Higher Education Subsidization: Part 3 – Federal Subsidies

Editor’s Note: This series is adapted from the new paper Higher Education Subsidization: Why and How Should We Subsidize Higher Education? Part 1 explored the justifications and rationales that have been used to subsidize higher education. Part 2 explored subsidy design considerations. This part explores federal subsidies.

The federal government provides five main types of subsidies for higher education: Pell Grants, student loans, tax benefits, campus-based aid, and research funding. This excerpt examines Pell Grants and student loans—the other types of subsidies are covered in the study.

Pell Grants

Pell Grants are a type of subsidy targeted at undergraduate students from low-income families. Recipients receive a grant—essentially a cash gift—to pay for college that does not need to be repaid. Around 6.2 million students receive an average of nearly $4,200 each year in Pell Grants, with a total annual spending of $25.8 billion.

When it comes to the structure of Pell Grants, they are largely well-designed. Because the justification for Pell Grants is to promote equality of opportunity and social mobility by providing funding for students from low-income families to attend college, the Pell Grant should be selectively—rather than universally—targeted at students from low-income families and should be distributed as financial aid—rather than institutional support—as this allows for selective targeting. Pell Grants are properly designed on both accounts. The grants are awarded to students as financial aid and are means-tested, with students from low-income families being generally eligible while those from high-income families are—generally—not. The grants are mostly targeted at students from low-income families in practice, with 65 percent of recipients in the 2020–2021 school year coming from households earning less than $30,000 per year and 93 percent coming from households earning less than $60,000 per year. The main exceptions are some students from high-earning families that also had several siblings in college, as the aid formula historically divided parental ability to pay by the number of students in college, allowing high-earning families with multiple children in college to also receive Pell Grants. Recent changes in the aid formula will likely eliminate most of these exceptions.

However, the size of the Pell Grant—$7,395 for the 2023–24 academic year—is likely non-optimal.

While there is room for disagreement, since the justification for Pell Grants is to improve equality of opportunity, the lack of parental contributions for college costs constitutes the financial disadvantage faced by students from low-income families. Therefore, Pell Grants should fill in for these missing parental payments. In particular, the size of the maximum Pell Grant should both:

1. Be equal to the median potential student’s parental contribution to college costs.
2. Vary by credential and academic field—e.g., a bachelor’s degree in nursing—to account for differences in the cost of providing different educational programs.

There are two key complications in implementing this recommendation. The first is defining and measuring parental contributions, which can come from current, past, or future income. Unfortunately, there is no authoritative source of parental payments for the median student based on credentials and academic field. The closest proxy we have found is Sallie Mae’s annual “How America Pays for College” series, which reports student and parent contributions to college costs. This is not a perfect proxy. We want the median among all potential college students, while this survey only covers those who enrolled, thus missing out on students and families who did not enroll for financial reasons. We also want the median by credential and academic field. Instead, the survey gives the average by type of institution. In addition, when there is a lower bound ($0) but no upper bound, the average can be wildly different from the median. Nevertheless, the Sallie Mae survey provides the best available proxy for how much parents contribute to their children’s college costs.

[T]he justification for Pell Grant is to redistribute income to promote equality of opportunity and social mobility.

The second complication in implementing our recommendation is the existence of the Parent PLUS loan program. This program allows most parents of dependent students to borrow up to the full cost of attendance, subtracting any other financial aid, such as Pell Grants. Because Pell Grants and Parent PLUS loans both promote equality of opportunity, the existence of Parent PLUS reduces the optimal size of the maximum Pell Grant.

Since grants given directly to disadvantaged students are better targeted than loans to their parents, our ideal policy changes would eliminate Parent PLUS loans entirely and then base the maximum Pell Grant size on parental contributions from current income, savings, and borrowing. However, if Parent PLUS continues to exist, parental contributions should be defined as parental payments from current income only since Parent PLUS already addresses parental borrowing. On the other hand, savings should be excluded from contributions because, from an equality of opportunity perspective, there is no difference between parental contributions from past or future income. Therefore, accounting for borrowing only would be a biased measure and unjustifiably discourage savings.

The Sallie Mae survey reports that for students enrolled in public two-year colleges in 2022-23, parents contribute an average of $6,851 annually, comprising $3,443 from current income, $2,548 from savings, and $860 from loans. Parents of students enrolled in public four-year colleges contribute an annual average of $14,097, comprising $6,463 from current income, $5,194 from savings, and $2,440 in loans.

A student with zero financial support from their parents would thus be at a $3,443 to $14,097 financial disadvantage depending on the type of college attended and how parental contributions are measured. The Pell Grant is designed to promote equality of opportunity by filling this financial hole and has a maximum of $7,395 for the 2023–24 academic year.

