Government subsidies are destroying the US education system

Restored Competition Will Lessen Inequality

By Luigi Zingales

The U.S. middle class is squeezed by the rising costs of college education and health care, and an economy that increasingly rewards only superstars. Fixing these problems requires introducing greater competition into each area.

Academics: The most dangerous crony capitalists are those who can wrap their requests for protection and subsidies in a noble cause. The market for higher education is far from competitive. Government subsidies and industry-controlled accreditation make entry for new institutions extremely difficult.

Consider accreditation. Vocational schools and for-profit universities rely heavily on federal loans that enable their students to pay tuition. But the federal government will provide loans only to attend schools that have been accredited -- and accreditation boards are typically staffed by the deans of existing schools, who have an interest in protecting their franchise.

Shielded Market Position

This shielded market position applies to nonprofit institutions, too. Comparing a reputational study of universities in 1906 with the influential U.S. News & World Report school rankings for 2011, two education professors found that only one private university, Cornell, had dropped from the top 13. (By comparison, only one of the 12 top companies on the Dow Jones Industrial Average at the beginning of the same period was still there at the end: General Electric Co. (GE))

This stasis is due less to the accreditation barrier than to the superstar nature of the academic business. The schools with the best reputations attract the best students, who, in turn, attract the best faculty. But the stasis is reinforced by huge government subsidies, even to the less exalted colleges. Colleges have no reason to compete aggressively, including on prices, which rise continuously.

The government subsidies come in many forms. In 2010, universities received $2 billion in congressional earmarks. Student loans are subsidized as well. According to the Congressional Budget Office, the federal direct-loan program costs taxpayers 12 percent of the amount lent. With student loans reaching $107 billion in 2010-2011, the total cost for taxpayers that year was $13 billion. In addition, 8 million students received Pell Grants in 2010, for a total of $28 billion. Including earmarks, the total amount of subsidies to university education was $43 billion a year, even before we start counting tax subsidies (for college funds); tax breaks (for university endowments, for example); and subsidies dedicated to research.

There are unintended consequences. The first is the effect on the equilibrium price of the subsidized goods. Standard microeconomic analysis tells us that when you subsidize demand for a good whose supply doesn’t respond much to its price, there is a small effect on the quantity of the good and a big effect on its price. The supply of college educations is limited by space constraints to the expansion of existing colleges and the difficulty of starting new ones. So the effect of the subsidies has been a limited increase in college enrollment -- but a significant increase in price.

Distorted Credit

The second unintended consequence is a distortion in the credit market. Because the government guarantees all student loans, lenders have no incentive to restrict lending. All of the burden of making the right decision falls on the borrowers. Unfortunately, 18-year-olds aren’t particularly good at judging the profitability of an investment without expert advice, and when they do get such advice, it generally counsels taking the largest possible school loan.

The stock of student loans has reached $1 trillion. The fraction of borrowers in default rose from 6.7 percent in 2007 to 8.8 percent in 2009. The situation appears ripe for another debt crisis, one in which Sallie Mae -- which originates, services and collects student loans -- plays a role similar to the one played by its cousin Fannie Mae in the last crisis; colleges play the role of the banks profiting from the subsidies; and students play the overleveraged homeowners.

A potential solution to this problem would be an equity- financing contract. Students would promise the lender a fraction of their future income or, even better, a fraction of their increased income as a result of having attended college.

Such contracts would share the risk of failure across students, with superstars who make large salaries helping pay the cost of financing for less lucky ones. More important is that they would provide lenders with an incentive to counsel students, as they would profit from good educational investments and lose from bad ones. This would create more informed demand for the schools, which would exert pressure on them to contain costs and improve quality.

Health care: In the U.S., health care isn’t purchased in a free market. Most employees have little choice: They must buy employer-provided coverage. This system distorts the choice of employment opportunities and it hides the real cost of health insurance from the true payers.

Further, even before President Barack Obama’s Affordable Care Act became law, the system was significantly distorted by government intervention, which boosted demand for services and prices, along with industry profits. Only 15 percent of the funds used to purchase health insurance is controlled by beneficiaries, while 33 percent is controlled by employers and 52 percent by the government. While employees end up paying the cost of this insurance through reduced wages, they fight employers’ efforts at cost containment. Anticipating that they must rebate part or all of any health-cost savings to workers, employers have no incentive to contain costs.

Lower Quality

Not only has this avalanche of money failed to improve the quality of health care; it may have worsened it. A recent study shows that states with higher Medicare spending have lower- quality care. There are certain simple, well-established procedures, such as beta-blockers after heart attacks and eye exams for diabetics, that are cheap, have desirable medical benefits and rarely have any contraindication. States where more physicians are general practitioners, as opposed to specialists, tend to use these procedures more frequently. But states that spend more on Medicare seem to have a higher ratio of specialists to general practitioners than states that spend less. One could conjecture that specialists routinely push for more advanced and expensive treatments.

How did we end up in this mess? Most employed people who are lucky enough to have health insurance are unaware of its real cost, because the employer pays for the largest share of the burden with pretax dollars. Greater visibility would lead to more pressure to contain those costs.

Corporate governance: Reducing the cost of health care and college would make increasing economic inequality in the U.S. less painful but wouldn’t attenuate it. To take a step in that direction requires fixing corporate governance, including the attendant problems of outsize executive pay, heavy lobbying, malfeasance, opaque management and cronyism.

In theory, companies are run by boards, whose members are supposed to act in the interest of shareholders; if a board member fails to do so, his reputation will suffer, and he will receive fewer offers to join other boards, decreasing his future income.

The trouble is that most board members care about their reputation in the eyes of the people who nominate and elect them. In elections for corporate boards, the number of candidates equals the number of seats. The vote is public, so investors who vote against management run the risk of retaliation. To add insult to injury, the list of candidates is chosen by the current board members. While most companies have a nominating committee that excludes the incumbent chief executive officer, candidates are usually vetted by him anyway. Dissenters are generally ostracized and not renewed.

Weak Controls

Corporate corruption and fraud occur when controls are weak, and controls are weak when the people in charge have no incentive to challenge the CEO. Yes, many serious board members do their jobs well, but they do so despite the incentives.

The way to fix this is to appoint board members who are accountable to the shareholders. Currently this isn’t possible because of regulation introduced by the Securities and Exchange Commission to prevent politics from affecting corporate decisions. During the Vietnam War, many political activists turned shareholder meetings into forums for protest, and even today, politically engaged groups try to push their agendas at the expense of shareholders.

As is often the case, a good reason provides cover for a bad one: protecting the incumbent managers from competition. Currently, incumbent boards have everything tilted in their favor. For example, they can present a slate of board members to be mailed to all shareholders at the company’s expense. Shareholders have to mount a very expensive proxy fight.

A simple way to change this would be to make it easy for shareholders to present some candidates to the board and reserve some seats for them, as long as they gather a sizeable consensus.

The high voting threshold for these seats -- it should be at least a third of shareholder votes taken -- would keep them from falling under the control of activists with little ownership and a misguided agenda. While organizing is costly for institutional investors, voting isn’t. Hence, while the barriers to entry in the form of the percentage of shares required to present a list should be low, the voting requirement should be high. This is exactly the opposite of what the Dodd-Frank Act has proposed: The barriers to entry are enormous while the votes necessary to be elected are few.