TCS Daily

A Terrible Waste of Taxes

By Arnold Kling - July 23, 2004 12:00 AM

Student: Why is society paying me to go to graduate school in economics?

Professor: Society doesn't know what the heck it's doing.

This interchange, which took place in 1975 at the Massachusetts Institute of Technology, was relayed to me by Jeff Hammer, a classmate of the student. The Professor, Nobel laureate Robert Solow, is known for his sense of humor, and he was surely joking. I am confident that Professor Solow would subscribe to the conventional wisdom, which is that government spending on higher education has great benefits for society and is particularly helpful to people with low incomes.

On the other hand, Richard Vedder, an economist at Ohio University, is convinced that society does not know what the heck it is doing when it subsidizes colleges and universities, and he is not joking. On July 19, I attended a session where Vedder discussed his new book, Going Broke by Degree. Although I disagree with some of the specifics of his argument, I think he successfully punctures the conventional wisdom.

Professor Vedder clearly sees institutions of higher education as mismanaged, with waste, misplaced priorities, and overpaid faculty and administrators. I have no doubt that this view has validity, but it also has validity for nearly every organization in the world. Human beings are imperfect, and large-scale enterprises seem to be particularly suited to showcasing our flaws. I am not surprised, or particularly outraged, that Dilbert management takes place on campus as well as off.

Professor Vedder did point out that the cost of a college education has been rising faster than that of just about every other good or service, including health care. This does suggest that mismanagement in the higher education sector is worse than in other sectors of the economy.

Subsidies to the Over-Educated

Most economists believe that productivity is the key determinant of the standard of living, and that better education contributes to higher productivity. For example, Brad DeLong, Claudia Goldin, and Lawrence Katz conclude that "A renewed commitment to invest in education is probably the most important and fruitful step that federal, state, and local officials can take to sustain American economic growth."

College graduates earn much higher incomes than people who do not graduate college, and this gap has widened over the past two decades, so that it is now over 50 percent. As Professor Vedder pointed out, it seems likely in a competitive economy that this pay differential reflects higher productivity. However, there is a question about whether college-educated workers are more productive because of what they learned in college, or whether they simply were more capable to begin with. Professor Vedder argues the latter, which would imply that the actual value added of college is nothing. I would be more cautious and simply say that while the value added of college is probably considerably less than the observed average wage differential, the value added is probably considerably more than zero.

However, even assuming that a college education does contribute to individual productivity, it is not necessarily the case that a taxpayer subsidy is warranted. If a college education leads to higher productivity and a higher salary, then that should be all of the incentive that students need to go to college. Only those who cannot afford to go to college should merit a subsidy.

The conventional wisdom is that spending more on higher education will enable more low-income students to obtain a college education. Professor Vedder instead argues that institutions divert resources to programs that benefit high-income students -- or that benefit no students at all. He says that much of the increase in spending goes to raise the "rents" earned by faculty and administrators. His statistics show that salaries and staff sizes have gone up much more than have the number of students graduating college.

Professor Vedder argues that even direct subsidies to students, such as tuition tax credits, may go to those who would go to college without the subsidy. Such subsidies serve only to increase the revenues extracted by the college from a given population of students. While politicians enact such programs in the name of making college more affordable for their constituents, Professor Vedder argues that the colleges quickly undermine the benefit by raising tuition to capture the subsidy. Only a narrowly-targeted voucher for low-income students is assured of actually adding to the pool of educated students, as opposed to adding to the wealth of those doing the educating.

The end result is that even though government subsidizes higher education, and even though most economists believe that higher education enhances productivity, the government subsidies do not result in higher productivity. Simply throwing money at higher education has the effect of enriching the over-educated (faculty and administrators) while providing little or no benefits to the under-educated and to society at large.

Playpens for the Privileged

Professor Vedder makes the same point that I made in The World's Nicest Holding Pen, which is that colleges and universities are competing for students by offering lifestyle benefits, such as fitness centers and fancy eateries. I did not make a moral issue out of this, based on the assumption that the consumers (students and parents) are driving the trend.

However, Professor Vedder made an interesting point, which is that at state universities, and at federally-subsidized colleges and universities, students are enjoying their high-end lifestyles at taxpayers' expense. Since the vast majority of students, even at state universities, come from the top half of the income distribution, this represents a regressive social policy, in which taxes paid by the less-affluent are used to fund the consumption of the more-affluent.

Puzzles to Consider

The rise in college tuition poses a number of puzzles. First, why are students willing to pay so much for college, if it does not add much value? Professor Vedder puts a lot of weight on the value of college as a "signal" of ability (a hypothesis associated with Nobel laureate Michael Spence). However, it strikes me that the cost of the signal is so high that employers and workers would have an incentive to figure out a cheaper approach. I have a hard time believing that such an enormous profit opportunity could exist without anyone finding a way to exploit it. I find it utterly implausible that the reason that the demand for college has been strong enough to support higher cost is that signaling has become a more important component of the employer-employee matching process.

Instead, I am partial to the view that high tuition has the perverse effect of increasing the demand for a college among some parents, because they want their children to attend school with rich kids. I call this a segregation equilibrium, because it means that there is a natural tendency toward a higher education system that is stratified by income.

The second puzzle is that faculty and administrators are able to earn such high salaries, when their "opportunity costs" (what they could earn outside academia) seem lower and when there are other individuals willing and able to perform their jobs. Why are these "rents" (salaries above what market forces would seem to require) not competed away? In other industries, high earnings cause more people to enter the market, driving down excess incomes.

At colleges and universities, incumbents are able to restrict the number of tenure-track positions. Would-be competing faculty are driven into "adjunct" status, where earnings and benefits might be less than one-tenth what is paid to "real" professors. In theory, an entrepreneur could hire good faculty at a wage above that of an "adjunct" and below that of a tenure-track professor. There must be entry barriers that prevent this, such as the obstacles to obtaining accreditation.

Vouchers Not Sufficient

In spite of a number of reservations and disagreements, I find myself persuaded by Professor Vedder that government subsidies to higher education serve primarily to drive up costs. I also am persuaded that subsidies serve to increase the pleasure of the college experience for the already-affluent who make up the bulk of the students. The bottom line is that the contribution of higher education subsidies to the American Dream, of access to education for the less affluent, is minimal, and possibly even negative.

Professor Vedder's main recommendation is that a progressive voucher system (meaning higher government payments to poorer students) should replace the current forms of taxpayer subsidies in higher education. I believe that this makes sense from an economic perspective. However, I do not think that vouchers are sufficient to put higher education on track to better performance and greater accessibility. I think that the "puzzles" I referred to above need to be better understood and dealt with.

In the private sector, improved performance is due to entry and exit. New firms produce the most dramatic innovations, according to William Baumol. Furthermore, incumbent firms tend to adopt best practices only when their survival depends on it, and often not even then. Only when the weakest firms exit does an industry show overall gains in efficiency.

In traditional higher education, entry and exit are almost non-existent. Vouchers would be helpful, in that it would make government funds more portable. Students would be free to transfer their business away from ineffective colleges and toward effective ones. The current approach, which targets existing institutions, serves as both an entry barrier and an exit barrier.

However, there are other barriers to entry in higher education, such as the accreditation barrier. Colleges also engage in bundling without inter-operability. In theory, the cost of entry would be lower if you could set up an institute that specializes in one subject and outsource other subjects to other colleges. Colleges discourage this form of entry by refusing to sell their courses separately.

Entry and exit are the vital component in the economic learning process that leads to growth in the capitalist system. I would be willing to bet that the biggest contribution that government could make to improving higher education would be to lower the barriers to entry and exit in the industry.


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