The three biggest economic policy problems of our time

As I see it, governments and central banks are currently facing three major economic policy problems.  First, there is the problem of how to manage the economy when interest rates are stuck at zero.  Second, there is the problem of how to deal with rapidly rising debt levels.  Third, there is the problem of how to deal with rising income inequality.  What is interesting is that in each of these problems, public finance economists are likely to play a key role in finding the solution.

When interest rates are stuck at zero, central banks can no longer manage the ebbs and flows of the business cycle by changing interest rates, so they will need a new policy tool to fulfill that role, and one likely candidate is to give central banks some control over fiscal policy.  Central banks can probably muddle through if interest rates remain at zero temporarily, but if this is a permanent problem, then it does probably make sense to start figuring out how the central bank might gain some control over government finances by sending out direct payments to individuals.  This is one key example where public finance economists are going to have to work together with macroeconomists to build a whole new policy framework that gives the central bank the ability to fulfill one of their primary functions over the long term going forward into the future by incorporating tools that come from fiscal policy.

Over the next several decades, governments are also going to have to worry about rising levels of debt whether this is due to dramatic new economic shocks like the housing bubble or the pandemic, or because interest rates are stuck at zero and governments need to run persistent budget deficits just to keep the economy performing at potential.  If the first problem had the public finance economists bailing out the macroeconomists by giving central banks some control over fiscal policy, the second problem has the macroeconomists bailing out the public finance economists by having central banks buy up lots of government debt through quantitative easing.  If interest rates remain stuck at zero as debt levels continue to rise, central banks will likely be doing a whole lot of QE during that time as well, so that even if debt levels go up, much of that debt will be held by central banks.  If central banks continue to roll over that debt in perpetuity and promise to buy more debt if there threatens to be a run on government debt, than it could be the central banks that keep governments from experiencing a debt crisis.  That means on both of these first two problems, public finance economists and macroeconomists are going to have to work together so that both of these highly critical economic problems can successfully get resolved.

In many rich countries (especially the English speaking ones), there has also been a persistent trend of growing income inequality, and public finance economists will likely play a key role in resolving this problem too.  Tax policy will clearly play a big role, as declining marginal tax rates on the rich is likely one of the causes, and increasing marginal tax rates on the rich is one of the likely solutions as well.  Figuring out how to make sure the rich pay their fair share in taxes will likely be left to the tax policy experts, and they might play a key role in deciding how that tax money gets distributed as well, since that could involve expanding tax refunds for low and middle income people.  

That puts public finance economists at the heart of all three of the major economic problems governments and central banks currently face, and I remember the time when I was beginning my career in public policy and had to decide on my application for a research assistant position at Brookings what field I wanted to go into.  I chose budget and tax policy as my preferred field and after I started working on the topic I was always struck how important those issues really were, since tax policy experts routinely dealt with proposals with costs in the trillions and even a billion dollars was just considered a rounding error.  What was especially surprising to me was how few people there were working on tax policy issues at the time, and now public finance economists are even more important than ever.  If people are trying to figure out how to have a big impact on the world, public finance as a field is a good place to start, and tax policy should be one key aspect that young public finance economists should also give special attention to learning. 

Kevin Carey's plan for higher education

Kevin Carey published his plan for reforming our higher education system in the Washington Monthly recently, and there is a lot to like in his proposal.  His plan consists of three major reforms.  First, the federal government would provide a $10,000 per student subsidy for every college that agreed to a transparent pricing system for tuition that made it free for those from families making less than $75,000 and charged only $10,000 for those from families making above $250,000.  Second, he would require any college participating in this system to accept credits from any other college in the system.  Third, he would reduce tax subsidies for charitable donations to colleges with large endowments.  

Biden offers his own plan to provide free tuition at public colleges for students from families making less than $125,000, but his plan has some serious problems that I describe in an earlier blog post, and Keven Carey's plan addresses many of those.  First, Carey's plan would not require states to pony up one-third of the money, which would avoid another patchwork of participating states as happened with the Medicaid expansion in Obamacare.  Second, Carey would have individual colleges decide whether or not to participate, rather than having the state government arrange a deal to have every public college in the state participate.  This would allow some private colleges to participate if they want, and some public colleges to not participate if they prefer that as well, and would get rid of the dynamic where the subsidies for an entire state could hinge on every public college in the state adhering to a number of strict rules.  Third, Carey's plan would get rid of the tuition cliff, where Biden would have students from families making less than $125,000 get free tuition, but students from families making $125,001 could be charged full tuition.  Carey smooths out this transition by ramping up the tuition colleges could charge starting with families making $75,000 all the way up to $250,000.  

