The U.S. Department of Education spends tens of billions of dollars a year on subsidies for higher education. The bulk of the spending goes to student aid, with the balance going to grants for educational institutions. Federal Pell grants are more than $30 billion a year, federal student loans are about $100 billion a year, and grants to colleges and universities are $2.5 billion a year.¹

This essay explores the origins of federal subsidies for higher education and the rapid growth since the 1960s. Then it discusses the harmful effects of higher education subsidies. Those effects include tuition cost inflation, increased regulatory control of colleges and universities, and large amounts of waste, fraud, and abuse.

Origins of Subsidies

Federal subsidies for higher education began in 1862 with the Morrill Act, which provided grants of federal land to the states. The states were supposed to use the proceeds of land sales to create colleges focused on agricultural and mechanical studies, but "many states squandered the revenue from this endowment."² A second Morrill Act in 1890 began regular appropriations for the land-grant colleges.

In 1917 Congress passed the Smith-Hughes Act, which funded the salaries of local vocational education teachers. The act imposed a range of detailed rules on the funded schools, which was an early precedent for today’s mass of federal regulations on state and local education systems.

The first major subsidy for students in higher education was the Servicemen’s Readjustment Act of 1944—the G.I. Bill—which allowed World War II veterans to attend college at no cost. The G.I. Bill was admired legislation, but like all subsidy programs it led to wasteful spending and abuse. Some colleges used federal funds for extraneous purposes, such as swimming pools and stadiums, while others increased tuition rates charged to veterans.³ There were also cases of outright fraud by schools that wanted to garner extra federal funds. Finally, studies have found that at least 80 percent of people who used the G.I. Bill would have gone to college anyway, and that it disproportionately helped higher-income veterans.⁴

In 1958 Congress passed the National Defense Education Act in response to the Soviet Union’s launch of Sputnik, which spread fear that the communists were getting ahead in technical skills. The act authorized funding for higher education loans and fellowships, vocational teacher training, and programs for the K-12 schools, including programs in math, science, and foreign languages.

The year 1965 was a landmark for federal expansion into both K-12 and higher education. The Higher Education Act of 1965 is the basis for many of today’s postsecondary education subsidies, including student loans, Pell grants, college library aid, teacher training programs, and other subsidies.

Since 1965, the federal government has provided steadily increasing funding for higher education. Just since 2000, the cost of Pell grants has soared from $10 billion a year to $34 billion, and federal student loans have jumped from $48 billion a year to about $100 billion.⁵ Meanwhile, grants to higher educational institutions, including Gallaudet and Howard Universities, increased from $1.3 billion in 2000 to $2.5 billion today.⁶

While new federal student loans are running about $100 billion a year, the ultimate cost to taxpayers will be some fraction of that. The federal budget includes an estimate of the expected subsidy value of loans on a present-value basis, based on projections of interest rates, defaults, and other factors. The budget currently shows that the government is making money on student loans, but that is a fiction stemming from the flawed accounting used in the official estimates. Using more sensible "fair value" accounting, the Congressional Budget Office found that federal student loans are expected to cost more than $10 billion a year in coming years.⁷

In recent years, Congress has expanded higher education subsidies in numerous ways. In 2007 the College Cost Reduction and Access Act cut interest rates on subsidized loans in half. That act also created the income-based repayment program, which caps repayments at 15 percent of a borrower’s discretionary income and forgives the remainder after 25 years. And it created a "public service" program for government and nonprofit workers that forgives all debt remaining after 10 years of on-time payments.

In 2008 the Ensuring Continued Access to Student Loans Act increased the borrowing limits on certain student loans and gave the Department of Education new authority to fund student lending. Also in 2008, Congress authorized an increase in Pell grant maximums from $5,800 to $8,000 over time and forgiveness of up to $10,000 in federal loans for people working in an area of "national need."

In 2009 the economic stimulus law directed about $100 billion toward education, with higher education receiving much of that money.⁸ The law increased Pell Grant funding, boosted funding of university research, and provided large grants to all states so that they could "backfill" any state budget cuts.

