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Funding Students Instead of Institutions

State budget shortfalls are fueling the debate about shifting appropriations away from institutional operating expenses and toward direct student funding.

By Robert B. Archibald and David H. Feldman

Despite soaring list-price tuition, spending per full-time student at public institutions has fallen further behind their independent counterparts during the past quarter century. This has caused some to ask if the old implicit contract can be replaced with a new system that preserves high-quality programs and maintains a sufficient number of places for state residents, but that recognizes the shrinking role of the state.

One idea gaining traction is for states to shift appropriations for operating expenses away from colleges and universities and give funds directly to students in the form of a savings account, scholarship, or voucher. The most well known of these efforts is a systemwide voucher proposal developed by Colorado’s Blue Ribbon Panel on Higher Education for the 21st Century. An amended version of this proposal has been adopted, and starting in the fall of 2005 most of the state appropriation—which formerly went to Colorado colleges and universities—will fund direct grants to students. A similar approach has been adopted unilaterally by Miami University of Ohio. Miami pledges to return all of its state appropriation directly to its Ohio resident students in the form of across-the-board grants and specific scholarships. All students would face the same list-price tuition. Proposals similar to these are being considered in other states. While calling this a revolution would be premature, such interest indicates the first stirrings of one. Significant budget shortfalls in many states clearly are a catalyst for this new thinking.

This article discusses why direct funding for students at public colleges and universities is a good idea. In making our case we do not imply that states should change the current mix of subsidies they give to public and independent higher education institutions. While our argument affects the mechanism used by states to subsidize their public colleges and universities, independent institutions may nonetheless find the discourse of interest. (See sidebar, “A Few Words About Our Proposal.”) If, as we suspect, this new funding mechanism strengthens public institutions—in part by improving the quality of education they provide—public colleges and universities ultimately will become more effective competitors, both for students and for private funds.

Funding Scheme Comparisons

While direct funding proposals may sound like a radical departure from traditional funding practices, when viewed closely they look more like an exercise in manipulating smoke and mirrors. Table 1 contains a simple comparison of a traditional funding scheme to a direct funding scheme. The example ignores out-of-state students, and all numbers are on a per-student basis. The major changes associated with a shift to the direct funding model are the elimination of state appropriations to institutions, an increase in list-price tuition, and the creation of a tuition grant that goes directly to every in-state student.

The accusation that these changes are an illusion or are only cosmetic has strong initial appeal. No more money is involved, and many things are unchanged. From the student’s perspective in this example, $8,000 is added to the tuition bill, but he or she is unharmed because $8,000 is given to each student as a tuition grant. From the institution’s perspective, it loses $8,000 in state appropriation, but it also is unharmed because it gains an additional $8,000 in tuition revenue for each of its students. Likewise, the state is unaffected; its checks are routed to the institutions through the students. Since all parties apparently wind up in the same place, what’s the big deal?

The Planning Problem

State appropriations are such an important and volatile part of an institution’s educational and general (E&G) budget that any plans a college or university makes are highly speculative. The recent recession in state revenues has emphasized this problem. Any long-range plan to add programs or to change the size of the faculty or its compensation is compromised by the inherent unpredictability of the state funding cycle.

By contrast, an institution’s auxiliary enterprises face no such problem. If the college or university sets its own dormitory fees, it can embark on a multiyear plan to finance renovations of the dormitories and follow that plan precisely. The reason for the difference in planning possibilities between E&G activities and auxiliary enterprise activities is easy to spot. Auxiliary enterprises are entirely funded by fees controlled by the college or university, while the E&G budget is funded by tuition and state appropriation. Universities do not control the state appropriation, and in many cases, they do not control tuition. If an institution has little control over its revenue, it cannot make reliable plans.

This planning problem could be mitigated somewhat if a public institution could save a portion of its state appropriation in a rainy-day fund. But in the usual state budgeting process, money can’t be moved easily from one budget year to another. Often there are legal limits on the amount that can be shifted out of any one budget. Some budget officers avoid any savings for fear the state will take these savings for other purposes. And any agency that reveals it can save has revealed to those who control funding and to competing agencies that it apparently can get by on a smaller budget. This creates a use-it-or-lose-it mentality among state agencies.

