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The College Cartel

by Vance H. Fried & Reihan Salam

Competition and innovation will lower the cost of higher education

There was a time when higher education wasn’t a national political issue. Then as now, the United States had a flourishing network of private and public colleges and universities, which were supported primarily by fee-paying students and subsidies from state governments, many of which took great pride in building academic powerhouses.

But in the decades since Sputnik and the Great Society, the federal role in higher education has increasingly taken center stage. Though Obamacare, taxes, and Iran are soaking up most of the attention, funding for higher education might emerge as a key dividing line in this year’s presidential election. Last year, the Occupy movement devoted much of its attention to mounting student-loan debt.

More recently, higher education once again became a flash point in the culture war. At a tea-party rally in Troy, Mich., last month, Rick Santorum called President Obama a “snob” for wanting all Americans to go to college. “I understand why he wants you to go to college,” he said. “He wants to remake you in his image.” The former Pennsylvania senator was suggesting that the president had embraced a one-size-fits-all worldview in which a college education is the highest aspiration of all students. And President Obama has dramatically expanded federal funding for higher education.

But President Obama has also been striking a different note on higher education in recent months. During his State of the Union address, for example, the former legal academic said, “We can’t just keep subsidizing skyrocketing tuition,” a message that has been advanced by a number of conservatives and libertarians. “So let me put colleges and universities on notice. If you can’t stop tuition from going up, the funding you get from taxpayers will go down.” This was a welcome breath of fresh air from a president who has never evinced a terribly strong taste for controlling the growth of public spending. It remains to be seen whether Obama follows up on his pledge, but he certainly deserves at least some credit for taking on an industry that has been his powerful ally.

It is easy to understand Rick Santorum’s frustration with the notion that college is for everyone. It really is true that, as Santorum said in Troy, “not all folks are gifted in the same way,” and it seems profoundly unfair to suggest that there is only one way to succeed. But there is a very simple reason that the universal college ideal has emerged: While Americans with a high-school education or less have seen their labor-market position deteriorate in recent decades, the wage premium for college-educated workers has increased. Moreover, the unemployment rate for college-educated workers has consistently been lower than that for workers with no more than a high-school diploma. As of January, the unemployment rates for the two groups were 4.2 percent and 8.4 percent respectively. There are, of course, confounding variables at work. The kind of person who attends and completes college might have a number of other qualities that make it more likely that she’ll be able to maintain steady employment. Nevertheless, the divergence in life outcomes between the college-educated and all other workers has been front-of-mind for policymakers for some time now.

What isn’t very well understood in today’s higher-education debate is that we can reconcile the positions advanced by conservatives and liberals. By doing the unthinkable — by dramatically reducing federal funding for higher education — we can actually make a college education more accessible and more affordable for working- and middle-class Americans. At the same time we can reduce the burden on taxpayers and alleviate legitimate concerns that we are unduly privileging one way of life over another.

Having a more educated population can in theory create a positive feedback loop, in which workers innovate faster and find ways to spread knowledge more efficiently. Some argue that this is exactly the dynamic that fueled America’s rise to economic dominance in the last century, which is why the case for subsidizing higher education has been so widely accepted. As Claudia Goldin and Lawrence Katz recount in The Race between Education and Technology, the United States educated its workers to a far greater extent than any other country at the start of the last century. As late as the 1930s, the U.S. was all but alone in providing a free and accessible high-school education to its young. And mass secondary schooling provided a solid foundation for a vibrant and diverse higher-education sector, which was and to some extent still is the envy of the world.

Yet in more recent years, something has changed for the worse. In our breakneck efforts to subsidize education, we’ve wound up spending more and more for the same mediocre outcomes. High-school-graduation rates peaked in the United States in the late 1960s, despite the fact that the labor-market position of high-school dropouts has sharply deteriorated in the decades since. Despite the fact that per-pupil spending on K–12 schools has increased threefold in inflation-adjusted terms since 1970, high-school-graduation rates have been stagnant. And while the number of students attending college has increased over this period, college-completion rates have been similarly disappointing. Until the 1970s, they rose at a healthy clip, but there was a sharp deceleration in the mid-1970s, driven in large part by the failure of men to keep up with women.

One curious result of this stagnation is that while American 65-year-olds are among the best educated in the world, American 21-year-olds are in the middle of the pack among workers in the world’s most advanced economies. Goldin and Katz observe that while the 25-to-34 age group is better educated than the 55-to-64 age group in most European nations, the two groups are nearly identical in the U.S. The economists Dale Jorgenson, Mun Ho, and Kevin Stiroh reached the sobering conclusion that, because educational attainment appears to have reached a plateau, the labor quality of the U.S. work force will stop improving within the next decade.

