The Rising Cost of Higher Education

Parents face two severe hurdles in trying to save for their children's college education. One is obvious: the heavy cost. But the other--the uncertainty of what an education may cost many years in the future--is just as imposing. The price of public higher education has increased sharply over the past two decades, compared with the average family income and the general rate of inflation. Between 1980 and 1995, for example, average tuition costs at public universities increased 234 percent, and tuition expenses at private universities increased even more rapidly. Over the same period, the general rate of inflation and the average household income increased only about 80 percent.⁶

Still, a college education significantly increases an individual's earning power--usually making college a wise investment. According to the U.S. General Accounting Office (GAO), "a graduated college student in 1980 earned about 43 percent more per hour than a person with a high school diploma. By 1994, this earnings advantage increased to 73 percent."⁷ Thus, while families are finding it increasingly difficult to pay for college without incurring a tremendous amount of debt, not going to college can be a very expensive decision in the long run.

The Uncertainty of Future College Costs

Unfortunately, it is very 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. For instance, during the past 15 years, the annual increases in private college costs fluctuated between 5 percent and 8.6 percent.⁸ Increases in tuition at public universities fluctuated even more.

To understand just how great an uncertainty this fluctuation means for a family's financial planning, consider a young couple saving for their newborn child's college education. If tuition and fees at a private university continue to rise at the same rate they have risen for the past few years, parents with a new child today will have to come up with just over $100,000 (in today's dollars) when that child heads off to college. If those costs rose two percentage points faster than today's pace, more like the average increase since 1980, the tab would be more than $150,000. Two points less than today's rate of increase would mean that parents must save about $75,000. Such uncertainty--a difference of $75,000--makes financial planning extremely difficult.

Until recently, the federal government responded to the rising cost of tuition by creating programs that (1) give cash grants to qualified students, (2) guarantee private student loans, or (3) lend money directly to students. For most families, this means that the federal government simply has made it easier to go into debt. Moreover, existing federal programs, including President Clinton's HOPE and Lifetime Learning tax credits passed in 1997, probably have boosted tuition inflation because they provide no incentives for colleges to control costs or for families to avoid debt.

The Development of Prepaid Plans

Fortunately, several states, as well as a handful of private firms and a consortium of over 120 private colleges and universities, are making saving for college easier and more certain. The most innovative such step--prepaid tuition programs--allows parents to purchase a contract denominated in units of education (such as one semester). These contracts typically can be purchased at today's tuition prices (or, in the case of one plan currently being designed, at a discount from today's prices) even if the buyer's children will not reach college age for many years. When the time for college arrives, parents redeem the pre-purchased units of tuition for education credits regardless of the cost at that time. This is much like pre-purchasing an airline ticket to lock in a cheaper fare.

How Tuition Savings and Prepaid Plans Help Families

These innovative programs are significant because they help reduce uncertainty and enable more American families to afford a college education for their children. But they also achieve another long-term goal: Rather than shackle families and graduates with years of debt, as current policies have done, these plans encourage families to finance their children's college education through savings.

In some cases, these plans actually will help reduce the cost of college. For example, Tuition Plan, a consortium of over 120 private colleges and universities located throughout the country (see Map 1), is establishing a prepaid tuition plan that will offer families future tuition at a discount from today's tuition rates. This discount, according to the plan organizer, may be as steep as 50 percent for families with a newborn child. Discounting tuition in such a manner will give many more families the opportunity to afford a college education for their children without going into severe debt or depending on handouts from the federal government. From the colleges' point of view, this is sound economics because it means they will have a stable source of income in advance.

Such plans will control tuition costs further by introducing market forces into the financing of higher education. As private investment companies become involved in managing the money invested through tuition savings and prepaid plans, they have an incentive to watch carefully the internal accounting of colleges and universities to ensure that everything possible is being done to curb tuition inflation.

A Market in College Futures Contracts?

Tradable Plans.
It is likely that a market in prepaid tuition contracts will begin to emerge in which families will be able to trade the contracts they have purchased with other families as their circumstances change. This innovation would allow parents to exchange a plan at one college for a plan at another college if they or their child decided not to attend the institution for which they had saved. This would address the drawback in many state programs today, in which parents lose some of the value of their interest earnings in the savings plans if their child switches to an out-of-state college. Addressing this deficiency would encourage more families to sign up for plans, since one element of risk would be removed.

