Episode 4

Do Loans, Financial Aid, and Tax Policy Really Make College Cheaper?  Or Do They Do the Opposite?

Do Loans, Financial Aid, and Tax Policy Really Make College Cheaper?  Or Do They Do the Opposite?  We will answer these questions on today’s episode.  I am Larry Bernstein and welcome to Charging U.

“Increases in financial aid in recent years have enabled colleges and universities blithely to raise their tuitions”  William Bennett, former Secretary of Education

We have seen in previous episodes that public funding of state colleges and universities has dropped and private not for profit colleges seek to extract as much current wealth and future earnings as possible.  The burden of paying for the increased cost of higher education has been shifted to the student.  It has not been met with a similar rise in wages for the average person.  This has led to a larger difference between what is charged and what most students and families can pay out of pocket.  This deficit has to be made up somehow and that somehow is with loans and grants.  In the past, this issue affected mostly low income students but now the middle class is also affected so that 85% of full time students attending 4 year colleges receive federal aid through grants or low interest loans.

The most common need based grant is the Basic Educational Opportunity Grant or Pell Grant named after its Congressional sponsor, Senator Claiborne Pell of Rhode Island. In 1972 Congress reformed the 1965 Higher Education Act which provided grants to qualifying programs. It created the Pell Grant which was an award, not a loan to be paid back.  It was meant to be the foundation of financial aid to which other sources could be added.

Today, over 6 million students or about one-third of all college students receive Pell Grants. Two-thirds of those grant recipients attend public universities. Students apply through the FAFSA, the Free Application For Federal Student Aid, and there is a standard formula based on family income to calculate how much the family and student are expected to contribute to college costs. If that number is less than the cost of tuition and fees, then the student can qualify for a grant of up to $7395 per year for the 2023-2024 academic year. The average grant is about $5000. 51% of Pell Grants go to those with family income less than $20,000 per year and 38% to those with family incomes $20-$50,000 per year. The funds are portable in that they travel with the student to whichever school he matriculates.  The money goes from the federal government directly to the school the student is attending. The student never touches the money.

If there is a further shortfall of funds, the student can borrow either from the private sector or more commonly from the US Department of Education. If the student demonstrates financial need and is enrolled at least as a halftime student then she can get a subsidized loan from the government. Dependent students can borrow up to $3500 the first year, $4500 the second year, and $5500 per year thereafter up to a total of $23,000. Students in graduate and professional schools can borrow more.  The lifetime interest rate is based on inflation and is below the market rate.  It has gone up annually from 2.75% for loans originating in 2020 to 5.50% for the current academic year.  Interest charges and repayment by the student begin six months after she is no longer enrolled in college.

An unsubsidized loan is available even if a student doesn't qualify for financial aid. She may borrow up to $34,500 total in unsubsidized loans. Those with any kind of student loan can qualify for a tax deduction for interest paid of up to $2500 per year- more on that later.

If additional funds are needed, then the parent of the student can take out an unsubsidized Parent PLUS loan which has a market interest rate.  The only cap on the amount that can be borrowed is the cost of attendance minus other financial assistance.

In 1987, then Education Secretary William Bennett wrote in a New York Times Op Ed piece that "increases in financial aid in recent years have enabled colleges and universities blithely to raise their tuitions, confident that federal loan subsidies would help cushion the increase… Federal student aid policies do not cause college price inflation but there is little doubt that they help make it possible.”

Thirty-seven years later this remains controversial but appears to be true.  Financial aid has a large effect on private college cost and a smaller but growing effect on the price students pay to attend public colleges.

How do Pell Grants and loans relate to the real world of public universities? First, let's talk about the City University of New York, my father's alma mater. It is the largest urban and fourth largest university system in the country. Though it was technically formed in 1961, the colleges that make it up date back to 1847. It was mostly free for New York City residents until the New York City financial crisis in the mid 1970s. Then, the system reflected back to the 1972 Keppel task force which looked at ways for New York to improve its financial situation.  It ”considered extremely important that the state take maximum advantage of federal funding in order to reduce the burden on state taxpayers.”  This was a diplomatic way of saying, “Why not charge students tuition which the federal government would pay for anyway?”  It wouldn’t cost the students much because they received Pell Grants from Washington to cover the new tuition charges and the university system got millions in extra revenue.  There was no reason to leave free money on the table. The City University says on its website that, today, Pell grants and New York State Tuition Assistance Program funds allow over 100,000 students or 58% of the full-time student body to attend tuition-free.

While this is an extreme example since almost all schools already charged tuition, it does put a floor as to how low even a public institution should set tuition. One wonders if, when those who set tuition at public colleges are making their decision whether the fact that up to $7395 is guaranteed to those with the lowest income is in the back of their minds.

