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Why Does College Cost So Much?$

Robert B. Archibald and David H. Feldman

Print publication date: 2010

Print ISBN-13: 9780199744503

Published to Oxford Scholarship Online: January 2011

DOI: 10.1093/acprof:oso/9780199744503.001.0001

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Outside Financial Aid

Outside Financial Aid

(p.171) 11 Outside Financial Aid
Why Does College Cost So Much?

Robert B. Archibald

David H. Feldman

Oxford University Press

Abstract and Keywords

This chapter discusses financial aid granted by entities other than the institution the student attends. Federal financial aid has played an important role. The chapter begins with a brief history of federal financial aid policy and then describes the federal needs-analysis system that determines a family's ability to pay. The chapter also explains the types of federal financial aid that are available: grants, loans, work-study, and tuition tax credits. State financial aid programs also are important, and the chapter shows how they have moved away from need-based systems toward merit-based grants. Lastly, the chapter explores the growing importance of private financial aid programs. The final section of the chapter discusses the interactions among these different sources of financial aid.

Keywords:   federal financial aid, merit-based grants, needs analysis system, private financial aid, state financial aid

This chapter completes our look at the relationship between the cost of higher education and the price that students and families actually pay. Higher education is a heavily subsidized activity, so the average student does not pay the full cost of his or her education. Universities also use tuition discounting to affect the composition of their incoming students, so the price paid by different students at the same university can vary substantially. The providers of outside financial aid supply the final part of the picture. The federal government, state governments, and various charities all offer grants to college and university students. As a result of both institutional grants provided by schools and these outside grants from governments and private groups, the actual amount many students or their parents have to finance is well below the list price charged by the college or university.

In addition to grants, loans play an important role in the financial aid system. But loans and the lending market will not play a significant role in our discussion here. We are interested in the final bill a student faces after he or she receives all grants. After a student (and the student's family) knows the final bill, they face a second decision about how to finance the expenditure. Loans allow the student and his or her parents to spread payments across time rather than paying the entire cost out of current funds. College students seldom have established credit ratings or collateral to offer lenders, so without some assistance many students who could succeed in college would be shut out of credit markets. Government loan guarantees solve this problem for students from low- and middle-income families, and having parents bear ultimate (p.172) responsibility for repayment solves the problem for students from higher-income families. We will have more to say about loan programs later in the book, but for this chapter our focus will be on grants that reduce what students must pay for higher education.

The federal government is the largest source of outside grants to students. Until quite recently, nongovernmental charitable entities were not very important, but they have grown in importance and now give the second largest amount of outside grants. State governments are the smallest source of outside grant funding to students, though as we have seen they remain are a large provider of direct subsidies to schools. We will assess all three sources of outside aid to students. Once we have those facts in hand, we will be able to tackle the interesting question of how these multiple sources of grant aid interact to determine a student's final bill. Grant aid plays a crucial role in creating access to higher education for many families, and the complex interaction of aid programs affects the decisions of millions of families each year.

To preview our main results, the aid system is a complicated labyrinth for students and parents to navigate. A main thrust of reform efforts in financial aid is simplification, and we will use our discussion here as a springboard to talk about broader reforms of the financial aid system in chapter 14. We also show why the order in which donors provide aid to students is quite important. The fact that federal aid is doled out to students before schools themselves decide how much in institutional grants to offer is not a distinction without a difference. But before we embark on this discussion, we want to offer some perspective by giving a brief historical overview of the growth and development of federal financial aid.

A Brief History of Federal Financial Aid

Financial aid as we know it has not always been an important part of the higher education system. Grants and scholarships always have been available, but over much of the history of the American higher education experience, they were very limited, and often they were directed to students pursuing particular career tracks such as the ministry. Prior to World War II, in the minds of most observers the appropriate type of aid for needy students was work-study. Needy students should be given a chance to work their way through college. Aiding students with college expenses was certainly not one of government's responsibilities. This view was widespread even among those who had a very expansive (p.173) notion of the role of government. As a prime example, in July 1939, Franklin D. Roosevelt said, “Just because a boy wants to go to college is no reason we should finance it.”1

Four factors played an important role in changing views on the advisability of government-sponsored financial aid. First, the Servicemen's Readjustment Act of 1944, typically called the G.I. Bill, demonstrated that more people could take advantage of higher education than the prewar norms suggested. Many of the veterans who took advantage of the G.I. Bill's education benefits were not from the kind of families who had previously sent children to college. Despite its prominence, the G.I. Bill was not a financial aid program. Since it was tied to service, the bill's benefits were not widely available, and the program was scheduled to end when veterans exhausted their benefits. The G.I. Bill is better thought of as deferred compensation for veterans. Still, it demonstrated that a large fraction of the country's youth would take advantage of a college education if they could afford it.

