Robin Hood goes to college - how economic formulas for families planning college tuition finances discourage saving and investment - Column

National Review, May 2, 1994 by Ed Rubenstein

WITH the demand for educated workers rising, and the growth in their numbers slowing, the economic advantage of a BA has never been greater. The average college graduate now earns 57 per cent more than someone without a degree, up from 38 per cent in 1979.

Tuition, meanwhile, has exploded-rising three times faster than the CPI since 1980. For many middle- and upper-income families, college saving goes on for years before a child's enrollment. Unfortunately, these thrifty, thoughtful families may only be hurting themselves.

The problem stems from the so-called "Institutional Methodology" (IM), a complex set of rules used by most American colleges to determine scholarship amounts. The IM's key calculation, the "expected parental contribution," is based on a family's "discretionary income" and the value of the assets it is deemed to have "available." An extra dollar of income or wealth (including the value of the family's home) means less aid.

The "tax rate" schedule implicit in the IM is quite steep. Under current scholarship rules, a family of four earning as little as $25,000 a year loses 22 cents in school aid for each additional dollar of income or assets. The scholarship tax rate peaks at 47 per cent at the still modest $47,000 gross-income level.

In a world of no taxes, a dollar invested at 3 per cent interest would grow to $1.126 after four years, and $1.267 after eight. If a 28 per cent income tax is imposed, the net amounts decline to $1.097 and $1.190, respectively.

Families with college students, however, are effectively taxed on interest as well as the assets that generate interest. During the first year of college they end up losing 7.5 cents for every dollar of accumulated assets. At the end of four years the scholarship tax has shrunk that dollar to 73 cents. A family with two children who attend college in succession will see an initial dollar of assets shrivel to 54 cents.

The most obvious effect of the college tax, notes Harvard economist Martin Feldstein, is to encourage families who would qualify for financial assistance on the basis of income not to accumulate any assets before their children start college. To the extent that scholarship aid and student loans fail to cover tuition, the family is better off borrowing funds than saving in advance.

Most families are probably not aware of the rules governing scholarships. For those that are, the effect on savings is dramatic. Mr. Feldstein's research, based on 1986 data, considers the impact on a household with a 45-year-old family head, two college students, and an income of $40,000 per year. The scholarship rules induce the family to save only $23,000, or half what they would have saved without the adverse incentives.

Under current rules, families with incomes above $120,000 are ineligible for financial aid. For them, educational expenses are like every other cost. For the overwhelming majority of American families, however, the progressive tax code imposed by U.S. colleges is more burdensome even than the one imposed by the IRS.

Value of $1.00 Invested for Eight Years
                             After Income Tax
       Before      After         and
Year    Tax     Income Tax   Education Levy
1     $1.030      $1.022         $0.925
2      1.061       1.044          0.856
3      1.093       1.067          0.791
4      1.126       1.097          0.732
5      1.159       1.115          0.677
6      1.194       1.139          0.626
7      1.230       1.164          0.579
8      1.267       1.190          0.536
Source: Martin Feldstein; calculations by author.