Taking the anxiety out of paying for college

The cost of higher education has been rising sharply for the past 25 years. The General Accounting Office (GAO) reported in 1996 that average tuition at public universities has soared since 1980 by 234%, much faster than earnings and general inflation. Tuition at private universities has grown even more rapidly over the same period. These increases have outstripped the general rise in prices as measured by the Consumer Price Index (CPI), which has risen 85% since 1980, and the average family's ability to pay for college as measured by household income, which has gone up 82% since 1980.

There are many important reasons for the explosion in college costs. These include:

The increasing value of a degree. The most important reason costs have escalated is that the value of a college education has increased. The GAO reports that the average college graduate earned about 43% more than the average high school graduate in 1980. Today, the difference in earnings between the same two workers is over 70%. Therefore. more families are finding it necessary to send their children to college, assuring them a better opportunity to succeed in the job market.

Research activities. The prestige of a college or university today is driven in large part by the publishing prowess of the institution's faculty. Publishing requires research, which demands time. This means that professors are doing less teaching and more research. In turn, less teaching on the part of each professor means that course and class selection are reduced, forcing students to take longer to finish a degree, or more professors are required on staff, making the institution spend more for salaries. Either way, the result is greater fixed or overhead costs that typically are passed on to students and parents through higher tuition and fees.

Reduced state funding. The current era of fiscal austerity in government has meant slower growth in state budgets, often leading to slower growth in financial support of public universities. Raising tuition has been the sole recourse for public institutions faced with higher salaries and increased demand.

Federal programs meant to assist students facing steep college costs have added to the rise in tuition. Starting with passage of the Higher Education Act of 1965, the Federal government has guaranteed student loans extended by private banks. The Student Loan Marketing Association (Sallie Mae) was established in 1972 as a government-sponsored enterprise to establish a secondary market in student loans. In addition, a limited direct government loan program was established in 1993. These loan programs not only facilitate indebtedness, but boost the scale of that indebtedness by encouraging steeper tuition hikes. As Thomas Donlan pointed out in Barron's (Dec. 23, 1996), "The faculty and staff can vote themselves higher salaries and more resources if the only consequence is that students and parents just have to sign on the dotted line to borrow some more money." With Federal debt assistance so readily available, schools have no incentive to control the costs of education.

Higher tuition because of increased demand and a rise in value is a natural market occurrence and should not be addressed by government involvement. Similarly, any overemphasis by universities on research will be corrected as students seek out schools focused on education. As for the fiscal restraint manifesting itself at the state level, it is the result of a decision by Americans who feel overtaxed. Therefore, Federal policy should concentrate on correcting the remaining cause of escalating tuition: the effect of Federal programs and their consequences for families.

One side effect of any policy designed to make money more available to help families to afford college will be to boost tuition somewhat. The wisest approach would be to promote saving for college, rather than to make it even easier for families and students to go deeply into debt.

The second issue to address concerning the rising price of higher education is not just that college costs a lot, but that the amount is uncertain. This makes it hard for families to know how much they must put aside or what debt they or their children will have to incur to pay for a college education. Over the past decade alone, private college inflation, as measured by the Independent College 500 Index, has ranged from a low of 5.05% in 1996 to a high of 8.61% in 1989. Tuition increases at public universities have fluctuated from a high of 8.90% in 1986 to a low of 4.69% in 1994.

The uncertainty makes saving particularly difficult because parents never can be sure they are putting aside enough money to cover the full costs of tuition, fees, room, and board. Alternatively, families may budget too much for higher education, in which case they will be sacrificing savings for other expenses such as retirement or a house. The uncertainty surrounding college expenses is like taking out a mortgage without knowing what the final price of the house will be when the closing date arrives.

To understand how much fluctuations in tuition rates can mean when planning financially for college, consider a couple who want to save for their newborn child's education. If tuition and fees at a private university were to rise at the 1994 rate of 4.69%, they would have to save $47,320 in today's dollars. If tuition and fees at the same school were to rise at the 1986 rate of 8.90%, the couple would have to save $102,407. It is impossible to plan efficiently for expected college expenses under such uncertain conditions.

State savings plans

Several states and private interests have begun to address escalating tuition and the uncertainty of those costs by offering savings plans for parents with young children. Although details differ from plan to plan, the state plans generally have two core characteristics. First, parents can save money for their children's education without paying state income tax on the interest. Second, they may purchase an amount of higher education at today's tuition rates to be redeemed in the future when their offspring enter college. As Peter Mezereas, executive director of the Massachusetts plan, explains, "These plans are a way to lock in tomorrow's tuition at today's rates."

The first of these state savings plans was established by Michigan in 1986. Florida and Ohio followed in 1988 and 1989, respectively. Today, 42 states either have implemented some form of tax-favored education savings plan or are studying the feasibility of such a program. These range from simple savings trust funds that allow parents to save whatever amount they wish, without having to pay state income taxes on the earnings, to complex prepaid tuition plans that let them purchase a semester of education at a school within the state at a specific date in the future.