Unless the Parent PLUS loan program, which accounts for parental borrowing—and indirectly, savings—is eliminated, parental contributions should be based on current income only. Accounting for contributions from income only, associate degree programs should have a maximum Pell Grant of around $3,400—the amount parents contribute from current income—and bachelor’s degree programs should have a maximum Pell Grant of around $6,500—though ideally, these would be set by credential and academic field rather than by credential alone. Both maximums are less than the Pell’s current maximum of $7,395, meaning that so long as Parent PLUS exists, the maximum Pell Grant should be reduced because the combination of Pell and Parent PLUS already ensures that students from low-income families are not at a financial disadvantage relative to the typical student. Alternatively, the Pell amount could be left unchanged, and Parent PLUS could be capped at the median parental contribution minus any Pell Grant award.

If the Parent PLUS loan program is eliminated, then parental contributions should also be based on parental contributions from saving and borrowing. In that case, associate degree programs would have a maximum Pell Grant of around $6,900—the amount that parents contribute, including saving and borrowing—and bachelor’s degree programs would have a maximum Pell Grant of around $14,100. Relative to the current maximum Pell of $7,395, this would be a small reduction for associate degree programs) and a significant boost for bachelor’s degree programs.

However, Pell Grants are also subject to a pernicious unintended consequence in the form of the Bennett Hypothesis. Colleges may raise tuition or reduce institutional aid—financial aid paid for by the college—when students receive Pell Grants. The response of colleges to Pell Grants with regard to altering tuition has not been studied, but Lesley J. Turner estimates that for every $1 in Pell Grants, colleges reduce institutional aid by 12¢—this figure is 67¢ at selective non-profit colleges and 5¢ at public colleges. Thus, colleges capture some Pell Grant funding at the expense of the program’s goal of increasing equality of opportunity and promoting social mobility. Reforms that reduce the extent of the Bennett Hypothesis harvesting of Pell Grants would be desirable.

To recap our assessment of the Pell Grant program, the justification for Pell Grant is to redistribute income to promote equality of opportunity and social mobility. There is a scholarly consensus that these grants substantially increase the enrollment of low-income students—though there is evidence that this was not the case in the 1970s when the program was first introduced—so the grants are sufficiently well justified. Pell Grants are selectively targeted for this purpose and use the appropriate distribution method, with aid primarily given to students from low-income families. However, the maximum Pell Grant size, $7,395, should be altered to better accomplish this goal. The Parent PLUS loan program duplicates the mission of Pell Grants, so if Parent PLUS continues to exist, then the maximum Pell Grant should be decreased to around $3,400 for associate degree programs and around $6,500 for bachelor’s degree programs—though ideally, these limits would be set at the credential and academic field level rather than just by credential. But if the Parent PLUS program is eliminated, then Pell Grants would be solely responsible for promoting equality of opportunity, and the maximum Pell Grant should then be reduced to $6,900 for associate degree programs but increased to $14,100 for bachelor’s degree programs—though again, these would ideally be set by credential and academic field rather than by credential alone. Unintended consequences are a concern, as there is evidence that colleges reduce the institutional aid they award to Pell recipients and may also raise tuition.

Student Loans

Another substantial subsidy program at the federal level is the student loan program. Under the current system, the federal government is the lender, loaning funds to individual students and parents who repay the loan. The government offers four main types of loans: subsidized loans, which do not charge any interest until the student leaves school; unsubsidized loans, which begin charging interest right away; and two types of PLUS loans, the first of which is the Grad PLUS loan when the borrower is a graduate student, and the second being the Parent PLUS loan when the borrower is a parent. Total federal lending amounts to around $83 billion a year, some of which will be repaid, though we won’t know how much for decades.

Student loans are not an appropriate subsidy method because they are poorly targeted. Subsidizing loans provides the subsidy only to those who borrow and provides the greatest subsidies to those who borrow the most.

The justification for a government role in student lending is that the lending market for student loans suffers from a market failure. Many college students are recent high school graduates, so financing a college education by borrowing can be difficult, as few lenders are interested in extending loans to those with little income and minimal—if any—assets, even if profitable educational investments are to be made. Thus, it can be “appropriate for the federal government to facilitate the market for loans” by addressing the market imperfection, namely, incomplete capital markets.

The size of this imperfection is debated. Some scholars argue the problem is small:

• “We find only a limited role for tuition policy or family income supplements in eliminating schooling and college attendance gaps. At most eight percent of American youth are credit constrained in the traditional usage of that term” ~ Carneiro & Heckman, 2003
• “The case for liquidity constraints is greatly exaggerated” ~ Heckman & Klenow, 1997

But while the scale of the problem may be exaggerated, it does exist, meaning there is some justification for the student loan programs. However, student loans, as currently implemented, suffer from three severe problems.

First, facilitating the student loan market does not require the federal government to be the lender, yet the federal government currently fills that role. The main problem with government-as-lender is that the federal government does not have the proper incentives to make appropriate lending decisions. Instead, it squanders vast sums on wasteful education, which is a predictability of bad investment. In addition to lacking incentives to prevent the waste of taxpayer dollars, this system will likely lead to the politicization of lending over time.

The second problem is that facilitating the market for loans does not justify subsidizing those loans. As Armen Alchian wrote:

There remains an even more seriously deceptive ambiguity—that between the subsidization of college education and provision of educational opportunity. Educational opportunity is provided if any person who can benefit from attending college is enabled to do so despite smallness of current earnings. Nothing in the provision of full educational opportunity implies that students who are financed during college should not later repay out of their enhanced earnings those who financed that education.

In other words, the market failure—incomplete capital markets—in the lending market for student loans justifies government facilitation of loans to expand educational opportunities. However, that facilitation does not require those loans to be subsidized.

This raises the natural question: Should student loans be subsidized? Note that the justification for student loans—market failure due to incomplete markets—is not one of the commonly used justifications for college subsidies. Indeed, scholars are clear that market failure justifies government involvement in facilitating the market for loans but does not justify subsidies for loans. As Eric Hanushek wrote, “There is no strong argument for subsidizing these loans.” Susan Dynarski and Daniel Kreisman provide the most concise explanation:

The government should seek neither to make nor to lose money from student loans. Student loans correct a capital market failure … Federal student loans therefore solve a liquidity problem, not a pricing problem. Student loans are appropriate neither for raising revenue nor for subsidizing college.

Student loans are not an appropriate subsidy method because they are poorly targeted. Subsidizing loans provides the subsidy only to those who borrow and provides the greatest subsidies to those who borrow the most.

[T]here is a good case for government facilitation of student loans—to address capital market imperfections—but no convincing case for subsidizing those loans.

Unfortunately, student loans are heavily subsidized.

The Congressional Budget Office (CBO) routinely estimates the subsidy rate for student loans. A subsidy rate is a profit or loss as a percent of the loan after accounting for all future payments and converting them into a present value using a discount rate. When student loans are subsidized, they have a positive value for the subsidy rate. A negative subsidy rate, on the other hand, would mean the government makes money from the loan.

However, the CBO’s estimate of the subsidy rate is underestimated for two reasons. First, when making the loans, the Department of Education has systematically overestimated future student loan repayments. Overestimating future repayments artificially lowers the subsidy rate by assuming future payments that fail to materialize. For example, a recent Government Accountability Office report examined actual student loan repayments with Department of Education projections with respect to loans made in the past 25 years. If the Department had accurately estimated repayments, it should have overestimated repayments in some years and underestimated repayments in others. Instead, the Department overestimated payments every year. As a result of these overestimates, subsidy rates have been about 15 percentage points higher than they were projected to be when the loans were made.

Second, the CBO is required to use the interest rate on U.S. government bonds as the discount rate—future payments are discounted into their value today using a discount rate. A lower discount rate corresponds to a lower subsidy rate because future repayments are worth more—e.g., a payment of $100 ten years in the future is worth $82 today at a two percent discount rate but only $61 at a five percent discount rate. The interest rate on U.S. government bonds is an artificially low discount rate for student loans because, unlike the government, students can die, move out of the country, or simply not repay their loans—not to mention, the government can simply print more money to repay its debt, an ill-advised option that is nevertheless unavailable to students. A more appropriate discount rate for students is called the fair-value rate, which estimates the discount rate that would prevail for similar lending in the market. Switching to the fair-value discount rate adds around 11 percentage points to the subsidy rate.

The CBO estimates the subsidy rate for student loans is 18 percent, meaning that the government will lose 18¢ for every $1 lent. However, accounting for the Department of Education’s systematic overestimates of repayments adds 15 percentage points to this value, and switching to fair-value discount rates adds around 11 percentage points more, yielding a more realistic subsidy rate of 44 percent. This means the government will likely lose 44¢ for every $1 it lends. Since the government lends around $83 billion annually, this will entail around $37 billion in losses. Note that these subsidy rates do not account for the Biden administration’s recent and forthcoming plans on student loan forgiveness, which would dramatically lower payments and massively increase the subsidy rate.

A third problem with providing subsidies through student loans is unintended consequences. As mentioned earlier, subsidies for higher education, including student loan programs, are subject to the Bennett Hypothesis, which relates to how colleges raise prices to harvest aid. One recent study estimates that colleges raise tuition by 40¢ to 60¢ for every $1 increase in loan limits. Thus, the concern of offsetting behavior, particularly colleges raising tuition to harvest student loan dollars, is valid.

In sum, there is a good case for government facilitation of student loans—to address capital market imperfections—but no convincing case for subsidizing those loans. Unfortunately, student loans are currently heavily subsidized, with the government likely to lose around 44¢ for every $1 it lends. There is also evidence that colleges have raised prices to exploit the availability of student loans. Two reforms are thus warranted: First, replace the government-as-lender model with private lending, and second, regardless of who is doing the lending, stop subsidizing student loans. Governments, for example, often subsidize private student loan lenders by offering loan guarantees.

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