Monday, December 18, 2017

Universities and taxes

The recent tax bill discussion revealed many ways that universities benefit from lots of obscure tax subsidies like everyone else in contemporary America, and that they're pretty good at lobbying to keep them. Two issues stood out to me as worth comment.

1) Taxing graduate school tuition waivers. This caused an uproar, even among economists and economics graduate students who should know better.

PhD students largely do not pay tuition, and most of them get modest stipends. The reason is pretty simple -- the supply curve of graduate students to research-oriented PhDs is pretty flat.  People won't come to graduate school if they have to pay tuition, or taxes on fictitious tuition. There is an annual bidding war in stipends to get the promising students, supply and demand in action. So the idea that graduate students would end up paying a lot either in tuition or taxes violates simple economics.

Moreover, nobody stopped to ask, why do universities pretend to charge tuition, and then waive it?Just how hard would it be for universities to adapt to the tax by not charging tuition in the first place? Why is tuition like medical bills, with a phoney-baloney list price and then everyone gets a huge discount of one sort or another?

Carlos Carvalho and Richard Lowery figured out the answer to this question: Many graduate students, especially in the sciences, get funding from the federal government, and to a lesser extent from private sources. The university charges "tuition" to the grant. So "tuition" is just a way for universities to tax federal grants, and to transfer money that would otherwise flow to students, departments, and research instead to central budgets and general university operations.


Surely universities and government agencies would have swiftly worked this out another way. Just how long would it take, for example, to add direct overhead to student grants, or for the university to give all students "financial aid," not linked to employment, for their tuition?  

(Professional schools -- business, medicine, and law -- do charge tuition, because there is a supply of students willing to pay it. Many universities also run profitable tuition-based masters programs. Some PhD tuition money also comes from foreign students, largely with external grants.)

Though it clearly is income -- if, in return for work, your employer waives rent in a company-provided apartment, that is taxable income -- and though it seems to me that it would have taken only minor tax finesse to avoid it and keep the federal money flowing, the university lobby seems to have preserved our exemption from the tax bill. Having a sympathetic hostage is a great lobbying tactic. "Look at the secretaries and administrators we'll have to fire" would have played less well.

2) Taxing endowment rate of return. The tax bill includes a small tax on the rate of return of endowments. Universities receive a pretty extraordinary tax subsidy, in that they can borrow money at tax-exempt rates and invest it like a hedge fund, but pay no tax -- dividend, capital gain, estate -- on the returns. Unsurprisingly, they have built up huge pools of hedge-fund like investments.

Again, this seems like a minor challenge to financial and tax creativity. Just how much return does an endowment make? As the WSJ points out regarding Harvard's endowment, there is a lot of room to choose just what illiquid assets are worth. Endowments could stuff their investments in real estate, private equity, and other hard to value investments, and rather than puff up the valuations to impress donors, keep valuations low, raise the payout rate, and easily avoid the tax.

Moreover, donors could set up a separate foundation, independently managed, which benefits the university with a flow of money. Given the antipathy of many donors to the way endowments are managed, I'm actually surprised this doesn't happen more often.

Universities be aware: Now that university activities are so overwhelmingly partisan, and so much is overt "activism" and "advocacy," they might not be surprised if Congress starts to tighten the many subsidies.

26 comments:

  1. My son is a PhD candidate in Applied Mathematics. Unlike grad students in gender studies, he has marketable skills. He makes money working a few hours a week for his old consulting firm. He also has savings and investments.

    If the tuition waiver thing is in the final bill (I hope you are right, but I am not wasting time reading drafts), he has said that he will drop out. Dropping out would deprive him of the income from being a TA (he hates being a TA), but save the taxes on his other income, which would be much higher than the TA stipend.

    He could still finish his degree as he has taken all of the required classes and passed all of his exams. He could increase his part time work and still write a dissertation.

    I completely agree that the tuition waiver thing is just a scam the Universities run on the funding agencies. The fair market value of grad school tuition is bupkis* as demonstrated by the fact that no one ever pays it. There is no reason in tax theory why tuition waivers should create a tax liability. Nothing from noting is nothing.

    *in Bankruptcy Latin (a/ka/a Yiddish) bupkis means having so little value as to be practically indistinguishable from having no value at all. The origin of the word is a Slavic term for caprine dejecta.

