63 Pages Posted: 20 Jan 2015 Last revised: 18 Dec 2015

Date Written: February 23, 2015

Abstract

Government subsidies to higher education have recently become a hot button political issue. But what if the federal government doesn’t actually subsidize higher education, but rather, taxes it?

This article gauges efficient investment levels based on marginal rates of return relative to other investments. Labor economists struggle to explain why the rates of return to higher education have remained much higher than the rates of return to other investments. This article proposes a novel explanation: distortionary taxation.

Economic theory suggests that when investments that are substitutes for one another are taxed inconsistently, investors are less likely to choose the investment option that is taxed more heavily. Unfavorable tax treatment of higher education relative to other forms of investment could create an undersupply of educated labor. This distortion would increase pretax returns to education and reduce economic growth and social welfare.

Part I of this article reviews empirical evidence linking higher education to increased earnings and economic growth, and considers student responsiveness to financial incentives. Part II explains why the unusually high rates of return to higher education may indicate underinvestment. Part III presents a mathematical model illustrating the link between tax rates and rates of return. Part IV reviews optimal tax theory and the distortion problem. Part V contrasts taxation of favored investments with taxation of higher education. Part VI considers policy implications.