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Financing Postsecondary Education: The Federal Role - October 1995

The Federal Role in Financing Higher Education:
An Economic Perspective

Sandy Baum

The same fundamental question currently being hotly debated with respect to the federal role in funding the arts underlies the ongoing discussion of higher education policy. Is this a market in which the federal government should be involved in the first place? Political debates on the issue tend to ignore economic principles that could provide a solid foundation for policy. Rational discussions are frequently derailed by the fallacious assumption that interference in market processes is, by definition, inefficient and can only be justified on equity grounds. In fact, there are strong arguments in terms of both equity and efficiency for federal subsidies to postsecondary students.

Although we can argue about whether specific government policies will increase efficiency or make things worse, there is a broad consensus among economists of all political stripes about conditions under which the market does not lead to optimal solutions. Because several of these conditions exist in the market for higher education, the number of young people who continue their education beyond high school would be less than socially optimal in the absence of government subsidies. Although the programs currently in place for public funding of postsecondary education are not necessarily the most efficient, the level of support now provided by the federal government is minimal, at best, and is easily justified by economic analysis.

Market Failure, Efficiency, and Public Subsidy

The conclusion that the invisible hand of market forces maximizes efficiency depends on the assumption of perfect competition. There must be free entry and exit into the market and consumers and producers must have complete information. However, even in cases where the invisible hand maximizes output, there is no reason to believe that the distributional outcome of unfettered market processes will be consistent with social values.

The most common violations of the assumptions defining perfectly competitive markets involve monopoly power and collectively consumed goods and services, such as national defense. More relevant for higher education is the fact that private markets will also lead to inefficient outcomes if there are externalities, which exist when transactions between consumers and producers have an effect on third parties not accounted for by the market. The absence of the complete information required for efficient market operation is also a frequent source of market failure. These last two types of market failure are quite significant for higher education.


The most common example of an externality is environmental pollution. Markets over-produce pollution because in the absence of property rights for air and water, firms do not view the destruction of these common resources as constituting a cost of production. The social cost of production exceeds the private cost of production.

If the social benefit of the consumption of a commodity is greater than the private benefit, there is a positive externality. The idea that there are significant positive externalities in elementary and secondary education is rarely debated. A literate citizenry is a prerequisite to the functioning of a democracy, and the skilled work force fundamental to economic development depends on universal education. The positive externalities of higher education are smaller and more elusive. But to argue that there are no externalities, one would have to accept the unlikely idea that the entire increase in productivity resulting from higher education is reflected in wages. In fact, better educated students are more likely to engage in professional activities with significant social benefits not fully compensated by the market. Even when high productivity levels are accompanied by commensurate individual financial rewards, the rest of society benefits from innovations and contributions. We are all affected not only by the level and quality of our own education but also by that of those around us, who can communicate and work more effectively if they are well-educated. Moreover, even if there is no shortage of, for example, scientists, if the best potential scientists are unable to enter the field because of financial constraints, society is poorer than it could be.

Incomplete Information

Standard examples of market failure involving incomplete information include markets for medical care, where consumers must rely on suppliers for information about the need for services and the quality of those services. In the case of higher education, there are several related problems. The consumers are generally young people. They have no experience with higher education and may underestimate its value. The very fact that the federal government is actively involved in subsidizing students to encourage college attendance is an important piece of information that may have a positive impact on choices. Their desire for immediate gratification and undervaluing of future benefits may cause young people to choose the job market (or a life of leisure) over human capital investment, despite the long-run inefficiency of this choice. The fact that in many cases students rely on someone else, such as parents, to pay for higher education also distorts the decision. Unfortunately, parents may be less willing to sacrifice for an education that will benefit their children but not themselves than they would be if they enjoyed the benefits directly.

All of these market imperfections work in the direction of underconsumption of higher education. People will underconsume because they are unwilling to pay for benefits that accrue to society at large. They will underconsume because they don't understand the benefits of higher education, they are unable to properly evaluate long-term benefits, and those who enjoy the bulk of the benefits are not usually in a position to finance the expenditure themselves. All of these factors suggest that government subsidies designed to increase participation in higher education may increase economic efficiency.

