Differentiating Colleges and Universities In A Tax On Endowment Income

by Ed Yingling '70

Washington insiders believe it is very likely that a significant increase in the tax rate on university endowment income will be enacted this year. They cite the need for additional tax revenue to offset the Trump tax cut agenda and the antipathy of many Republicans to what has been happening on campuses for the last two years. They also focus on the fact that then-Senator JD Vance introduced a bill in the last Congress imposing a 35 percent tax on endowment income.

Existing law imposes a 1.4 percent tax on endowment income of private universities that have endowments of $500,000 or more per student. The type of tax that might be considered in the current Congress is exemplified by a bill, H.R.446, the Endowment Tax Fairness Act, introduced by Congressman Nehls (R-TX), which raises the current 1.4 percent tax rate to 21 percent. The 21 percent is the same as the tax rate imposed on corporate income. Another bill, H.R. 1128, introduced by Congressman Lawler (R-TX), increases the rate to 10 percent, but it also greatly increases the number of schools covered by including private colleges and universities that have endowments of $200,000 or more per student.

The purpose of this article is neither to endorse nor to oppose a tax increase on endowment income. Rather, it is to lay out a possible approach to such a tax that would incentivize universities to adopt and implement positive core values.

Proponents of a higher endowment income tax cite different reasons, or combinations of reasons, as to why such a tax should be imposed, but the reasons generally fall into three categories. The first reason is the need for additional tax revenue to offset both the anticipated extension of most of the Trump tax cuts, which expire at the end of this year, and additional tax cut proposals, such as exempting tip income from taxation. A House Budget Committee list of possible “pay-fors” (offsets to lost revenue) includes a 14 percent endowment tax that would raise $10 billion over ten years.

The second reason is some general feeling of antipathy toward many colleges and universities, especially the large “elite” schools that have big endowments -- a feeling they are wasting money on things that are far removed from, and often the antithesis of, their avowed purpose and the core values colleges and universities should have. Rep. Nehls states that his 21 percent tax “is far lower than what many hard-working Americans pay in taxes.” He notes that many universities “have significantly increased their tuitions” and says his bill “would put elite universities with massive endowments on notice by holding them to the same tax standards as corporations.” Nehls does not say what the schools would be on notice for. (Notably, the formula for taxation in current law, which is picked up in Nehls’ bill, does not apply to only the largest endowments because it is based on the size of the endowment per student.) In his introduction of the Endowment Accountability Act, Rep. Lawler cites similar concerns. 

The third reason, which up until now has received much less discussion, is to incentivize colleges and universities to return to what I will call their “core values”: educating students and advancing knowledge, while encouraging academic freedom, free speech, and open discourse to flourish on campus. However, at this point, all congressional proposals for an endowment income tax apply to all schools that meet some measure of endowment size.  A university with a good record on the core values is treated the same as a university with a terrible record. There is no incentive to create better universities. 

An endowment income tax could be structured to encourage schools to achieve and maintain core values. Certainly, the tax code is replete with deductions and exemptions designed to encourage public policy objectives. For example, capital gains are taxed at a rate below the income tax rate to encourage investment and long-term economic growth; mortgage interest is deductible up to a certain amount to encourage home ownership; and Congress created a tax credit for energy efficient home improvements to help the environment. Having our colleges and universities fulfill their critical role in shaping our country’s future surely is a very important public policy objective.

In fact, compared to the cost of many other federal tax incentives, the cost of using an endowment income tax exclusion to encourage universities to fulfill their critical roles would be very modest. For example, the Budget Committee list of “pay-fors” cites many current tax incentives that would seem less important than an endowment tax exclusion, such as $20 billion in savings over ten years by eliminating the exclusion of employer provided on-site gyms. By comparison, the Committee’s example of a 14% endowment income tax raises $10 billion, and if, for example, half of that was not raised because of the exclusion being discussed here, the cost of the exclusion would only be $5 billion over ten years.

