We must fix the perverse incentive in higher education. Here’s how.

A question we’ve had to ask ourselves as Americans, time and time again, is why can’t an innovative, rich country like the United States figure out how to provide affordable, even free, college education? First, let’s discuss what “free” means. Like President Biden’s student loan forgiveness, which is really a transference of debt to other taxpayers, free college is a bit of a misnomer. 

When we think of free college, we think of free tuition to the student, which presumably means college supported by the average taxpayer. I’d argue this is an excellent use of tax money. The problem is that it’s too expensive as is, and there is no federal incentive for colleges and universities to innovate to make it efficient.

College continues to be one of the best pathways to a well-paying job and a fulfilling career. This is why the fantastic and admirable mission of the Department of Education is “to promote student achievement and preparation for global competitiveness by fostering educational excellence and ensuring equal access.” The financial aid system was designed to ensure equal access to education, essentially fueling demand for higher education while ignoring the supply side of the equation. Thus, the perverse incentive for higher education institutions was born.

A perverse incentive is one that “has an unintended and undesirable result that is contrary to the intentions of its designers.” Despite the clearly good intentions of the financial aid system, it has instead led to inaccessible, expensive and unequal educational access. By one estimate, the cost of college has risen at nearly five times the rate of inflation over the last 50 years.

The primary problem is the way financial aid is calculated fails to provide pressure on colleges to innovate. A comedian once said, “The goal of evolution is to be as lazy as possible without actually dying.” I’ve found this is true among businesses and institutions as well as people. It’s up to us as a society and Congress as policymakers to provide an incentive to innovate. 

Keep in mind that the rising cost of college is not simply due to the construction of fancy gymnasiums and the over-hiring of administrators. The price of a single teaching hour has increased over the last couple hundred years as a single human hour has become more efficient elsewhere. This is Baumol’s cost disease and is well-explained by my friend Mike Smith. The only way to fight Baumol’s cost disease is to innovate; to make an instructor’s teaching hour provide more instruction to more students than the current and past sage-on-a-stage strategy does. 

With the respectful recognition that this traditional method of teaching has been enormously effective and helped land a person on the moon, it has been allowed to remain stagnant and balloon in price because of the inputs to the federal financial aid calculation. 

For all the complexity of the FAFSA paperwork, the equation that determines a student’s financial aid eligibility can be boiled down to these simple inputs: household income, number of dependents (or if you are a dependent) and whether you are attending school part-time or full-time. With those inputs, independent students can borrow up to $57,500 in direct loans for their undergraduate degree and receive up to $6,895 per year if they qualify for the Pell Grant.

Notice the critical missing input to the calculation: the cost of the school the student is attending. Without this input, there is little incentive for a school to limit what they charge or innovate to find more efficient ways to deliver quality education.

Reversing the perverse incentive for higher education institutions is simple. We need to drive innovation by adding an input to the financial aid calculation: total cost per student at the destination institution. 

Total cost per student is not the same thing as tuition per student. Tuition numbers can be gamed, and the goal is to recognize the total tax dollars an institution receives to educate a student. For example, while the average public two-year college tuition is around $3,800 per year, the total cost per student is about $18,000 per year, of which 71 percent are tax dollars. Meanwhile, total cost per student at a private non-profit four-year institution is about $65,000 per year. 

Thus, to compute access to financial aid, the government should set a cap on the total cost per student, after which financial aid contributions drop. Let’s say that cap is $18,000 a year. Access to any financial aid (especially loans) should go down in 10 percent increments for every additional $2,000 over $18,000, until at $38,000 the contributions become zero. 

Will this policy shut low-income students out of elite institutions like Harvard and Yale? Most students don’t go to those places; they go to the other 4,300 colleges not in the top 100. And the top few schools have huge endowments to make up the difference. Kudos to Princeton for making tuition, room and board free for students of families making less than $100,000 per year.

We need to fix the perverse incentive driving up the cost of college. The solution is to change the input for federal financial aid calculations to drive innovation on the supply side of higher education.

Aaron Rasmussen is CEO and founder of Outlier.org and co-founder of MasterClass.

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