In the past, it was felt that the loan program did not affect tuition at public colleges.  In public colleges, tuition is set by the state legislature or other body. The one set price is widely known and has to appeal to a very large range of citizens.  The relatively low price made it affordable for even low and middle income families.  In the previous episode, we talked about reduced state appropriations and public colleges beginning to adopt a high tuition, high discount model with targeted non need based aid.  We mentioned that they met a decreasing amount of the demonstrated need of low income students.  This forced more students to take out loans, and larger ones at that.  The public colleges could only pursue this strategy because of the existence of the federal loan program so it seems that upon closer evaluation, the presence of the federal guaranteed loan program does allow public colleges to make it more costly for many low income students to attend.

Private, nonprofit colleges are a different story.  At private colleges there is no real set price. It is a one on one negotiation in which the school attempts to extract in the present and future as much money as possible out of the student and his family. The school tries to determine how much pain the student and family will endure to attend their college. The school knows how much the Pell grant amount will be and for the student giving up free money that he has never held in his hands and he would not get otherwise, it does not hurt. In addition, agreeing to give away borrowed money does not cause much pain in the present and the student is more likely to do so.

Consider the following hypothetical scenario.  Imagine that hackers have pulled off a successful ransomware cyber attack on your new business which was expected to show a nice profit in the future (that’s the college wage premium or how much extra money a graduate will earn with her degree).  Before issuing ransom demands, the hackers want to see a certified copy of your tax returns and bank statements. They examine these documents and a few days later announce their demands. First, is that they want the U. S. government to hand over $5000. It just so happens that the U. S. has a fund set aside for just this sort of thing. It’s called Pell Grants.  You say, “Sure, the federal government should give them $5000. No skin off my back.”  Next, they say they want you to pay them $77 a month for 10 years beginning in four years.  That’s the repayment for $8,000 in loans at 3%.  You might be willing to go along with that. You get your business back now and pay in the future when you fully expect to have more money. And besides, $77 doesn’t sound like that much money.  Then, they say they want $30,000 in cash right now. Ouch!  Now we’re talking real money and hardship.  And remember they know exactly how much money you have in savings now and how profitable your business will become in the future. They have outside advisors with the data to know how much other businesses paid in ransom to get their businesses back so they could make money in the future.  Now you balk and think, “Is it worth $30,000 or can I spend that money on something else?” This $30,000 is the number that really counts. The rest is either not your money or a future cost which doesn't affect you in the present to the same degree as paying a lump sum today.  If you agree to the $30,000, the hacker gets $5000 (from the government) + $8,000, the principal of all the loans + $30,000 of your money or $43,000 total.  But it only costs you $30,000 now - actually $27,500 now because of the American Opportunity Tax credit which we will go over shortly, and approximately $9,000 later $77 x 12 months x 10 years or $9,240 total principal and interest minus the tax credit on interest which we will also discuss in a few minutes or $36,500 total over your life. 

The cyber attack which we just mentioned corresponds more closely to the behavior of private colleges and universities. The influence of Pell grants and loans on private colleges and universities is greater than that on public universities. Since tuition sticker price is so high and the amount paid by a student more individually determined, the school can take into account how much the student will receive in grants and loans. The New York Federal Reserve estimated that for every one dollar of federally subsidized loans, tuition at private institutions goes up 60 cents. So that’s 60 cents on the dollar for loans.

For grant aid, other studies show that the amount of tuition increase to students with grants is probably even higher than 60 cents on the dollar, especially at private institutions.  When more government aid is given, less aid is given by the college itself.  The college is looking to find that Goldilocks out of pocket amount that is not too high to scare away the applicant and not so low as to give the student the economic surplus.

Think about it. What would happen if the US government gave out vouchers or subsidized loans for a Taylor Swift concert … or for the Super Bowl … or for a combination Super Bowl-Taylor Swift concert? … That could happen.   Do you think the price for seats would stay the same or go up?  I bet that it would go up.

There are a couple of other related topics which might imply but certainly do not prove that an increase in loans or aid tends to lead to an increase in the amount spent. One study looked at the effects of an increase in the mortgage deduction in Denmark and concluded that it induced people buy bigger and more expensive houses, induced them to increase indebtedness, and did not change the overall percent of homeownership. Similarly, people tend to buy larger, more expensive cars when car loans are more accessible or have a lower interest rate. A car loan does not reduce the cost of the car, it makes it easier to buy the vehicle by stretching out the payments.  It does not discount the cost of the automobile.  Likewise, grants and loans have improved accessibility to higher education but they have not reduced the cost. 

We saw something similar to the results of the Danish mortgage deduction and lower car interest rates when home prices skyrocketed in 2020 and 2021.  The supply of homes for sale was limited and demand was high.  Prices skyrocketed because the amount of the loan payment was still relatively low due to low interest rates. Homebuyers were buying a monthly payment. It didn't matter how much the house actually cost; what mattered was how much they had to pay out each month when factoring in principal, tax benefits, and interest rates.  So if the interest rates were very low, it was OK if the principal of the loan or the price of the house was high as long as the monthly payment was affordable.  Likewise, if students are paying less in interest, there is room for the college to charge more so that the total payment of principal and interest by the student was the same as if interest rates were higher, that is to say, not subsidized, and tuition were lower. In the example of the ransomware attack, we had the student borrow $8,000 at 3%.  To get the same $77 monthly payment on a loan with an interest rate of 5.5%, the principal would be about $7,000.  With the higher interest rate, the student would only be able to afford a tuition that is $1,000 less. So the college could raise tuition or reduce the amount of aid or discount if the interest rate were low but could not raise tuition as much if the interest rate were high.  In fact, the New York Fed found that tuition did not go up as much with an increase in unsubsidized loans with their higher interest rates as it did with subsidized lower interest rate loans.

