Policy Brief: Higher Education Spending

Introduction  

            Over the past several decades, the popularity of college education has been increasing significantly.  According to the Bureau of Labor Statistics, approximately 65.9% of high school graduates enroll in college.¹ Of these enrollees, about 60% attend 4-year institutions seeking degrees most commonly in business, social science and history, health professions, and education.² Finally, the overall graduation rate for 4-year degree-granting institutions was 59%.  By working through these numbers, we find that just over 23% of high school graduates go on to complete 4-year college degrees.    

            Given the fact that nearly a quarter of high school graduates complete 4-year college degrees, it is important to consider the value of post-secondary education.  There are two economic models at play here.  The first is the human capital model which reasons that those who continue their education receive skills through education that are valued in the labor market.  The second is the signaling model, which conversely reasons that those who attend higher education institutions are simply signaling their pre-existing abilities by attaining a degree.  By analyzing the implications of these two perspectives, we can arrive at useful conclusions about the value of education. 

Background

            One of the most appealing aspects of obtaining a 4-year college degree is the wage premium that arises due to this additional education.  The National Center for Education Statistics finds that the median earnings for the average adult holding a bachelor's degree is about 50% higher than the respective adult with only a high school diploma.³ Interestingly, those who go to college but do not obtain a degree typically earn only 6.8% more than high school graduates. 

            Many education studies assume that the relationship between education and earnings is linear.  This makes sense under the human capital model because increases in education should lead to increases in human capital.  However, the data suggest that this may not be the case.⁴  In fact, those who drop out just prior to graduation, completing up to 96% of their degree, still hover around a 10% wage premium.  This empirical evidence is highly suggestive of a so-called "sheepskin effect" that supports the assumptions of the signaling model.  The sheepskin effect is the impact of earning a degree on wage premiums.  The fact that someone can finish only a slightly higher degree of education and yet is expected to earn a nearly 40% wage premium over the person that dropped out just prior to graduating implies that it is the degree that carries the most value, not the human capital increases through education. 

Proposal

            This analysis forces us to consider several structural issues surrounding education.  One of the most important issues to consider is who pays for higher education.  The federal government spent 146 billion dollars in academic year 2010-2011 in the form of grants and loans to students.⁵ However, we must ask ourselves if it is appropriate for the federal government to subsidize education when the data suggest that education does little to increase productivity through human capital increases and truly acts as more of a signal of already existing abilities.

            My proposal is that government subsidization of higher education spending should be significantly reduced or phased out.  The reasoning here is that government subsidy is causing an inefficient allocation of resources to education.  Since education evidently does not provide useful increases in the human capital stock but rather only signals the students most innately suited for the workforce, it is not necessary for government to correct for the "market failure" of a less than socially optimal level of education.  Congress should eliminate loans for anyone other than perhaps the truly low income students who have little chance at being able to attend college without some form of assistance.  Even in the case of low income individuals, I would recommend that grant programs be converted into loan programs as to not distort the value of education.                          

Analysis

            Furthermore, government subsidy in the education market causes several additional moral and economic issues.  Since 1965, the federal government has increased real spending on funding for higher education continuously.  This increasing subsidy has several adverse effects in the market for education.  Americans have been increasing their demand for education continuously as well, especially given the fact that it is becoming a larger social norm for women to become educated.  This increase in demand pushes prices higher.  Normally, these increases in prices would be restrained by consumer surplus, but the federal government, acting as a third party, has cushioned the cost of tuition thus diminishing the budget restraint of prospective students.⁶

            Although the federal government has hugely inflated the sticker price of college, federal aid has probably allowed more students to attend college granted that enrollment increased about 48% between 1986 and 2006.⁷ However, this likely caused additional distortions outside of simply rising prices.  More students required remedial work and were less likely to be able to handle the increased academic rigor of college - causing them to drop out.  This has likely placed downward pressure on the quality of academic institutions as they seek to increase retention rates by lowering the standards and rigor of their courses.  This is further evidenced by the fact that literacy among college graduates decreased at similar rates that enrollment grew between 1990 and 2000.⁸ 

            The moral issue surrounding government subsidization of college students is that it is wrong to take money from taxpayers in order to fund college students looking to bolster their future income.  It is particularly unfair when you consider that many taxpayers did not go to college themselves and are indeed paying for someone else to become wealthier.  This extracts money from efficient users and transfers it to less efficient students who have not earned the aid.  Moreover, by ensuring that aid recipients bear the costs of education provides incentives for those best motivated and prepared to succeed in higher education to attend school. 

Conclusion

            The proposed method of eliminating government grants to college students in favor of loans to only means tested individuals would work to correct the distortions caused by a high level of government spending in the education market.  Additionally, decreasing government subsidy in this market would work to lower the sticker price of education, increase the value of education, and increase the quality of academic institutions.             

References

1. U.S. Department of Labor, Bureau of Labor Statistics. (2014). College Enrollment and he Work Activity of 2013 High School Graduates. Retrieved at bls.gov/news.release/hsgec.nr0.htm

2. U.S. Department of Education, National Center for Education Statistics. (2013). Digest of Education Statistics, 2012 (NCES 2014-015), Chapter 3.

3. U.S. Department of Education, National Center for Education Statistics. (2013). The Condition of Education 2013 (NCES 2013–037)

4. Skalli, A. (2007). "Are successive investments in education equally worthwhile? Endogenous schooling decisions and non-linearities in the earnings–schooling relationship." Economics Of Education Review, 26(2), 215-231.

5. U.S. Department of Education, Federal Student Aid, Title IV Program Volume Reports, Direct Loan Program, Federal Family Education Loan Program, Grant Programs. Retrieved from studentaid.ed.gov/about/data-center/student/title-iv.

