Dump the Discount Rate

A commonly reported higher education financial statistic is the discount rate, intended to capture the extent to which colleges and universities cut prices through financial aid to attract students. One recent study reports that the average discount rate has been rising continuously over the past decade and now tops 50 percent.

One may interpret this as an indication that competition among higher education institutions is driving down the actual price that students pay after factoring in financial aid. That interpretation, however, is a vestige of the way the discount rate is constructed. In reality, the data do not support that conclusion.

A simple example illustrates the flaw in this reasoning. Consider a college with a sticker price of $50,000. Half the students enrolled receive financial aid and pay $25,000, while the other half pay full price. This college’s discount rate is 25 percent.

Now suppose that this college sought to raise substantial additional revenue and doubled their sticker price to $100,000. Let’s simplify and make the heroic assumption that those students who paid full price before can afford the new higher price as well. Financial aid recipients obviously cannot afford that tuition hike, but suppose they are asked to pay $5,000 more, raising their net price to $30,000.

In this world, the college is collecting considerably more revenue, but the discount rate actually rises to 35 percent. This clearly isn’t consistent with the notion that a rising discount rate reflects greater competition to attract students. In fact, the higher discount rate coincides with higher prices paid by all students.

By construction, the discount rate rises as tuition rises even if financial aid becomes no more generous (or potentially even less generous). This highlights a fundamental flaw in the way we sometimes talk about financial aid. What matters for colleges’ finances -- and for the students -- is what we ask financial aid recipients to pay, not the gap between that amount and the full cost of attendance.

The real issue is the economic concept of opportunity cost, or what one gives up when one undertakes an action. In theory, the opportunity cost for the college of admitting a student who requires financial aid is the gap between what they would pay and the full cost of attendance.

In practice, however, finding enough qualified full-pay students to fill one’s class is difficult. Imposing that goal may also violate the institution’s mission, like educating a socioeconomically diverse group of students. If that option is not viable, the discount rate poorly captures the opportunity cost.

Yet measuring how much students actually pay to attend college, and how much of a subsidy they receive, is a worthy goal. Statistics available from the College Board provide a better indicator of this as part of its “Trends in College Pricing” series. It presents data on two things: 1) total educational expenditures and 2) net tuition revenue, which is defined as the total revenue received from students, incorporating the lower payments made by financial aid recipients.

The gap between these two statistics provides a better measure of the true subsidies that colleges and universities provide -- educational expenditures that aren’t covered by tuition revenue received. Other sources of funding (like endowment returns, gifts or state appropriations) are required to cover that gap.

Comparing these statistics to the discount rate provides useful insights. First, net tuition revenue is actually rising. On average, students are paying more to attend college, not less. Second, educational expenditures are rising at about the same rate. Third, in percentage terms, the subsidy students receive has been virtually constant. Funding from sources other than net tuition revenue constitutes about 45 percent of total educational expenditures. Students pay about 55 percent of these costs.

Although the levels of this subsidy are different at different types of institutions, the table below, with data from the College Board and the National Association of College and University Business Officers, demonstrates no obvious trend among private colleges.

(Note: All dollar values are inflation adjusted to 2015 dollars.)

At public doctoral institutions, however, the subsidy rate is actually falling: students are paying a larger share of educational expenditures (not shown here).

Why is the trend in the discount rate different than the trend in this alternative subsidy rate? It is well-known that the costs of running a higher educational institution have been rising more quickly than the overall cost of living, and that has generated growing revenue needs and rising tuition. As in my earlier stylized example, rising tuition has led to increases in the traditionally computed discount rate, leading to the false impression that colleges are reducing the prices that students are charged. Net tuition revenue is not subject to that problem and correctly captures the fact that students are, indeed, paying more to attend college.

One puzzle that still remains is who is paying more? Certainly, tuition increases generate additional revenue from students who do not receive financial aid. Net tuition revenue per student captures those increased payments. How much extra a financial aid recipient is paying, though, is difficult to ascertain based on these aggregate statistics.

The main takeaway here, though, is that the discount rate is a flawed statistic for tracking college finances. Net revenues from tuition and the subsidy rate generated from that are a much better metric to track how much students are really paying, on average, and how much of their education is truly subsidized.