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    1. Your comment illustrates why economics training is so valuable. WIthout it, people just think "What would I have paid under the new tax law?" rather than "What will I pay once the new tax law comes into effect AND EVERYONE CHANGES THEIR BEHAVIOR ACCORDINGLY." Even an Applied Math PhD student doesn't think to ask the right question. Scientists in general don't (though ecologists should know better), because their particles, molecules, and organisms don't react strategically. But Prof. Cochran is quite right--- if the original bill had passed, it would have had ZERO effect on PhD students, because it was trivial to get around the tax by relabelling tuition discounts as preferential prices or scholarships.

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  2. An interesting sidebar here: my prior is that waiving tax on tuition for grad students is plainly a regressive policy, but I have struggled to find a single (non-economic) grad student or academic who has even considered this point, despite the much-more-progressive-than-average politics of that population. Economists get some flack for modeling agents as being self-interested, but my conversations about this aspect of the tax debate gives me no reason to second-guess that choice.

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    1. Similar point: why aren't critics praising how the bill limits the state and local tax deduction to $10,000, a provision which raises taxes on extremely wealth people and only on them?

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  3. "Universities ... can borrow money at tax-exempt rates and invest it"

    If a tax exempt entity does that, the income from the investments is unrelated business taxable income (UBTI) and is subject to the unrelated business income tax (UBIT) which taxes UBTI at the corporate rate. IRS Pub 598. If a tax exempt entity rhas excessive UBTI, it can lose its exemption.

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  4. Raising the issue of UBTI and UBIT, the changes in corporate taxation raise an interesting equation. The rule of UBTI is that dividends from taxable business corporations are exempt from that classification, on the theory that the tax exempt entity cannot use its privileged status to protect the profits of non-exempt businesses from taxation. When corporations were taxed at the same rates as individuals, this seemed fair. If corporations are now going to pay taxes at substantially lower rates, perhaps a potion of dividends received by tax exempt entities should be subject to UBIT. The argument for doing so is even stronger if we consider corporations controlled by the tax exempt entity.

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  5. "Endowments could ... keep valuations low, raise the payout rate, and easily avoid the tax."

    The new tax as I understand it is an extension of a tax that private foundations have been paying for a long time. The tax is not ad valorium. It is a tax on the net investment income. I.E. dividends, interest, and capital gains less losses and expenses.

    Let's say that an endowment that meets the threshold test of size makes a total return of 10% (1000 bps). The tax is 1.4% of that amount or 14 bps. It is trivial, they may have to cancel the open bar at the Christmas party and lay off a couple of supernumerary vice presidents, but it will not cause any real pain.

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  6. Let me add one more global comment. A number of people have pointed to the biggest endowments and said, gee they look more like hedge funds that use a subsidiary tax exempt as a tax shelter than like a charity*. I think the thought needs to be taken seriously, and that it deserves a lot more attention from policy makers than it has received.

    The Universities have received massive benefits from the government (Federal and state) not just tax exemptions, but grants for research and to students, subsidized loans, tax deductions for contributions, and on, and on. They have responded to this largess by raising salaries, hiring more administrators, spending billions on construction, and continually raising tuitions far faster than the rate of inflation. I really do not think the tax payers should be carrying this much of a burden at a time when deficits are mounting without limit.

    Henry VIII solved a similar problem by confiscating assets. We have constitutional limits on that sort of activity, but I think there a lot of constitutional steps that should be considered. Here a few:

    1. There is ample reason to tax the the investment gains of the endowments as unrelated business taxable income (UBTI, see IRS Pub 598 and IRC 511-515) defined as income from a business conducted by an exempt organization that is not substantially related to the performance of its exempt purpose. If they do not want to pay tax on their investments, they should purchase treasuries and municipals, and hold them to maturity.

    2. The definition of an exempt organization could be narrowed to exclude schools that charge tuition. Charging $50,000/yr and sitting on 30G$ of assets looks a lot more like a business than a charity.

    3. Donations to overly rich institutions should be non deductible to the donors. Overly rich should be defined in terms of working capital needs and reserves for depreciation of physical assets.

    * See: "Paying Tuition to a Giant Hedge Fund: Harvard's academic mission is dwarfed by its $30 billion endowment." By Ron Unz at The American Conservative on December 4, 2012 http://www.unz.com/article/paying-tuition-to-a-giant-hedge-fund/ I do not endorse Unz or any of the rather sketchy characters that he publishes, but good ideas should be evaluated on their merits, not on the eligibility of the author for sainthood.