Assume that Congress does decide to impose a higher tax on endowment income but also wishes to exempt schools that practice the core values in order to incentivize schools to do so. How might such a tax be structured? What criteria would need to be met to qualify for such an exemption?

There are two types of criteria that could be used, and it seems likely that both would be needed. First, there are criteria that are mathematically measurable; however, there may be a limited number of these that relate directly to the core values. One such criterion could be a limitation on the ratio of administrators to faculty and students, or at least on the growth in the number of administrators. There is increasing evidence that the huge growth in the number of administrators in recent years is not only a significant cause of large tuition increases but also has resulted in limitations on free speech and academic freedom. However, a blunt, oversimplified limit would raise serious issues. Some universities, because of their particular academic focus, may need more administrators than others. For example, schools with medical schools and hospital systems need a higher ratio of non-faculty positions.

Furthermore, a material portion of the increase in administrators is generated by the increase in government mandates and red tape. Congress should take this opportunity to review and significantly cut back on mandates and reporting requirements.

A second measurable criterion could be a requirement that a specified percentage of endowment usage each year be devoted to scholarships or other specific uses. There is precedent for such a requirement in the tax treatment of private foundations, which are required to distribute 5 percent of the fair market value of their endowment each year for charitable purposes. This issue also is more complex than it might seem. For example, large percentages of endowments are earmarked by the contributors for specific purposes. Furthermore, it is notable how many universities are already using endowment growth to provide increased support for low- and middle-income students.

Because mathematically measurable criteria may be insufficient to justify an exemption, a list of other criteria to qualify for the exemption may need to be developed. A college or university would qualify for the exemption only if it met all the criteria. Here is an example of a list of criteria that could potentially be used:

1. The school has adopted a general statement of principles on core values. An example of such a statement is the recent statement by the leaderships of Washington University and Vanderbilt.

2. The school has adopted a specific policy statement on free speech. Over one hundred schools have adopted the Chicago Principles. 

3. The school has adopted institutional neutrality at both the college and departmental levels.

4. The school has adopted specific criteria of excellence in teaching, training, and scholarly research for academic appointments and promotions, with no consideration of group characteristics, religious beliefs, or affiliations. A prominent example of such criteria is contained in the University of Chicago’s Shils Report.

5. The school has adopted specific rules governing protests on campus -- including time, place, and manner requirements and penalties for violations. Importantly, the school would be required to enforce such rules, including explicit penalties. In many instances in the recent, sometimes violent, protests on campuses, existing rules were violated; but in many cases where the rules were initially enforced, penalties were eventually reduced or waived.

 6. The school does not require statements that are, in effect, litmus tests for applicants for admission or for faculty positions, and no such  statements are required in annual reviews of faculty.

7. The school does not have a  bias reporting system that chills free speech.

8. The school includes a robust discussion on free speech in every student orientation, discussing both the importance of free speech and the school’s policies on free speech.     

9. The school annually holds events that model free speech, and in particular debates and discussions that model open discourse.

There are three areas of concern that will likely be raised about using these types of criteria. The first concern, and a very important one, will be that enacting such criteria could lead to the further politicalization of higher education, as criteria could be used to lead schools in directions favored by those in power. It clearly should be a goal of any tax policy on endowments to limit such politicalization. 

While some will disagree, the criteria outlined above are fundamentally based on concepts that are not political and in most cases are firmly grounded in First Amendment principles. In some cases, these principles have already been articulated by the Supreme Court or are likely to be at some point. For example, campus rules governing time, place, and manner restrictions for protests and prohibiting the shouting down of speakers are often attacked, usually by protesters on the left, as limiting their free speech. But there is ample constitutional basis supporting time, place, and manner restrictions (as long as they are narrowly drawn and content neutral) and denying the “heckler’s veto.”  It would be important to use criteria that have a clear foundation in nonpartisan principles.

