Monday, September 10, 2012

Bad Incentives in Financial Aid

I blogged a bit last week about why artificially lowering the interest rate on financial aid for college or increasing grants to potential students may not help all students, but instead lead to rising tuition, higher taxes, or inefficient amounts of schooling.

Today the WSJ reports on bad incentives in the process for applying to financial aid (through both colleges and the government). Of course, the article isn't pitched as a call for changing the bad incentives, but as a guide for parents and students on how to maximize their aid.

Most of the bad incentives come from the following facts about aid:
1) A rule of thumb: a 10,000 dollar reduction in income leads to an increase of about 3000 dollars in aid.
2) The only year of income looked at is the year before the student enrolls in college.



Why do these facts create bad incentives? Because people (parents, students, grandparents, . . . ) can partially control their own income, and only looking at one year makes it easy to transfer income from the aid year into the year before or the year after. In addition, and less obviously, if the aid would have come in the form of grants, to the extent the rule of thumb holds, it can be thought of as a 30% marginal tax rate on wages for that year. [UPDATE: Unsurprisingly, John Cochrane saw this as well and expounded on why the total marginal tax rate matters so much and why it's much higher than many people think. See his post here.]

The WSJ dispenses the following advice summing up the mess:
Experts urge families to get an early start and keep their earnings as low as possible during that year. 
Yes, that's right. Your goal is to earn less. If that isn't signaling that there are some distorted incentives, I don't know what is. Some specifics:
[T]ake any big windfalls, such as capital gains or the sale of a property, before [that year]. . . . If you own a business, you may want to defer compensation or take a lower annual salary.
But wait, it gets even better:
You don't want to overdo it. The Internal Revenue Service may come after you for not paying yourself a fair wage. 
I doubt many people would like it if they knew the IRS was going after business owners and executives for not paying themselves enough. Yes, this is partially to correct for bad incentives to underpay oneself, but why not just fix the underlying incentives problem, instead?

Also, there is a third fact:
3) Accounts and transfers are not treated equally

Money that is in the student's name is treated more harshly than money in the parents' names, for instance. Money marked for education spending is treated more harshly. For example:
Adding 10,000 dollars to a child's bank account could mean 2000 dollars less aid.
Grandma giving your child 5000 dollars from her 529 plan could mean as much as 2500 dollars less aid.
Mom and Dad putting 10,000 dollars into their 529 plan could mean up to 564 dollars less aid. 
And this great advice:
[P]arents should transfer the child's assets -- that includes any money in checking and savings accounts -- into a 529 plan, a tax-advantaged saving account for college.
Yes, that's right. If you try to teach your high schoolers' financial responsibility by giving them their own accounts, they get less aid. And if you save responsibly for your children's education over the years, your children get less aid. This incentivizes undersaving for college, leading to expectations that the government or university aid will pick up the slack. This is another example of unintended consequences: aid is meant to help those who can't save enough for college, but instead it encourages people not to save for college even when they can. 

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