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  7. I thought federal grants include an "overhead" to the University. This can range very high. It was a 67% add-on at Stanford some years ago when an audit found it buying flowers for the presidents office and other such.
    Quite a kerfufle at the time but I'll bet they're still charging it.

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    1. Overhead includes things like lab space (upgrades and depreciation), computers, utilities, administrative assistant support, and support for university operations that enable compliance with the many and ever-growing federal regulations pertaining to receipt and use of federal funds. This includes the salaries of people tasked with making sure grant monies aren't spent on things such as flowers.

      Abuses have occurred in the past, which is why the various federal funding agencies have gotten more aggressive about auditing large institutions. I am glad this has happened; I am aware of egregious past abuses. However, overhead is not a "research tax." Some studied have concluded that it often doesn't cover the actual institutional costs of supporting STEM research. Institutions negotiate their indirect/overhead rates with the government based on actual audited expenses. There's a reason big research institutions have higher overhead than PUIs, and it's because expenses increase with quantity and complexity of research sponsored.

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  8. Did my comment on unrelated business taxable income get lost?

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    1. No other comments in "awaiting moderation" at the moment.

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    2. "Universities receive a pretty extraordinary tax subsidy, in that they can borrow money at tax-exempt rates and invest it like a hedge fund"

      A tax exempt entity (TEE) is not taxed on income realized from activities that fulfill the purpose that is the basis for its exemption -- e.g. tuition charged by a university. But, if a TEE engages in a business not substantially related to its exempt purpose (other than by way of providing funds) it receives unrelated business taxable income (UBTI) on which it must pay income taxes (UBIT). Not only that, if a TEE has too much UBIT for too long a time, the IRS can revoke its exemption. See IRS Publication 598.

      Dividends from ordinary investments are not UBTI. But if the acquisition of corporate shares is financed by debt, the dividends will be UBTI. Therefore TEEs almost never do that.

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    3. "The tax bill includes a small tax on the rate of return of endowments."

      My understanding of the provision is that it is an extension of a tax now paid paid by private foundations. The tax would be 1.4% of the net investment income. Net investment income is the sum of all interest, dividends, rents, royalties, and capital gains received by the TEE less capital losses, and the ordinary and necessary expenses paid or incurred to produce or collect investment income.

      Valuation is not part of the determination of the tax.

      The tax is really tiny. If an endowmnet makes 10% (1000 bps) on its assets, the tax would be 14bps. They would need to have a cash bar at the Christmas party next year (just as well anyway), and dump a couple of supernumerary vice-presidents.

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    4. "Moreover, donors could set up a separate foundation, independently managed, which benefits the university with a flow of money"

      You would be running a private foundation. There are limits on the deductibility of contributions to private foundations that contributions to public charities are not subject to. How much credit the university will give you for such a gift is hard to say.

      You can set up a charitable remainder annuity trust, but the trust may be taxable and contributions to it might not be deductible.

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    5. In the previous "charitable remainder" trust should be "charitable lead" trust

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    6. "Now that university activities are so overwhelmingly partisan, and so much is overt "activism" and "advocacy," they might not be surprised if Congress starts to tighten the many subsidies."

      The big universities have been accused of being hedge funds that run educational institutions as a tax shelter. I think that they deserve a lot more attention from policy makers than they have received. The universities have received massive benefits from the government (Federal and state) not just tax exemptions, but grants for research and to students, subsidized loans, tax deductions for contributions, and on, and on. They have responded to this largess by raising salaries, hiring more administrators, spending billions on construction, and continually raising tuitions far faster than the rate of inflation. I really do not think the tax payers should be carrying this much of a burden at a time when deficits are mounting without limit.

      Henry VIII solved a similar problem by confiscating assets. We have constitutional limits on that sort of activity, but I think there a lot of constitutional steps that should be considered. Here a few:

      1. There is ample reason to tax the the investment gains of the endowments as unrelated business taxable income (see IRS Pub 598 and IRC 511-515) defined as income from a business conducted by an exempt organization that is not substantially related to the performance of its exempt purpose. Corporate dividends have been exempted from UBIT because they derive from income that was taxed in the hands of the corporation. If corporate taxes are dramatically reduced, perhaps, the UBIT exemption should be reduced or eliminated. If the TEEs do not want to pay tax on their investments, they should purchase treasuries and municipals, and hold them to maturity.

