Starting next January, some 35 very wealthy private colleges and universities will start paying an annual 1.4 percent college endowment tax under the new tax reform law. That’s very few of the nation’s institutions of higher learning, and the tax will not apply to assets that directly contribute to an educational purpose. When you hear wisecracks such as “Harvard is a hedge fund with a university attached,” you are listening to one reason for the tax. Other reasons include resentment toward elite universities for allowing leftwing domination of modern faculties and rising campus disrespect for free speech and intellectual diversity.
The precedent to exempt colleges from taxation emerged during the colonial era when newly established colleges were subsidized, in part, by exempting them from property taxes. Given their mission to educate young men for civic leadership and the clergy, the employment of an infant industry policy to exempt colleges from taxation to encourage their growth and sustainability seemed reasonable. Colleges, however, are increasingly astray from the mission of creating and disseminating knowledge, which serves a useful social function that arguably merits subsidization. They are increasingly engaged in revenue-generating activities that resemble those pursued by taxpaying commercial enterprises.
This includes endowment investment portfolios at some universities that look like highfalutin hedge funds. The commercial interests of universities should be taxed in the same manner as taxpaying enterprises and individuals, not granted the special privilege. The endowment tax moves us closer to this ideal.
The endowment tax mainly applies to wealthy universities such as Harvard, MIT, Princeton, and Yale. These four institutions collectively control about a quarter of the $500 billion assets held by college endowment funds, providing them an unprecedented advantage in attracting top students and faculty. The tax may reduce endowment inequality and improve the competitiveness of higher education. Some donors may redirect their philanthropy from the wealthy institutions to less well-endowed ones where their gift will have a higher long-term impact because it will grow tax-free. This would improve the financial position of institutions benefiting from such reallocation of gifts, allowing them to invest in strategic areas to better compete for top students and faculty.
Finally, the endowment tax may send a symbolic message to colleges that the public is increasingly dissatisfied with their behavior. Lawmakers with the ability to subsidize colleges also have the option of taxing them. This could serve as an impetus for university leaders to control profligate spending, improve affordability, enhance learning, and promote intellectual diversity.
Will It Reduce Financial Aid?
Some college officials have suggested that the endowment tax will reduce access among talented low-income students because a portion of their endowments is earmarked for financial aid. Returns attributable to such funds may end up exempt as an argument could be made that scholarships directly contribute to an institution’s educational mission.
While the endowment tax will nonetheless result in a modest revenue loss for wealthy institutions, most of these schools have what economists refer to as highly inelastic demand curves. This means they could raise tuition without significantly reducing the number of qualified students willing and capable of paying sticker price. The loss in revenue from the endowment tax could be made up by charging full price payers more, without adversely impacting access to low-income students. Proponents of redistribution should favor this. But then again, affected colleges might respond by reducing the number of low-income students admitted or the aid packages offered to them.
The endowment tax of 1.4 percent is lower than the 2 percent rate imposed on net investment income of private foundations. Meanwhile, individual investment income is taxed at the marginal rate (up to 37 percent post-reform) and long-term capital gains up to a 20 percent tax rate, plus any state levies. The net investment income and capitals gains of corporations are taxed at the corporate rate (21 percent post-reform). Why should wealthy universities such as Harvard, whose $37 billion endowment exceeds the GDP of countries such as Bahrain and Latvia, pay a lower tax rate than a middle-class family or small business for performing the same economic activity?
In addition to the direct revenue loss from the endowment tax, the new policy will also impose indirect costs. The higher education community is likely to increase its lobbying efforts to try and shape the final details of the policy in their favor to minimize losses. The policy will likely be complex, imposing new compliance costs. Lobbying and regulatory compliance are costly and will divert resources from more productive uses.
A Small Tax Needn’t Stay Small
Though the new tax is small, we should learn from history. The Revenue Act of 1913 imposed a very modest 1 percent federal income tax but has evolved into the federal government’s largest revenue stream, propagating a Leviathan central government.
While the endowment tax is likely to have a modest impact, it is a slippery slope for further federal meddling in and politicization of higher education. Faced with a rapidly expanding national debt and unfunded liabilities, lawmakers may view universities resources, including their endowments, like a pot of gold at the end of an ivory tower. They may also increasingly use the power of the purse to coerce university conformity to whatever ideology is in vogue, further reducing intellectual diversity.
Federal intrusion into higher education has been a root cause of many of the issues fueling growing public resentment towards it. Calling upon the government to fix problems that it helped create may prove to be foolish and perpetuate them indefinitely. As Milton Friedman once said, “there is nothing so permanent as a temporary government program.” His wisdom suggests that we ought to move in the direction of reducing government involvement in higher education, not increasing it.