The conventional solution for America’s education problems, advocated by politicians on the right as much as those on the left, is to invest more resources in higher education. But that is exactly what we’ve been doing. At the end of the Clinton presidency, a time many look to with great nostalgia, the federal government provided the higher-education sector with $64 billion in grants, loans, and tax credits in inflation-adjusted 2010 dollars. As Kevin Carey, head of the think tank Education Sector, has observed, that number soared over the intervening decade to $169 billion. And over this same period, the total amount of outstanding student-loan debt doubled to $1 trillion.

So what exactly is happening to all of this money? Why isn’t a sharp increase in the amount we’re spending on higher education translating into higher college-completion rates? The discomfiting answer is that the higher-education industry is enriching itself at the expense of taxpayers and students. Students and recent graduates burdened by debt shouldn’t be calling for more public subsidies, the banner taken up by many in the Occupy movement. Rather, they should take aim at the higher-education cartel that has been extracting ever more resources without offering an improved product.

Higher education has become a very profitable industry. Since most colleges are legally organized as non-profits, they do not earn profits in the traditional sense. But a kind of profit occurs whenever a non-profit derives more revenue from providing a service than it costs to provide. Universities do not pay out these profits in the form of dividends to shareholders; they spend them.

For most colleges, the revenue derived from providing undergraduate education exceeds the actual cost of providing that education. The excess is spent in two ways: economic rents and subsidies for other missions. Economic rents are payments made to college insiders that do not increase the college’s output. Excess compensation (e.g., when the president of a small college makes over $1 million) and featherbedding (e.g., a 10:1 student-to-faculty ratio) are economic rents. Subsidies for other missions include the revenue from undergraduate tuition that is spent on graduate education and research. Unlike economic rents, this spending does increase colleges’ output and is not bad per se. Yet it is spending beyond what is necessary to provide an undergraduate student with a high-quality education.

The free-spending nature of non-profit colleges is well known. As longtime Harvard president Derek Bok once quipped, “Universities share one characteristic with compulsive gamblers and exiled royalty: There is never enough money to satisfy their desires.”

Thirty years ago, Howard R. Bowen, an economist who served as president of three different colleges, proposed what is known in education circles as Bowen’s Law. It can be summarized as “Colleges raise all the money they can, and spend all the money they can raise.” But don’t colleges try their best to keep costs low in order to keep tuition down? No, it turns out that they don’t. As Bowen pointed out: “The question of what ought higher education to cost — what is the minimal amount needed to provide services of acceptable quality — does not enter the process except as it is imposed from the outside.” And those who provide the money, the legislators and students and families who pay tuition, have failed to check the tendency to overspend.

Robert E. Martin, an economics professor with substantial experience as a faculty member at both a large state research university and a small liberal-arts college, recently expanded on Bowen’s Law. He concluded that “because costs in higher education are capped only by total revenues, there is no incentive to minimize costs.” So when colleges are able to secure new revenues, costs increase commensurately. And these higher costs, in turn, are used “as justification for more revenue.” Suffice it to say, this dynamic wouldn’t be tolerated in many other industries. Bowen proposed his law over 30 years ago. In the time since, colleges have spent money and raised tuition as rapidly as the market and legislators have been able to bear. They have been so successful at raising prices that their basic financial model has changed. Non-profit colleges, whether private or government-owned, were originally designed to provide an education to students funded by a mix of commercial and donated financing. The commercial financing came in the form of tuition paid by students. The donations came in the form of charitable giving and state subsidies, and benefited students by reducing tuition. This is how most non-profit colleges were funded until the 1980s.

Since then, the amount of donated financing has increased substantially. In 1980, states were the primary donors to higher education through the subsidy they provided to state-owned colleges. They have continued to generously fund higher education. While in some years there have been cuts because of downturns in state tax revenues, historically the subsidy has gone back up as the state’s financial position has improved. In fact, between 1987 and 2009, per capita state spending on higher education increased by 31 percent after accounting for inflation.

At the same time, private donations have gone up, and the federal government radically increased financing for higher education. From 2000 to 2010, annual student lending went from $42 billion to $96 billion, and Pell grants increased from $9 billion to $28 billion. Congress also created federal tax deductions and credits. For example, in 2010, a married couple with an income under $160,000 received a $2,500 credit for their child’s college tuition. Total federal tax benefits for higher education in 2009 totaled $18.2 billion.