One of the advantages of Carey's plan is that it provides a boost in funding to colleges that charge little tuition.  Many colleges charge less than $10,000 in tuition so the $10,000 subsidy would allow them to reduce tuition to zero for everyone if they wanted, and still spend more on a student's education.  At the same time, it would allow expensive colleges to opt out, which would provide for some independence, but comes at the cost of doing little to reduce tuition or making pricing more transparent at the schools that need it the most.  Plus, because those expensive colleges would now be competing with colleges who did get some major subsidies by participating and dramatically reduced tuition as a result, those expensive colleges would face substantial pressures to reduce education spending on their own students in order to attract them to their school.  Clearly, spending more on low tuition colleges is something that is badly needed and often overlooked, but putting price pressure on schools that do not participate might decrease education spending on our best students, which is something we would probably like to avoid.  

I would propose changing his proposal slightly, where schools would either get half of their net tuition revenue in federal subsidies or $10,000 whichever is higher (up to say $25,000), and could charge up to $10,000 or half of their net tuition revenue (up to say $25,000) which ever is higher.  This would encourage some of the more expensive colleges to opt in, which would spread the dramatic tuition discounts to a wider range of schools, and impose some pricing transparency on the schools that need it the most, while also relaxing some of the competitive pressures to reduce spending on those schools who now decide to participate.  The most elite colleges could still opt out and not be subject to the requirements of the federal government, which would still allow for some independence.

As far as Carey's other proposals, making it easier to transfer credits would be very worthwhile, but I am not sure the effect would be quite as transformative as he suggests.  He also proposes eliminating the charitable deduction for donations to colleges with big endowments, and it is useful to point out that Biden's tax plan would reduce the generosity of those deductions already for high income households, which is probably a good idea.  Biden's plan allows for some tax subsidy for donations to colleges, which I also support, but perhaps the full deduction could be allowed for donations to low endowment schools in an effort to spread the wealth beyond a few elite colleges.  Carey would also propose having participating colleges charge the same for in state and out of state students, which is another good idea that is often overlooked.  Charging different prices for in and out of state students distorts decision making among some of our best students (especially for those with few in state options), and provides no overall advantage to the country once every state decides to do it.

In his article, Kevin Carey provides a very useful proposal to reform our higher education system.  It is not perfect, and I would make some tweaks around the edges, but fundamentally, his plan is much more sound than the plan to provide free tuition for those from families making less than $125,000 that Biden proposed.  He specifically addresses some of the major shortfalls of Biden's plan and provides other useful ideas that would make our system of higher education even stronger.  The article is definitely worth a read, and should be getting more attention in our current debate over higher education.

The Triumph of Injustice by Saez and Zucman

I just finished The Triumph of Injustice by Emmanuel Saez and Gabriel Zucman and I have to admit, it is the perfect antidote to this week's breaking story about how Donald Trump managed to successfully avoid paying virtually any federal income tax at all.  The book even leads with a story about how Trump bragged about avoiding taxes in one of the presidential debates with Hillary Clinton in 2016, declaring that this just shows how smart he is.  One of the key points of the book, which I hadn't fully considered myself, points out that one of the way progressive tax systems fall apart is through a surge of avoidance and evasion that causes policymakers to throw up their hands and give up on high tax rates because they appear to be too difficult to collect.  They even argue that tax avoidance gave low tax advocates key leverage when they passed the 1986 Tax Reform Act, because they were able to strike a deal that had all the extra revenue gained from closing loopholes and ending the massive tax avoidance practices go to reducing the tax rates, especially at the top. 