The point of all this is not to say that grant and loan programs should be eliminated.  It is to indicate that they may be responsible for a portion of the rising tuition and should be evaluated more closely.

I should address loan forgiveness as well.  If this becomes a precedent, there is no doubt that it would enable colleges to jack up tuition.  They could raise tuition $10,000 and collect that extra money.  The student can borrow $10,000 more and not be concerned, not care about the rise in tuition, confident that the extra amount borrowed will be forgiven.  The higher tuition does not cost the student anything.  The university has the extra money and keeps it; the student got off paying nothing extra; and the taxpayer is left with the debt.

We have covered government grants and subsidized loans. There is another area where the federal government supports paying for the college years and that's through tax incentives. The first is very straightforward and visible: the American Opportunity Tax Credit taken on the Federal 1040 return. The credit is 100% of the first $2000 spent on qualified education expenses and 25% of the next $2000 spent for a maximum credit of $2500 per year per student. To qualify for the full credit, the modified adjusted gross income must be below $80,000 for a single filer and below $160,000 if filing jointly.  In the second episode we had a baseball player applying to a fictional college and said his family would have to come up with $4,000 to pay for college.  With the American Opportunity tax credit, they would get up to a $2,500 tax credit so the real cost to them could be only $1,500.  In the example of the cyberattack earlier in this episode, though the business owner/student paid $30,000, he or she also gets to deduct $2,500 from the amount of taxes he or she will have to pay on the federal return.  

Also in that scenario, if the student had a 10 year loan for $8,000 at 3% the monthly payment would be $77 and the total interest paid over the term of the loan would be $1,240.  This interest could be deducted from his or her federal taxes.  So if the student were in the 20% bracket, he or she would pay $248 less in taxes.

The second area of government support is the 529 plan. This began in the 1980s with a prepaid tuition plan. In Michigan, citizens could pre-pay future tuition at the current amount so as to be shielded from the rising rate of tuition. The state of Michigan paid federal tax on the investment earnings but subsequent court challenges said they did not have to pay tax on the earnings. Legislation in 1996 established section 529 of the tax code, hence the name 529 plans, making the earnings tax deferred until distribution. In 2001, Congress made distributions tax free as well.

529 plans yield government sponsored financial relief in several ways. First is at the state level though there is much variation of the benefit between states because each state has different rules and different tax rates. As of 2021, only six states offered no benefits for 529 savers and nine states had no income tax to allow for a deduction. 32 states and the District of Columbia allowed some sort of tax deduction and three states gave a tax credit. The total benefit of the deduction depends on the tax rate and the limit as to how much of the 529 contribution is deductible. Therefore, in 2021 the actual maximum benefit varied from a low of $48 per year in Rhode Island to a high of over $1300 per year per student in Colorado.  New Mexico, South Carolina and West Virginia had no ceiling on the amount of the contribution which is eligible for a state tax deduction and the savings in those cases could have been much higher.

At the federal level, the saver does not have to pay taxes on the capital gains of 529 investments so if a family with income between $83,000 and $517,000 per year invested money which grew by $50,000 over time, they avoid paying 15% of $50,000 or $7500 of capital gains taxes. For those with income is greater than $517,000 the rate is 20% so they save $10,000. Those with incomes less than $83,000 don't pay capital gains taxes so they do not receive a benefit since they don’t have to pay for the stock appreciation accrued in 529 accounts.  Dividends and income of 529 investments are also not subjected to income taxes so there is further saving there depending on the tax bracket of the saver.

But the biggest benefit of 529 plans has been the explosive growth in the stock market, which we quantified in the second episode.

While families may think that they are pocketing more money and coming out ahead with tax benefits and a rise in the stock market, they are just deluding themselves. Remember that private colleges and their enrollment advisors know all this and they want at least a chunk of that money. In fact the consequence of grants, loans, and tax breaks is a rise in the cost of college proportional to the benefits provided.  The average student and family do not get a leg up on the price of tuition but just keep from falling further behind in their attempt to match the pace of the increased cost of higher education. 

Thank you for listening to Charging U.  In this episode we discussed how aid, loans, and tax breaks may lead to an increase in the tuition charged and collected.  In the next episode, we will examine the role rankings play in determining the price of attendance.

If you found this episode of Charging U informative, please leave a rating and review and spread the word to everyone who has paid, is currently paying, or will soon be paying for college.  I welcome feedback at larry@chargingupodcast.com.  Until next time be well and be safe.