In 2010 the government essentially completed the nationalization of student lending. The Federal Family Education Loan Program—in which the government guarantees loans delivered through private lenders—was eliminated as part of the Affordable Care Act (ACA), and was replaced with lending directly from Washington. In recent years, only 10 percent of student loans have not been originated by the federal government.⁹

That move eliminated subsidies that the federal government had paid to private lenders, and the budgetary savings on paper were assigned to the ACA. The purpose was to reduce the advertised cost of the ACA, but the official scoring of these savings from ending subsidies for private loans was dubious.¹⁰

Other provisions in the ACA liberalized aspects of federal student loans, including changing the income-based repayment program. It dropped the cap on monthly payments from 15 to 10 percent of adjusted gross income for all new federal borrowers with loans originated after July 1, 2014, and allowed full forgiveness after 20 years instead of 25.

In 2012 interest rates on subsidized federal loans—which were cut in half from 6.8 percent to 3.4 percent in 2007—were due to jump back to 6.8 percent. Congress froze the rates for one year. Then in 2013 the jump was looming again, and Congress passed legislation pegging federal student loan rates to 10-year Treasury bill rates, with different plus-ups depending on the type of loan. Subsidized loans were pegged at the T-bill rates, plus 2.05 percentage points.

Finally, a growing part of federal support for education is through the tax code. In 1995, there were just 7 special breaks in the income tax code for K-12 and higher education. Today, there are 18 breaks, including the lifetime learning tax credit, Hope tax credit, and education savings accounts, which together deliver tens of billions of dollars of assistance.¹¹ Such special breaks make the tax code more complicated, while violating a basic principle of justice to provide equal treatment before the law.

Supporters of student aid often say higher education is a "public good," and would be underprovided without government tax breaks and subsidies. But that is probably not the case. For one thing, people have a strong incentive to invest in their own education because it will lead to higher earnings. Those with college degrees earn, on average, about 84 percent more during their lifetimes than those with just high-school degrees.¹² That is a big incentive for people to save or borrow in markets to pay for their own college costs.

When considering federal college subsidies, one should also think about fairness. The subsidies—paid for by taxpayers—benefit people who are expected to earn higher future incomes as a result of their advanced educations. Thus, the effect of subsidies, in part, is to tax blue collar workers who do not attend college to pay tuition for future white-collar professionals. But why should the government subsidize future high earners at the expense of average working people?

Subsidies and Education Inflation

While the aim of student aid programs is to help students, the programs also transfer wealth from taxpayers to academic institutions. That is because the rise in student subsidies over the decades has fueled inflation in education costs. Tuition and other college costs have soared as subsidies have risen.

It is matter of supply and demand. As more Americans have sought a college education, prices have been pushed up. Ordinarily, such upward demand pressure would be restrained by consumers’ willingness and ability to pay, but because federal subsidies have helped absorb tuition increases, the public’s budget constraint has risen.¹³ Peter Wood, a professor at Boston University, noted that federal subsidies "are seen by colleges and universities as money that is there for the taking . . . tuition is set high enough to capture those funds and whatever else we think can be extracted from parents."¹⁴

One can look at average cost data to see the inflationary effect of rising student aid. From 1994 to 2014, there was a strong upward trend in average per-student costs of public and private universities (tuition, fees, and room and board). However, if you subtract from those costs the value of grants and tax benefits, there has been a more modest increase over two decades.

Consider four-year private, nonprofit colleges and universities. The average real sticker price (in 2014 dollars) per student rose from $26,490 in 1994 to $42,420 in 2014, a 60 percent increase. But students did not bear that large increase because they benefitted from grants and tax benefits. After netting out those out, the average cost grew from $18,270 to $23,550, a much smaller 29 percent increase. A similar pattern holds for price increases at public institutions.¹⁵

A 2015 study by scholars at the New York Federal Reserve Bank looked at the statistical relationship between college tuition and federal grants and loans.¹⁶ They found that "institutions more exposed to changes in the subsidized federal loan program increased their tuition disproportionately around these policy changes, with a sizable pass-through effect on tuition of about 65 percent."¹⁷

To an extent then, rising federal aid is causing college cost inflation. Nonetheless, even after taking that into account, federal aid has likely helped to increase student enrollment. Total U.S. college and university enrollment has increased about 37 percent since 2000.¹⁸ But that leads to an important question: Have those enrollment increases been a good thing?