With direct funding of students, a college or university has no reason to avoid saving since no direct appropriation exists for the state to cut the following year. If savings allow the institution to improve its allocation of E&G expenditures across years, it can store some of its tuition revenue for future needs. The incentive for individual universities to take a longer view is reinforced if the direct tuition grant is systemwide or by tiers. In that case the state is unlikely to change the size of the grant except for general fiscal needs.

This suggests some political limits to the usefulness of direct grant proposals. To receive the planning benefits associated with control over revenue, an institution must be able to set its own tuition, and tuition has to be considered institutional revenue, not state revenue. The fact that many state legislatures either directly set tuition or put severe constraints on what university boards or regents can do clearly limits the number of state-supported institutions that could easily use this model. For an institution that has the freedom to set tuition or that might be able to arrange for this freedom as part of a new deal with its state, the direct funding model allows the institution to make reasonable business plans. The resulting increase in the quality of education that this institution could offer is a major advantage of the direct funding model.

Fear of Shifting Risk

When we talk to people about the direct funding model, one common reaction is a fear that risk will be shifted from universities and placed squarely on students and their families. Within the traditional funding scheme, the risk of a shortfall in state revenues is borne by the university. With direct funding, a state’s budget shortfall cannot adversely affect an institution’s revenue because institutions do not receive a state appropriation. Students, on the other hand, do receive funds directly from the state in the form of tuition grants. These grants could be cut to help the state deal with a budget shortfall. Since the net tuition to families is list price minus the grant, lower grants mean higher net tuition.

Table 1: A Comparison of Funding Schemes

  Traditional Funding Direct Funding

In-state tuition

$5,000

$13,000

State appropriation

8,000

0

Tuition grants to students

5,000

8,000

Net tuition expense

5,000

5,000

Revenue

13,000

13,000

Cost to the state

8,000

8,000

The change here is less real than it may appear. For the most part the difference is a one- or two-year change in timing. With the traditional funding scheme, when a state budget shortfall occurs, colleges and universities take budget cuts along with other state agencies. Since colleges and universities have the ability to recoup some of any budget reduction by raising tuition, they often face larger budget cuts than most other state agencies. The pattern of large tuition increases following budget shortfalls is evident in almost every state. The result is that the students end up paying in the form of higher tuition. Because institutions are at times unable to change tuition rapidly, these higher tuition payments are likely to be in the years following the actual budget shortfall.

If the state legislature does not allow public colleges and universities to raise tuition, families still bear the risk of budget cuts, but the consequences are measured in reduced quality instead of tuition dollars. In the short run, lower state appropriations mean larger class sizes, fewer courses, deteriorating facilities, and less-capable faculties. In the long run, a state’s public assets in the form of its higher education institutions are weakened, and the value of the diplomas those institutions grant are debased.

Two additional factors are worth noting. First, the political nature of a tuition grant would seem quite different from the political nature of a state appropriation to a college or university. Although we have no experience to guide us, tuition grants may end up being so popular that they would take a smaller hit during budget shortfalls than appropriations to state-supported colleges and universities traditionally do. If true, this would moderate the increase in net tuition that students usually experience during times of state budget duress.

Second, the direct funding model dramatically changes the relationship between recessions and the list tuition charged by state-supported institutions. With the direct funding model, no reason exists for large tuition increases to accompany recessions. If a state is forced to reduce the tuition grant, institutions may well respond by moderating tuition increases. Because an institution realizes that its competitive position depends in part on its net tuition, if the net tuition is increasing because of a cut in the tuition grant, the institution has an incentive to reduce any planned tuition increase. Some institutions actually may choose to decrease list tuition during a recession.

Effects on Fundraising

Another result of direct funding of students is that state-supported institutions would approach fundraising like independent institutions. While all state-supported institutions have active private fundraising ventures that augment lobbying a state’s legislature, the direct funding model would make private fundraising more effective.

For instance, when a state-supported college or university president asks for support, potential donors may often wonder whether the president is asking them to bail out the state. Ironically, successful fundraising may affect a state’s future willingness to fund an institution. While college presidents have to spend significant time convincing donors that their gifts will not affect the level of state support received, they are not always convincing or correct. States can effectively tax private donations by reducing an institution’s annual E&G appropriation. This induces donors to be very specific about what their contributions will fund and to steer their donations toward new projects—projects that may be of less use to the university than gifts that would fund ongoing needs.

