Financial Aid Increases and the Law of Unintended Consequences

By Richard Vedder

Before I forget it, read Wick Sloane's great column in today's INSIDE HIGHER ED. It is a gem.

On to business. The Democratic promise to ramp up financial aid and reduce interest rates on loans led me to dig out some regressions that the Whiz Kids have run on the relationship between tuition fees and grants and loans. The results below, using data for 1971 to 2002, are confined to public universities. We (CCAP) find:

1. That for every new dollar of grant made per student, tuition rates rise by somewhere between 35 and 40 cents per student, meaning the net financial gain to the student is very substantially less than what would appear to be the case.

2. The relationship between loans and tuition is smaller per dollar of loan, as is the grant-tuition relationship at two year public schools.

These findings are provisional, and could be altered with different data sources, different years, different methodologies. None the less, they conform with the expectations of economic theory: bigger grants (e.g., Pell Grants), are far less effective than planned because they increase the ability of schools to raise tuition fees. Indeed, higher Pell Grants might help some lower income kids go to school, but lead to some other slightly better off students to forego college because of the higher tuition. If those foregoing school are better students than those induced to go to college by bigger Pell Grants, it is entirely possible greater aid might lead to lower long term graduation numbers relative to the 18 to 24 year old population. Moreover, if bigger grants lead to higher fees for part-time adult students not receiving aid, this problem is compounded.

What about interest rate subsidies? The Dems propose slashing interest rates in half. As an economist, I much prefer overt subsidies to disguised ones in the form of below-market interest rates. Don't mess with market forces, at least directly. But interest rate subsidies are the equivalent of a grant, not a loan, since they lower the cost to those students with loans. Thus my suspicion is this move would aggravate the tendency for tuition fees to rise.

Given the anti-equal opportunity bent of most American top colleges (discussed earlier), there is a decent humanitarian case to be made for expanding Pell Grants as an equal educational opportunity move, even if the positive impact on the impacted students is less than intended. However, the case for interest rate subsidies and tax benefits (which primarily serve the middle and upper classes) is extremely weak. It probably would be asking too much to ask our President to veto an expenditure bill -- he seems temperamentally incapable of making such a move. But hopefully Senate Republicans will use their considerable filibuster powers to effect a compromise that does less harm than the initial Pelosi proposals.