Many of the additional students may not have been ready, or suited, for college. Consider that the percentage of first-year college students who need to take remedial classes is very high at around 35 percent.¹⁹ Consider also that institutions have reduced their standards to adapt to the growth in second-rate students. The American Academy of Arts and Sciences reported that from the mid-1960s to the mid-1990s, college grade point averages grew steadily, but Scholastic Aptitude Test (SAT) scores fell.²⁰ So there appears to have been grade-point inflation since the more objective SAT showed declines.

The decline in the average student quality is also suggested by research showing a falling amount of time in college spent actually studying, and by research showing that there are only small measured gains in critical thinking as students progress through today’s colleges.²¹ Finally, rising college enrollment has been accompanied by declining adult literacy for people with degrees.²²

With all this in mind, cutting federal aid would probably not result in reduced accessibility for truly needy and deserving students. For one thing, college cost inflation induced by federal aid may hurt low-income families more than others because they face sticker prices that appear daunting. The share of Americans from the lowest income quartile with a bachelor’s degree by age 24 rose from 6 percent in 1970 to 9 percent in 2010. But the top quartile attainment rose from 40 percent to 77 percent.²³ Additionally, many private philanthropists support promising, low-income college kids, and they would have more interest in doing so if the federal government got out of the student aid business.

Also note that because college education has real value, qualified young people and their families have strong incentives to invest in higher education, and private lenders and aid providers have a strong motive to lend to them. Unlike the government, however, private lenders have more incentive to scrutinize aid applicants to judge whether they are ready for college and are studying in useful fields. Thus, private aid would likely reduce the problem of people entering college, racking up debt, and then not finishing college, or getting degrees that the economy does not need.

By cutting federal subsidies, tuition and related costs would be restrained as students shopped around for the best deals. In turn, that would force schools to reduce their bloated costs, and there is plenty of bloat in academia. In recent years, while student groups and college officials have decried supposed funding cuts, colleges and universities have been in the midst of a building boom.²⁴ Staffing has also grown rapidly. Between 2001 and 2011, enrollment in degree-granting institutions rose 35 percent, but executive and administrative staffing rose 57 percent.²⁵

There are at least three further signs of bloat. First, as many as 40 percent of people who enter a four-year program do not finish, nor do roughly 70 percent of people who enter two-year programs.²⁶ Second, about a third of those who finish four-year degrees end up in jobs not requiring their degrees, and the quality of those jobs has declined over time.²⁷ Third, even those who find jobs related to their degrees may have learned little in college applicable to those jobs. Research has found numerous job categories in which employers advertise for people with degrees, but college skills do not seem to be needed for the jobs.²⁸ This is called "credential inflation." Employers ask for a college degree, regardless of actual job needs, because degrees are so ubiquitous that not having one is seen as a sign of a deficiency.

Here are other signs that both students and institutions could tighten their belts:

• Almost half of 18- to 22-year old college students binge drink.²⁹
• College students devote just 3.3 hours to education on an average weekday, versus 4.0 hours to "leisure and sports."³⁰
• About 50 presidents of public and private nonprofit colleges are making more than $1 million per year.³¹
• A fair bit of campus spending seems to be frivolous, such as the trend to build costly waterparks. The University of Missouri’s Tiger Grotto features "a high-powered vortex, lazy river and waterfall."³² Texas Tech’s Leisure Pool has a "645ft. long lazy river as the centerpiece."³³ Auburn University’s aquatic center has a pool featuring a "20-foot AquaClimb Wet Wall" and a "45-person, tiger-shaped hot tub and fire pit."³⁴

Finally, an analysis by Oklahoma State University professor Vance Fried found that both public and private nonprofit colleges bring in thousands of more dollars per undergraduate than it costs to educate them.³⁵ Nonprofit schools do not call this differential "profit," but it is essentially the same thing, as it is distributed in the form of higher salaries, reduced teaching loads, more administrators, and other bloat.

Rising Federal Regulatory Control

Even with its problems, the American postsecondary education system is considered to be the best in the world. Driven by consumer choice and competition between independent institutions, it has an unmatched vibrancy.

