New Financial Logics and Repurposed Tax Policies in a Financialized Economy
New endowment logic of asset growth
Prior to the early 1970s, university endowments and the legal framework of their tax exempt status were not intended to achieve substantial asset growth over time. Rather, the prevailing theory was that endowments were maintained to protect intergenerational equity by providing resources for comparable levels of effort towards the university’s mission from one generation to the next (Tobin 1974:427). Tracking financialization and the adoption of new financial logics throughout the US economy, endowment managers adopted a new strategy of diversified investments in equities (Davis 2009; Epstein 2005; Fligstein 1993; van der Zwan 2014). The strategy originally aimed to increase endowment asset growth beyond inflation and depreciation. The strategy actually provided far greater endowment return rates to the point that growing endowment assets could support increased spending on university activities over time. This success would provide incentives for other endowment growth strategies such as fundraising for the endowment and indirect tax arbitrage.
In 1969, the Ford Foundation laid the groundwork for the new endowment investment strategy by commissioning a report to address the problem of widespread depreciation of real endowment asset values in the 1950s and 1960s (Cary and Bright 1974). Entitled “Endowment Funds: The Law and the Lore,” the report transformed endowment management, arguing that endowments should pursue a capital growth strategy. The strategy particularly relied on diversifying their investments to include more stocks and bonds and by reinvesting capital gains to further grow the endowment
The strategy of indirect tax arbitrage
Diversification into higher yield and higher risk investments is not the only asset growth strategy that wealthy universities have pursued. Universities can also boost endowment growth by directing donations to the endowment rather than operational spending or non-financial capital investments. Universities can then engage in indirect tax arbitrage by borrowing through tax-exempt municipal bonds to pay for capital projects instead of using ample endowment wealth (Congressional Budget Office 2010). This process is illustrated in Figure 1. Universities choose to undertake such borrowing with municipal bonds and notes because the interest rate for municipal bond borrowing tends to be lower than average annual rates of return on endowment assets. As a result, the university can make more money by investing endowment wealth than the university can save by spending endowment wealth in place of borrowing. Direct tax arbitrage, borrowing using municipal bonds to directly fund university investments, is prohibited by federal tax law because it would allow private investors to earn untaxed income on interest from lending through municipal bonds to finance an unlimited amount of university financial investments.
break by engaging in indirect tax arbitrage. First, donors receive a tax deduction for giving to the endowment. Second, investment returns for the endowment are tax exempted as non-profit income. Finally, interest income for investors is exempted for municipal bonds used by private schools in place of capital expenditures from their endowments. As noted earlier, the employment of this latter tax break is referred to by policy makers as indirect tax arbitrage because it indirectly uses tax exempt municipal bond borrowing to support endowment investment (Congressional Budget Office 2010). The triple tax break should then become more lucrative for endowments and more costly for government if colleges shift to asset growth investment strategies and indirect tax arbitrage.
Repurposed tax policies in endowment growth
State support for endowment growth has occurred primarily through failure to update policies that have been used in ways that were not originally attended—and at much greater cost. In the wake of the “Law and the Lore” endowment report, 47 states and the District of Columbia did make policy changes to clarify and codify their non-profit laws to allow for universities to pursue the endowment capital growth strategies recommended by the Ford report (Conti-Brown 2011:718). Tax exemptions for municipal bond borrowing and endowment investment returns, however, are primarily legacies of earlier policy frameworks that did not anticipate recent endowment strategies and growth. Failure to update such policies in the wake of unintended consequences is known as policy drift to scholars of social policy (Hacker 2004, 2005).
Indirect tax arbitrage was not a common practice when municipal bond borrowing was extended to support private universities. Prior to the mid1970s, most universities still adhered to the intergenerational equity theory of preserving, rather than growing endowment assets. In addition, private universities used Department of Education bond borrowing under the 1962 Higher Education Facilities Act. As the Department of Education bond program wound down, states set up financial authorities in the late 1960s and early 1970s to borrow money through municipal bonds on behalf of private, nonprofit universities. Private universities incur all of the liability and the costs under this municipal bond borrowing arrangement. Municipal bond borrowing, however, comes at a public cost because income earned from interest on municipal bonds was left tax exempt under the establishment of federal income taxes because of doubts about the constitutionality of taxing such income (Johnson 2007:1260). It has since been determined that there is no constitutional problem with taxing income from interest on municipal bonds (Joint Committee on Taxation 2008:16). The tax exemption, however, has been left unchanged, in part because it is thought that investors tend to lend money at lower interest rates through municipal bonds than through taxable bonds. The logic is that investors accept these lower interest rates as they can keep all of the income earned from interest paid on municipal bonds and pay no state or federal taxes on the income (Congressional Budget Office 2010:2).
The tax exemption for income on interest from municipal bonds, however, primarily benefits wealthy private and corporate investors. This is mainly because all investment income is already tax-exempt for pension funds and other non-profit investment funds. As such, pension and non-profit investment funds tend to invest their assets in other investment assets that pay higher rates of return. We thus have the irony that university endowments never invest in municipal bonds.
