Congress has increased the tax colleges and universities with large endowments pay on the income from their investments. The budget reconciliation act enacted on July 4 replaced the 1.4 percent tax on net investment income of institutions with endowments exceeding $500,000 per student, which affected fewer than 60 institutions. The new tax rises gradually to 8 percent and applies to institutions with 3,000 or more tuition-paying students. It will affect fewer institutions than the tax it replaces, but some will see large increases in their tax burdens.
Critics on both the left and the right have long proposed taxes that could have a significant impact on elite institutions and educational opportunities for students. But this tax on a few institutions is incompatible with the tax-exempt status of nonprofit educational organizations, and its purpose and measures of success are unclear.
Why endowment income has historically been exempt from taxation
Since its inception, the federal income tax has included tax exemptions for charitable organizations, avoiding government interference with the missions of churches, private nonprofit educational institutions and other covered entities. Tax-exempt institutions must meet a number of requirements, the most salient of which are nonprofit status, restrictions on political activity (but not on the viewpoints or ideologies of the organizations or their members), and using any retained earnings for the advancement of their charitable missions.
The 2017 Tax Cuts and Jobs Act imposed a 1.4 percent tax on the net investment income from endowments held by wealthy private colleges and universities—a first-time levy on institutions historically exempt from federal income tax.
College and university endowments support long-term planning and student financial aid
Endowments allow colleges and universities to support their missions over the long term, supplementing other current revenue sources and protecting against economic downturns and an uncertain future. About half of the income institutions draw from their endowments supports financial aid. Colleges and universities also use investment earnings to educate undergraduate and graduate students, carry out research, and engage in other community activities.
A few colleges and universities have large endowments, but most do not. At the end of fiscal year 2021, the 13 universities with the largest endowments held half of the total $700 billion in endowment assets of over 2,600 four-year postsecondary institutions. The top four universities held one quarter of the assets.
An endowment is not a complete measure of an institution’s wealth. For example, Harvard is frequently cited as the richest university because it has by far the largest endowment. But because it enrolls almost three times as many students as Princeton, its endowment per student is about half of Princeton’s. Harvard also has more graduate students, more part-time enrollment, and a medical school and extensive research labs—all of which affect its financial profile.
Debt is another factor: Some institutions have debt levels equivalent to a sizeable share of their endowments while others have not borrowed extensively.
In other words, a tax based on endowment-per-student may obscure key differences among institutions, creating unintended and disproportionate effects.
The goal of the endowment tax increase remains unclear
The new endowment tax will raise less than $1 billion over ten years. It is not clear what additional goals it might achieve, nor how the tax could benefit students.
Unlike some earlier proposals, the law does not include incentives to increase educational opportunities for low-income students, nor does it direct revenue toward activities that could support college and university missions.
Such provisions might well be ineffective. A tax linked to the share of endowment income spent on financial aid for low-income students could lead to increased financial aid, but with accompanying tuition increases.. And earmarking endowment tax revenues for specific purposes such as subsidizing community colleges would involve complex Congressional actions that could be challenging to implement and sustain.
If the goal of a tax on income from large endowments is to encourage colleges and universities to enroll more low-income students, other policy approaches directly related to the goal are likely to be more effective.
If the goal of the tax is resource inequality across postsecondary institutions, direct subsidies to less affluent students and the institutions struggling to support them could more effectively improve educational opportunities.
The endowment is poorly structured and could have unintended effects
The structure of the tax could lead to large tax burden changes with only small changes in enrollment or endowment value. Wesleyan University, with about 3,200 students, could be subject to the new tax, but not with its endowment per student of about $491,000. But if its endowment grows by a small amount, a 1.4 percent tax will apply to all its net income.
The new tax, with three tax rates, each applied to all net income, creates additional cliffs. Harvard’s endowment of over $2,000,000 per student faces an 8 percent tax rate and an estimated annual burden of about $300 million. But a small decline in its endowment per student (should its endowment value fall or number of tuition-paying students climb) could drop it to the 4 percent bracket, cutting its tax burden in half.
In addition, unlike the corporate income tax, which excludes expenses devoted to producing goods and services, the endowment tax only allows deduction of the cost of managing the endowment. Net investment income spent on educational activities, including financial aid, is subject to taxation. The tax is more likely to decrease educational expenditures than to increase them. The tax could lead to a range of changes in university policies that could divert resources from their mission of educating students,
The endowment tax selects a few institutions from one group of charitable organizations, taxing income that has historically been exempt. Absent a clearly stated policy goal of the tax, there is no way for policymakers to make evidence-based decisions about its effectiveness.
The concentration of wealth among a small number of institutions may deserve the attention of policymakers, but an arbitrary and poorly structured high tax rate invites unintended consequences harming institutions and their students without accomplishing constructive change. Future Congressional action can either mitigate or exacerbate these problems.