However, increasing top-down control and subsidization from Washington is creating a threat to the system. As we have seen in K-12 education, the growth in federal subsidies has been accompanied by calls for more oversight, micromanagement, and red tape imposed by Washington.

The waste and bureaucracy of top-down federal control is exemplified by Title IX of the education amendments law of 1972. It banned discrimination based on sex for any education-related program receiving federal aid. Title IX has created major dislocations in activities such as college athletics, and it has generated a large legal industry in administering, enforcing, and litigating the complex rules. The law is overseen by the Office of Civil Rights in the Department of Education, which had 544 employees in 2015 earning an average annual compensation of $142,000.³⁶ Title IX is a regulatory octopus with arms in education programs, athletics, cheerleading, fraternities, and other activities. Whole books have been written about its broad and negative effects.³⁷

The Obama administration has used Title IX to subvert basic notions of justice, such as with its issuance of guidance on sexual assault allegations. In 2011 the administration told colleges that they were required to use a "preponderance of evidence" standard to determine if students accused of sexual assault or harassment were guilty and should be punished, typically with expulsion from school. The administration pushed aside the idea that people are innocent until proven guilty, and school officials would only need to feel 51 percent sure that the people they accused were guilty.

Expansions in federal control also include efforts to impose "national standards" on higher education. In the George W. Bush administration, Education Secretary Margaret Spellings created a commission to formulate a "comprehensive national strategy" for higher education, indicating that it wanted to tighten federal control. The commission’s report stopped short of advocating outright federal imposition of standards and tests, but it did call for a "national strategy for lifelong learning" and a federal database with information on every college student in the country.³⁸

Secretary Spellings also took a step toward imposing outcome requirements on colleges through the regulation of accreditors, which are organizations whose approval is needed for the receipt of federal aid. In her plan, accreditors would have been required to have schools report explicit outcome measures, which would probably have meant standardized tests for incoming and outgoing students.

Congress rejected those proposals, but the Obama administration has attempted to impose its own top-down standards. In 2013 the president said that the administration would formulate metrics to rate colleges. The proposal would tie the ratings to each school’s ability to enroll students with federal student aid, a major source of funding for nearly all schools. However, it stepped back from that plan in favor of publishing a college "scorecard" that lists college graduation rates, average earnings of former students who used federal aid, and other information.³⁹

In 2015 the Obama administration proposed actions to micromanage the accreditation process, including publishing each accreditor’s standards, letters that accreditors send to schools, and individual school graduation rates, loan default rates, and post-graduation salaries of former students. The actions are another step toward imposing one-size-fits-all standards from Washington.

The Obama administration has imposed at least three other major regulations on higher education. The first defines what constitutes a "credit hour." Federal officials decided that it is at least one hour a week in class and two hours working outside of class. The regulation also dictates how programs that use "clock hours"—actual hours in class—must be converted to credit hours.

The second major regulation requires that colleges with physical campuses in multiple states be authorized to operate by each state in which they function. This requires, among other things, that states have processes in place for taking student complaints about schools. The administration had also tried to impose such rules on online course, but it ultimately backed off that misguided idea.

The third set of major regulations are "gainful employment" rules, which relate to the ability of graduates to pay back loans. The target was for-profit schools, which mainly run programs aimed at job skills. They are unpopular with the political left, and often appear to have poor outcomes relative to other institutions, but only if one does not control for important factors.⁴⁰

A version of the gainful employment rules was overturned in 2012 by a federal court, which found them unacceptably arbitrary. The Obama administration issued new rules, which punish schools if a typical graduate’s annual loan repayments exceed certain ratios relative to their earnings.⁴¹ Those regulations were upheld by a federal court and went into effect in July 2015.

Waste, Fraud, and Abuse

Most federal subsidy programs suffer from large amounts of waste, fraud, and abuse. Medicare, Medicaid, school lunches, farm aid, and other programs all suffer from these problems. When programs hand out billions of dollars of grants or loans, they attract dishonest individuals and criminal gangs.