The combined cost of tax expenditures in support of endowments
The importance of state support for endowments is illustrated by the combined tax expenditure in support of endowments through the triple tax break for higher education municipal bonds, for donations to endowments, and for endowment investment returns. Table 1 outlines an estimate for a combined annual tax expenditure of $19.6 billion in 2012. This estimate aligns with a recent report on proposed taxes for endowments (Klor de Alva and Schneider 2015). First, a 2010 report by the US Congress Joint Committee on Taxation (JCT) estimated that the total federal tax expenditure for higher education municipal bond debt was $5.5 billion for that year alone (Congressional Budget Office 2010:2). The JCT estimated separately that 28 percent of the tax expenditure for indirect tax arbitrage went to tax exemption of income for corporate investors while 72 percent of the tax expenditure went to tax exempted in come for individual investors (Joint Committee on Taxation 2008:53).
The tax expenditure on higher education municipal bond debt comes on top of the tax deduction for donations to the endowment and tax exemptions for endowment returns. The intersection of financialization and state tax policy should here also contribute to increasing endowment wealth at increased public cost. This is because financialization has contributed to an increasing share of income and wealth going to the very rich (Tomaskovic-Devey and Lin 2011). This in turn should provide the wealthy with greater resources for potential donations to the endowments of elite colleges. The JCT estimated a federal tax expenditure of $4.6 billion from tax deductions for donations to universities in 2010. If a university increasingly directs donations to its endowment, this tax expenditure will increasingly go towards boosting endowment growth. The estimate in Table 1 assumes that 25 percent of higher education donations go to endowments. This may be conservative. For example, 50 percent of donations have consistently gone to the endowment at Stanford University since 1998.
Finally, because of the exemption for non-profits from the 35 percent federal capital gains income tax, endowment investment returns come at the cost of another $12.9 billion tax expenditure.
This is based on current average annual endowment investment returns of $36.9 billion a year (National Association of College and University Business Officers 2013). The $12.9 billion tax expenditure for the exemption of endowment investment returns brings total tax expenditure for endowments by the federal government alone amounts to $19.6 billion annually. This does not account for parallel tax expenditures by state and local governments.
The total tax expenditure is for all endowments, not just wealthy endowments. There are signs, however, that these tax benefits go disproportionately to wealthy endowments and investors. We shall soon examine how endowment assets are concentrated at a small number of wealthy institutions. These wealthiest endowments have also been found to attain annual rates of 10 percent since 1990 while average rates of return for poor endowments have averaged just 5 percent (Piketty 2014:448). At the same time, almost 75 percent of tax-exempt bond debt was held by the wealthiest 4 percent of a representative sample of 931 schools examined by the CBO for the Joint Tax Committee. The wealthiest 4 percent of schools in the JCT also all had investment assets valued far in excess of the equivalent of a reserve for a year’s worth of spending. Economists meanwhile argue that the social benefits of the tax exemption are limited because wealthy investors do not actually lend to municipal bond borrowers at significantly lower rates. If private investors in the 35 percent tax bracket passed on all of their savings from the income tax exemption by offering lower interest rates to municipal bond borrowers, the interest rate offered would be 35 percent lower. In fact, interest rates tend to be on average just 2 to 8 percent lower than a borrower could pay in interest on taxable debt (Johnson 2007:1260).
The wealthy beneficiaries of the ivory tower tax haven
There is a long literature on how elite universities tend to serve and reproduce a small elite (Bourdieu and Passeron 1990; Collins 1979; Karabel 2005; Sewell and Hauser 1976; Stevens 2009). Elite colleges tend to maintain their elite status by keeping enrollments down. Managers and university ranking schemes give significant weight to admissions selectivity along with high spending on faculty (Espeland and Stevens 1998; Sauder 2007).
Recent research has shown that 38 of the most elite schools in the US enroll more students from the top 1 percent of the income spectrum than from the bottom 60 percent combined (Chetty et al. 2017). We need more scholarship that tracks how this enrollment disparity has evolved over time. We also need a closer examination of the relationship between this exclusivity and the financial wealth of colleges.
If students at wealthy universities themselves tend to come from wealthy backgrounds (Karabel 2005; Stevens 2009), we can now reimagine wealthy universities as a sort of tax haven. The children of wealthy donors would be more likely than low-income students to directly benefit from tax exempt donations to endowments by attending the college upon which the donation is bestowed. The donors can thereby reduce their tax liability for the education of others by contributing financially to the education of their own. If that wealthy donor so chose, she could even park her wealth in municipal bonds for the very same university in exchange for tax-free interest income. And through indirect tax arbitrage, the university could then preserve its in endowment assets for even more lucrative investments. New data is needed to determine the extent to which endowment growth has particularly gone to benefiting a small number of students to wealthy backgrounds or a broader array of social groups. I constructed a new database for this purpose.