Sunday, February 17, 2008

A Dysfunctional College Financial System: Another Dimension

By Richard Vedder

My friend and former Spellings Commission colleague Charles Miller and I compete with one another over who can say the most times that the American system of financing student higher education is dysfunctional. We often talk about it in terms of its excessive complexity, the contradictions between various loan programs, the fact that the loan system gives schools carte blanche to raise prices, etc., etc. All true, all damning.

But that is not the half of it. Let me repeat an example I used a few months ago, but illustrate it even more vividly. Let us take two kids who are virtually identical --same grades, same SAT scores, from families with identical incomes. Let us suppose one kid has fiscally conservative prudent parents while the other comes from a go-go family of socially pretentious people who engage in conspicuous consumption.

Patrick Prudent's parents make $120,000 a year, the father $60,000 as a veteran high school teacher, his mom $55,000 a year as a senior nurse, and they earn $5,000 annually from $150,000 in carefully accumulated investments in stocks and CDs. They live in a nice, but unpretentious $200,000 house that is all paid for. They both drive sensible cars, like Toyota Camrys or Nissan Altimas. They have no debt. Total net worth is about $400,000.

Stephen Spender's parents also make $120,000 a year, the father making all the income in his job as an insurance salesman. The Mom does not work, preferring to spend a lot of time at the country club or at the Florida condo. They have a $300,000 house in an upscale neighborhood with a $200,000 mortgage, a small $200,000 condo in Florida with a $150,000 mortgage, no savings, a $40,000 car loan on the wife's Porsche Boxer sports car (the husband leases his Lexus), and a $15,000 loan on their boat that they keep at the Florida condo and $$10,000 in credit card debt-- big spenders, fiscally irresponsible. The family net worth is about $175,000 --far less than the Prudent's who saved for their son's education and did not join country clubs, buy fancy sports cars, or a condo in Florida. Suppose both sets of parents are the same age, have the same retirement schemes, and have no other children.

The federal tax system slightly favors the Spenders over the Prudents --they have more deductions for mortgage interest. The federal government says "we give you benefits if you borrow to finance your consumption, but take them away if you save for your or your children's future." But that is nothing compared with what the collegiate financial aid system does.

Suppose both boys are accepted at good quality private schools a notch below the elite Ivy League schools --maybe Boston College, George Washington University, or Carleton College. Because of robust savings revealed on their FAFSA form and non-existent monthly mortgage payments and credit card bills, the Prudent family likely will end up having to pay most of the $45,000 annual tuition, room and board charges --maybe a tuition discount of $5,000, leaving $40,000 to be taken from savings and cash contributions. After four years, the family will have very little savings. The Spenders will get a significantly larger tuition discount --say $15,000 a year, borrow $25,000 a year (a good portion federally subsidized), and get the remaining $5,000 from a small family cash contribution and some small work earnings by Stephen.

This system punishes the savers, rewards the spenders. It rewards parents who are so self-centered that they put their own interests ahead of their children, and punishes parents who believe their first obligation in life is to nurture and support their kids. The system sends all the wrong signals. It is bad for the Nation, contributing to our low savings rate, the need to borrow investment funds from abroad, etc. It raises interest rates, other things equal. The damage done by government through tax and spending policies is aggravated by the privately imposed "tax" on savings levied by the colleges and universities. That is why I think a decent case can be made to abolish the FAFSA form.

The new Harvard (and most likely Yale) financial aid system is a boon to the Prudents, who would only have to pay $12,000 if Patrick were accepted there --the same as the Spenders would pay. It is a step in the right direction, moving to a less perverse incentive system. But if college itself were less expensive, the problem for both families would decline. The root cause of the problem is the inefficient system of higher education delivery in the United States which third party payments, the non-profit nature of university organization, and other factors combine to create.

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