The conclusion that follows is that in order to save our system of progressive taxation and ensure rich people pay their fair share is to reform our tax structure and methods of tax administration in order to end the corrosive tax avoidance and evasion currently plaguing our system.  To their credit, they have a comprehensive plan to make sure this happens that includes reconstructing the way we tax multinational corporations, taxing capital at normal income tax rates, raising the top marginal tax rate, and imposing a new wealth tax on the richest individuals, while also creating a new government agency to regulate tax shelters.  Included in this list are some important new innovations in tax policy that really could improve the way we tax the wealthiest people and corporations.

I'll even admit that they changed my mind on the usefulness of wealth taxes.  I originally thought they were tough to administer, easy to avoid, didn't raise much money, and also encouraged the wealthiest to just move to another country.  Many liberal European countries who have tried to adopt wealth taxes have ultimately gotten rid of them, so that internationally, even in very friendly political environments, the trend has been away from wealth taxes rather than towards them.  They point out that the billionaires in the US have a lot of their income tied up in unrealized capital gains from the companies they founded, and therefore don't report much of any income in a given year, so raising the income tax won't hit them.  Therefore, if you don't have a wealth tax, many billionaires can avoid paying taxes entirely until they die or sell the company, which might take decades and protect them from paying any taxes for most or even all of their lives.

I also have to give them credit for creating an abundance of fascinating tax data, which includes a policy simulation you can use to craft your own ideal tax plan that you can find at taxjusticenow.org.  In addition, one of their first key points shows that the US essentially has a tax system that charges most everyone the same tax rate (between 25% to 30%) except for the ultra wealthy who pay only about 20% in taxes.  They also make the useful point that taxes were much more progressive during and after WW II, even to the point of being deliberately confiscatory, and this still allowed our society to grow and prosper quite successfully. 

I also have to confess that even though I was agreeing with them for virtually the entire book, they did lose me a little bit in the last chapter just before their conclusion.  Here they bad mouth the prospect of creating a VAT in the US, and instead propose an entirely new type of tax, a national income tax, that includes taxes on wages, business profits, and interest income at one flat rate with no deductions.  They argue this is better than a VAT because it is less regressive and has a broader base.  

My reply would be that first we should gradually raise taxes on the top 1%  either until it reaches its revenue maximizing point or until politically it becomes unacceptable to raise them any further.  If we do this first, and then create a VAT, we do not have a progressivity problem because that has already been solved by the other more progressive taxes.   In this case, it does not matter if a VAT even imposes no tax at all on the rich because we have already reached the optimal combined tax rate for that group, and raising taxes even further on that group through a new national income tax would just mean we would need to reduce other progressive taxes to get back to our optimal rates for the rich.  If you are worried about a narrow base, this is largely driven by political pressures and could be a problem in a national income tax as well if political concerns end up overruling ideal policy design.  For me then a better approach is to figure out the taxes on the rich, then raise any additional revenue we need through a VAT and try and solve the narrow base problems by broadening the base on existing payroll, income, and corporate taxes rather than creating a whole new type of income tax.  Plus, given that this type of tax has never been tried before, we should experiment in some smaller states or countries first to work out the kinks, and this could take decades to test and learn how to do right, where a VAT can be implemented right away with few problems off the shelf.

All in all, I came away very impressed with the book, and they provide a tremendous service to those interested in building a just and prosperous society by showing how the rich can and should be taxed.  There is no reason we have to accept increasing levels of tax avoidance and evasion, either from the super rich or multinational corporations, since they have provided a detailed road map as to how we can fix all of these problems and address the issue of income inequality in our country in a very fundamental way.  Progressive taxation it turns out is quite useful and can be saved, and we should move ahead on the task of doing exactly that. 

Claudia Sahm's proposal to make automatic direct payments to individuals in a recession

I just read Claudia Sahm's chapter on direct payments to individuals that was part of a larger book put out by The Hamilton Project at Brookings, called Recession Ready: Fiscal Policies to Stabilize the American Economy.  In it, she proposes a specific automatic trigger based on the unemployment rate to send out cash payments in the midst of a recession.  To her credit, I think she basically nails it.  First, she has Congress and the IRS set up an automatic payments system and the legislation in advance, so the money can go out the door quite quickly.  Second, she creates a reliable and fast acting trigger to get the annual payments out while the recession is still occurring, and third, she also develops a system for multiple payments during severe recessions, that makes sure Congress doesn't take the money away too quickly. 