Second, at a time when the federal government was doing little to redress inequalities in educational opportunity, in the early 1950s, a group of colleges and universities acting together as members of the College Entrance Examination Board made considerable progress. In 1954, the College Board formed the College Scholarship Service (CSS) as a clearinghouse for information on the financial need of college students. The CSS developed the first widely-used system for calculating financial need. A large number of institutions subsequently adopted the CSS approach. This needs-analysis methodology regularized what had been a fairly chaotic system and provided a pattern the federal government followed when it started its own financial aid programs over a decade later.

Third, the launch of the Sputnik satellite by the Soviet Union on October 4, 1957, shocked the United States. One of the reactions was the National Defense Education Act (NDEA) of 1958. This act created federal scholarships for students in particular fields, primarily the sciences. The NDEA was not a full-blown financial aid program, but it was a start. Most of the scholarships were for graduate students, but some were for undergraduates. The NDEA put the federal government in the higher education business in a way it had not been earlier. Since the founding of the country, education had been a state or private function. Many in Congress believed strongly that the federal government had absolutely no business getting involved in education, either at the K–12 level or in postsecondary schooling. The NDEA challenged this notion in a big way.

(p.174) Finally, the landslide victory of Lyndon Johnson in the 1964 presidential election, along with large Democratic majorities in Congress, paved the way for important social legislation. One of the new laws was the Higher Education Act of 1965. This act set up the major components of the existing federal financial aid system: needs analysis, grants, work-study, and loan guarantees. The Higher Education Act clearly put the federal government in the business of trying to assure that all qualified students had sufficient funds to pursue some form of postsecondary education.

Since 1965, there have been many changes in federal financial aid programs, but most of them have been variations on themes and not wholesale changes. For example, in 1972 the Pell Grant replaced the basic grant that had previously been administered on campus. Pell Grants depend only on a family's ability to pay, not on any decision made on campus. Also, the original Higher Education Act gave more money directly to institutions than it did to students. Over time, direct aid to students grew in comparison to the amount allocated to institutions. Now the vast majority of the funding authorized by the Higher Education Act goes to students as need-based student aid. The one really dramatic change in federal financial aid since 1965 was the introduction of tuition tax credits in 1997. Tuition tax credits were discussed in 1964 and 1965, but they were not part of the financial aid landscape until 1997.

We will turn next to how needs analysis is done. Needs analysis is a critical part of many financial aid decisions made by federal, state, and private decision makers. We will discuss each of these aid givers in turn. The final part of the chapter takes up the complex interactions among financial aid programs. Because financial aid is an amalgam of programs administered by schools, the federal government, state governments, and private entities, the result is a bewildering maze of programs and options. Janet S. Hansen (1991) is too kind when she says the system is “not the result of a grand design.” Charles T. Clotfelter (1991) is closer to the mark when he likens the financial aid system to “a Rube Goldberg machine.” The lack of coordination and systemic planning in such a non-system is a serious issue for families and policy-makers alike.

The Needs-Analysis System

To be eligible for federal financial aid, a student has to demonstrate that he or she has financial need. Once the student's eligibility for federal (p.175) financial aid has been established, this triggers eligibility for many other types of financial aid. The process starts with students and parents filling out the Free Application for Federal Student Aid (FAFSA). The FAFSA asks a series of questions about the family's income and assets. Typically, families cannot fill out the FAFSA until they have completed their federal income tax forms for the year. In what follows we will describe the way the federal government takes the information on the FAFSA and calculates the family's Expected Family Contribution. Do not despair if this seems quite complicated. It is.

