Policies to Improve the Effect of the Endowment Tax on the Public Good

In 2017, the Tax Cuts and Jobs Act imposed a 1.4 percent excise tax on net investment earnings of a set of private colleges and universities that meet certain conditions. Currently, the excise tax applies to private colleges and universities that have at least 500 students and assets per student greater than $500,000, in practice reaching highly selective, high-endowment schools.^[1] In 2023, 56 institutions were subject to the tax and paid a total of $380 million.^[2] The stated goal of the tax was to encourage these institutions to lower their prices and offer more generous financial aid.

This is a worthy goal. These selective, high endowment institutions have exceptionally high graduation rates, including for lower-income students, and are also successful at moving students from lower income families to higher income quintiles after graduation. While these institutions have high sticker prices (tuition, room and board, and other fees), they also offer significant need-based financial aid which reduces the net price paid by lower income students. These net prices are often lower than at public institutions for these lower income students because of the amount of need-based financial aid offered. And, while these institutions currently educate a very small share of total postsecondary students, they do have an oversized impact on the public’s perceptions of higher education, making their actions, and the demographics of their student bodies, an important signal to broader society.

This tax will probably be revisited under the new administration, likely during the reconciliation process, given the Republican trifecta. To extend the 2017 tax cuts which expire in 2025 through a reconciliation process, Congress will be looking for offsetting tax revenue. Currently, a variety of proposals have been made to increase either the tax rate or the number of schools subject to the tax or both. For example:

• The Protecting American Students Act, HR 8913, included provisions that would increase the number of schools subject to the tax, by requiring that eligibility determinations exclude international and DACA students from the total number of students in calculating assets per student. By reducing the number of students in calculating the ratio, assets per student increase and more institutions on the margin will be required to pay the tax.
• The College Endowment Accountability Act (S. 3514) introduced by Vice President JD Vance, then senator, called for increasing the tax to 35 percent for secular, private colleges and universities with $10 billion in assets under management. This would have affected three quarters of the Ivies, along with about 10 other high endowment institutions.^[3]

As these proposals preview, the tax is more likely to go up than to go away in the coming year. However, to create the stated incentives of the tax, a better outcome than either the current tax or one that were simply higher would be to amend the tax in ways that encourage colleges and universities to better serve the public good.

In this blog post, we discuss the impact of the tax on institutional behavior and propose policy alternatives to better meet the stated goal of the tax.

Impact of the tax on institutional behavior

No two institutions respond the same way to policy changes, and internal institutional decision making is not part of the public conversation. However, there are some ways to estimate how institutions have responded to the endowment tax so far, and how they may respond to an increased tax.

• Institutions on the margin of eligibility may look to alter institutional characteristics to avoid eligibility for the tax. The primary way for institutions to do this would be for them to grow significantly to reduce their endowment per student below the threshold, or to reduce their endowment by spending it down, such that they fall below the endowment per student threshold.^[4] In the long-run, these short-term changes would leave institutions with fewer resources for spending that enhances the public good, including both 1) need-based aid for lower and middle-income students and 2) the academic program offered to all students. Spending down the endowment is not sustainable over time and a lower endowment per student from growth results in less income to support each of those students.
• For most institutions subject to the tax who aren’t on the margin of eligibility, it is likely that they will pay the tax and treat it as a negative income shock, reducing expenditures in response to the lower income. The response of colleges and universities to the 2008 financial crisis is an example of how institutions respond when income is lower than expected. In 2008, the decline in the stock market reduced endowment earnings, just like the endowment tax does (although the magnitude of the 2008 decline dwarfs the impact of the endowment tax to date), and colleges and universities responded by reducing expenditures and/or looking for alternative revenues in the ways that least compromise their objectives. This includes turning to increased tuition and reductions in financial aid, working completely contrary to the stated objectives of the endowment tax.

Either way, institutions will be left with less endowment revenue to spend on the thing that matters most for access and affordability: need-based financial aid. Even for the richest institutions, endowment earnings only cover about half of their current total spending on grants and scholarships, with other sources of revenue covering the balance. This means that as endowment earnings are taxed or there is less per student to spend, the allocation from the endowment to financial aid will decline.^[5] To sustain financial aid spending, alternative sources of income will need to be found to replace the reduced endowment distributions. Alternatively, reductions in total financial aid will result.^[6]

Table 1 reports data for a small selection of the wealthiest universities and liberal arts colleges subject to the endowment tax. These data demonstrate that the colleges and universities with the largest endowments are using those endowments to support financial aid, but that even these institutions must supplement those resources with non-endowment resources to meet their total expenditures on financial aid. For example, Stanford spent 4.8 percent of its endowment in 2022/23, a spending rate considered sustainable over time. The university spent 22.7 percent of this, or 1.1 percent of the endowment on financial aid. This covered 59.1 percent of its total spending on financial aid, with other sources of income covering the remainder. If Stanford is to sustain its spending on financial aid in response to an endowment tax, its options are to increase spending from the endowment which might not be sustainable over time, reallocate endowment earnings to financial aid which might not be possible to the extent endowments are restricted to other types of expenditures such as faculty salaries or research, or find other sources of non-endowment income.