When I thought about the problem of direct payments, I usually came at the problem from the perspective of the Federal Reserve, where in the last two recessions, interest rates hit zero right after they started, which means the Fed lost their primary tool for managing the ups and downs of the business cycle.  I even suspect that interest rates might stay at zero for very long periods of time, say across the entire business cycle, and thought giving the Fed some power to issue direct payments to individuals would give them a new tool to pursue their counter-cyclical policy mission.  I thought letting the Fed issue direct payments worth $100 per person per month for up to a year, worth about 2% of GDP, at which point Congress could extend them, would be useful.

Examining how the Fed might get some control over fiscal policy was beyond the scope of her paper, so my current view is that I think it makes sense to combine the two proposals.  Congress could pass legislation to set up the automatic unemployment rate trigger, and in one twist, I might give the Fed the power to send out the first annual payment if need be since they might be able to react even faster than a data driven trigger, but if the Fed did not do that, then once the trigger was set off, Congress could vote to up or down whether or not to let the payments go out.  You can debate whether it takes approval from both the House and Senate for the payments to happen, or whether it takes rejection from both the House and Senate (and perhaps the President too) to block them from going out, but I think giving Congress some say in the matter assuages any concerns about giving up too much control over their power of the purse.  Then, once the first annual payment went out, the Fed could decide to provide a monthly direct payment up to $100 per person per month on top of the annual automatic stimulus payment determined by the unemployment rate trigger.  Perhaps after a year of monthly payments, Congress could be given a vote to determine if this should continue or be blocked, just to make sure the Fed doesn't abuse their newfound partial control over fiscal policy.

This would give you the best of both worlds, where individuals would get the benefits of large annual payments on top of a smaller monthly benefit.  Plus, the Fed could make sure the money goes out the door even faster, and adjust the total amount of fiscal stimulus based on the severity of the recession as it happens. I think this balances the need to provide more fast acting and timely counter cyclical fiscal stimulus while still giving Congress some oversight and control over how it takes place.  Given how important the stimulus checks were in this recession, I think it clearly makes sense to have a system already in place to do something similar when the next recession hits.

CBO's long term budget outlook and the impact of interest rates

CBO just came out with their long term budget outlook, and they paint a pretty grim picture.  Federal debt is expected to grow to 195% of GDP by 2050, where the short term spike in deficits due to the pandemic is expected to go away, but the budget imbalance that existed before is expected to continue indefinitely.  Once that existing deficit gets combined with the rising interest costs from the debt (along with rising health care costs), debt rises at an alarming rate for decades into the future.  

My contribution to this debate is to provide some insight into how the path of future interest rates interacts with this long term budget outlook.  The standard way of understanding this connection is to say that if interest rates stay low (say near zero) for a long time, then the costs of servicing the debt goes down over time as well, and this could substantially improve the long term budget outlook.  I would suggest a different problem, however, where if interest rates are stuck at zero, then interest costs might go down, but the primary deficit (the deficit excluding interest costs) needs to stay high in order to keep the economy at full potential.  I estimate then that this need to run high deficits when interest rates are at zero vastly overwhelms any impact on debt service costs, as you can see from the experience of Japan who now has debt as a percent of GDP reaching nearly 240% even though interest rates have been astonishingly low for decades. 

The real wild card in the scenario if interest rates stay stuck at zero is determining what the Federal Reserve will be doing during this time.  If interest rates are stuck at zero, then the Fed will likely be doing a significant amount of QE, which is just buying up a lot of government debt with printed money.  If interest rates stay at zero indefinitely, then the Fed will be doing QE indefinitely, so that even if the federal government is forced to run high deficits every year, the debt that this creates will largely be bought up by the Fed.  This then creates a scenario, much like Japan, where debt levels are very high, but so much of the debt is owned by the central bank that there is more than enough available funds from the private sector to buy up any new debt and hold the existing debt issued by the government, and this combination of printed money from the central bank and excess available private funds makes the debt easy to manage with little fear of a debt crisis.  

That is one way this long term budget outlook could change, where interest rates stay at zero indefinitely for decades into the future.  The other possibility is that interest rates rise above zero again to modest levels, and the Fed stops doing more QE.  In this case, the US will likely be able to reduce the extremely high deficits necessary to deal with the pandemic, but then after that, there will still be a remaining deficit that causes debt as a percent of GDP to continue rising over time.  CBO estimates that in 2025, the deficit will need to be cut by an additional 3.6% of GDP to get debt back to the levels that existed in 2019 before the pandemic by 2050.  This is the real budget danger, where if interest rates rise above zero, then we really do need to cut the deficit, or else debt will continue to grow to alarming levels without the benefit of having the Fed purchase a large proportion of that debt.

The question then is how easily will we be able to achieve that level of deficit reduction.  If a Democrat is president, it is seems perfectly plausible, where both Clinton and Obama enacted changes to the deficit worth more than 6% of GDP.  Clinton took deficits worth 4% of GDP and turned them into surpluses worth 2% of GDP, and Obama took deficits worth 10% of GDP and turned them into deficits worth less than 3% of GDP.  If a Republican is president, then this might prove to be a more difficult task to pull off, where Republicans only seem to be interested in closing the deficit when a Democrat is president, and are perfectly willing to let it grow when a Republican is president.

The real danger then arises not if interest rates stay low in perpetuity, because then the central bank will likely own a good portion of the debt, but if interest rates go above zero, the Fed stops doing QE, and we we elect too many Republican presidents.  These are the kind of things that CBO can't talk about, but are likely going to be the true drivers of long term debt risks, and are also very important to understand.

Improving on Biden's plan to expand Pell Grants

Biden does have a lot to like in his plans for higher education, but I thought it would be useful to focus on a couple of parts that could likely be improved.  Last Friday, I talked about some possible changes to his plan to provide free tuition for all students from families making less than $125,000, and today I thought I would talk about his plan to expand Pell Grants by doubling the maximum amount.

Pell Grants are nice because they are need based and effectively target a lot of money on students who need the most help.  Unfortunately, there are some problems with this program as well.  First, it is overly bureaucratic, where in order to get a Pell Grant students need to fill out a long and complicated FAFSA form, and then they do not find out how much aid they get until after they apply to college and get accepted.  This means that even if it helps students from low income families afford college, the bureaucratic complexity imposes a serious barrier to attending college, especially since they have no idea how much aid they might get when they are making the decision to go to college.  As a result, some studies have shown that Pell Grants have not been effective in encouraging more students to go to college, though they might be more helpful in keeping students in college once they do actually start attending.  

Because of these problems, I would eventually like to reduce our reliance on the federal system of financial aid, and have my own idea about how to provide need based subsidies that accumulate over a child's entire lifetime.  The seed of the idea started with the insight that having the government deposit money into college savings accounts each year as a child grows up (where kids in low income families get significantly more) would be incredibly transparent and easy to understand because students would always know how much is in their accounts well before they decided to go to college as they do in Canada.  This way students would know they have money waiting for them when they graduate, and would also set the expectations that they will eventually go to college early on in their life.  Both features would make it more likely students will decide to attend college, and would be much more administratively simple in some ways since the government could automatically figure out how much to deposit in the account based on income their parents report on their tax returns anyway, thereby requiring no separate form to be filled out.  Plus, benefits would be based on a families lifetime income rather than just one year, so there would be a smaller work disincentive for parents who did qualify for aid.

The problem is that individual accounts are administratively costly, especially when you are allowed to decide how to invest the funds in your accounts, and often have low take up rates, which might especially hurt low income families who have more difficulties signing up.  In addition, it would take decades for a system of college savings accounts to be fully funded, where the benefits for those graduating from high school right now would be quite small.  My key insight is that rather than create college savings accounts for students, instead the government should create a sort of college Social Security plan.  One of the most successful tricks that Social Security pulled off is to have everyone believe all their payroll taxes were saved up and used to pay for their own Social Security benefits, when really all the money they put in was used to fund the benefits for those currently retired.  Similarly, the government could send out statements showing how much a student will have available to them as soon as they graduated from high school, and those statements would start arriving in the very first year a child was born.  The money would not go into individual accounts that could be invested but instead all the money would be used to pay benefits for those currently graduating.  The government could then use existing tax data to calculate how much a student graduating this year would have gotten as if the program had been in place from the very day they were born.  This means those graduating right now would get a full benefit, while at the same time those growing up would know how much they aid they will get when the graduate based on their income so far and would feel like they have a sense of ownership in the system, even though all the money goes to those graduating this year.

The end result would be a kind of system of college pensions, which are actually government funded need based scholarships, where the government puts money into a fund that is used to pay current benefits, but at each point along the way, students growing up are told how much they will get in the future which depends on the income of their parents growing up.  You get the transparency and incentive effects of a college savings account, but the lower administrative costs of SS type system without the decades long delay until the program is fully in effect.  If you gave every child born a $1,000 benefit and then topped that off with $200 a year for kids living with parents in the lowest half of the income distribution (so that a low income student would have about $4,600 to spend on college after they graduated from high school), this would cost about $11 billion a year.  This would allow you to spend some money on expanding Pell Grants, but perhaps the rest of the funds could be used to pay for this special SS style scholarship program, and if this new type of need based scholarships works well, you could gradually divert more and more money from Pell Grants to make the new system more generous over time.  I do think we need to carefully consider how to improve on our current system of financial aid, and this idea offers a new approach and new strategy for providing need based aid that creates a number of important advantages that makes it particularly attractive.

Improving Biden's plan to provide free tuition to everyone making less than $125,000

Today, I'm going to be looking more carefully at one particular part of Biden's higher education plan. In particular, the plan to provide free tuition to all students in families making less than $125,000 a year.  I know this provision is politically popular, especially among college students, but I had a hunch that coming up with an actual plan to do this is actually much more difficult than it initially appears.  To his credit, Biden does have a detailed proposal and actually has links on his website to specific legislation introduced in Congress.  To get a sense of how this works, I actually read the part of the bill with the legislative language that would be used to implement this proposal.  My sense, based on this reading, is that, in its current form, the proposal isn't really workable and would need substantial changes in order to be passed into law.  In particular, I noticed 6 specific problems with the bill.

First, the bill would require states to come up with one-third of all the revenue necessary to fund this plan.  The basic way this plan works is that states go around and get all their state colleges and universities to agree to provide free tuition, and then the states pass legislation to provide one-third of the necessary funding.  States then apply for a grant from the federal government to provide the other two-thirds of the funding and if they meet all the other requirements in the bill, then the federal government will send a check to the states, who will then presumably pass on the money to state colleges and universities, which would reimburse them for all the money lost from eliminating tuition for student from families making less than $125,000 a year.

The basic problem is that it would be very difficult for states to come up with this new funding, especially in these difficult times, so only a patchwork of states would likely participate and in the states that didn't, this generous federal aid could be delayed entirely for many years until they did manage to come up with necessary state portion.  The bill provides about $40 billion a year in federal funds and would require states to provide about $20 billion in federal funds, which would represent approximately a 25% increase in state spending on higher education (unfortunately, I don't have detailed figures for the latest in state spending).  The thing is if states could bump state spending by 25% right now, we wouldn't be talking about the college funding crisis at all, and providing a 2-1 federal match might not be enough for many states to come up with the money themselves (and some states will refuse to participate just to spite Democrats).  Obamacare provided a much more generous match (paying for about 90% of the costs of expanding Medicaid) but many states still have refused to do so.  I'm not really sure why the proposal requires states to provide one-third of the revenue when clearly the federal government is in a better position to provide funding, but by adding this provision it ensures the proposal will get mired down in state budget politics for years to come.

Second, the bill provides insufficient year to year funding growth to replace the cost of lost tuition over the long term.  The way the bill is supposed to work is that in the first year, colleges basically provide free tuition to everyone in families making less than $125,000, and the states and federal government teams up to provide a grant that replaces all the lost revenue.  In future years, this amount is adjusted based on how many people enroll in college, and also by a yearly adjustment.  If colleges end up with more students than they projected, then the funding rises by the increase in the state's GDP deflator (basically an indicator of how much prices went up in the state).  If colleges end up with fewer students than projected, than funding rises by the interest rate of the 5 year Treasury bond.

Clearly, this last part is a mistake.  I think the legislation was designed a few years ago when interest rates were higher.  Right now, the rate on 10 year Treasury bonds is lower than the rate of inflation.  In theory, if student enrollment increases, colleges were supposed to see their funding rise by the amount of enrollment and the amount of inflation in a state, however if student enrollment is declining then the program was supposed to partially offset the loss in funding from declining enrollment by providing a larger increase in state and federal reimbursement for lost tuition revenue by linking it to the rate on 5 year Treasury bonds.  Now that interest rates are lower than inflation, colleges are punished even further when enrollment declines, which is probably not what they intended.

One of the big problems with the entire free tuition approach is that colleges lose a major source of revenue that they can control and replace it with a large government grant that might not grow as fast, so that over time colleges and universities get squeezed.  At first, this might not be a big deal but over the course of decades, colleges might face serious funding problems as their major sources of revenue don't keep up with the rising costs of providing a high quality education.  In theory, if this gets bad enough, colleges could increase teaching loads, which reduces the cross-subsidization of academic research, and research productivity at state colleges and universities could suffer as well.

This legislation basically confirms this fear by only providing an adjustment for enrollment and inflation under normal times when enrollment is increasing.  Clearly, the funding needs to be adjusted for enrollment, but instead of linking the funding increase to inflation, they should link it to overall wage growth.  Colleges spend a ton of money on professor salaries and these costs go up at the very least by the growth in wages and perhaps even more since they need to attract teachers from an extremely talented pool of individuals who are probably seeing even faster wage increases. If this plan is going to be sustainable, they need to make the yearly funding adjustment much more generous when enrollment is increasing (by linking it to wages), and perhaps switch the link to the interest rate on the 5 year Treasury bond when enrollment is decreasing to the growth in wages plus 1% or 2%. 

The third problem with the legislation is that it not only provides for limited year to year inflation adjustments, but also prevents colleges from raising tuition on students not receiving free tuition by more than the year to year adjustment of the overall government grant.  I always thought one advantage to limiting free tuition to those in families making less than $125,000 was that it provided a release valve for colleges, where if the government grants grew too slowly then colleges could just raise tuition on those not covered by the free tuition proposal to make up any gap in funding.  Tuition is already quite a bit lower at state colleges and universities, and high income families have seen a lot of wage growth, so they could probably afford to pay more to send their kids to a public college or university.  By blocking this source of revenue, this just puts an even tighter squeeze on state colleges over the long run when it would actually be quite reasonable for them to raise more money from rich students.

The fourth problem with the legislation is that it allows state colleges and universities to charge tuition on out of state students.  The legislation does limit the cost of tuition on out state students to the marginal cost of instruction, but this in general could end up being quite high, where out of state students could be excluded not only from the benefits of existing state appropriations, but also from the new federal and state funds provided under this program to reduce tuition as well.  I always thought states should charge the same amount to in state and out of state students because otherwise you just punish the ambitious and effectively restrict the choice of colleges for many of them.  This problem is even worse in many small states that might not have a robust system of higher education, where many of their best students really do need the chance to attend public colleges in other states in order to reach their full potential.  Even if it might be unrealistic to expect the legislation to require public colleges to provide free tuition to out of state students too, perhaps they could limit the difference to say $5,000 a year, rather than letting colleges exclude them from the benefits of lower tuition provided by these major sources of state and federal aid. 

The fifth problem with the legislation is that it doesn't provide for any phase-in of tuition for those who are right above the $125,000 cutoff.  The idea seems to be that students from families making less than $125,000 pay no tuition, but students from families making $125,001 would pay full tuition.  Coming from the world of tax policy, large cliffs and cutoffs create bad incentive effects, where if the tuition jumps up too quickly you get some ridiculous marginal tax rates on income, and this could motivate some people to try and game the system by finding ways to reduce their income just below the cutoff.  Realistically, public colleges would have to provide some tuition discount for a dedicated phase-in range, so that maybe if those making less than $125,000 would get free tuition, only those making above say $150,000 or $175,000 would pay full tuition.  The state and federal program only provides funds to replace the lost tuition from those from families making less than $125,000 but doesn't accommodate the need for partial tuition discounts for those from families making just above the cutoff, so some extra funds should be added to make sure this is possible for colleges to try without breaking their budgets in the process.

The sixth problem with the legislation is that it provides a litany of new requirements states and colleges need to meet in order to receive the funding that may or may not really be enforceable.  Not only do colleges need to provide free tuition to students from families making less than $125,000, they also have to maintain the amount they spend on instruction, they cannot deliberately reduce the number of students enrolled, they need to maintain the amount they spend on financial aid, they cannot raise tuition above inflation on students who do not get free tuition, they must have 75% of their teachers be on tenure track, they cannot use grant funds to pay for sport stadiums, merit based scholarship, school administrator salaries, or capital outlays, and states must maintain their previous support for higher education and cannot reduce other spending on need based financial aid.

Now, of course, many of these restrictions have good intentions, but practically things often do not turn out quite as planned.  First, money is fungible.  If you ban grant funds from being used for certain purposes, states and colleges can oftentimes create budget gimmicks to get around them.  Maybe a college wants a new sport stadium, and won't use new grant funds explicitly, but will divert some existing state aid for the stadium from student instruction, and fill in that gap in instruction using new grant funds.  Perhaps states won't be able to explicitly increase tuition, but could jack up room and board fees by quite a bit to raise new revenue.  Its unclear whether this law really will be able to change the behavior of states and colleges, or whether it will just inspire them to create new budget gimmicks.

Second, even if states or colleges do violate these rules, they might be difficult to enforce.  Right now, the federal government only has one very blunt instrument to ensure compliance, and that is denying them access to the federal funds used to reimburse states and colleges for providing free tuition to students from families making less than $125,000.  If one college reduces enrollment by say 2% or only has 74% of instructors on tenure track, the only recourse the federal government has is to withhold all federal funding from their free tuition program for the entire state until the individual school complies.  This is clearly an imperfect way to regulate public colleges, especially since it applies to a long list of new rules and not just one narrow issue like gender discrimination.  Plus, if Biden is President we might be fine, but do we want the next Republican President, who could have a vendetta against the generally liberal institutions of higher education, to have such leverage that they could withhold the equivalent of the vast majority of revenue from tuition for an entire state for some minor infraction?  Virtually every state will have at least one school in violation in some way, and a Republican administration could threaten to block all funding for the state unless they made major concessions in a broad array of unrelated areas to satisfy their demands.  Normally, this scenario would sound implausible, but given today's political reality it might not actually be that unrealistic.  

Third, it is unclear whether we want these restriction to be carefully adhered to over the long term.  Essentially, by blocking changes in tuition, enrollment, need based funding, merit based funding, state policies on higher education are locked in just where they were before the free tuition policy took effect.  Over the short term this might not be a big deal, but states over the long run would probably like to be able to adjust their policies eventually, and not be micromanaged at every step by the federal government under this new subsidy plan.  In general, the states have been more successful designing useful higher education subsidies and implementing them effectively than the federal government, where both Pell Grants and federal tax credits have turned out to be overly bureaucratic, poorly understood by the public, and done little to actually increase enrollment in college.  Giving the federal government the opportunity to micromanage every aspect of state higher education policy might turn out to be ill advised if states can make better decisions on their own.

Practically then, I have offered some important substantive suggestions on how to improve Biden's plan to provide free tuition to every student from families making less than $125,000.  Ideally, however, I would adopt an entirely different approach, where if the federal government wants to spend $40 billion on higher education subsidies, and states currently spend approximately $80 billion a year themselves (again I don't have precise current figures), then the federal government should just offer a 50% match for every dollar the state spends on higher ed, and let them decide how to use it.  States might not lower tuition down to zero, but they would likely reduce it substantially, and giving them some flexibility on how to use the funds might encourage new innovations and approaches that turn out to be even more successful, and this flexibility would be especially important amidst the financial chaos of the pandemic.  This way, the federal government wouldn't be micromanaging state higher education policy and colleges wouldn't get squeezed long term with insufficient funding, so you do get substantial upsides of better affordability and lower tuition without the major downsides that could completely upend higher education in the US.  I think this approach merits serious consideration, especially given that Biden's current plan has some significant problems, and I hope this blog post highlights some ways that higher education policy could be made better if Biden wins the election in November.