The Long Shadow of the Recession
The economic downturn’s aftermath casts ominous clouds over the future of higher education. The final article in our yearlong series, “Catalyst for Change,” explores the recession’s lasting implications.
By Matt Hamill
The past two years have been sobering for higher education as it has adjusted first to the Great Recession, then to an uncertain, sputtering recovery. While the nature of the economic recovery might seem somewhat academic, dominant economic and policy trends affect higher ed in numerous ways. They shape families' ability to finance a college education, they impact investment returns, and they are powerful determinants of the level of public resources for institutions of higher education and for student financial aid. The relationship between economic forces in the United States, our system of public finance, and the public resources available to support higher education will be the focus of this article, the final in Business Officer's series, “Catalyst for Change: The Economic Downturn Reshapes Higher Education.”
A Square-Root Recovery
Economists assessing the state of the global economy have debated whether the current recovery is shaped most like a “V,” a “U,” or a “W,” while an emerging school of thought argues it is shaped more like a square-root symbol. The V-shaped recovery has historically been the most common type, one in which economic activity surges about as sharply as it plunged and reasonably quickly returns to growth rates that preceded the crash. However, the uncertain state of the housing and credit markets, and the prospect of continued relatively high unemployment and soft consumer spending levels, already suggest that we are unlikely to experience this type of recovery.
As the current recession extends past 18 months—the longest since the Great Depression—some economists believe we are experiencing a U-shaped recession, similar to the protracted economic slump of the early 1970s. Without the effect of the stimulus, key industrial indicators could continue struggling to have a sustained increase from their lowest levels of the recession, in effect stretching out the downside of this cycle. The U-shape description is a bit more subjective and is defined by the time it takes to get growth back on a sustained upward track. Some argue that it might be the best indication of where our economy stands today.
A W-recovery was last seen during the Great Depression. During that era, the U.S. economy suffered through a series of partial recoveries and market plunges of 20 percent or more throughout the 1930s. Now often called a “double-dip” recovery, a W-shaped recovery would suggest that the tentative growth of 2009 and 2010 would soon have to be eclipsed by negative economic forces, such as rising energy prices or rising nominal and real interest rates.
The comparison of the current recovery profile increasingly being invoked for the current crisis likens it to a square-root symbol. Under this depiction, the economy bottoms out, bounces back about halfway to the previous peak, and levels off for an extended period of time, thus giving the appearance of the mathematical square-root symbol.
It isn't just economists who recognize that this type of recovery may best describe what we are experiencing. In commenting for the July/August 2010 Business Officer article “Down, But Not Out,” Scott Pattison, executive director of the National Association of State Budget Officers, observed that “this downturn is not only the longest-recorded postwar recession but also broader than previous ones, in terms of geography and sectors.” He went on to add that the longer and broader the recession, the longer the recovery time.
Past Promises Loom Large
Lurking in the shadows of our somewhat tentative recovery, however, are a set of ominous developments that hold the potential to reshape the financing of higher education in far more dramatic ways. Three features of public policy, coupled with inexorable demographic changes taking place, point to an unsustainable system of public finance: the imminent diversion of general revenue to pay Social Security benefits, significant increases in spending on federal health-care programs, and enormous interest costs that will take up ever-larger shares of federal spending.
General revenue used to pay Social Security benefits. At the federal level, decisions made in the early 1980s on how to handle the retirement income and health needs of a gradually aging population will increasingly affect public finance, in profound ways. While the precise impact won't be known until policymakers reshape spending patterns and priorities, the scope of the problem is relatively clear.
When lawmakers and then-President Ronald Reagan negotiated an overhaul of the Social Security system in 1983, they attempted to do something that hadn't been done before: to “pre-fund” the massive liability facing the Social Security program attributable to the impending retirement of the baby boomer generation. They agreed to increase FICA taxes above what was needed to pay current benefits to retirees, and to hold these extra funds in a Social Security “trust fund.” These funds would be invested—loaned to the Treasury to pay for other federal spending programs, which would later repay the trust fund when the FICA tax collections were no longer sufficient to pay Social Security beneficiaries. Since the 1983 reforms went into effect, the Social Security trust fund has accumulated more than $2 trillion in special bonds issued by the Treasury Department. These special bonds held by the trust fund also accrue interest—in 2008, the trust fund “earned” almost $106 billion in interest payments (credits, really, since no funds were actually exchanged).
The theory behind the 1983 reforms was that the Social Security trust fund could redeem these bonds and draw upon the interest they had accrued when it needed funds to pay benefits. According to Social Security actuarial projections, this tipping point will likely occur in 2016. At that time, annual FICA tax collections will no longer be sufficient to pay current benefits, and the trust fund will need to begin redeeming these special Treasury bonds in order to meet benefit obligations. These same projections point to a rapidly growing deficit between taxes collected and benefits paid as the population ages faster than the workforce grows.
When this tipping point is reached, the funding needed to pay Social Security benefits will no longer come exclusively from workers' FICA taxes. Instead, it will be partially paid by income taxes collected by the federal government. With each passing year, the share of income taxes being diverted to pay for this program will grow rapidly; absent fundamental and relatively dramatic changes, the resources to fund other federal spending will become ever more scarce.