The second concern will be that the criteria are not specific enough. Schools could, and likely would, adopt differing approaches to at least some of the criteria, raising questions about whether the criteria were met. For example, schools have adopted different policies on institutional neutrality, some of which appear to contain gaps. To avoid that risk, it might be suggested that the government approve language for the criteria. However, that would be a mistake since it would increase the risk of politicalization and would limit future enhancements that might be developed by schools, groups of schools, or outside experts.

What is likely to happen is that model language will be developed by various groups, and that schools will use such models as a type of safe harbor. For example, groups such as the Foundation for Rights and Expression (FIRE), the American Council of Trustees and Alumni (ACTA), and the distinguished group which developed the Princeton Principles might create model language. Indeed, in some cases such model language already exists, for example in the Chicago Principles.

Furthermore, if a school adopted language for a criterion that was inadequate, it would run the very real risk that the inadequacy would be exposed in practice. For example, if a school had a policy on institutional neutrality that did not adequately limit positions taken by departments, eventually some department may take a position that violates institutional neutrality. And, as discussed below, unlike in the past, it is now highly likely that such an action would be exposed quickly.

The third concern that will be raised, and for good reason based on recent history, is that schools will have policies and rules that meet the criteria, but they will not be enforced in practice. For example, as noted above, in numerous situations during the recent protests, including violent protests, school administrators stated that specific students or faculty had violated rules, and yet in the end there was either no punishment or the punishment was highly diluted.

However, it would be extremely difficult for a given school not to enforce the criteria it has adopted for the simple reason that any such failure will quickly become public. There are, in effect, thousands and thousands of potential whistleblowers on such failures, and there are organizations such as FIRE and the Academic Freedom Alliance specifically focused on stopping abuses of free speech and academic freedom principles. For those who follow campus free speech issues closely, there are almost daily articles exposing where schools fall short. There are many, many examples – faculty exposing  litmus tests, court challenges on bias reporting systems, and students reporting antisemitism.

The types of criteria listed above are not new. They are among those most often discussed as key indicators of schools that wish to reform. Similar lists are already in existence. For example, FIRE has its “10 Common-Sense Reforms for Colleges and Universities” and ACTA has its “Gold Standard for Freedom of Expression.”

A few other points are worth making. First, while the current endowment income tax only applies to private universities and any increase may also only apply to private schools, the criteria developed will be helpful to state governments in evaluating their state schools on the core values. 

Second, it is likely that one or more coalitions of universities will develop to work on principles related to the core values and possibly to develop voluntary standards and model language. Even before there was a real threat of an increase in the endowment tax, some schools were recognizing that faculty, alumni, job recruiters, and prospective students were going to demand change. Universities that already had developed good reputations on free speech issues include the University of Chicago, Purdue, the University of North Carolina, Washington University, and Vanderbilt.

Indeed, well before the last presidential election, the leaderships of Washington University and Vanderbilt had begun an effort to encourage the leaders of colleges and universities across the country to discuss how they should address the pressing issues facing higher education.

Third, while there would be complexity in creating and enforcing a taxation approach along the lines of what is proposed in this article, there are existing federal tax deductions and exemptions that are more complex and involve many more taxpayers. These existing rules can provide guidance on how to proceed. An example of such a rule is the Energy Efficient Home Improvement Credit, which has many different types of criteria that must be met.

Many of our colleges and universities are in trouble, and that means our country’s future is in trouble. Our students are our future, and yet our education system is failing them. If Congress chooses to increase the current 1.4 percent tax on certain endowments’ income, it should consider using the new tax not just to raise revenue or “punish” large private colleges and universities, but also to incentivize positive behaviors. To do so, there needs to be a workable system to differentiate among colleges and universities. Hopefully this article will encourage a discussion on how best to craft such a system.

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Edward Yingling is a founder of the alumni group, Princetonians for Free Speech, and a founder and Chair-Emeritus of the Alumni Free Speech Alliance. He is a former President and CEO of the American Bankers Association and partner in the law firm of Covington & Burling.