Why I Changed My Mind on the Endowment Issue

by Andrew Gillen

Until a few days ago, if someone had asked me what my views were on the endowment issue, I would have said that I supported a 5% spending rule for schools with above a certain amount of money per student in their endowment.

I no longer believe that. Here is why.

My original support for the spending rule was not based on any sort of belief that 5% is the correct amount to spend, but rather on the fact that other organizations that receive tax deductable contributions were required to spend 5% of their “endowment.” The appropriateness of the tax deductibility and the 5% rule are separate issues that can be questioned, but given that others were forced to play by these rules, I saw no reason why universities shouldn’t as well. Essentially, I wanted the government to treat every organization the same, and I saw the exemption of universities from the 5% rule as a violation of this principle.

My views changed as a result of a public lecture and a roundtable discussion on the book Mission and Money: Understanding the University (you can order the book here) that I attended last week. One point that is repeatedly addressed in the book is that universities have variety of revenue sources, and that these revenues are fungible. There was also a comment, from the President of Northwestern University, along the lines of: I wouldn’t even need an accountant to help rearrange figures so as to satisfy a 5% spending rule. Combined these two points convinced me that an endowment spending rule would be ineffective.

To clarify, consider these two examples. First, consider normal businesses that pay taxes on their profits. The government can tax the profits of businesses fairly easily because the goal of the business is to make profits. To achieve their goal, they must maximize precisely what the government taxes. Second, consider non-profits that are subject to the 5% spending rule. These are predominantly organizations where the main source of revenue is tax deductable contributions. To ensure that the money goes towards the purpose, the government insists that 5% of it is actually spent every year. This is an effective rule (whether it is a good rule is another question) because contributions are the sole, or at least a dominant source of revenue for these organizations.

Thus, government decrees will be effective if they are aimed at the goal of the organization (taxes on profits) or if the only source of revenue for the organization is the one that is to be regulated (typical non-profits subject to the 5% rule because their "endowments" are funded by tax deductable contributions).

Neither of these conditions is satisfied by a 5% spending rule for universities. The goal of universities is not to accumulate endowments (though some of them are quite good at it), and the proportion of their revenue that actually comes from endowments is typically quite small. Because most of their money comes from other sources, and because money is fungible, universities will find it very easy to “satisfy” a 5% spending rule without actually changing anything.

So a minimum payout rule would be ineffective, meaning that it would have no benefits. It would however, impose costs, primarily in the form of compliance costs (accountants and lawyers filling out forms). Whenever something would provide no benefits, but would have positive costs, it should not be done. Thus, the 5% spending rule should not be imposed on universities.