Greater spending on federal health-care programs. Similarly, as the population ages, the share of the federal budget dedicated to the Medicare program will also increase, at a projected growth rate that is faster than Social Security spending, due to expected greater annual increases in health-care costs.
For the past two years, the Medicare trust fund has been paying out more in hospital benefits and other expenditures than it receives in dedicated revenues. The difference has been made up by redeeming trust fund assets—meaning that general federal tax revenue is supporting this program with its own dedicated revenue stream. These annual deficits are projected to exhaust the Medicare trust fund “reserves” in 2017, at which time the share of benefits paid from dedicated tax revenue would have fallen to about 80 percent of total program costs—meaning general federal revenues would be paying about 20 percent of the costs of running the Medicare program. By 2035, that subsidy would grow to about 50 percent, and by 2080, to almost 70 percent of total Medicare costs.
Escalating interest costs as a growing share of federal spending. The dramatically changing fiscal demands of the Social Security and Medicare programs are driving another budget dynamic—the rapid escalation of interest payments as a share of the overall budget. As Figure 1 indicates, the fastest rising component of the federal budget is interest payments on the rapidly accumulating federal debt, including the special debt held by the Social Security trust fund. Over the next three decades, interest payments as a share of gross domestic product will grow from their current levels of about 1.5 percent to more than 10 percent.
The challenge that these colliding demands for public resources pose is put into stark relief when you consider the likely levels of tax revenue available to meet spending needs. Since World War II, annual federal tax collections have averaged about 18 percent of GDP, and have never exceeded 20 percent of GDP for more than two consecutive years. Put another way, Americans' tolerance for taxes can be expressed fairly precisely, and there is ample history to suggest that our willingness to pay taxes to Washington will be insufficient to pay for our retirement income, health-care programs, and annual interest payments, let alone for any other federal spending, including student financial aid.
While this dramatic trajectory of spending and tax policy is relatively easy to document, what is less well-known is the timing of any systemic effort to confront it, and what set of political ingredients would be necessary for such an effort to be successful.
Constricted State Fiscal Future
While state budgets don't hold the looming liability of the Social Security system, they have comparable challenges awaiting them. These structural problems are rooted in some of the same demographic trends that will drive fundamental changes at the federal level—the aging of our population and rising health-care costs—with other, state level-specific issues added in, such as greater state and local government responsibility for an aging public infrastructure.
For example, recent studies have concluded that in the aggregate, states have underfunded their public employee pension systems by more than $1 trillion—a figure that does not fully reflect the extent of the market losses due to the recession, since the study was based on 2008 data. With many state budgets being slashed, contributions to pension funds continue to be a frequent target for spending cuts, exacerbating an already-serious problem.
Beyond the ongoing maintenance of their pension funds, states also face the challenges of managing an array of health-care programs, including Medicaid, the health program for low-income citizens. Since its inception, Medicaid has been jointly financed by the federal government and the states, with the federal government currently paying, on average, about 57 percent of the cost. The new health-care reform law will, at least in the short term, change this allocation of costs. To mini-mize the financial burden on states of the Medicaid expansion that was included in the legislation, the federal government assumed 100 percent of the additional costs of covering newly Medicaid-eligible individuals for the first three years—2014 through 2016. By 2020 and in following years, the federal contributions will have phased down to offset 90 percent of these additional costs. Alongside this infusion of federal resources, Medicaid spending, which already consumes about 20 percent of state budgets, is projected to increase over the next decade by an average of about 8 percent annually.
The interrelationship between state and federal budgets is further reinforced by the fact that some one quarter of all state expenditures are made with funds that have been provided by Washington (see Figure 2). The federal government has arguably been relatively generous to the states during the recession, providing more than $130 billion in additional funding over the past two fiscal years in an effort both to boost economic recovery and stave off even more dramatic reductions in state budgets. However, with the fiscal limitations described earlier, one can plausibly say that the federal government's continued ability to fund state-level spending will be severely constrained in the future.
Outdated State Revenue Structures
While current and future state spending needs can be reasonably predicted, the capacity of state revenue structures—with their mix of income, sales, property and other taxes—to adequately meet projected spending needs based on current policies is more uncertain. Analysts and policymakers have fairly regularly weighed in on the frail condition of state tax systems, and the frequency and urgency of such critiques have escalated by virtue of the current state of the economy.
The state tax systems in use today, after all, were implemented more than a half-century ago and fundamentally have not kept up with societal changes. The sales and personal income taxes, the two dominant sources of state revenue, were developed during an earlier time to raise revenue in a vastly different economy. The sales tax began as a temporary revenue measure during the Great Depression; the personal income tax was implemented more than a generation before that. The other types of taxes levied by state governments (corporate income, excise, inheritance, and property) are just as old—or in some cases older than—the sales tax.