The first piece of information is family income, typically the Adjusted Gross Income from the federal income tax form. The first deductions from family income account for taxes: federal income taxes, state taxes, and social security taxes. The second deduction is called the income-protection allowance. This allowance accounts for the costs of feeding, clothing, housing, and providing medical care and transportation for the family. The income-protection allowance varies with the size of the family. The final deduction is the employment-expense allowance, which is available to families with two wage-earners. The amount left over after making these deductions from family income is called the Parents' Available Income.

The second part of the process involves the family's assets, excluding the value of its home. It may also include a portion of the value of a business or farm. An asset-protection allowance is subtracted from the value of the family assets. The asset-protection allowance depends on the age of the parents. Older parents receive larger asset-protection allowances because they are closer to retirement. The Parents' Contribution from Assets is 12 percent of the difference between assets and the asset-protection allowance.

In the final step of the process, the Parents' Available Income and the Parents' Contribution from Assets are added together to get the Parents' Adjusted Available Income. The parents' portion of the Expected Family Contribution is then determined using a progressive scale in which the rates increase from 22 percent to 47 percent of Adjusted Available Income as the Adjusted Available Income increases.

The calculation of the Student's Contribution is done in a similar fashion. There are three differences. First, 35 percent of the student's assets, not 12 percent, are used to determine the Student's Contribution from Assets. Second, there is no asset-protection allowance for students. Third, the entire sum of the student's available income and contribution for assets are added together (i.e., there is no progressive scale applied to (p.176) determine the student's contribution.) Finally, the total of the Parents' Contribution and the Student's Contribution is the Expected Family Contribution (EFC).

This basic strategy for calculating the EFC traces back to the first needs-analysis system developed by the College Scholarship Service in the 1950s. The system is generally sensible. Families are expected to contribute a fraction of their after-tax income and accumulated assets. The amount they are expected to contribute is sensitive to the age of the parents, the size of the family, and the number of workers. After deductions, families with greater income and/or assets are expected to shoulder more of the costs of college than less-well-to-do families. And lastly, students are expected to contribute more of their disposable income and accumulated assets than are their parents.

There are separate calculations for independent students without dependents other than a spouse and independent students with dependents other than a spouse. These calculations follow the basic pattern described above. The biggest difference is in the way assets are treated. The percentage of assets that are finally included in the EFC is 35 percent for independent students without dependents other than a spouse and 12 percent for independent students with dependents other than a spouse.

A major difficulty with the needs-analysis system is that to most parents and students the process is a black box. They submit their numbers, and out comes the amount that they are expected to pay for a college education. Parents have little sense of how the number is calculated, and they have few, if any, options if they feel the number is too high.

Also, the timing is unfortunate. Critical parts of the required information depend on entries on the income-tax forms the family submits for the tax year prior to the year for which the financial aid is to be awarded. For example, the 2008 income-tax information is needed for a family whose child is going to start college in the fall of 2009. The needed information, W-2 forms, 1099 forms, and so on, may not be available to the family until early February. Several important decisions are already made well before early February. Students applying for early decision have already applied and have been accepted or rejected by that time. Also, many regular-decision application deadlines have passed before the first of February. Students and their families are making a lot of decisions in a cloud of uncertainty over the cost consequences of their choices.

There are frequent calls to simplify the needs-analysis system. Many have proposed basing the EFC solely on income information. This makes (p.177) the EFC something that could be calculated more easily and with much less information and documentation. Many families could estimate their EFC fairly accurately in the fall, many months before they fill out their form 1040 for the tax year. All of the uncertainty has not been resolved, since the actual EFC awaits the actual 1040. The only way to eliminate all uncertainty is to use the previous year's tax information (2007 income in 2009), but this is deeply problematic as well since a family's fortunes may have changed substantially and the financial aid system is trying to match aid with current need.

This kind of simplification is very appealing, but there are tradeoffs to consider. Basing the EFC only on income information could create some inequities. There are some families with low income and high assets. Some of these families can afford to pay quite a bit of their children's college education, so they might have no need for federal help. These families could qualify for a substantial amount of federal aid if the system were one based entirely on income. In essence, the determination of the EFC faces a tradeoff between simplicity and equity. The simpler the system, the more possible inequities it may contain. Adding complexity may eliminate some possible inequities, but it will make the system more cumbersome and harder to understand. It will also reduce the amount of information people have at the time they need to make important decisions.