6. Vedder, Richard. Going Broke by Degree: Why College Costs Too Much. Washington:

American Enterprise Institute, 2004.

7. Cato Institute, Cato Handbook for Policymakers, 7th Edition

8. National Assessment of Adult Literacy, “A First Look at the Literacy of American Adults in the 21st Century,” 2006, p. 15.

Wage Laws - Are They Good for Us?

Wage laws, including so-called living wage laws, have been getting a fair bit of attention and political consideration lately.  The President advocates a federal increase of the minimum wage to $9/hr and the city of Seattle has gone even further by contemplating a $15/hr "living" wage.  Surprisingly, economists almost unanimously disagree with wage laws.  Personally, I believe higher minimum wage laws would be exceedingly dangerous.

            One of the biggest issues with the government setting wages is that increasing wages does not increase the value of labor.  "Forcing" a business to pay someone a certain wage does not make their labor worth that particular wage, and when a product is not worth its price, there is no transaction as the transaction would not be mutually beneficial.  This means employees could be laid off or not hired in the first place.  Alternatively, price levels could simply rise to accommodate the increase in input costs, which means those to receive the higher wage will also see a rise in their cost of living.  Another thing to consider is that the more productive workers who make over minimum wage currently will lose their incentive to be more productive because it is very unlikely that they would make more than the new wage and thus would have little reason to be more productive than the less productive workers who are now making the same wages.

            Typically we think of jobs subject to the minimum wage as being entry level food service or retail jobs.  I contend that these types of jobs are not the type of jobs that people who need to be self-sustaining should be working.  If wages are high, employers look for more qualified laborers.  This means that students, young people, and underprivileged people, who generally occupy these low-level positions, may begin to be passed up for people with more work experience.  This is dangerous not only because it leads to high youth unemployment, but also because it can create a generational gap.  Since young people may not get into the workforce and learn basic skills, these skills will be non-existent when they need them to get higher paying jobs in the future.  We already have evidence of these problems being created by the issues youths face in Europe. 

            So, in summary, these wage laws will likely create high youth unemployment, less employment overall, less productivity, higher prices, or any combination in between.  So what could politicians do to raise wages without causing all of these horrible side effects?  The answer, I believe, is most to undo several key regulations they have already built upon.  Politicians could study the industries where the minimum wage is most prevalent and then attempt to make creating new businesses in those industries as easy as possible.  By reducing or eliminating things like licenses to sell food, zoning laws, or any other barriers that firms face in entering markets in order to make it as easy as possible for them to go into business.  If this approach worked, it would benefit literally everyone.  Businesses would fight for laborers, driving wages and employment up while simultaneously driving costs to consumers down. 

The Role of Risk in Free Markets

As we move even closer to the big election, I continue to hear people voicing opinions, often in angst, about how big business and big banks are evil.  Many point to the idea that capitalism is evil because it is a system that takes advantage of people and operates on greed.  I find these notions absolutely astonishing, but at the same time, I can understand how people could arrive at these conclusions.

Capitalism is a system that is fueled by what some may call "greed."  While I prefer to call this motivating force "self interest," the money or satisfaction attained from pursuing self interest is simply a measurement of earned success.  The word greed implies taking something that does not belong to you, but the free market operates on a system of voluntary transactions.  Those who prosper by providing goods and services must do so by satisfying the needs and wants of their customers.  However, some people fail to realize that innovators put themselves in jeopardy by trying to provide new goods and services to their consumer base.  This is where risk comes into play.

When an entrepreneur wants to develop a new product or service, they must take on risk by underconsuming and saving in order to invest in the development a new product.  They temporarily take on risk with the hopes that their new product will be successful, or they face a failed investment and the consequences that come along with that.  If they do succeed, they get the benefit of profiting from their business venture and these profits symbolize a measure of earned success.  The system works quite well, but the United States has seen great decline in true capitalism.

Unfortunately, the federal government and Federal Reserve are undercutting the risk that businesses are supposed to take on.  Keeping interest rates for investment banks at 0%, subsidizing risky companies, and bailing out failed companies makes it much easier for entrepreneurs to attempt business interactions that would be far too risky in a free market.  Since the Federal Reserve is continuing to give out money at 0% interest rates, it allows big banks to keep loan rates fairly low.  This sounds like a great thing, but in actuality it is a form of price fixing.  Sometimes the market needs to raise rates to encourage saving instead of rampant spending.  If money is too easy to attain, it is less risky to invest.

We have seen just recently that the federal government thinks it knows what companies should have the burden of risk removed, but they have once again illustrated that government intervention rarely works.  In the case of A123 Systems Inc., the $249.1 million dollars granted by the Obama administration was not enough to prevent this company from filing for bankruptcy.  Although instead of A123 Systems dealing with the consequences of a failed investment, it is the American tax payer that bears the burden.  Government subsidies prevent companies from restructuring into efficient business models.

We also see very low risk in the banking sector, which make consumer's decisions about who will hold their money far too easy.  When the FDIC is ready to refund you if your bank goes under, you do not really care if they are making bad investments with the leverage they get from your deposits.  This leads consumers to make uninformed decisions about what banks they should be using.  The Federal Reserve and federal government also played an obvious role in reducing the risk of investment banks when they decided to bail them out after the banks took on too much risk and their investments failed.  By bailing them out, the government essentially erased the consequences of their malinvestment, which will likely lead to further moral hazard in the future. 

By listening to people attack capitalism, it becomes clear that they do not really seem to understand it.  Many of the problems that people attribute to capitalism actually arise due to government intervention in the system.  There are countless more examples of how government intervention in free markets negatively impacts the American people, but these problems are near the top of the list.

-Bob