Endowments and Federal Tax Policy

Brief

Endowments and Federal Tax Policy

July 16, 2019

Abstract

The Tax Cuts and Jobs Act of 2017 imposed a new tax on investment income for some private nonprofit colleges and universities with large endowments. This move was met with strong objections from the institutions affected and throughout higher education, as well as from other observers concerned about the tax’s motivation and its implications.

Proponents of taxing endowment income say this policy could increase educational opportunities because institutions with large endowments now enroll relatively few low- and moderate-income undergraduates but receive larger subsidies than institutions with smaller endowments that serve the vast majority of these students. But this argument oversimplifies the role of endowments and misjudges the policy approaches most likely to narrow the gaps in educational opportunity.

Our report examines the justification for the tax-exempt status of public and private nonprofit college and university endowments—and the public subsidy that policy involves—and the merits of the arguments for and against modifying this exemption.

We find that taxing endowments is not the most effective way for the federal government to increase college access, affordability, and success for low-income students. Instead, the federal government should provide more funds to underresourced institutions and students. At the same time, colleges and universities that hold significant endowment assets should redouble their efforts to make larger contributions to increasing educational opportunities for students from low- and moderate-income backgrounds, reducing inequality, and building a society committed to these goals.

Comparing endowments is difficult

Endowment size alone does not necessarily accurately reflect an institution’s wealth. Better measures are endowment per student (endowments go further at schools with small student bodies than at larger institutions) and endowment size relative to expenditures (research universities fund activities not correlated with the level of undergraduate enrollment). Moreover, institutions with sizeable endowments have varying amounts of debt, which affect their actual wealth.

Endowments fund a wide range of institutional activities with social benefits in addition to supporting students who would otherwise not be able to pay the price of attendance. Endowment income subsidizes research, public service activities, and graduate students. Colleges and universities make different judgments about both the amount of endowment income they can responsibly spend each year and how that income is allocated.

Institutions’ behavioral changes in response to taxation might have unintended consequences

In both the public and private nonprofit sectors, institutions with larger endowments tend to enroll smaller shares of low-income undergraduate students than those with lower levels of wealth. This pattern, along with rapidly rising tuition prices, generates opposition to the tax exemption for endowment income. But wealthy colleges and universities in both sectors use their resources to provide financial aid that lowers the net prices paid by low-income students. The relatively small number of disadvantaged students who manage to enroll at these institutions pay less for their education than their more affluent students—and less than they would pay at lower-tuition, less well-resourced institutions.

It is not clear how these institutions will respond to the new tax or other potential taxes on their endowments. They might do more fundraising or lower their spending on financial aid, as well as other activities to cover the tax. If policy required them to raise spending on financial aid, they might raise tuition at the same time to fund the increase.

Policy conclusions

Colleges and universities with large endowments should recognize the public subsidy they are receiving and ensure that they allocate their resources to maximize the welfare of both their students and the larger society. They should recognize the responsibility they have for addressing the issues of inequality and social mobility and should carefully consider the trade-offs between expenditures today and saving for future generations.

But subjecting high-endowment institutions to a tax will do little to improve outcomes either for the low-income students who enroll at these colleges and universities or for the vast majority of low-income students who do not attend elite institutions of higher education. A more effective federal intervention would increase funding to institutions and students with limited resources.

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