Table 1

Source: ProPublica Nonprofit Explorer, https://projects.propublica.org/nonprofits/organizations.
2022/2023 fiscal year, Form 990, Schedules D (grants and scholarships) and I (financial aid to students)

Alternatives to the Endowment Tax

Even though the motivation for the endowment tax may have been mostly political, changes to the endowment tax, rather than its elimination, could encourage greater spending on financial aid and improved access to these high graduation rate schools on the part of low and middle-income students, the stated objective of the excise tax.

Alternative Policy Option 1 – Introduce a Tax Offset for Spending on Financial Aid

A tax offset would change the trade-offs that institutions face in deciding between spending on financial aid and spending on other priorities. Because the institutions subject to the tax are among the wealthiest and therefore benefit the most from various federal tax advantages, it would be possible to structure the tax offset in a way that encouraged those with the most resources, and the largest tax benefits, to spend the most on financial aid to receive the offset.

Some institutions might argue against this on the grounds that they are already admitting the students they believe to be most qualified and meeting their financial aid needs. But, federal tax benefits are in part justified on the grounds of equal opportunity and social mobility, and there is significant evidence that there are many highly talented lower and middle income students who are not finding their way to these institutions. In addition, many of the institutions currently subject to the tax are not fully need blind in the admissions process. This means they are denying admission based on students’ financial need, not because of their desirability as applicants otherwise. Greater incentives to spend on need-based financial aid would push them toward admitting larger numbers of these students, including more transfer students from community colleges, where many very talented lower income students start their higher education journeys.

Alternative Policy Option 2 – Exempt Institutions Meeting Minimum Lower-Income Threshold

Perhaps a simpler option would just be to exempt institutions from the endowment tax if they meet some minimum threshold on lower income students. The share of Pell grant recipients is the most easily available metric that could be used.  An alternative could be a maximum on the share of very high-income students. The share of students at these institutions from the top 1 percent and 5 percent of the income distribution has attracted hostility as much as the low share of lower income students. But, this would require a new data source, since students who do not apply for financial aid are not required to report their incomes to the institution.  Requiring all applicants to fill out the FAFSA whether applying for financial aid or not would address this problem, although this has met with resistance on privacy grounds.

Alternative Policy Option 3 – Require a Minimum Endowment Spending Rate

Some have argued that colleges and universities are saving excessively and that they could spend more on financial aid today without jeopardizing their long-run financial stability. Requiring a minimum spending rate from the endowment is challenging, at least on an annual basis, because of the volatility in financial markets. Without some smoothing of spending from the endowment over time, volatility in financial markets would lead to volatility in spending, which is problematic for colleges and universities. But, encouraging more spending and less saving over time, given the amount of federal subsidy received, is reasonable.

Conclusion

Greater educational attainment is in our nation’s interest. The endowment tax, as currently structured, or as threatened to be amended, does not contribute to this objective. While eliminating the endowment tax could in fact lead to increased spending on need-based financial aid, an alternative to the endowment tax could go further in encouraging the wealthiest schools to matriculate a greater number of lower and middle-income students.

While we present some suggestions above that are connected to the current policy, we also want to note that the endowment tax has broken with past norms of not taxing charitable non-profits, which is a troubling precedent. Any change in the endowment tax should be compared to alternative policy approaches that encourage these institutions to do more for low and middle-income access, supporting economic and social mobility, without this troubling precedent. For example, offering these institutions an antitrust exemption in exchange for higher shares of low and middle income students could create the desired incentives without creating the conflicts of granting non-profit status to colleges and universities including exemption from taxation, and then imposing taxes on some.

This is only part of what is needed to improve postsecondary educational attainment in the country. Improving student success at the large number of public and less selective institutions where most students in America are educated should be a national priority.

[1] This included the Ivies along with other private, non-profit research universities, including the University of Chicago, Stanford, and selective liberal arts colleges, such as Amherst and Williams.

[2] In 2023, 56 institutions were subject to the tax and paid a total of $380 million. See https://www.acenet.edu/Pages/dotedu/122-Higher-Ed-Path-Forward.aspx.

[3] Phillip Levine, “How Trump Could Devastate Our Top Colleges’ Finances, The Chronicle of Higher Education, January 15, 2025, https://www.chronicle.com/article/how-trump-could-devastate-our-top-colleges-finances.

[4] Initially, there was uncertainty about how to assess eligibility for the tax and how to calculate net investment earnings. The IRS has since issued regulations which make it possible to identify with some certainty, even if not precisely, the institutions subject to the tax and the amount of the tax, allowing examination of the tax’s impact as currently structured. According to the American Council of Education (ACE) citing IRS data, in 2023 56 colleges and universities were subject to the tax and paid a total of $380 million.

[5] Using IRS 990 data, it is possible to compare the use of the endowment earnings for financial aid to total financial aid spending. Over time, it should be possible to estimate the impact of the tax on the allocation of endowment earnings to financial aid and total financial aid offered by these institutions, compared to institutions not subject to the tax.

[6] For additional commentary on how institutions respond to the endowment tax, see Phillip Levine, “Should College Endowments Be Taxed?” Brookings, September 3, 2024, https://www.brookings.edu/articles/should-college-endowments-be-taxed/.