How would such a trading system work? Assume that Mr. Jones has purchased a bond for one semester at Howard University, but his daughter decides to attend the University of Notre Dame. He could decide to trade the Howard University bond to Mr. Smith, who previously purchased a bond redeemable at Notre Dame, and any difference in value would be made up in cash. As with any market, such a college futures market would generate industry ratings that determine the relative value of each contract based on underlying factors--such as the quality of education being provided by each institution and the measures employed by the institution to improve value for money and to control costs. Individual colleges and universities concerned about the positive or negative signals these ratings are sending to the pool of future students and their families would have an incentive to work to keep or earn a good rating.

An Options Market.
Many other market-based mechanisms likely will emerge as tuition savings and prepaid plans develop. For example, it is possible that families in the near future will be able to purchase a "call" option at a small price now for the right to buy a tuition contract at a later time at a fixed price. This means that, for a modest price today, a family could lock in the right to make the full payment for a futures contract for a college education sometime in the future--but still well before their child attended college.

Parents might want to do this if they have a modest income today but expect a higher income in the future (for example, when the mother returns to work after the child is older), or if they sold their house and became "empty nesters." As with any futures market, parents essentially would be locking in a future price without having to pay for the product today. In short, families planning for the education of their children should soon be able to take advantage of the full range of financial instruments the market has developed and uses today in other areas.

WHAT NEEDS TO BE DONE TO STRENGTHEN THE PLANS

State governments, private colleges and universities, and private financial firms already are leading the way in developing these innovative methods of financing a college education. But by retaining most double taxation on these savings programs, the federal tax code still restrains savings for higher education while subsidizing families and students who choose instead to plunge into debt. By correcting this tax bias, Congress and the President can clear away the remaining obstacles to the expansion of savings, prepaid tuition, and other innovative plans. Specifically, Congress and the President should:

1. Extend current-law tax treatment to tuition savings and prepaid plans established by private colleges and universities and by private investment firms.
   Twenty states have established prepaid tuition plans that allow resident families to lock in today's tuition rates for tomorrow's education. Moreover, 27 states and the District of Columbia have tuition savings plans that do not guarantee families a particular amount of education but do provide a secure savings vehicle for families preparing to meet the costs of higher education.⁹ (See Table 1.) Federal income taxes on the interest earned through all of these state-sponsored accounts are deferred until the account is cashed in to pay for college. Then taxes are paid at the student's rate, which is typically lower than that of the parents.

Current law, however, discriminates against families wishing to send their children to
private colleges, because this easing of double taxation on state-sponsored savings plans
does not apply to plans sponsored by private colleges. This places private schools at a distinct and unfair disadvantage vis-à-vis their public counterparts. To correct this distortion, Congress and the President should, at the very least, extend deferred-income tax treatment to tuition prepaid and savings plans established and maintained by private colleges and universities, and even those established by private investment companies. This would place all savings and prepaid plans and all schools on an equal playing field.

2. Make all interest earned through tuition savings and prepaid plans tax-free.
   Not only should all tuition prepaid and savings plans receive equal treatment, but they also should be extended the same tax treatment as regular education IRAs. In other words, accrued interest earned through these plans--state and private--should be tax-free when the student redeems the savings to pay for college costs. This would eliminate double taxation on interest earnings applied to this form of education savings in the tax code. It would eliminate one of the penalties in the current system of higher education financing imposed on families who work hard and save for college. And it would take a major step toward encouraging Americans to use savings for higher education, rather than encouraging students and parents to take on a huge debt.

3. Make it easier for families to transfer education savings from one savings or prepaid plan to another.
   Families should have the flexibility to accommodate to their changing needs. For example, families that move from state to state, or that are unhappy with their current method of saving for college expenses, should be able to transfer their savings from one savings or prepaid plan to another. Conventional IRAs currently benefit from this treatment; an individual unhappy with the performance of a specific mutual fund within an IRA can sell the holdings in that fund and roll the money into another fund without incurring a tax penalty.

The key policy change needed for this to be the case with respect to education plans is for the increase in value of the account to remain tax-deferred--or preferably tax-free--if the plan is cashed out but the funds are transferred promptly to another plan. In addition, the federal government and the states should explore ways to make these transfers much easier to accomplish. Ease of transferability would allow additional market-based products and mechanisms to emerge that could expand the options families have available in saving for college.