Should Universities Have to Spend 5 Percent of Their Endowmen Annually?--Posner

Senator Grassley of Iowa has expressed concern recently about the conjunction of huge increases in the size of the endowments of many universities (and colleges--for the sake of brevity, I shall use "universities" to denote colleges as well) with continued increases in tuition. Both types of increase have far exceeded the rate of inflation in recent years. The senator urges that investment income generated by the endowments be used to reduce tuition, and he threatens to introduce legislation that would require (as a condition of the universities' retaining their favored tax status as charitable institutions) that universities spend a minimum of 5 percent of their endowment every year. That is a condition already imposed on foundations, but universities are exempt. Several major universities have announced recently that they will reduce tuition substantially to children of nonwealthy, though modestly affluent, families. I do not know whether these announcements are a response to Senator Grassley or to the concerns of the public that may have inspired his proposal. The 5 percent rule makes less sense for universities than for foundations. Foundations normally derive all or most of their income from investing their original endowment, and so they are not in competition with each other. Nor have they the spur of profit maximization. They are governed by self-perpetuating boards of trustees; so there is no democratic check either. The idea behind the 5 percent rule is to prevent the hoarding of endowment income, perhaps to provide high salaries and generous perks to staff and to prod the trustees to seek additional grants and thus compete with other foundations. But the prod is slight so long as the average return on investing the endowment is at least 5 percent a year. With inflation currently running at 4 percent, a 5 percent return is easily achieved. Higher education, in contrast to the foundation sector, is a highly competitive industry, even though most universities are nonprofit. They compete vigorously for students, faculty, and grants, which include alumni donations, foundation and other third-party donations, and government grants; state universities also receive money appropriated by the state legislature, but this is a diminishing source of the revenue of major state universities such as Berkeley, UCLA, Michigan, and Virginia. The different sources of income are complementary: good students attract good faculty and vice versa, and a university's academic standing attracts donations and grants. The universities' principal income consists of tuition plus donations and grants plus endowment income, but some universities have income from television contracts for their athletic teams, and others have income from patents developed by members of their faculty. The major universities not only have large endowments but also receive large annual gifts from alumni and others. Generally, wealthier universities are better, or at least more prestigious, than poorer ones, and so they can and do charge very high tuition even though they could "afford" to charge lower, or even zero, tuition; but that would not make economic sense for them. Given the competitive structure of higher education, it is hard to see why government should step in and try to limit tuition. The universities have a competitive incentive to provide financial aid to highly promising applicants who cannot afford full tuition; why those who can afford to pay for it should not be asked to pay for it escapes me. Forcing abolition of tuition would be a subsidy for rich kids. If universities were somehow prevented from charging tuition, moreover, applicants and their families would not have to think carefully about educational options. A free university education would be attractive to many people for whom it would be a poor investment if they had to pay stiff tuition, though it would not be completely free in an economic sense because they would have to forgo income from working. And a 5-percent-fits-all solution would make no sense for universities that had very small endowments and good reasons for wanting them to be larger. The difficult question involves the federal income tax exemption for donations to universities. It is a legitimate question why the federal taxpayer should be subsidizing Harvard, with its $35 billion endowment. The only justification would be if the type of research and teaching that goes on at Harvard or the other major universities generates external benefits that, were it not for the subsidy, would be smaller by more than the subsidy. This seems unlikely. The cost of the scientific research and graduate scientific training conducted in these universities is already heavily subsidized by federal and corporate grants and contracts; and increasingly the scientific research done by universities is applied rather than basic and so is eligible for patent protection. The contribution of nonscientific fields to welfare is not negligible, but one does have a sense that in many of them the marginal product is slight or even negative--is there really social value in having 400 English-language philosophy journals (the approximate number today) rather than 50? Because universities, though competitive, are not profit maximizers, because of age-old uncertainty concerning the effectiveness of various methods of teaching and the value of various forms of scholarship, and because of a tradition of faculty autonomy reinforced by the tenure system, universities have much the character of workers' cooperatives, which are not notably efficient enterprises. Conservatives, who inveigh against big government, should not ignore tax subsidies. There is no economic difference between giving universities federal money and allowing donors to universities to deduct their donations from their federal income taxes. If the exemption were repealed, tax rates could be reduced without any increase in government spending, and in fact government spending would be reduced, since the cost of administering the exemption and the higher cost of collecting taxes when tax rates are higher would be eliminated. Hence all tax subsidies deserve close scrutiny. I am not convinced that the tax subsidy for donations to universities would survive that scrutiny. A few peripheral points merit brief comment. First, the endowments may not be as large, realistically, as they seem. In recent years, a number of universities have been reporting annual increases in endowment in the 18 to 20 percent range. Unless the endowment managers are geniuses, there are only two ways in which they can obtain such returns. One is by generous year-end appraisals of endowment assets that are not frequently traded, so that their market value must be estimated. The other is by leverage, which generates above-average returns in a rising market--and above-average losses in a falling one. Second, the universities' argument, contra Grassley, that many contributions to university endowments come with restrictions that might make it hard for a university to spend 5 percent of its endowment every year is unconvincing. Suppose 50 percent of the endowment could not be spent (or the earnings on it); then to meet the 5 percent requirement the university would have to spend 10 percent of the unrestricted portion of its endowment. That would not be a hardship. Third, Senator Grassley's concern that increased endowment income is being squandered on high salaries for university presidents is also unconvincing. The reason those salaries are soaring is that universities are becoming increasingly large and complex, requiring management skills comparable to those required by substantial corporations.

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You wrote that a five percent return is easily achievable in an environment of four percent inflation. No -- or more accurately, no today. Endowed institutions spend the returns in excess of inflation. Spending five percent when inflation is four percent means earning nine percent. The average investor is not likely to earn nine percent over the long term, for reasons too complicated to explain here.

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