      2. The definition of an exempt organization could be narrowed to exclude schools that charge tuition. Charging $50,000/yr and sitting on 30G$ of assets looks a lot more like a business than a charity.

      3. Donations to overly rich institutions should be non deductible to the donors. Overly rich should be defined in terms of working capital needs and reserves for depreciation of physical assets.
      Ron Unz has written about the problem of multi-billion dollar endowments:

      "Paying Tuition to a Giant Hedge Fund: Harvard's academic mission is dwarfed by its $30 billion endowment." By Ron Unz in The American Conservative on December 4, 2012 http://www.unz.com/article/paying-tuition-to-a-giant-hedge-fund/

      Note: Unz's website publishes essays by authors that many genteel readers would consider to be infra dig. I endorse neither Unz nor his web site. I think ideas should be considered on their own merit, not on the eligibility of the author for sainthood.

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    7. A final sort of unrelated comment. Bryan Caplan is a Professor of Economics at George Mason University. He is a contrarian whose writings do not echo conventional wisdom, but which are to me, very interesting. He has written: "The Myth of the Rational Voter", and "Selfish Reasons to Have More Kids". His new book is "The Case Against Education". Caplan summarizes his argument in:

      "The World Might Be Better Off Without College for Everyone: Students don't seem to be getting much out of higher education." by Bryan Caplan in the January/February 2018 Issue of The Atlantic
      https://www.theatlantic.com/magazine/archive/2018/01/whats-college-good-for/546590/

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  9. Just a quick correction: PhDs in business schools don't pay tuition either (unlike law or medicine). We are treated under the same (silly as you point out) system where we get charged a tuition and then it is waived.

    The only difference here is that business schools usually don't fund this through grants, as there is very little grant activity involved in b-schools. It is mostly (or all) self-funded by the b-schools: in essence the b-school pays the university for the tuition. The left hand pays the right hand, in this case.

    - A b-school PhD student

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    1. As I understand it such grants would not have been taxed. The tax would have applied if you receive a tuition waiver in exchange for work, i.e. TA or RA work. Then the waiver is compensation for the work, and following usual principles taxable. If you don't have to work for it, I don't think you would have been taxed.

      If not, it seems b schools, which should house some decent tax expertise, would have been in an excellent position to simply not charge tuition for PhDs. As you note, all PhD students receive at least enough grant that they do not pay tuition. So, just abolish tuition. There must be some other accounting or tax fiction that makes it attractive to seem like there is tuition and then give a grant to pay the tuition instead.

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  10. The tax on endowment returns while small, can on the margin push universities toward current spending and avoiding risky asset that pay higher rates of returns. You can read more of my thoughts on this here

    https://www.wsj.com/articles/a-hedge-fund-that-has-a-university-1510615228

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  11. Christopher Hrdlicka: I liked your WSJ article. But, I think the 1.4% tax is too small to have much effect. The most direct way to have the effect you want is to make corporate dividends subject to the UBIT. As noted above, the cut in corporate rates may justify that move.

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  12. Strictly FYI, as I have not yet had a chance to read it:

    "The Peril of Taxing Elite Higher Education" By N. Gregory Mankiw on Dec. 22, 2017
    https://www.nytimes.com/2017/12/22/business/the-peril-of-taxing-elite-higher-education.html

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  13. I'm on our faculty senate. Our Provost was seriously concerned about this, and had just returned from a conference of Provost/President types who also were. Nobody had told her the obvious point the post above makes: that PhD stipends were completely safe. When I made the point at the meeting, the lawyer-members nodded their heads approvingly, but most faculty were freaking out.
    My original theory was that the Republicans were doing this as a red herring to panic academics and take their eyes off the rest of the bill. One of my students gave what I think is the real motivation: this is indeed a pretend tax, and the Republicans knew it, but the Senate rules require them to limit the deficit increase to $1.5 trillion, so they liked pretending it would raise a lot of money.

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  14. On the endowment income tax:
    The post makes a good point: universities can do their accounting to make income look smaller. But anyone can do that, and it doesn't get rid of tax entirely. There's only so much wiggle room with accounting. What is awkward for universities, as for corporations, is that it's hard to explain to the people you get your money from (donors, shareholders) that your investment return is really better than it looks.

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