The Oregon House recently approved a plan for experimenting with a new method of financing higher education: providing students with tuition-free education at state universities in exchange for a percentage (around 3%) of future earnings (over the next 25 years). The great free-market economist Milton Friedman proposed a similar idea in his Capitalism and Freedom. With a few significant modifications, the Friedman-Oregon plan could provide an attractive free-market alternative to the existing mix of grants and subsidized loans, at least for that component of higher education that is purely vocational in nature. The funding of a liberal education raises quite different issues, which I will take up in a follow-up post.
The Oregon plan suffers from a number of obvious defects:
1. It is limited to funding tuition, and excludes fees, books, and living expenses
2. It can only be used at state colleges, limiting student choice and undermining the diversity of higher education.
3. Since the percentage of future earnings is being collected by the state, it encourages students to flee out of state, where collection costs for the state would be prohibitive.
4. It provides students with no guidance about finding a major and a school that would, given their individual characteristics, maximize their long-term earning potential.
5. It does nothing to control costs, encouraging students to take on more of a financial burden than is prudent, given their actual educational progress.
6. Outlays are immediate and revenues are deferred, putting pressure on the current state budget.
7. Given past experience with fiscal management at the state and federal levels, we have every reason to expect that the program will be fiscally unsound, with payments greatly exceeding the present value of future revenues.
Despite these limitations, the Oregon proposal has some merit. In Capitalism and Freedom, Friedman explained why the unassisted free market is likely to result in under-investment in human capital: the transaction costs involved in collecting a share in future earnings is too great for such direct investment to take place entirely under private auspices. Ronald Coase, the British economist who won the Nobel Prize in 1991, pioneered this analysis of transaction costs. In addition, there is some doubt as to whether the courts would enforce such a contract without statutory license.
As Friedman explains, the state’s role in this method should be limited to the collection of a percentage of future earnings. Obviously, this role would best be served at the federal level, since the IRS keeps tabs on all earnings. It would be easy to combine the revenue collection with current withholding mechanisms. By doing this at the federal level, we would eliminate the state flight problem (#1). It might also be possible to establish federal-state partnerships in which individual states contract with the IRS to do the collecting.
What the Oregon plan is missing most fundamentally is a free-market component. Instead of simply foregoing current tuition revenues, the state could enable students to sell percentages of their future earnings on the open market. In addition to the federal collection mechanism, we would need two further elements: private investors to buy the shares in students’ future earnings, and investment banks or insurance companies to bundle college students into tranches, based on shared characteristics (college, major, academic record, etc.). The bundling institution would be paid by commission on the sales of securities, and the investors would provide 100% of the funding and bear all of the risk.
Students should be free to apply the financing to any form of post-secondary education or training, including private and for-profit schools, in pursuit of bachelor’s degrees, associate’s degrees, or certificates.
The main advantage to this method of financing is that the free market would provide students with counselors and advisors who share a common interest in maximizing the realization of the students’ earning potential. The securitization companies would face pressure from investors to provide tranches with maximum expected earnings, and they in turn would provide students with state-of-the-art guidance in selecting those programs, majors, and tutors best suited to the student’s individual characteristics. In addition, the investors would guide the students to make the best use of their financing, avoiding wasteful spending on over-priced programs.
In addition, the securities market would help to prevent grade inflation and falling standards through requiring objective and reliable assessment of student learning. Finally, the system would provide students with strong incentives to work hard and succeed, since students with good academic records would be able to obtain financing on more favorable terms. Of course, egalitarians will object to this feature, since it would direct more funding to students with greater intellectual gifts and proven virtues of industry and perseverance. Given the scarcity of our resources, such prioritizing of investment makes perfect sense.
As both the federal government and states face increasing fiscal pressure, thanks to the expanding piece of the pie absorbed by entitlements (including Social Security, medical programs, and nutrition assistance), more creativity will be needed to ensure that the education and training of the rising generation is not shortchanged. A public-private partnership of this kind would provide millions of older American with the opportunity to invest in our country’s future.