Credit Markets and Student Loans

Another market failure likely to cause underconsumption of higher education is in credit markets. There is strong evidence that some groups of borrowers have less access to private sector loans than they would in a perfect market. Many potential students without the resources to pay for higher education would suffer from this reality even without the basic fact that students generally have no collateral to back their loans because the capital in which they are investing is human capital. In addition, it is difficult to assess the risk of any individual student loan, the potential for default is considerable, and the cost of evaluating loan applicants and of administering loans in the relatively small amounts required by students would be high enough to make private loans unavailable to most needy potential students.

These circumstances support a government role in guaranteeing student loans, but they do not address the issue of whether the loans should be subsidized. The most logical federal program would separate subsidy from liquidity, targeting subsidies to those who would benefit from higher levels of education than they are likely to obtain otherwise. These would be people who have reasonable preparation but very restricted access to education.

Guaranteed unsubsidized loans are a sensible mode of finance for many students. However, the argument is flawed that contends it is reasonable for students to finance their own educations completely because the rate of return to the investment may be inadequate to pay off the loans incurred and, therefore, the investment will not be efficient. As previously discussed, students are likely to underinvest in education if they are not subsidized. In addition, even if debt burdens are manageable over the long run, they may look unmanageable in advance and deter attendance.

If we had only a simple, unsubsidized loan program, an additional factor contributing to underconsumption would be that the future return from any individual's education is uncertain. Although the characteristics of students and the type of education they are pursuing explain some of the variance in the rate of return, many other factors, frequently out of students' control, are also involved. This means that risk-averse students will be discouraged from borrowing to obtain the optimal level of education. The recent development of income- contingent repayment plans is a step in the right direction for addressing this problem.

But the real, practical problem with abandoning subsidized loans is that we would effectively do away with subsidies. A policy reform designed to separate liquidity from subsidy would be a positive step if the subsidy now incorporated into student loans were to be converted into grant aid. Given the low probability of such a scenario, the efficiency and equity arguments for continued federal subsidies of college students should provide convincing arguments to maintain loan subsidies.

Equity Arguments

A Merit Good?

Currently equity arguments seem to be less politically acceptable than efficiency arguments, but it is a long-standing notion that the fundamental value of equal opportunity in our society requires that access to higher education not be limited by ability-to-pay. It is not "fair" that bright and motivated students should be unable to further their education simply because their families cannot afford to pay. This suggests that we think of higher education as a merit good -- one to which all members of society should have access. The definition of merit good is dependent on social and historical circumstances and may be controversial. But economic reality and the current structure of the labor market make it difficult to argue that access to higher education should not be a merit good in our society. Average monthly income for college graduates is almost twice that for high school graduates, and the gap is growing. The unemployment rate of college graduates is about half that of the total labor force. Denying access to higher education is tantamount to denying access to economic success.

In fact, this access argument can just as easily be based on the goal of efficiency. If students who have the potential to increase significantly their productivity by furthering their education are not given the opportunity to do so, society will possess less human capital and fewer productive resources than it could. There will be a smaller pie for all of us to divide.

Higher Education for All?

This does not mean that our goal should be for everyone to go to college. Simple laws of supply and demand suggest that college degrees will lose their economic value if they are too plentiful. The 1970s decline in the rate of return to higher education and the resulting concern over the "overeducated American" illustrated this. If everyone had higher education, it would cease to be the ticket to economic success or to any sort of prestige.

In addition, education cannot be distributed to people, it can only be made available. The unfortunate reality is that many people are unwilling or unable to take advantage of the benefits of higher education. Confusion over access to opportunity and actual participation in higher education has contributed to the problems we now face in convincing skeptics of the importance of higher education subsidies. Funding higher education will not solve our most basic social problems. In many cases, the least privileged members of society stand to gain the most from education opportunities. But we cannot expect postsecondary education to repair all of the damage done to those who have grown up in destitute or dysfunctional families and attended woefully inadequate elementary and secondary schools. Job training is critical, but pushing unprepared people into higher education programs may dilute the programs these institutions are able to offer and may lead to nothing more than debt defaults for the high-risk group.

Many people who agree with my strong support of significant public subsidies for students will not agree with this argument. But recognizing that higher education is not the right solution for everyone may help us to avoid some past mistakes. Certainly much of the opposition to current student aid programs arises from abuse by institutions not providing quality education and by students not adequately prepared to become educated.

The Distribution of Subsidies

Just as equity and efficiency are compatible goals in the decision about whether the government should be in the business of subsidizing college students, equity and efficiency considerations lead to similar conclusions about the targeting of subsidies. From an efficiency perspective, we should think about the increased social benefit that might result from subsidies to different groups of people.