Federal student aid programs have been subject to waste, fraud, and abuse for decades. In 1991 an in-depth Senate investigation found that federal student loan programs were "plagued with fraud and abuse at every level."⁴² The investigation accused the Department of Education of "gross mismanagement, ineptitude and neglect," and found that it had a "dismal record" of dealing with loan abuses.⁴³ The report found that losses from the student loan program totaled $13 billion between 1983 and 1990.

One fraud scheme in the early 1990s involved a group of Jewish schools in New York, which received millions of dollars in Pell grant money but spent little on education. One school pocketed $3.2 million in grants and spent just $21,000 on education.⁴⁴ Another scandal at the time involved a business college in Puerto Rico, whose leaders used $3 million of Pell grants to buy items such as sports cars and real estate. Yet another scandal involved a college in Florida that recruited "students" at food stamp offices and housing projects, and helped them to get loans.⁴⁵ The school owners received tens of millions of dollars in loans, and simply pocketed it. In 1994 the Department of Education admitted that it was losing $3 billion or more annually to waste, fraud, and loan defaults.⁴⁶

Those scandals prompted some reforms, but the waste continued. In a 2002 investigation, the GAO created a fake university and fake students and applied for federal student loans—and received them.⁴⁷ A 2005 investigation revealed that owners of a company called the CSC Institute stole $4.3 million of the $13 million it received in Pell grants.⁴⁸

The fraud and abuse continues today. Here are some recent cases we came across, which illustrate the widespread nature of the problem:

• In April 2013, leaders of a university in California were found guilty of illegally receiving $686,000 in Pell grants by falsifying applications for students who already had degrees and were ineligible for grants.⁴⁹
• In February 2014, a group of individuals in Alabama were found guilty of fraudulently claiming $1.2 million in federal student aid. The group found people to help apply for aid with false information, and then split the illegal proceeds with them.⁵⁰
• In October 2014, leaders of a Florida college were indicted for receiving $6.5 million from 1,300 fraudulent student loans and Pell grants.⁵¹
• In November 2014, a woman from Flint, Texas was found guilty of claiming $564,000 in fraudulent student loans and Pell grants.⁵²
• In March 2015, a couple in Canton, Ohio, was sent to prison for defrauding the government of $2.3 million of student aid for their fly-by-night college.⁵³

Presumably, for all the crooks that are caught there are more that escape detection. Both individuals and schools have incentives to cheat, and there are many ways that forms can be falsified to gain unwarranted benefits. A common type of cheating is the misreporting of income on application forms for needs-based grants and loans.

Federal taxpayers also suffer losses from the high level of defaults on student loans. There are different ways that default rates are calculated, but they all point to billions of dollars in losses.⁵⁴ The three-year cohort default rate is the share of loans that are defaulted on within three years of entering repayment. As of September 2015 it stood at about 12 percent.⁵⁵ The "budget lifetime" default rate is the estimated share of total loan volume each year that will enter default at some point over the subsequent 20-year period. It is currently about 18 percent.

The federal government currently issues about $100 billion in new student loans each year. Total student loans outstanding have doubled over the past seven years—from $577 billion in 2008 to $1.2 trillion in 2015.⁵⁶ Student loans now surpass auto loans and credit cards as the second largest type of household debt, after mortgage debt.⁵⁷ Student loan debt has a high rate of delinquency compared to other types of debt, and delayed or non-repayment is encouraged by a number of federal loan forbearance or forgiveness programs. Taxpayers could be hit with billions of dollars in losses in coming years.

Many federal subsidy programs are targets for widespread abuse because they are such large programs and are poorly administered. With college aid, there are over 40 million loans outstanding and more than 7,000 postsecondary institutions. The Department of Education has shown itself to be incapable of efficiently managing such a huge system. Private alternatives are less likely to be abused, and more likely to benefit those students most in need.

Conclusions

Federal student aid is harmful in many ways. It drives up tuition costs, encourages bloat and inefficiency, and is an unfair burden on taxpayers. But most importantly, because federal aid comes with top-down regulations, it poses a threat to the core strengths of American higher education, including institutional autonomy, competition, and innovation.

All efforts to impose federal regulations on colleges and universities should be rejected. At the same time, federal subsidies to students and institutions should be reduced and ultimately eliminated.