Thursday, March 24, 2016

Funding a College Education

Some basic concepts are missing in the public discussion of college education financing. There are individuals who should not go to college, and we should stop setting them up for failure. They hate school. They lack the combination of conscientiousness and intelligence that is required to benefit from a college education. They simply won’t finish, or they will finish with a garbage degree and no useful job skills. We can predict fairly well who will and will not finish college based on their academic performance and test scores collected by the end of high school; this information should certainly be used to sort high- and low-risk students. It would be merciful to spare a likely future drop-out of the massive debt accrued from a failed education. A college education is an *investment.* For those students who make good on their education, the payoff is very big and the investment is worth it. For those students who fail to make good use of their time in college, the investment has a negative return. Indeed, the investment has a negative return *regardless of who foots the bill.*

This point is what annoys me most about the debate over public financing of college education. So much time is wasted and ink spilt over college “affordability.” Affordability isn’t a problem if you finish your degree in a reasonable time frame and graduate with a marketable degree. The “wage premium”, the increase in your future earnings due to finishing college, is enormous for these students. They can finance the high cost of college with their future earnings. (Crudely, college graduates earn ~80% more than high school graduates. Controlling for the fact that students who finish college are initially more talented than those who don’t (ability bias), you get something in the 30-60% range, depending on the student’s major. See here .)

Suppose a college education increases your income by $10,000/year forever. At a 5% discount rate, that is worth $200,000 dollars. (Hint for people who don’t like present value calculations: $200,000 earning 5% interest annually will get you $10,000 a year forever.) It’s worth paying up to $200,000 for this education. Of course, that “payment” includes more than just the tuition payments; it includes the opportunity cost of not working for 4+ years, the sometimes agonizing, long hours of study, and many other costs. Then again, if we think of college as a consumption good, like going to a country club for 4 years, these costs are “offset” by the benefits of that consumption. But I digress. The point is there is a huge value-added, and a huge wage premium from which one can finance a college education. Going $50k - $100k into debt is easily worth it if it returns $10k a year.

Suppose on the other hand that college only increases your income by a few hundred dollars a year, or doesn’t increase your future earnings *at all*. These scenarios are likely for someone who gets a bullshit degree or who doesn’t finish their education. If college only increases your earnings by $1,000/year, then (again at 5% interest rate) this investment only worth $20,000. If four years of tuition costs $50,000, then the problem is *not* affordability. The problem is that the investment just plain isn’t worth making. Changing who pays doesn’t change that. If you do insist on spending $50,000 to help this person, it would be far more merciful to just give him the money, or an annuity of comparable value. He won’t be set up for failure, he won’t drop out of college with massive debt, he won’t feel the sting of failing something he intended to finish.

“College affordability” is a red herring. It is true that sometimes considerations of affordability cause a person to decide against a college education. That is a feature, not a bug. “Unaffordable” usually actually means “the investment doesn’t pay off, *regardless of who pays for it*.” Such investments shouldn’t be made with public money.

There are various rationales for the government to subsidize or finance higher education, and there are obvious drawbacks to such a system. I’ll deal briefly with a few of them, although honestly each of these deserves a book-length treatment.

Maybe financial markets are inefficient and so they don’t bother to finance college, even though objectively it’s a good investment. Or maybe they will only do so at extremely onerous interest rates. I don’t find these stories terribly compelling. Financial markets are always looking for ways to create value (of course, so they can capture some of it). In the above example, we had a $50,000 investment with a $200,000 payoff (I think these are somewhat realistic numbers). That’s an enormous surplus, so it’s just implausible that no investors would be willing to finance it. Lenders are always trying to undercut each other to attract good credit risks, so we should expect that the interest payments on such a loan wouldn’t be overly burdensome. Lenders would have various criteria for who is or isn’t likely to finish college, who is a good credit risk *assuming* they finish, what is the likely wage premium for this individual, etc. They would be part of the sorting mechanism that determines who does and who does not go to college. This does not put us back in a world where only the rich can go to college. A poor-but-talented individual will look like a good investment to several lenders. At any rate, government funding could limit itself to scholarship for such poor-but-talented students, or subsidize the interest repayment for those talented individuals. What it should *not* do is subsidize education so thoroughly that we get a lot of negative-payoff investments as described above.

There are also externalities (costs or benefits to third parties) to consider. First, the signaling theory of education. If a college degree is mostly “signaling”, then your degree raises your status relative to everyone else, but doesn’t make you any more productive. All the time and resources spend educating you are, from society’s point of view, a waste. Subsidizing education would be like subsidizing peacocks to grow bigger, more extravagant tail feathers. The peacock’s colorful fan has no practical use, but it does allow peahens to discriminate good and bad potential mates. We wouldn’t want to subsidize this already-wasteful arms-race, which is closely analogous to the human race for better credentials. In this sense, subsidizing college education is like subsidizing the purchase of nicer interview suits. You could even show that the job applicants with “subsidized” interview suits did better than those with “unsubsidized” interview suits, but it would be a signaling effect, not a real boost to worker productivity. Few people think that college education is actually 100% signaling, but some economists who study this topic say the college wage premium is up to 80% signaling and only 20% skill-building.

Supposedly there are also positive externalities from education, but the discussion of this is very muddled. Supposedly getting an education makes you a “more productive member of society.” Well, you capture that extra productivity in your personal income, so it’s difficult to argue that this is truly an externality. A related argument is that being better educated makes you a better voter, and thus a better educated society will pick smarter policies. This is plausible if you compare levels of education in dysfunctional countries to modern developed democracies. But I think it’s overblown, and it’s certainly hard to tell a causation story here. Certainly most of the highly educated individuals on my Facebook feed aren’t competent to do a cost-benefit analysis. Most of them would probably even fail to articulate the relevant trade-offs for any given policy. The positive externality story is mostly fluff. People often support policies they like by listing good things about it while failing to quantify those things *at all*; that’s exactly what’s happening here. It’s hard to say whether accounting for externalities should make us want to subsidize or tax college educations, but there’s at least a plausible argument that it should be a net tax.

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