Given this massive inflow of donated financing, what have colleges done with their prices? They have aggressively raised them. For example, in 1980, in-state tuition at the University of Texas at Austin was a bargain, at $1,176 (in 2010 dollars). By 2010, it had soared to $8,930. Huge tuition increases were the norm at public universities throughout the United States; in fact, today, Texas is still a bargain in comparison with Penn State and the University of Illinios at Urbana-Champaign, which charged in-state tuition of $17,344 and $15,144 respectively in 2010.

The emergence of a large number of explicitly for-profit colleges has done little to undermine Bowen’s Law. The main difference between for-profits and non-profits isn’t, as we’ve seen, that non-profits don’t actually generate profits. Rather, the difference is that for-profits disburse their profits in a somewhat different way — to private investors as well as to college insiders. The great virtue of the for-profit sector is that it has been able to expand rapidly and serve the needs of so-called non-traditional students, such as working adults who are obligated to take their classes at night and on weekends. This is one reason for-profit schools such as the University of Phoenix now enroll 9 percent of America’s students, up from 2 percent in 1987.

The main drawback of for-profit colleges is that they’ve proven very effective at gaming existing federal education subsidies, particularly since the federal government has until recently subjected colleges to only the most minimal scrutiny. Basically, many for-profit colleges have taken a poorly designed funding formula and pushed it to its limits, as suggested by the fact that, according to the think tank Education Sector, for-profit colleges produced an extraordinary $43,383 in debt for every degree, as opposed to $21,827 for private non-profits and $16,247 for four-year public universities.

Recently, the Obama administration has focused its efforts on regulating the for-profit sector by, for example, denying federal aid to schools that produce graduates who can’t secure paid employment and repay their loans. Congressional Republicans have called for extending these regulations to non-profits as well, recognizing that while for-profits have gone the farthest in gaming subsidies, there are non-profits that do the same. This is a position that the president and his allies have so far been reluctant to take.

The trouble with regulating the lucrative higher-education industry is that it won’t necessarily force colleges, whether explicitly for-profit or “non-profit,” to lower their prices. The reason is that the flow of new entrants into the higher-education industry has been severely restricted by regional accreditation bodies, which effectively determine whether colleges are eligible for the lucrative federal subsidies. These accreditation bodies present themselves as the guardians of high standards. In practice, however, they serve as cartels that protect higher-education incumbents by setting difficult and sometimes arbitrary hurdles to accreditation for new schools. In the past, for-profit colleges simply bought faltering accredited institutions outright to avoid having to go through the onerous accreditation process. Now, however, regional accreditation bodies have closed off that option, further limiting competition.

The existence of accreditation cartels is not in itself a reason to abandon regulatory efforts, but it does suggest that addressing accelerating cost growth in higher education might require more radical solutions, such as dramatically reducing federal funding and creating a process through which innovative schools can do an end-run around regional accreditation bodies.

There is good reason to believe that actually eliminating federal subsidies for higher education would lead to lower tuition even as it reduced federal spending by $60 billion a year. This doesn’t mean, however, that federal loans should be eliminated; such loans serve the valuable function of guaranteeing that everyone, regardless of family income, can secure a long-term loan with interest deferral until graduation. Rather, loan programs need to be redesigned and operated on a break-even basis.

Even given today’s high in-state tuition, it is quite possible for people with a net worth of zero and no family support to work their way through college and graduate owing no more than $30,000, a very serviceable debt. The problem with the current loan program is that it doesn’t adequately protect the interests of students and taxpayers. The default rate has risen considerably, in no small part because many young adults who can’t finish their degrees are nevertheless burdened by an enormous amount of loan debt. Imposing reasonable caps on the amount students can borrow, and implementing better monitoring and collection policies (such as reducing the amount students are eligible to borrow if they fail to complete some number of credit hours), can do a great deal to limit the burdens upon students.

Improving the design of the federal loan program will greatly reduce, if not eliminate, the need for the Pell Grant program, which currently subsidizes 40 percent of students. Only students with extremely low incomes will require any additional assistance, which state governments are well positioned to provide. In a similar vein, it is important to eliminate the provisions in the tax code that subsidize tuition, which overwhelmingly benefit relatively affluent households.

Will reducing the flow of subsidies into higher education simply starve colleges and universities out of business? That is the claim we will no doubt hear from members of the cartel. But returning to 1980 prices just means returning to 1980 profit margins. While this will certainly be painful for colleges, it is doable. However, it would be naïve for policymakers to expect established universities to take a lead in reducing their own profits. That is where competition comes in.

