Universities and taxes

The recent tax bill discussion revealed many ways that universities benefit from lots of obscure tax subsidies like everyone else in contemporary America, and that they're pretty good at lobbying to keep them. Two issues stood out to me as worth comment.

1) Taxing graduate school tuition waivers. This caused an uproar, even among economists and economics graduate students who should know better.

PhD students largely do not pay tuition, and most of them get modest stipends. The reason is pretty simple -- the supply curve of graduate students to research-oriented PhDs is pretty flat.  People won't come to graduate school if they have to pay tuition, or taxes on fictitious tuition. There is an annual bidding war in stipends to get the promising students, supply and demand in action. So the idea that graduate students would end up paying a lot either in tuition or taxes violates simple economics.

Moreover, nobody stopped to ask, why do universities pretend to charge tuition, and then waive it?Just how hard would it be for universities to adapt to the tax by not charging tuition in the first place? Why is tuition like medical bills, with a phoney-baloney list price and then everyone gets a huge discount of one sort or another?

Carlos Carvalho and Richard Lowery figured out the answer to this question: Many graduate students, especially in the sciences, get funding from the federal government, and to a lesser extent from private sources. The university charges "tuition" to the grant. So "tuition" is just a way for universities to tax federal grants, and to transfer money that would otherwise flow to students, departments, and research instead to central budgets and general university operations.

Surely universities and government agencies would have swiftly worked this out another way. Just how long would it take, for example, to add direct overhead to student grants, or for the university to give all students "financial aid," not linked to employment, for their tuition?  

(Professional schools -- business, medicine, and law -- do charge tuition, because there is a supply of students willing to pay it. Many universities also run profitable tuition-based masters programs. Some PhD tuition money also comes from foreign students, largely with external grants.)

Though it clearly is income -- if, in return for work, your employer waives rent in a company-provided apartment, that is taxable income -- and though it seems to me that it would have taken only minor tax finesse to avoid it and keep the federal money flowing, the university lobby seems to have preserved our exemption from the tax bill. Having a sympathetic hostage is a great lobbying tactic. "Look at the secretaries and administrators we'll have to fire" would have played less well.

2) Taxing endowment rate of return. The tax bill includes a small tax on the rate of return of endowments. Universities receive a pretty extraordinary tax subsidy, in that they can borrow money at tax-exempt rates and invest it like a hedge fund, but pay no tax -- dividend, capital gain, estate -- on the returns. Unsurprisingly, they have built up huge pools of hedge-fund like investments.

Again, this seems like a minor challenge to financial and tax creativity. Just how much return does an endowment make? As the WSJ points out regarding Harvard's endowment, there is a lot of room to choose just what illiquid assets are worth. Endowments could stuff their investments in real estate, private equity, and other hard to value investments, and rather than puff up the valuations to impress donors, keep valuations low, raise the payout rate, and easily avoid the tax.

Moreover, donors could set up a separate foundation, independently managed, which benefits the university with a flow of money. Given the antipathy of many donors to the way endowments are managed, I'm actually surprised this doesn't happen more often.

Universities be aware: Now that university activities are so overwhelmingly partisan, and so much is overt "activism" and "advocacy," they might not be surprised if Congress starts to tighten the many subsidies.

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