Furthermore, while public college and university presidents currently are selected for their political expertise and reputation in the legislature as much as for educational leadership abilities, the direct funding model could change this. Since direct student funding proposals usually involve operating expenses only, a public-sector president’s ability to lobby the legislature for capital projects would certainly remain important. However, the amount of time a college president and his or her staff would need to spend in the state capitol likely would diminish considerably. This is a good thing, since much of this expensive lobbying is a socially unproductive exercise in protecting a university’s existing budget from legislators who have other priorities and from other public institutions that might encroach on its share of the higher education pie. This lobbying by institutions diverts a considerable amount of time, effort, and talent from other activities that would contribute more to the college’s long-range success, such as running the institution or trying to increase its private resources.

A Few Words About Our Proposal

Our specific proposal for a direct student funding model, “New Compact for Higher Education in Virginia”—discussed generally in the accompanying article—is available at http://faculty.wm.edu/dhfeld/NewCompact.pdf.

Several points of clarification are worth mentioning regarding our proposal and the issues raised in this article. First, it is important to recognize that our proposal does not affect the financial status quo. We advocate neither diluting the subsidies for public institutions by making additional grants available to students at independent institutions, nor using any of the subsidies currently going to independent institutions or to their students to enlarge subsidies to students at public institutions.

Second, because our proposal is based on the idea of direct grants to students, some people are tempted to call this a voucher plan. To do so confuses our proposal with others that would create a public subsidy entitlement that is portable between public and independent institutions. That portability is at the heart of school choice plans that are well known in the debate about funding K-12 education. While a need may exist for more school choice in K-12 education, we believe there already is ample school choice in higher education. Our focus is on the funding mechanism of public institutions. Shifting from direct appropriations for institutions to direct funding of students would strengthen public colleges and universities.

Third, direct funding of students shares an important similarity with block grant proposals for higher education funding. Block grants also give institutions more predictable revenues by freezing the state appropriation for an extended time period. Combined with the freedom to set tuition, an institution gains the same ability to make reliable long-range plans. Direct student funding is like a block grant of zero dollars. This number is exceedingly difficult to reduce. Other block grants—no matter how sincere the intentions of the legislature that enacted the program—might well be reduced if the state’s budget is in really bad shape in some succeeding year.

And finally, our discussion suggests that the direct funding model should be limited to four-year institutions. These are the institutions that should be able to control the size of their student bodies. On the other hand, part of the mission of two-year institutions is to serve as a second chance for students whose high school records do not forecast success in college. Because students mature at different rates or change educational interests after gaining experience, by taking advantage of the education offered at a two-year institution, many students with less-than-stellar high school careers eventually become college graduates. Because of their different mission, two-year institutions should not be selective. By contrast, most four-year institutions should be selective, with spaces reserved for individuals whose high school records or two-year college careers forecast success in college.

Financial Aid Incentives

Most state legislatures currently face a tradeoff between funding institutions and funding financial aid for needy or talented students. Within the direct funding model the decision becomes a choice between funding across-the-board grants that go to every student—independent of income or ability—and providing financial aid targeted to needy or talented students.

As a general rule, college and university presidents favor a well-funded state financial aid system. Yet, if funding for financial aid comes at the expense of funding for his or her institution, a college president likely will oppose financial aid funding. A direct funding system changes the incentives. Because the college or university has no state appropriation to protect, its leadership can support increases in funding for the state financial aid system. This support for increased financial aid might well be the case even if the increased aid is financed by decreases in tuition grants. For universities that control their tuition revenue, cuts in the tuition grant don’t change the institution’s revenue the way that cuts to E&G appropriations do today. In this regard, it is perfectly sensible to favor increased financial aid because it is better targeted than are tuition grants.

State Responsibilities

Although the direct funding model grants more decision-making power to colleges and universities, certain responsibilities should remain with the state. Most importantly, the state must be able to control the number of in-state students attending its public institutions. If states allowed institutions to determine their own size, legislatures would be making open-ended commitments. A state also has a responsibility to provide sufficient funding to maintain the physical plant necessary to accommodate the educational programs at its institutions. For these reasons there should be binding long-range plans negotiated between the state and each institution that govern the size of the institution. If a plan calls for an increase in the student body, this should be coordinated with a process to increase teaching and research space for the institution.

