Study shows link between income inequality and net tuition

Study shows link between income inequality and net tuition

Growing income inequality in the United States plays a significant role in rising college tuition prices, according to a recent paper published in the American Economic Review.

Economists have studied and speculated about the rising cost of college in the U.S. for some time, blaming the ever-increasing prices on decreased state funding, ballooning operating costs and steep tuition-discounting practices. While a host of factors contributes to each institution’s pricing, a new study by Zhifeng Cai, an assistant professor of economics at Rutgers University, and Jonathan Heathcote, a monetary adviser in the research department of the Federal Reserve Bank of Minneapolis, points to the widening income gap as the main driver of climbing net tuition prices.

Together, the effects of rising income inequality and rising average income accounted for more than half the increase in average net tuition at public and private four-year institutions between 1990 and 2016, according to Cai and Heathcote’s model.

The authors also write that increasing income inequality can account for the growing gap between average sticker price and average net tuition. Sticker price, or list price, is the total tuition price posted for each institution, and net price is the amount students and families pay out of pocket after federal and institutional financial aid is taken into account.

An institution’s educational quality is closely correlated to the average ability of its students, the authors argue. As a result, all colleges and universities are motivated to admit “high-ability” students, regardless of their income, in order to better the quality of the education they offer. As income inequality grows, institutions must offer steeper discounts for high-ability, low-income students.

This pricing strategy, called tuition discounting, is widely used by private institutions. It allows institutions to set high sticker prices for their wealthiest students and to subsidize those prices for lower-income students. Most private colleges discount tuition to some degree, and very few students actually pay the listed price.

Bill Hall, president and founder of Applied Policy Research Inc., a higher education consulting firm, has helped colleges and universities set tuition and financial aid strategies for some time. The advice he used to give many clients was the same: “high tuition, high aid.”

“I am no longer the high-tuition guy. I’m a moderate-tuition guy,” Hall said. “We’ve been aware of a broad price sensitivity across low-, middle- and upper-income families. Higher education pricing has risen faster than practically anything in American society.”

High list tuition prices and steep discounts for talented low-income students have helped some colleges diversify their student bodies, said Ronald Ehrenberg, an economist and professor of industrial and labor relations at Cornell University.

“Many of these institutions made the decision that to try to attract more relatively low-income students, they had to increase the generosity of the financial aid policies for these students,” Ehrenberg said. “But unless you can make up new revenue sources, that is going to mean that you have less revenue to do everything else.”

Wealthy institutions—including Harvard, Yale and Princeton Universities—can rely on their swelling endowments for financial aid funding. Institutions with less financial flexibility—which includes most colleges and universities—need more tuition income or public funding to finance greater low-income student enrollment, Ehrenberg said. As a result, such institutions opt to set higher prices for their wealthier students in order to subsidize tuition for poorer students.

Rising income inequality also increases the wealth of high-income students, incentivizing colleges to charge those students more money, the study authors write. Doing so allows institutions to offset the greater tuition scholarships paid to high-ability, low-income students.

“The student body will tend to be a mix of relatively rich, low-ability students who pay relatively high tuition and relatively poor but higher ability students who enjoy tuition discounts,” the paper states.

David Feldman, a professor of economics at the College of William and Mary, applauded the authors for creating a model that captures several key factors of the higher education market, but he is not convinced that growing income inequality is directly causing the increase in average net tuition prices.

“They’re absolutely right that the income distribution over the past 40 years has become more skewed or unequal. And at the same time, average net tuition has gone up,” Feldman said. “What I’m not clear about is the causal connection.”

Feldman has another theory about why college prices are so high—cost disease. While many industries have seen an increase in productivity in recent years, those increases have been concentrated in industries that produce things, such as manufacturing, mining and agriculture. Service industries, such as daycare, medicine, legal services and higher education, have not seen such a boom in productivity, Feldman said. That’s because it’s difficult to increase productivity in these industries without compromising quality.

Cost disease is “a natural result of industries that experienced low productivity growth,” Feldman said. Because even though colleges and universities can’t increase productivity by educating more students without sacrificing educational quality, their operating expenses continue to rise.

Cai and Heathcote note that though income inequality could reduce the number of students who pursue college, rising average income counteracts that effect.

“By itself, greater income inequality would depress enrollment rates, but we find that growth in average income and more generous college subsidies are countervailing forces that have pushed more people into college,” they write.

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