The positive externality from a grant that allows an upper-middle-class student to avoid borrowing to pay for a private college is less than that from a grant that allows a young person at high risk of unemployment or permanent exclusion from the primary labor market to attend college. The social benefit from Pell Grants, which allowed talented and motivated incarcerated people to earn college degrees before being put back on the streets, may have been the greatest of all. The demise of this program and the declining real value of grants to low-income students in general provide clear evidence that politics dominate efficiency considerations in the design of federal subsidy programs.

Many proposals currently under consideration similarly reflect neglect of equity and efficiency. The current suggestion from a variety of political perspectives that we move toward substituting tax deductions for direct aid may solve political problems, but it does not solve economic problems. Tax expenditures have the same impact on the budget deficit as direct expenditures; only the political appearance differs. And the targeting of this form of subsidy on those who most need it and whose behavior is most likely to be altered in ways beneficial to society is more difficult. Any changes to current aid policies should be required to pass the test of increasing both equity and efficiency.

The Level of Federal Funding

Given the importance of government subsidy of higher education, is the magnitude of our current effort appropriate? Less than 1 percent of the federal budget is devoted to higher education. Although not all of these dollars are being used efficiently or equitably, it is difficult to imagine an effective policy requiring less funding.

Total federal aid to postsecondary students is approaching $35 billion, but about 70 percent is in the form of loans. Appropriations for federal aid reached just over $13 billion in the l995 fiscal year. This represents an annual real rate of increase over the preceding decade of less than l.5 percent. Even without considering the skyrocketing cost of attending college over the same period, this growth rate pales beside those of many other components of the federal budget.

lf there is a clear role, both on equity grounds and on efficiency grounds, for public subsidy of higher education and if neither the proportion of the federal budget nor the rate of growth of expenditures devoted to higher education is out of control, the remaining question is whether the federal government should transfer even more of the cost of higher education to the states, which have traditionally borne most of the burden of financing postsecondary education.

Federal and State Roles

Unfortunately, the reality is that the strains on state budgets are leading to significant declines in institutional funding and direct student subsidies are also stagnating or shrinking. Because education captures a much larger portion of state budgets than of the federal budget, it is difficult to imagine an imminent reversal of this trend. The minimal role of postsecondary education in the federal budget makes it quite reasonable to maintain funding without dooming prospects for bringing the deficit under control. The federal government has a choice and if it chooses to leave the subsidies to the states, it is essentially accepting the reality that subsidies will wither away.

In any case, there are good economic arguments for a strong federal role in higher education subsidies. One criterion for judging which level of government should provide a service is the geographical distribution of benefits. When state university funding began, there was considerably less mobility within the United States than there is today. Although it is true that the direct economic benefits of an educational institution are concentrated in the surrounding area, the graduates of these institutions, even if most of them grew up in-state, are likely to be spread around the country during their working lives. Our economy is much too integrated to suggest that if some states choose not to educate their work forces, other states will not be affected. Even if income maintenance were perceived purely as a state function, the direct economic effects on the nation of this neglect would be significant.

From an equity perspective, if we believe that no American should be denied access to higher education because of inability to pay, the federal government must take responsibility for supporting this principle, not leave it to the discretion of financially strapped states.


Congress, the Department of Education, and the higher education community must face current dissatisfaction with both higher education institutions and student aid programs head on. Clearly, existing policies must be modified and strengthened. But eliminating student subsidies because they are not working perfectly, or in the name of deficit reduction, is irrational.

The percentage of high school graduates between the ages of 14 and 24 who have completed one or more years of college rose from 40 percent in 1960 to 66 percent in 1992. This represents considerable progress unlikely to have occurred in the absence of federal aid efforts. We should now devote more attention to questions such as why low-income and minority youth are so much less likely than others to earn college degrees. We should be attempting to solve the fundamental problems creating these disparities, not destroying programs that have created the possibility for increased access.

The current federal role in financing higher education, while flawed, is minimal and to reduce it further would be to abandon a basic principle of American society.

Sandy Baum is Professor and Chair of Economics at Skidmore College.


College Board. "Trends in Student Aid: 1984 to 1994." Washington, DC: The College Board, September 1994.

U.S. Department of Commerce. Statistical Abstract of the United States, 1994. Washington, DC: U.S. Government Printing Office, 1994.

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