Blog Post

AEIdeas

Here’s how steep the rise in college costs has been over recent decades: If tuition and fees — net of aid — had risen only as fast as skyrocketing healthcare costs had from 1987 through 2010, they would have increased to $8,700 from $6,600. Now that’s plenty as it is. Instead, however, they hit $10,300, according to the new working paper “Accounting for the Rise in College Tuition” by Grey Gordon and Aaron Hedlund.

But what explains surging costs? One explanation is that the increase in the returns to college has driven up demand for a college degree. Another is that rising productivity growth in the economy overall pushes up wages and increases cost pressure in service sectors like education and healthcare that aren’t sharing in that productivity growth. As the paper explains, “To cope, these industries increase their relative price and pass the higher costs onto consumers.”

Then there’s the “Bennett Hypothesis,” referring to a 1987 New York Times op-ed when then Secretary of Education William Bennett asserted “increases in financial aid in recent years have enabled colleges and universities blithely to raise their tuitions.”

Good call by Bennett, according to Gordon and Hedlund:

With all factors present, net tuition increases from $6,100 to $12,559 [and] the demand shocks — which consist mostly of changes in financial aid — account for the lion’s share of the higher tuition. … These results accord strongly with the Bennett hypothesis, which asserts that colleges respond to expansions of financial aid by increasing tuition. In fact, the tuition response completely crowds out any additional enrollment that the financial aid expansion would otherwise induce, resulting instead in an enrollment decline from 33% to 27% in the new equilibrium with only demand shocks. Furthermore, the students who do enroll take out $6,876 in loans compared to $4,663 in the initial steady state. The college, in turn, uses these funds to finance an increase of investment expenditures from $21,550 to $27,338 and to enhance the quality of the student body. In particular, the average ability of graduates increases by 4 percentage points. Lastly, the model predicts that demand shocks in isolation generate a surge in the default rate from 17% to 32%. Essentially, demand shocks lead to higher college costs and more debt, and in the absence of higher labor market returns, more loan default inevitably occurs.

Indeed, the single most important factor — one driving 40% of the tuition jump — is the expansion in borrowing limits:

To grasp the magnitude of the change in borrowing capacity, first note that real aggregate borrowing limits increased by 56% between 1987 and 2010, from $26,200 to $40,800 in 2010 dollars. Second, the re-authorization of the Higher Education Act in 1992 introduced a major change along the extensive margin by establishing an unsubsidized loan program. We also find that increased grant aid contributes 17% to the rise in tuition, which mirrors the 18% impact of the higher college earnings premium. Our model also suggests that financial aid increases tuition at the bottom of the tuition distribution more so than it does at the top. These results give credence to the Bennett hypothesis.

So what would happen to college spending if college were “free,” as some on the left now advocate? More money would equal more spending but not necessarily more value to students. And as my colleague Andrew Kelly notes, strained public budgets could lead to shortages rather than increased access. Of course, just increase funding further, right? But how much more? The Bernie Sanders “free college” plan would already cost some $70 billion a year as a starting point. Kelly: