How can it be? Student financial aid fuels increase in college tuition.

When federal (and state) financial aid programs make money available to well-off students, it is in a college's interest to capture that aid and use it to 'improve' the college, thus driving up costs and tuition. Aid must be restructured so that more of it goes to needy students.

AP Photo/Butch Dill/File
Students attend graduation ceremonies at the University of Alabama in Tuscaloosa, Ala., last August. Tuition increases drive even those who are well off to beg for access to financial aid.

Something is fundamentally wrong with America’s college financial aid system when students from families with triple-digit incomes receive plenty of federal aid – while the less well-off are scrambling for it.

According to the Department of Education, 35 percent of dependent students from families making at least $100,000 a year received Federal Stafford Loans in 2008, and 15.6 percent received the “subsidized” variety (where the government pays the interest while the student is in school). Stafford loans account for 82 percent of all federal financial aid lending.

Two theories compete to explain this, and they offer radically different policy prescriptions.

The first explanation holds that college costs are mostly determined by factors over which colleges have little control, such as prevailing faculty salaries. Colleges can do little other than react by setting tuition to cover costs.

If students are having to pay more, then financial aid and state appropriations budgets must be inadequate. The solution is straightforward: The federal government should increase the money available for financial aid.

We think this theory is incorrect. An alternative, which holds that the real problem is out-of-control spending in higher education, provides the better explanation.

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Under this view, more money for financial aid will simply be absorbed as college spending increases. Our research (most notably our 2009 study, “Financial Aid in Theory and Practice”) found that increased financial aid can be downright counterproductive by fueling the academic arms race – a major driver of the cost and tuition explosion in higher education.

The underlying problem is that the “value-added outcomes” of colleges (how much their students learn, how much their skills increase, etc.) are not easily observed or measured. That largely precludes colleges from competing based on the education they provide.

Instead, they compete on prestige or reputation. Their goal is to signal high quality, and the easiest way to signal that is to have high-quality “inputs,” such as prize-winning faculty and state-of-the-art equipment.

But these are costly, and without a measure of the true benefits they bring to a school, cost-benefit analysis cannot reliably guide decisions. Thus, anything that has a plausible claim of improving the institution will be funded if money is available, with the final allocation of spending largely determined by stakeholder struggles among constituencies of the university.

Regardless of how money is allocated, the end result is that schools have an insatiable need for more money – a phenomenon described as (Howard R.) Bowen’s Rule, and thoroughly documented by Charles T. Clotfelter in “Buying the Best: Cost Escalation in Elite Higher Education.”

Colleges know that students operate under the assumption that a college education serves as a passport to the middle class, and that students are willing to pay a significant amount to get one. So colleges act accordingly by charging them more.

Thus when financial aid programs make money available to well-off students, it is in the colleges’ interests to raise their tuition to capture that aid and use it to improve the college, or more accurately, its perceived quality.

Unfortunately, the increases in costs and tuition soon drive even those who are well off to beg for access to financial aid. And sure enough, by 2004 the median parental income of dependent unsubsidized Federal Stafford Loan borrowers was more than $75,000.

The end result is that the college has more money, which is often spent on dubious schemes to increase its perceived quality, such as paying faculty members to write the 21,674th academic piece on Shakespeare. Meanwhile the government and the students struggle to come up with ever increasing amounts to pay for college.

All of this is not to say that students and their families, even relatively affluent ones, are not struggling with paying for college. But providing financial aid will not help those in the upper-income range – it will just allow colleges to raise their price while saddling students with more debt.

To be clear, bad financial aid design is not the underlying cause of the explosion in college costs – the root cause being competition based on reputation leading to the academic arms race. But federal aid does exacerbate the problem by pouring fuel on the fire.

This can largely be avoided with more careful design of federal (and state) financial aid programs. The more programs look like Pell grants (means tested, modest in size, empowering students rather than colleges), the better.

So far, little indicates that this is a priority or even recognized within influential higher education or public policy circles, which are virtually unanimous in calling for more federal financial aid spending. More money funneled through existing federal aid programs is not the solution, but smarter aid spending might be.

Richard Vedder directs the Center for College Affordability and Productivity (CCAP), is an adjunct scholar at the American Enterprise Institute, and teaches at Ohio University. Andrew Gillen is the research director at CCAP and is an adjunct professor in Washington DC.

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