Another advantage of the direct funding model is that it allows a state to gain control of the amount of state subsidy for which each student can qualify. Within the current system, an in-state student can receive subsidized tuition for his or her third master’s degree. While education is a good thing, it is hard to argue that a state should be responsible for subsidizing multiple degrees at a particular level. A state may wish to limit the number of semester hours for which a particular student is eligible to receive a tuition grant. While these limits should be liberal, leaving room for mistakes and experimentation, it is sensible to have limits.

Institutional Accountability

A system of direct student funding gives considerable independence to colleges and universities. For starters, it relieves them of the responsibility to go to the legislature every year to justify an increase in state appropriation. And with control of their own tuition revenues, institutions become independent financial entities within their states. While campuses may seem less accountable to elected officials and to the public without the government’s power of the purse, this accountability deficit is more apparent than real.

A state and its public higher education institutions often have disputes about size or programming. Within a traditional funding mechanism, institutions can play games with a legislature by expanding enrollments and then clamoring for more support because of a decrease in per-student funding. On the other side, legislators may think that institutions are not doing their part in advancing the economic development of the state. Legislators may urge universities to initiate or expand particular programs. The legislative hearing on an institution’s state appropriation currently is an important venue for these and similar concerns. A direct funding model would eliminate these regular hearings and so would appear to diminish legislative control, but this is not as large a concern as it might first seem.

With tuition grants, states would have a direct policy lever with which to influence the size of their public colleges and universities. In consultation with institutions, a state would set the number of tuition grants it would fund. Little incentive exists for an institution to admit students without tuition grants, especially if the institution is mandated to meet financial need for state residents. Discussions about the number of tuition grants also provide a collaborative way to address state desires and university goals for new or expanded programs.

If a state’s governor and legislature have specific programmatic goals that they believe are not currently being met by any of the state’s institutions, the state has great power to craft incentives for colleges and universities to meet the perceived unmet need. A state could, for instance, offer to construct and equip a building to house an institute, school, or laboratory if a university commits to developing and staffing the program desired by the state. Competition among a state’s universities would help clarify the costs and benefits of various sites for the program. These incentives are fully compatible with the ongoing support provided by a system of direct tuition grants to students.

Accountability often is equated with careful monitoring of spending undertaken by public agencies. State control of public universities typically includes rules that guide the way state money can be spent (e.g., only this much for lunch, never to buy alcohol, and only this much for a hotel room). States often have other oversight rules. At the College of William and Mary in Williamsburg, Virginia, we need formal state permission to erect a tent. Ten tents require 10 separate permissions. For the most part this external micromanagement is inefficient and redundant. Our proposal for a direct funding model envisions many of these controls disappearing, since colleges and universities would become financially independent agencies within their state. Instead, colleges and universities should then accept the responsibility of strict post audits.

Clear thinking about what public institutions of higher education are supposed to produce is far more important than micromanaging spending. Here, too, less-intrusive approaches are more likely to generate better outcomes. No regulatory apparatus can ensure that talented and motivated students leave a university better trained than when they entered. A state government that adopts a hands-on approach to managing what universities must do risks politicizing higher education in ways that are unlikely to attract talented faculty and administrators to its public institutions.

A state can enhance institutional accountability by acting as a clearinghouse for information about university performance. This is important, because institutions of higher education operate in an extremely competitive environment. In most states, a number of public and independent institutions compete for students, and institutions in other states provide additional competition. Unlike competition in many industries, the object of this competition is not to expand sales but to increase the quality of programs. Many advantages accrue to an institution that attracts able students. This competitive setting provides an important source of accountability. If an institution sees the quality of its student body declining, it receives a strong signal that it should change its behavior.

Editor's Note: Business Officer welcomes feedback about the views presented in this article. Send letters to Jane Rooney, managing editor, at jane.rooney@nacubo.org.

A great number of details would need to be worked out before an actual proposal to switch to a direct funding system for students at public colleges and universities could be put in front of a state legislature. However, the benefits of doing so should prompt those involved to determine how such a system would best work with their state’s existing institutions and history. Any resulting proposal will not be perfect. Still, we believe that a direct funding system need not be perfect; it needs only to be superior to the existing system.

Author Bios Robert B. Archibald and David H. Feldman are professors of economics at the College of William and Mary, Williamsburg, Virginia.
E-mail rbarch@wm.edu; dhfeld@wm.edu