As Bowen observed, cost containment must come from the outside — either from state legislatures, or from students and their families, or from competitors. At the time Bowen wrote, most state legislatures were actively involved in controlling cost. Tuition increases required lawmakers’ approval, which was often hard to come by.

Then legislatures began to cede the power to set tuition to their colleges. Not surprisingly, the colleges chose to raise tuition aggressively. Prices have risen so much that many legislatures have become alarmed. There is a natural tendency for policymakers to try to micromanage individual colleges — something that will not work, either politically or practically. They can, however, create a competitive higher-education system that places the power to keep costs down in the hands of students and families.

State governments would be wise to pursue two complementary strategies:

First, break up existing higher-education cartels. State governments often insulate incumbent schools from competition. For example, State X might prevent the University of State X from competing with State X U by barring it from opening a campus on the other school’s turf. This might make sense if our goal were to preserve the market share of both schools, but it does not make sense when our goal is to foster robust consumer-friendly competition. Prices are often fixed by the state so as to eliminate any potential for competition. States should let their individual public colleges freely compete with one another. Some colleges will be winners and others losers, but the consistent winner will be the student, who will get lower tuition and a higher-quality education.

Second, level the playing field. State higher-education subsidies are generally paid only to state-owned colleges, giving such schools a huge competitive advantage over private colleges: State colleges can spend just as much as a private colleges, but then charge a substantially lower price, because of the subsidy. States should instead allow private colleges to receive the subsidy as well. One approach would be for state governments to develop partnerships with private colleges. For example, private colleges located within the state could become private charter colleges, akin to K–12 charter schools. In return for the state subsidy, private charter colleges would agree to charge in-state students a lower tuition than the most expensive public college currently charges. The goal of leveling the playing field would be to pressure the most expensive public colleges to spend public resources responsibly, not to run the public colleges and universities out of business.

Not all states will take such steps, and very few will take them quickly. But the federal government might contribute to breaking up higher-education cartels by providing an alternative route to accreditation. The aforementioned Kevin Carey of Education Sector has called on the federal government to create a mechanism through which high-quality providers of instruction — for example, a program exclusively devoted to teaching college-level calculus or Mandarin — can get approval to accept federal loans. Carey would require that such educators offer their services at low cost and provide transparency regarding their effectiveness. If they meet these criteria, any college or university that accepts federal loans would have to accept the credits they provide. While some may find Carey’s approach heavy-handed, it has the potential to strongly encourage the adoption of low-cost business models in higher education. Existing schools that can’t compete with the new providers will die out as they see their business cannibalized. Those that rise to the challenge will do so by improving the quality and cost-effectiveness of their offerings.

There have been a number of promising recent developments in higher education. The most impressive may be the rise of Western Governors University, a highly innovative institution built around entirely online delivery and a competency-based degree — i.e., WGU grants credits based on test performance, and does not require class attendance. A WGU student who is already very knowledgeable about software programming, having worked as a coder before starting work on her degree, might secure a credit in computer science by passing a final exam without actually taking a course. In essence, WGU offers the equivalent of a CPA exam for every subject.

Moreover, WGU charges its students based not on the number of credits they complete, but rather on an “all you can eat” basis over two semesters: If you can demonstrate competency in seven or eight semesters’ worth of credits in only two semesters, you pay the price for two. The beauty of the WGU model is that it allows students to seek instruction anywhere they can find it — they can read independently, study with a tutor, enroll in some other school, etc. — while turning to WGU to certify that they’ve mastered the relevant material.

In a somewhat similar vein, the Massachusetts Institute of Technology has sponsored MITx, a program through which students who take free online courses offered by MIT can, for a modest fee, secure an MITx credential by demonstrating a thorough understanding of the material.

It’s not just online programs that show promise. Grace College, a small institution in northern Indiana, uses a much more traditional, residential model. But it has recently trimmed some unnecessary spending and moved summer school totally online. As a result, a Grace degree can now be earned in three years for total tuition of $38,000, about the same as an Indiana resident pays over four years to get a degree from Purdue or Indiana University Bloomington.

The combination of low profit margins and innovation-encouraging models might even allow higher-education costs to fall well below 1980 levels — and if current levels of state-government subsidies were maintained, higher education could even be tuition-free. Through competition and innovation, we can achieve the dream of left-wing higher-education visionaries — but without breaking the bank.

– Mr. Fried is the Riata Professor of Entrepreneurship at Oklahoma State University and the author of Better/Cheaper College: An Entrepreneur’s Guide to Rescuing the Undergraduate Education Industry. Mr. Salam writes National Review Online’s domestic-policy blog, The Agenda, and is a policy adviser at the economic-research think tank e21.

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