The economics of financing higher education

Participation in higher education has increased considerably over the last decades. The resulting budgetary pressure, in combination with the recent financial crisis, has led to reforms in the financing schemes for higher education many countries. These reforms often shift a substantial share of the costs towards students and their parents. Not only have tuition fees increased, but new modes of financing—for example, fees and grants that depend on study progress, or loan repayments that are contingent on future income—are increasingly introduced as well. Participation in higher education is unlikely to decline in the future and the resulting budgetary pressure is therefore likely to stay. In addition, other budgetary needs, in particular the financing of health care and pensions, are higher on the political agenda in many countries. Ad hoc reforms in the financing of higher education can alleviate some of the budgetary needs in the short-run, but there is a great need to design structural policies that are sustainable in the long run as well. The current review spells out economic arguments to guide our thinking about the financing of higher education. Such a review is not only useful to the current public debate in many countries, it also provides a well-timed update of the current academic literature. First, some of the older arguments, like externalities and signalling, turn out to be difficult to validate empirically, while others, e.g., credit constraints, have become more important over time. We review the empirical literature with special attention to the causal evidence that has become increasingly available over the last years. Second, recent insights from behavioural economics provide new arguments for intervention in higher education. Additionally, multiple recent studies in the public finance literature have analyzed the pros and cons of different innovative financing schemes, such as income-contingent loans and graduate taxes. We integrate the theoretical and empirical findings of behavioural economics and public finance in the current review. The starting point of our analysis in section 2 is the following question: do we need government intervention in higher education? The second welfare theorem provides a clear answer. If there are no market failures, if individuals behave rationally, and if non-distortive lump-sum transfers are feasible, then there is no need for government intervention other than redistribution based on lump-sum transfers. The obvious next question is: do these assumptions hold? Economic arguments for government intervention may arise if one of the assumptions fail. Insurance, credit, education and labour markets—all highly revelant to higher education—may malfunction in the absence of government intervention. In addition, there is ample evidence that individuals do not always behave rationally, and students turn out to be no exception. Finally, although non-distortive lump-sum transfers are (first) best, they are not feasible in reality. In sections 3, 4, and 5 we discuss market failures (incomplete insurance, credit constraints, externalities, and signalling), behavioural failures (misprediction, positional goods, and peer interactions), and first-best failures (distortions, perverse redistribution, and fiscal externalities). In each section we identify the theoretical problem, analyze the consequences for participation in higher education, and provide the available empirical evidence. The final section seeks to answer one last question: how should educational subsidies and redistribution policies look like? In section 6 we first take stock and identify the failures that we consider essential for an optimal policy design. Afterwards, we discuss the pros and cons of the different financing modes (general taxation, classical loans, income-contingent loans, and graduate taxes) in more detail. We focus on the economics of financing higher education, so other fields (e.g., psychology and educational sciences), other interventions (e.g., regulation), other educational levels (e.g., compulsory education), and other tasks of higher education (e.g., research) only enter the discussion if deemed essential. In addition, the current review is limited to the study of demand side aspects (versus supply and governance). In particular, we mainly focus on the participation decision (versus effort and success) in higher education from a welfare point of view (versus a political economy view).