Econ 101: Who Benefits from Boost in Student Grants?

     One of the priorities of the new Congress, and something approved of by most of the media, is to expand federal grants and loans to college students. While this may sound like a good way to increase access to higher education, it is another case where people, in Sherlock Holmes’s words, see but do not observe.

     Before Congress increases spending on financial aid to college students, it should think about what the end result will be. That result will certainly be higher tuition costs for all students, and may result in no net tuition reduction for those who receive the aid.

     Suppose the federal government decided to provide $5 billion in grants to people to buy DVD players. Most people would realize that such grants would increase the demand for DVD players, bidding up prices for everyone. Those who didn’t get the grants would certainly pay a higher price than before the grants. The people who got the grants would also be paying the higher price, and thus while the net price they pay might be lower than before the grant, they would not benefit from the full amount of the grant.

     The only question is how much the price of DVD players would rise – not whether they would rise. Thus, the companies that sell DVD players would certainly capture some of the benefit of the grant.

     For some reason, people seem to not recognize that this same thing will happen if the federal government gives more than $94 billion in loans and grants ($18 billion in grants) for students to go to college. There should be no question that such aid drives up tuition prices. How much tuition goes up will depend upon a myriad of factors and will differ by college and university. In some cases the net tuition will go up by the amount of the grant, so the student receiving the grant gets no net benefit and the rest of the students face higher prices.

     So who gets the true benefit? In some cases it will be the college, and in some cases the state government will capture it.

     When students receive grants to attend college, the demand for seats at the public university, say the University of Michigan, will rise. The University might raise its tuition in response to this extra demand, and all students pay a higher price. The students with aid will have some relief from the higher price as long as the tuition doesn’t rise more than the grant.

     The University might, instead, keep its tuition the same and lower the in-house financial assistance it gives to students. So the student with the Pell grant might get less financial aid from the University – meaning the Pell grant displaced University of Michigan aid, and the University now has captured the Pell grant.

     Another possibility is that the Michigan legislature might appropriate less money to the University of Michigan. The University might keep its tuition the same, provide less financial aid from the University to the student, ending up with the Pell grant but a lower appropriation – so in that case, the Michigan legislature captures the Pell grant.

     The bottom line is that billions of taxpayer dollars handed out in grants and loans increases tuition for everyone. It may be providing some reduction in the net cost of tuition for some students, but it might simply allow some colleges and universities to keep more revenue by reducing their financial aid expense. Or, the Pell grants could end up being captured by state legislatures reducing appropriations to public colleges and universities.

     With 4,000 colleges and universities in the United States, each having a different board of directors with different objectives, some funded by state governments and some not, it is unlikely that anyone can determine where the benefits of Pell grants would end up. The only clear point is that Pell grants raise tuition for all students.

     Rather than spending billions more on a program with such detrimental and uncertain effects, Congress should do what it can to improve the market for human capital. The late Milton Friedman suggested decades ago that we develop human capital contracts, whereby investors could pay for a student’s education in return for a share of that student’s future income. This is a much more reasoned method of ensuring that students who will gain from access to higher education receive that opportunity. Perhaps the time has come for another of Professor Friedman’s ideas to turn into public policy.

Dr. Gary L. Wolfram is the George Munson Professor of political economy at Hillsdale College in Hillsdale, Mich. He also serves as an adviser to the Business & Media Institute.