The final difficulty with the needs-analysis system is that it determines the family's Expected Family Contribution. There is often a difference between what the federal government expects the family to pay and what it is willing to pay. Some families are willing to pay more, and other families are willing to pay less. There are few options other than private loan markets for students whose families are unwilling to pay as much as the government thinks they should pay. This is a problem without a solution. There is no way a family can be forced to contribute as much as the government expects. And adjusting the financial aid awards of students whose families were unwilling to pay the EFC would set up an obvious incentive problem.

Federal Financial Aid Programs

The broadly available federal financial aid programs come in four flavors: Pell Grants, campus-based programs, guaranteed student loans, and tuition tax credits.2 Pell Grants are by a large margin the most (p.178) important federal grant program. Pell Grants are based solely on the student's EFC. Each year, Congress sets the maximum Pell Grant. A student who has an EFC equal to zero receives a Pell Grant equal to this maximum. A student who has a positive EFC that is less than the maximum Pell Grant receives a Pell Grant sufficient to make his or her EFC plus the Pell Grant equal to the maximum. A student who has a positive EFC that is larger than the maximum does not qualify for a Pell Grant. Essentially, the Pell Grant program provides a minimum ability to pay college expenses for every student in the country. The Pell Grant is based solely on the EFC and not on the list-price tuition of institution the student decides to attend. The Pell program is about basic access to the higher education system, not choice within it. In almost all years, the amount guaranteed by the Pell Grant has exceeded the average tuition and fees at two-year institutions, but it only covers a fraction, and sometimes a very small fraction, of the tuition and fees at most four-year institutions.

The campus-based programs have three components: the Supplemental Economic Opportunity Grants (SEOG), Perkins Loans, and work-study. The federal funds for these programs are given to campuses to distribute. These programs are available to students with financial need. A student has financial need if the cost of attendance at his or her college or university exceeds the EFC (or EFC plus the student's Pell Grant). These federal funds are supposed to be distributed to the students with the most financial need. Often they are the students who have already received Pell Grants but who still have unmet need. As a result, a needy student frequently will get a financial aid package that contains money from several of these pots. Unlike Pell Grants, the campus-based programs are sensitive to the price of the institution the student attends. Students attending high-price institutions will have more unmet need than students attending low-price institutions.

The third federal program is the Guaranteed Student Loan Program. Prior to 2010 loans are either made by private lenders as Stafford Loans or directly by the federal government as William D. Ford Loans. Starting in July 2010 all federal student loans will be direct loans. The government pays any interest that accrues while the student is still in school, provides a loan guarantee to the private lender involved in a Stafford Loan, and pays subsidies to lenders so that the borrower is charged a below-market interest rate. These subsidized loans are available to students with unmet financial need, but there are limits on the size of the loans. These loan limits are larger for students in their third and fourth year as (p.179) an undergraduate than they are for students in the first and second years of their undergraduate program.

As college costs have risen, the volume of federal loans has increased dramatically. Figure 11.1 gives the percentage of total federal financial aid given in the form of loans, grants, work-study, and tax benefits from 1970–71 to 2006–7.3 Loans have grown in importance relative to grants with the exception of increases in the grant percentage in the years after the creation of Pell Grants in 1972. After 1980, loans accounted for the largest share, and by 2006–7, 70 percent of federal financial aid is in the form of loans. Work-study has never been a terribly significant program. The tuition tax credits, which first affect the 1998–99 data, were immediately more important than work-study, but they are not as large as either grants or loans.

The tuition tax credits are the final part of federal financial aid. There are two kinds of tuition tax credits. First, the Hope Credit, whose name was changed to the American Opportunity Credit in 2009, covers undergraduate education. It gives a tax credit of up to $2,500 for tuition payments for a dependent student who is enrolled at least half time in a degree-granting program. The tax credit is phased out for high-income

Outside Financial Aid

Figure 11.1 Percentage of Federal Financial Aid as Loans, Grants, Work Study, and Tax Benefits, 1970–2007

(p.180) tax payers. The phase out starts for taxpayers filing single returns with incomes of $80,000 and joint returns with incomes of $160,000. Taxpayers filing single returns with incomes over $90,000 are completely ineligible for the tax credit. In like fashion, taxpayers filing joint returns with incomes over $180,000 are ineligible. The second tax credit is called the Lifetime Learning Credit. This credit is available for any kind of postsecondary education. It allows a credit of 20 percent for up to $10,000 of tuition payments. The Lifetime Learning Credit also has income limits. It is phased out for single filers starting at $50,000 of income, and single filers with incomes of over $60,000 are completely ineligible. The limits for joint filers are $100,000 and $120,000.

