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September 14, 2015

Do Elite Universities Abuse their Tax Subsidies?

A recent op-ed in the New York Times with the provocative title “Stop Universities from Hoarding Money” once again raises the issue of university endowments. It focuses in large part on the extraordinary amounts elite universities either “hoard” or spend on fees to investment advisors and hedge funds in contrast to the much smaller sums spent on “tuition assistance, fellowships and prizes,” those things seen as the university’s true mission. The author, a tax professor, suggests that universities with endowments in excess of $100 million should be required to expend at least eight percent of their endowments each year. This is not a new proposal; similar proposals arise periodically. Of course entities with such large sums (Harvard’s endowment is reported to exceed $32.5 billion) are formidable players in politics so these calls generally go unheeded.

To understand why we all have an interest in these matters one must know a thing or two about federal tax law as it applies to charitable organizations. Universities are classified as “public charities” which status means that they can generally earn and accumulate money exempt from federal income tax. Policy experts sometimes refer to these benefits as a taxpayer “subsidy,” to the university, because exempting the university from tax is the same as taxing it like other entities and then returning to it its tax payments rather than using them for other public benefit. Imagine the potential tax liability of an institution like Harvard if its receipts (tuition, income and gains on investments) were subject to the income tax. That figure would reach at least tens of millions of dollars annually. The idea behind the tax exemption, of course, is that it allows universities to provide more research, knowledge and education—all seen as public goods. And tax-exemption is not the only federal tax subsidy from which universities benefit. Donors’ taxes are reduced when they make contributions to universities through generous tax deductions. Like exempting universities from the income tax, subsidizing donations to those institutions with taxpayer dollars increases the availability of the public goods produced by universities.

By implementing the foregoing tax benefits, Congress apparently assumed that we (the taxpayers) are getting what we pay for. But is that true as respects university endowments? Why does Harvard have $32.5 billion and what is it doing with all that money? Why did Yale pay $480 million to private equity fund managers compared with $170 million for tuition assistance, fellowships and prizes? Should these wealthy elite universities be spending more of their endowments on their core mission? That question has been considered by a couple of scholars. Unfortunately, the results seem to suggest that when it comes to at least some university endowments, we are not, in fact, getting what we pay for.

It seems to be generally accepted that a university should spend no more of its endowment than the endowment generates in income and (perhaps) capital appreciation. Many spend income only and allow capital appreciation to accrue, which will generally allow an endowment to grow much larger over time. These practices are justified on the basis of “intergenerational equity.” Maintaining the endowment’s value over time means that it can continue to support the university’s activities indefinitely. But a 1990 study found that the basis for the intergenerational equity argument had little merit. And the fact remains that elite university endowments are growing at substantial rates.

A more recent study, undertaken in 2010 sought to determine why universities, in the immediate aftermath of the 2008 financial crisis, slashed operating budgets, laid off employees, froze salaries, and delayed expansion projects, among other things, rather than dipping into multibillion dollar endowments. Reasons given by the universities were that pre-crisis spending was unsustainable, the endowments were legally restricted as to use, and that the investments were generally illiquid and difficult to access. This study found each of these reasons to be unpersuasive. The author concluded that the endowments served primarily as status symbols, and that universities would reach for any other source of funding to avoid diminishing their endowments.

There is certainly precedent for requiring tax-exempt organizations to expend a minimum percentage of their assets. Private foundations are different from public charities in that rather than being supported by a wide range of public contributions they might be funded only by one family or even one individual. Because private foundations are not “publicly-supported” federal tax statutes require them to expend at least five percent of their net investment assets on charitable endeavors each year. Failure to comply subjects them to a potentially crippling penalty tax. Under the same principle, universities should be using their tax-subsidized endowments to support their core charitable missions. Those who don’t should be penalized.

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