States are not the only entities creating innovative savings programs for parents and future students. Private savings instruments have developed as well. For instance, the College Savings Bank of Princeton, N.J., offers the CollegeSure Certificate of Deposit, a Federally insured savings vehicle with a rate of return tied to an index of the tuition inflation at 500 public and private colleges and universities. The CollegeSure CD is more flexible than the state plans because the savings can be used at any school in the U.S. and applied toward tuition, room, board, or any other expense associated with a student's education. If the beneficiary decides not to attend college, the money can be withdrawn without losing interest income. Because it is indexed, the purchaser increases the investment will cover average increases in college costs -- though it does not lock in a specific amount of education at any particular institution.

The plan offered by the College Savings Bank does have some drawbacks, largely due to state and Federal law. Most important, interest earned on the CD is fully taxable at the state and Federal levels, and the profits of the bank are taxed at both levels. To cover these four taxes and plan for a semester of college costs 10 years in the future, parents have to invest more than that semester actually costs in present dollars. For example, if a semester at a particular university currently runs $2,012, an investor with the College Savings Bank must deposit $2,318 to cover fully the expenses of a semester 10 years from now as well as the taxes paid by the bank at the state and Federal levels. In addition, the investing family must consider that they will be responsible for paying personal taxes on the interest they earn. In this example, the principal will increase from $2,318 to $3,848, thus earning $1,530 in interest. While the family is guaranteed a rate of return tied to future tuition costs, it is at a premium to cover all the applicable taxes.

In 1996, Congress and Pres. Clinton made the state savings programs even more attractive by deferring Federal income taxes on the interest earned by investors. This provision was passed as part of the Small Business Job Protection Act of 1996. Moreover, at the time the plan is cashed in, the accrued interest income is taxed at the child's rate, which is usually less than the tax rate faced by parents. Since passage of this special tax treatment, many more states have chosen to consider or implement tuition savings plans.

However, Congress and the President did not extend this preferential tax treatment to similar private education savings plans such as those offered by the College Savings Bank. This has placed these private investments at a distinct disadvantage compared to state-sponsored plans, because investors in the private plans must continue to pay taxes on the annual earnings of their savings.

Several additional reforms would make the state and private savings plans even more attractive to parents who are trying to save for their children's higher education and are looking for predictability in tuition costs. Specifically, Congress and the President should adopt the following strategies:

* Strategy #1: Make investments in all state savings programs purchased with after-tax dollars completely tax-free. For plans that invest in equities and private bonds, this would eliminate the inequitable double taxation that currently exists. For those financed by a state's general obligation fund, tax-free status would place education savings bonds on a par with other general government bonds. Eliminating all Federal income taxes on the imputed interest earned through the state programs would create an additional incentive for savings that would help fuel greater economic growth.

The most comprehensive way to eliminate all taxes on interest earned on the state prepaid tuition bonds would be to adopt the proposal of Sen. William Roth (R.-Del.) for a super IRA. This would allow parents to invest money in their individual retirement account that then can be withdrawn tax-free for specified items, such as a first-time home purchase, major medical expenses, and higher education costs. Classifying the existing state-based prepaid tuition plans as qualified IRAs would preserve the unique characteristics of the various programs while extending fair tax treatment to all investors in education savings plans.

Short of this. Congress should allow interest income earned from the existing private and state savings plans (and any higher education bonds issued by private investors or colleges) to be deductible from Federal income taxes. This could be accomplished simply by deducting interest received from taxable income.

* Strategy #2: Extend tax-free status to private education savings programs. Many innovative private savings plans are available to parents who want to save for their offspring's education. However, none of these plans currently qualifies for any special tax treatment. Therefore, they are at a disadvantage compared with state plans that are free of state taxes and tax-deferred at the Federal level. This disadvantage should be corrected by allowing tax-free investment in private as well as state programs. The same rationale for tax-free status applies to private plans as well as state plans. Tax-free status would eliminate double taxation and provide incentives for personal saving.

Private programs offer several advantages to families when compared with state initiatives. They are not limited to schools within a specific state; therefore, parents can save for their children's education without locking themselves into a limited number of institutions. Although just a handful of private plans currently exist, there is no reason why more companies could not offer innovative products if they are given the same tax treatment as state-sponsored plans. Any increase in competition among providers would benefit families by allowing them a greater selection of products with which to save for college.

* Strategy #3: Direct the Commodities Futures Trading Commission to sanction a private futures market for education savings bonds. Independent investors or schools could offer bonds denominated in educational units (semesters or credit hours, for instance) at particular schools. Parents could purchase the bonds for the year in which their child was expected to enter college. There could be an additional choice whereby they could buy a "call" option at a small price for the right to buy a bond at a later time at a fixed price. That time might be when the family could expect a higher income or when the parents sold their house and became "empty nesters." As with any other futures market, parents essentially would be locking in a future price without paying for the product today.