The argument that kept tuition tax credits out of the original Higher Education Act of 1965, and that kept them out of subsequent reauthorizations until 1997, is that they represent very poorly targeted financial aid. The lowest income families have no federal income tax liability, so they would receive no benefit from tax credits. Tuition tax credits are a much bigger benefit to the middle class. These families have an income-tax liability that the credit can reduce, but their incomes are below the upper limits beyond which the benefit disappears. Given the limits, up to $90,000 for single returns and $180,000 for joint returns, a broad stretch of the middle class is eligible for this financial aid. The American Recovery and Reinvestment Act of 2009 changed this somewhat. Starting in 2009, up to $1,000 of the American Opportunity Credit is refundable. That means that a family can still receive some of the credit even if the credit exceeds the family's total income-tax liability. Still, the vast majority of the tax credits go to families much further up the income distribution than the families whose children are eligible for Pell Grants and other federal financial aid.

State Financial Aid

States have always provided large general subsidies to state-supported colleges and universities. They also provide student-specific aid in the form of state-sponsored scholarships and other financial aid. For quite some time, state financial aid practices mimicked federal practice. In fact, many of the state programs were created in response to incentives in the form of federal matching funds. The resulting state financial aid systems were need-based systems that worked much like the campus-based federal programs.

(p.181) More recently, quite a bit of state financial aid has shifted toward some measure of merit and away from a strict need-based formula. In 1993, Georgia jump-started this with its HOPE (Helping Outstanding Pupils Educationally) Scholarship Program. Any Georgia student who had a certain grade point average was eligible for a HOPE Scholarship covering full tuition at a state-supported college or university. Several states subsequently created programs like Georgia's HOPE Scholarship. Data from the National Association of State Student Grant and Aid Programs show that in the academic year 1996–97, 84.9 percent of state grants were need-based grants. That percentage declined to 71.7 percent in 2006–7.4 In 1996–97, only six states (Alabama, Alaska, Florida, Georgia, Louisiana, and North Carolina) gave less in need-based grant aid than they offered in non-need-based grant aid. In 2006–7, the number of such states had grown to thirteen (Florida, Georgia, Idaho, Kentucky, Louisiana, Michigan, Mississippi, Missouri, Nevada, New Mexico, South Carolina, Tennessee, and West Virginia).

These merit-based scholarships are politically very popular. In some cases, the programs represent an expansion of financial aid, but in other cases they are squeezing out need-based financial aid. Michael McPherson and Morton Schapiro (2006) demonstrated that institutional aid seems to be more sensitive to measures of ability and less sensitive to measures of need than it used to be. Combined with the shift toward merit aid in state programs, this represents a serious retreat from the notion that financial aid should be based on need.

Private Financial Aid

The final source of financial aid comes from private sources not directly associated with a college or university. Many companies, private organizations, and secondary schools give scholarships of various sorts to college students. These organizations can be as well known as the National Merit Corporation or the Rotary Club and as little known as the WJCC Community Scholarship Fund. The latter is a private nonprofit organization that raises scholarship money for students from Lafayette, Jamestown, and Warhill, which are the three high schools in Williamsburg, Virginia, where we live. The private scholarships can be based on need, merit, a combination of both, or neither. The scholarships given by some companies to the sons and daughters of their employees explain the last category.

(p.182) Figure 11.2 presents the data on grants awarded in constant dollars from 1970–71 to 2006–7.5 The College Board only started presenting data on private grants in 1988–89. As the figure indicates, private grants have grown rapidly since that time. By the mid-1990s, private grants had surpassed state grants in total, and if their present trajectory continues, they might well surpass federal grants in the foreseeable future. This is part of a general shift of the responsibility for financial aid to the private sector. Adding private and institutional aid together, the government share of all grants clearly has been declining for most of the last twenty-five years. The dramatic increase in institutional grants and the less precipitous but nevertheless steady growth in private grants lead to this result.

