.  Potential scholarships should have the effect of increasingly the incentive for higher grades.  Whether the higher grades are more likely to be attained through harder work or more pressure on teachers to relax standards or through shifts away from more difficult courses and schedules still is an open question.

            Experience with merit-based aid suggests that it reallocates, but not necessarily increases, college attendance; that it probably skews assistance more towards academically talented students from financially able families and less towards students from low-income families; and that it may or may not lead to increased study effort and learning.

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Notes:

1.         National data are taken from "2005-06 college costs," College Board, at http://www.collegeboard.com/parents/csearch/know-the-options/21385.html

2.         See "Evaluating HOPE-Style Merit Scholarships" by Christopher Cornwell and David Mustard, Proceedings, Federal Reserve Bank of Cleveland, 2005, pp. 33-37.

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Testing Yourself

To test your understanding of the major concepts in this reading, try answering the following:

1.         Explain the economic rationale for government subsidies for college educations. 

2.         Explain why economists might prefer need-based aid to government grants that lower tuition for all.

3.         Explain the economic disadvantage of using need-based aid.

4.         Explain and discuss the possible advantages and disadvantages of South Carolina’s merit-based aid plan.

5.         Discuss three different reasons why grades might rise as a result of merit-based college scholarships.

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