Should We Tax University Endowments?

October 19, 2022

Taxing university endowments has gained popularity recently, partly in response to the Biden administration’s forgiveness of student loan debt. Some view it as a means of holding universities accountable for the product they’re selling. Others view it as a tool to tamp down tuition rates or punish ideological opponents. But do these arguments hold water and is an endowment tax sound policy?

The United States already taxes large university endowments—the Tax Cuts and Jobs Act (TCJA) introduced a 1.4 percent tax on university endowment income for universities with at least 500 students and endowment assets above $500,000 per student, a small tax that raises minimal revenue. Current proposals would increase the tax or alter its structure to influence universities’ behavior.

To begin with, taxing nonprofits is something of a non-sequitur. As my colleague Jared Walczak noted in his discussion of the taxation of churches, nonprofits (unlike for-profit corporations) do not have net income. In some years, their revenue from contributions and returns from their financial assets may exceed their expenses, but these are not the same as a company’s profits.

But beyond this legal truism, we exempt (or largely exempt) nonprofit universities from taxation because they provide a good with positive externalities (i.e., larger social benefits). While yes, the Harvard endowment has as much money under management as many of the world’s largest hedge funds, its income serves a social purpose: financing a portion of the university’s operations and ensuring its long-term stability. This gets to the heart of the endowment tax debate: a disagreement about the value of higher education, itself.

Higher Education—What Is it Good For?

The conventional case for higher education is focused on human capital formation—or, more simply, knowledge. By learning things in college, students become more productive workers, raising both their incomes and overall economic output. And for the most part, workers with college degrees significantly outearn workers without them.

Skeptics, perhaps most famous among them economist Bryan Caplan of George Mason University, argue that the benefits of a college degree are mostly about “signaling,” not knowledge. In this view, the college wage premium reflects that, by graduating college, the employee has demonstrated a level of intelligence and diligence to make them worth hiring, not necessarily that they learned specific information to make them a more productive worker.

This argument is appealing—after all, most classes end up having little to do with the work one does as an adult, and most people forget a lot of their college coursework. But still, from a student’s perspective, the private benefits of a college education are present, whether they come from signaling or human capital formation. And signaling has some social value, as it makes it easier for employers to search for employees. Yet the question remains: is it valuable enough to justify the enormous cost of higher education? Certainly, there’s a better way to signal that you’re smart and hard-working than spending four years and $300,000 in tuition.

This critique maintains that policymakers have wrongly pushed too many people towards what is effectively a very expensive signaling device, ignoring potential alternatives that could perform the same role at a lower cost.

There is also a separate argument for higher education’s value: agglomeration effects. Agglomeration effects are the benefits of having many highly skilled people close together. For example, universities serve as hubs for research and create networks that drive entrepreneurship and innovation (think of the classic story of the company founded in a dorm room). These connections help explain why Boston was able to claw its way back from industrial decline to a center of high technology, and why Silicon Valley developed so close to Stanford.

I’m certainly not going to resolve the debate about the higher education system in this blog post. But disagreements about the value of higher education underpin the debate about taxing college endowments—and one’s answer can greatly change one’s policy conclusions.

To Tax, or Not to Tax

Some commentators advocate taxing endowments as a form of restitution for student loan debt. Under this theory, colleges and universities have not held up their end of the bargain to make students financially better off, instead leaving them with large amounts of loan debt. Therefore, colleges and universities should be the ones to foot the bill for student loan debt forgiveness, not the general taxpayer.

However, this theory unravels upon scrutiny. While some people certainly get raw deals economically from their college experience, there is still a wage premium for college graduates in the aggregate—and most college degrees have positive returns on investment (although ROI varies heavily according to major).

Of course, some institutions provide subpar services and do not provide significant value for students. But those institutions are not the elite universities with eye-popping endowments—they are mostly schools with very high dropout rates. Therefore, taxing endowments would not hit the schools that are underserving their students.

Similarly, an endowment tax is not a well-targeted solution to an overly pervasive “College-for-All” mindset. The problem implied under this view is not the top rung of colleges, but the bottom rung: low-quality institutions that have been propped up by policies intended to get people into a college, no matter what the return on investment looks like. The elite universities would stick around without our network of demand-side subsidies. Ultimately, the endowment tax is not a real solution to those concerns and is a poor substitute for structural educational reforms.

But there’s a more modest case to be made. A substantial, though indeterminate, amount of the value conferred by these elite schools is the name brand on the degree. Harvard, for instance, is internationally recognizable. And to some extent, this is self-perpetuating: Harvard built a reputation for being an elite school, so the best and brightest want to go to Harvard; Harvard, therefore, produces elite graduates, who often donate back to the school later, strengthening it financially.

This dynamic probably helps explain why there is so little turnover in top university rankings, where so many of the universities were founded at least a century ago, if not much longer (juxtapose that with the average age of, say, companies in the S&P 500). The endowment tax is arguably justifiable as a tax on the returns to this accrued brand, which provides mostly zero-sum benefits to graduates.

Elite schools provide social benefits too, in terms of human capital, funding research, and concentrating top talent. Along those lines, taxing endowment returns at a rate much lower than the conventional rate that, say, hedge funds pay, but not making them entirely tax-exempt, makes some sense.

Current Proposals

The most important fundamental design question is the tax base. For example, the bill from Sen. Tom Cotton (R-AR) would impose a 1 percent tax on the fair market value of the largest endowments—in other words, an endowment wealth tax. The bill from Rep. Dave Joyce (R-OH) would raise the TCJA’s tax on university endowment income from 1.4 percent to 10 percent.

As is the case with wealth taxes, low rates can be deceiving. Let’s say a billion-dollar endowment makes a respectable 6 percent return in one year, or $60 million in income. Under the Joyce bill, they would pay $6 million in tax. However, the wealth tax in the Cotton bill would mean they owe $10.6 million, in addition to the $840,000 owed under the existing 1.4 percent tax on endowment income.

Additionally, many proposals suggest attaching strings to the tax to incentivize universities to change their behaviors in some way. However, creating a reduced rate or exemption for lowering tuition prices or financial aid spending poses some problems. College tuition operates according to price discrimination, where colleges charge what attendees can pay. As a result, incentivizing reduced tuition prices could, counterintuitively, mostly end up benefiting higher-income students (because lower-income students already receive financial aid).

Neutrality is also important. The tax code should not be used as a tool for punishing ideological opponents. For example, the Cotton bill provides a carveout for religiously affiliated universities. But if there is going to be a tax on endowments, then it should be applied neutrally, independent of religious affiliation (or lack thereof).

Broadly, a college endowment tax is a small part of larger debates about the U.S. higher education system, and its possible merits are heavily contingent on what one believes about those bigger questions.

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A tax is a mandatory payment or charge collected by local, state, and national governments from individuals or businesses to cover the costs of general government services, goods, and activities.

A wealth tax is imposed on an individual’s net wealth, or the market value of their total owned assets minus liabilities. A wealth tax can be narrowly or widely defined, and depending on the definition of wealth, the base for a wealth tax can vary.