This shift toward the private provision of financial aid represents an important evolution. In the 1970s and 1980s, when the federal government dominated the provision of grants, the resources of the country were being redistributed from the general tax base to students from low-income families. Financial aid was part of a progressive taxing-and-spending system designed to increase access to higher education for students with demonstrated financial constraints. More recently, the redistribution that takes place through the financial aid process is much

Outside Financial Aid

Figure 11.2 Grants from Federal, State, Institutional, and Private Sources in Constant 2006 Dollars, 1970–2006

(p.183) less clearly progressive. Institutional aid offered by schools redistributes income from the general student body to students the school identifies as more talented or merit worthy about as much as it does from students of high-income backgrounds to students of low-income families. States also are reducing the progressivity of their aid systems by putting an increasing share of their financial aid dollars in merit-based programs. Private financial aid muddies the waters further. Many of the donors who support outside financial aid are very well-to-do, so this voluntary redistribution might be progressive. But many of the grants are based solely on merit, so the progressive nature of the redistribution is muted.

Interactions between Financial Aid Programs

This section completes our description of the financial aid system in the United States. As we have said, the use of the word “system” suggests more design than is really present. The system is a largely uncoordinated hodgepodge of programs that interact in many ways. Some of these interactions are well known, but many are poorly understood. The interaction between outside financial aid and institutional aid depends on the ordering of the decisions to award aid.

Determining who gets to go last is critical in the distribution of need-based aid. The entity that gets to go last faces the least amount of unmet need. Suppose a student has a $10,000 gap between the cost of attendance at the chosen school and his or her EFC. This need can be met by a variety of contributors. Suppose the student gets an SEOG grant of $2,000. This reduces the unmet need to $8,000. Next suppose the student receives an outside scholarship of $5,000. This reduces the unmet need to $3,000. Finally, the institution awards the student an institutional grant to complete his or her aid package. Further suppose that in the absence of the outside scholarship, the institution would have been willing to make a grant of $8,000 to the student. In this example, because it got to go last, the institution was able to reduce its contribution to the funds used to meet the student's need.

The difficulty this example illustrates is that awarding the privilege of going last to the institution undercuts the incentive for private organizations to award grants. In this example, the private grant reduced the student's institutional grant dollar for dollar. The motive of the donors who support outside scholarship programs is to benefit students, not institutions. A practice of allowing institutions to go last thwarts that (p.184) intent since the school can essentially tax the private grant at a 100 percent rate. The alternative of allowing private scholarships to go last yields a different problem. Suppose the institution awarded an $8,000 institutional grant that met the entire remaining need, then the $5,000 outside scholarship would allow the student's family to contribute less than the Expected Family Contribution or it would allow the student to spend more lavishly than the typical student relying on need-based aid.

A common solution to this problem is for institutions to count only a portion of an outside scholarship as a contribution toward meeting need. For example, many schools only count 50 percent of outside scholarships in their calculations of remaining need. Using the same example, the institution would credit $2,500 of the $5,000 outside grant toward the unmet need. This leaves $5,500 in unmet need the institution would have to cover with a grant. In this way, the institution and the student and his or her family split the benefits of the outside scholarship. This eliminates some of the difficulty associated with going next to last for private donors, but it does not eliminate it entirely. With no central coordination, the problems of the ordering are very difficult to manage.


(1.) The quotation of Roosevelt can be found in Blum (1965, 42).

(2.) Our discussion of federal financial aid programs leaves out the two newest programs: Academic Competitiveness Grants and National Science and Mathematics Access to Retain Talent (National SMART Grants). These grant programs started in 2006. We have left them out of the discussion because they are not available to all college students. Academic Competitiveness Grants are for first- and second-year college students who completed a very rigorous high school curriculum, and National SMART Grants are for the third and fourth years of college and are aimed at students specializing in particular courses of study. For details, see http://www.ed.gov/about/offices/list/ope/ac-smart-families.html (accessed October 14, 2009).

(3.) The data for figure 11.1 come from Trends in Student Aid 2007 published by the College Board.

(4.) The data on state grants come from the National Association of State Student Grant and Aid Programs, NASSGAP 38th Annual Survey Report on State-Sponsored Financial Aid 2006–07 Academic Year.

(5.) The data for figure 11.2 come from Trends in Student Aid 2007 published by the College Board.