While the structure of state taxes has remained essentially unchanged, the underlying economic activity that generates tax revenues has moved from a manufacturing base to one dominated by services, intellectual property, and global electronic commerce. This shift in our economy has had dramatic consequences for state finance. An important component of most state tax systems for more than a half-century, the sales tax has accounted for nearly one third of state tax revenue. In 1998, for the first time since the Great Depression, the personal income tax replaced the sales tax as the single most important source of revenue for the states.
Specialized excise taxes, one of the oldest sources of state revenue, account for approximately 20 percent of total state tax revenue. Unlike income and sales taxes, excise taxes can promote social policy objectives while raising substantial revenue. For example, excise taxes on alcohol and tobacco can limit consumption of those substances, and gasoline taxes can encourage fuel conservation.
However, the states collect only about 40 percent of their total revenue through taxes. Nontax revenue sources used by state governments include intergovernmental aid, revenue from lotteries, various user fees and licenses, and increasingly, litigation. Despite the mix of revenue sources, state revenues still exhibit relatively high levels of volatility. To the swings in state revenue, add ongoing fiscal commitments and the larger and more significant demographic and fiscal challenges described earlier—then throw in the common requirement that state budgets be balanced. All told, it's difficult to see how states will be able to fund their higher education systems in the future at anywhere approximating historic levels.
A Redefined Model of Higher Education
To be sure, the recession has forced most colleges and universities to broadly reexamine themselves in an effort to reduce costs and adjust to rapidly changing enrollment patterns. Earlier articles in this series have examined institutional actions resulting from these internal initiatives. As Martin Van Der Werf, former director, Chronicle Research Services, Washington, D.C., observed in the March 2010 Business Officer article, “Regular, Express, or Online,” the changes are too broad and too fundamental to attribute to current economic conditions. “There is a rethinking of the way education is being delivered,” he says, “but I don't know if the financial crisis could be isolated as a single factor producing these changes. The financial crisis is encouraging students and families to question what they were already questioning, such as the delivery model, the cost of college, and the difficulty in obtaining a degree. The recession is merely accentuating what people were already thinking.”
Modified practices. The last several years have seen a wide variety of changes to institutional practices in the areas of resource allocation, budgeting, and budget management, but we have also witnessed more significant changes in educational delivery models. This array of initiatives shares one central goal: to drive down students' cost of getting a degree by taking significant costs out of the model. Examples of creative delivery models include online learning incorporated into the curriculum, adoption of three-year bachelor's degree programs, and programs created to blend an associate degree within a four-year program.
Other initiatives have expanded the use of consortia mechanisms to streamline certain campus functions, such as library services, information technology, and cooperative purchasing. Generally, these programs can be successful because of their cost-saving potential, without fundamentally changing what is unique about each participating institution. Another strategy employed by many institutions has been to adjust the price that students pay by revising their overall pricing and financial aid strategies, and their associated budgets.
Market-driven changes. While institutional responses to the economic recession have begun to reposition colleges and universities for an uncertain future, it is important to note that students may be responding to both short-term and long-term economic forces faster than institutions. Over the last decade, enrollment growth at low-cost institutions has grown faster than at more expensive institutions, and the recession is likely to have accelerated this trend. According to National Center for Education Statistics data, between 1998 and 2008, enrollment at two-year public colleges grew 32 percent, while enrollment increased at four-year public institutions by 19 percent and at four-year private institutions by 17 percent. With these enrollment gains, two-year public colleges now enroll the largest share of full- and part-time undergraduate students, as seen in Figure 3. A steady and long-term decline in the public resources available for higher education is almost certain to accelerate this trend.
The Emerging Era of Austerity
For our April 2010 article, “Steady Aim,” Greg Roberts, executive director of ACPA–College Student Educators International, observed that “in higher education, we're accustomed to saying that we need to do more with less. Well, with this economic downturn, it's time we learn how to do less with less.” Many have referred to this as the “new normal”—an environment where the public and private resources available for higher education are constrained, where the levels of financial support enjoyed in the past are unlikely ever to return, and where there is greater pressure to keep tuition low. All this comes at a time when there is increasing public interest in—and public policies aimed at—broadening access to higher education to more Americans as well as significantly increasing the number of degrees earned.
If it can be said that there is a silver lining to the Great Recession, it may well be that it has helped illuminate longer-term financial trends, and has served as the impetus for innovation and new solutions to old problems. This year's Business Officer recession series has examined many of these trends and new solutions. The public finance challenges that are emerging from the shadows of the recession will affect colleges and universities and the students who attend them. However, unlike the recession, which arose relatively rapidly, the fiscal and demographic trends facing our country will slowly but surely redirect public resources at every level of government in ways that are certain to have a direct impact on higher education.
Institutional efforts to respond to the seemingly short-term challenges of the recession placed significant demands on institutional leadership. As colleges and universities have identified strategies for handling these challenges, they've also gained a glimpse of the future, fraught with a similar need to do less with less. Adequate preparation for this evolving “new normal” will place even greater demands on institutional leaders, and put a premium on further innovations in how colleges and universities serve our society.
MATT HAMILL is senior vice president, advocacy and issue analysis, NACUBO.