Not only would this guarantee to parents that their savings would be sufficient to pay for the educational needs of their offspring at a particular college, but a family could trade one bond for another good at a different college if the family's means or desires changed. Thus, a market would develop in which investors who hold a bond for one school could trade the bond with other investors who hold bonds redeemable at another institution. For example, if the Jones family has purchased a bond for one semester at Harvard University, but their daughter decides to attend the University of Notre Dame, they could trade the Harvard bond on the futures market with the Smiths, who previously purchased a bond redeemable at Notre Dame, and the difference in value would be made up in cash.

Who benefits?

Private issuers of education bonds would benefit from a stronger market because they could reinvest the savings and earn a higher rate of return than would be necessary to cover the cost of tuition, even in the future. The principle is the same as with any other futures market or mutual fund: The issuer of the bond guarantees to pay to the purchaser the cost of tuition in the future. Any income earned on investing the money above that level is reserved for the issuer. As long as the actual rate of return is higher than the future cost of education, the transaction is profitable for the investor and the purchaser of the bond is guaranteed to meet his or her goal of covering the expenses of higher education. To protect consumers against fraud, these private bonds would be covered by the same rules and regulations covering all other futures contracts.

If schools were the issuers of the education bonds, a likely development, they could raise money to build additional classrooms, upgrade computer systems, or pay for any number of other capital-intensive projects. Issuing bonds would be an attractive offer to schools that otherwise would have to borrow money from a bank or solicit private donations. Meanwhile, the bondholders would represent a pool of potential future students.

Participation patterns indicate that the primary beneficiaries of the state and private plans are working, middle-income American families. For instance, the average annual income of families participating in the Florida higher education savings program -- the largest of the state-based prepaid tuition plans, with 316,000 active contracts -- is $50,000.

Most of the state plans have options for families with limited incomes. The Florida program, for example, offers community college contracts for as little as $11 per month. A joint private-public initiative known as the Florida S.T.A.R.S. program offers free prepaid tuition contracts to exemplary students from low-income families. Kentucky has a lower limit of S25 annually on the amount of money that can be saved by parents in their education savings fund. The average monthly savings in Kentucky is a mere $48 per year. The private College Savings Bank requires a minimum investment of $1,000 per year $83 per month, payable in quarterly installments). The key to all of the programs is that they allow parents of all income levels to save at least a portion of their income for their children's education.

Families also would be able to purchase higher education for their offspring one piece at a time. With the existing state-sponsored prepaid tuition plans, parents can buy one semester or any number of credit hours each year until they have accumulated a full education. However, the existing plans are limited to in-state schools, and more often to in-state public schools. A private bond market would allow families -- even those of limited means -- to purchase pieces of education at any institution of higher education in the country, including private universities. Moreover, because these bonds would be tradable, parents would not be restricted to a specific school or state school system. The uncertainly of tuition inflation would be eliminated because rates would be locked in; private schools would be more accessible for all families because private bonds would not be limited to in-state schools; and flexibility would be introduced because the bonds would be tradable.

The goal of all the education savings plans -- whether state or privately operated -- is to encourage savings for college. Since there basically are three ways to pay for college (save, work, or borrow), any increase in savings likely will result in a decrease in work or borrowing. Therefore, a decrease in student loans and reduced participation in work/study programs would be expected. However, this is a desirable outcome. The more parents and students are paying in advance for education and the less they get into debt, the better.

Moreover, a rise in family savings would mean that existing Federal grant programs can be targeted better to the truly needy. During the 1995-96 school year, 46% of students from families with incomes between $30,000 and $39,999 received Pell Grants worth an average of $1,060 each. The state and private savings programs are most attractive to families in this income range. Thus, as middle-class families save more, Federal grants could be redirected to those who are most in need (i.e., those who can not afford to save even a small amount of money).

It is true that, under current law, many families who save money for higher education costs are penalized in the Federal grant process. This is because any money saved is counted as income and can offset Federal grant money dollar for dollar. This is also true of the tax credit and deduction proposed by Pres. Clinton. In fact, Lawrence Gladieux and Robert Reischauer reported in the Washington Post (Sept. 4, 1996) that "nearly 4,000,000 low-income students would largely be excluded from the tax credit because they receive Pell Grants which, under the Clinton plan, would be subtracted from their tax-credit eligibility." However, this is a deficiency of the Federal grant programs, not an argument against college savings programs. Federal grants that discourage independent savings promote dependency on the government and lead to all the correlated problems. These programs should be reevaluated during reauthorization of the Higher Education Act, not held up as a red herring to stop progress toward enactment of education savings plans.

COPYRIGHT 1997 Society for the Advancement of Education
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