08/06/2015 02:45 pm ET Updated Aug 06, 2016

Take the Money and Run: For-Profit Colleges, Student Aid, and the Bennett Hypothesis

Authored by James D. Ward

In 1987, then Secretary of Education William J. Bennett, noted the link between the availability of federal student loans and the rapid increases in postsecondary tuitions. In response to claims that higher education was facing cutbacks in student aid support, Bennett wrote, "If anything, increases in financial aid in recent years have enabled colleges and universities blithely to raise their tuitions, confident that Federal loan subsidies would help cushion the increase." For-profit colleges and universities (FPCUs) receive a disproportionate amount of federal student aid funds and produce a disproportionate number of student loan defaults. Given that FPCUs are consuming so much federal student aid, should we be concerned that these companies are merely raising their prices because available aid allows them to? To frame this question, we need to consider the differences between nonprofit and for-profit colleges.

Nonprofit colleges seek to maximize revenue, not profits. Some colleges use revenues to meet collegial goals of access, others to achieve particular pedagogical ideologies, and others to maximize prestige. No matter the specific objective, nonprofits reinvest excess revenues into themselves, all seeking to meet their stated educational goals.

Although Bennett initially wrote about federal student loans in particular (not grant programs), the sentiment has been repackaged by pundits to include all federal student aid programs. The hypothesis assumes that as the availability of government aid increases, colleges will raise tuition and fees, and capture the additional revenue for themselves. If the assumption holds, increases in aid will result in higher prices rather than increased affordability.

As tuition prices persistently rise, people are concerned that federal funds are not being used efficiently. Researchers have responded to this concern by testing the hypothesis. In a 2013 report for the American Council on Education, Don Heller provided a comprehensive review of the limited literature and focused on seven studies. The studies, including one commissioned by the US Senate, use disparate methodologies, test different segments of the nonprofit sector, and their findings vary widely. About half validate the hypothesis, but the inconsistencies make it difficult to conclude that nonprofits are simply capturing increases in student aid for their own misguided purposes. For-profit colleges, on the other hand, may be an entirely different story.

For-profit colleges are fundamentally different from nonprofits in that they are profit-maximizing rather than revenue-maximizing. That is, where a nonprofit that produces excess revenues must reinvest the money into itself, a for-profit can use these excess revenues to pay dividends to owners or shareholders. The possibility of earning a profit changes the incentives for FPCUs, thus the impact of changes in student aid on firm behavior should be carefully examined.

As grant and loan aid increases, FPCUs may respond with proportional increases in tuition in order to capture the increased aid as profits for shareholders. Although the research is limited, recent studies, including one released in July by the New York Federal Reserve, suggest that the Bennett Hypothesis holds at proprietary colleges. In short, for-profit colleges appear to be capturing increases in aid as additional profits. These findings are certainly troubling, but not surprising given the fundamental difference between FPCUs and nonprofits.

However, FPCUs may have other strategies to maximize their profits. Increases in aid may increase the accessibility of a for-profit education, which is typically more expensive than its public counterpart, to more students. While traditional colleges might be unable or unwilling to expand their enrollment rapidly, FPCUs typically operate by seeking to maximize the number of paying students. In order to grow its capacity, a for-profit may simply need to rent another floor in an office building or increase its internet bandwidth to accommodate more online learners. Thus, when aid makes a for-profit education more accessible to learners, the firm may not respond by increasing tuition to capture the aid, but by increasing capacity in order to enroll more students who will spend their aid at the college. One recent study found that aid programs increased participation in postsecondary education at FPCUs, but at the same time these colleges captured more than half of both grant and loan aid as increased profits through tuition hikes.

Because of their structure, FPCUs are nimble. Their responses to increases in aid will be calculated quickly by evaluating the potential for growth in enrollment, the cost of educating these students, the potential income generated from these students, and a host of regulatory considerations. At the end of the day, a for-profit college is going to act in whatever way will maximize its profits given the increased aid. Obviously, making a profit isn't inherently bad, especially if the profit comes from increased access to useful postsecondary training for more students.

The Department of Education already has regulations in place to curb bad behavior at FPCUs. The so-called "90/10 rule," which limits the amount of revenue a for-profit can receive from federal aid programs, was initially passed to keep prices down. Nonetheless, there is mounting evidence that for-profits are artificially increasing their prices to simply capture student aid. Research produced by Stephanie Cellini and Claudia Goldin, Christopher Lau, and the New York Federal Reserve all suggest the Bennett Hypothesis holds true at for-profit colleges. In this research published in the last two years, these scholars all have found evidence that FPCUs are capturing federal student aid as increased profits.

The solution may lie in increased regulation, higher accreditation standards, and more transparency. To ensure any increases in revenue produced from higher aid are not merely being captured as profits, the Department of Education might consider setting a baseline percentage of total revenue that must be used on educational expenditures. This would ensure any rises in prices result in a better education for students, not profits for colleges. To prevent FPCUs from creating dubious educational costs to meet such a minimum, accreditation would need to be more stringent and account for these expenditures.

Accrediting bodies must ensure FPCUs are spending money on worthwhile educational expenses and doing so efficiently and in the best interests of students. Moreover, creating more transparency in the accrediting process and the resulting findings would make both the for-profit college and the accrediting agency publicly accountable for effective use of federal student aid.

The pass-through of student aid to FPCUs as profits is a troublesome problem that needs a solution. No matter how the federal government chooses to combat this, policies should be well thought out and deliberate in action. A continued push to better understand how FPCUs interact with federal aid can help develop ways to identify those seeking to make large profits off students and taxpayers without producing well-trained graduates. Enhancing our ability to identify the specific for-profit colleges that are fleecing students will allow us to provide the space for well-intentioned proprietary colleges that contribute valuable workers to the American economy to exist, and to help students access this necessary training.