Although she was a gifted child who devoured books, S. Georgia Nugent never thought she’d be able to go to an elite college. The daughter of a racehorse trainer, she figured that even if she got in, the cost would be prohibitive. “Princeton charged about what my dad made in a year,” she remembers.

But as it turned out, Nugent did get to go to Princeton, graduating cum laude in 1973, because the university offered to cover the full cost of her tuition. That life-changing break launched her on a distinguished academic career that culminated in her serving as president of Kenyon College for ten years before stepping down this past June. And it also helps to explain why Nugent now spends much of her time speaking out against a trend in higher education that is making stories of upward mobility like hers less and less common.

“Financial aid available to the lowest-income students has plummeted, and financial aid to the highest has soared,” she says. The trend is so powerful that, try as she might, even Nugent herself could not resist it during her presidency at Kenyon. The school found itself engaged in a relentless arms race in which it felt compelled to offer more and more of its financial aid to precisely those students who need it least.

Today, many leaders in higher education would like to break free of the commercial logic that leads to this perverse result. But it can be difficult to escape, especially for schools that lack deep endowments and have to compete hard for revenue. Either a school offers tuition discounts to students from affluent families, or else those students (and the revenue they could provide) wind up going to other institutions that offer similar or more generous discounts.

There is now a whole industry of consultants who will gladly explain the math—not that it is very difficult to grasp. After all, if a school offers a single low-income student a full scholarship of $20,000, the school may feel good about itself, but it’s out $20,000. But if it can attract four affluent students to its campus instead, by offering them each a $5,000 discount off full tuition, it can collect the balance in revenue and come out way ahead financially. Such competitive discounting to the affluent may not be equitable, and it may not be sustainable over the long term, but once the cycle starts it can be very difficult for any one institution to resist unless they all do.

Today, these tuition discounts usually come in the guise of “merit scholarships,” but often the students who get them are hardly the best and the brightest. For example, 10 percent of college admissions directors at four-year colleges (and nearly 20 percent of those at private liberal arts colleges) admit that they give affluent students a significant leg up in the admissions process—meaning that they are admitting affluent students with lower grades and test scores than other applicants. Indeed, nearly a fifth of all students receiving so-called merit scholarships have less than a B average, and a largely overlapping 19 percent have only mediocre SAT scores, according to a report by the National Center for Education Statistics.

These colleges are, in other words, providing affirmative action for the wealthy, and the scale has grown very large. During the 1995-96 school year, only 24 percent of first-time, full-time students at private colleges received merit aid; by the 2007-08 school year that number had risen to 44 percent.

Of course, it’s true that all schools would prefer to offer merit aid only to students who are highly accomplished academically. If nothing else, attracting more students with high grade point averages and high SATs helps bolster an institution’s ranking on college guides such as those published each year by the U.S. News & World Report. But such is the competition to boost short-term revenue that so-called merit aid often goes these days to students who have little academic merit.

Adding to the inequity are two related trends. First, the proportion of low-income students who receive financial aid of any kind has continued to fall since the mid-1990s. And moreover, for those who do receive aid, the amount of tuition they must still finance on their own has soared. Indeed, these days the net price paid by low-income students is often as high as, or higher than, that paid by more affluent students at the same institution. Nearly two-thirds of private institutions charge their poorest students (those whose families make $30,000 or less annually) a net price of over $15,000 a year.

This is one reason why even after historic increases in Pell Grant funding, the gap between the percentage of high- and low-income students who go to college remains as wide as ever. Low-income students are paying more and more out of their own pockets while their wealthier counterparts get discounts. There is compelling evidence to suggest that many schools are engaged in an elaborate shell game: using Pell Grants to supplant institutional aid they would otherwise have provided to financially needy students, and then shifting these funds to help recruit wealthier students.

By now, the trend has spread to many public colleges and universities as well and is rapidly getting worse as those institutions struggle with declining support from state governments. In a survey it conducted last year of nearly 600 college admissions directors, Inside Higher Ed found that more than one-third of public colleges and nearly two-thirds of private colleges engage in “gapping”—providing lower-income students with aid packages that don’t come close to meeting their financial need.

Ending this vicious spiral will not be easy. “I’m very involved nationally in trying to urge colleges to cut back on merit aid, and so I really regret that we end up doing more of it,” Nugent told Kenyon’s student newspaper last November. Yet she and many college presidents who agree with her see no easy way out. “I just don’t know how colleges are going to step off of that merry-go-round.”

To understand how this cycle came about and what might be done about it, take a closer look at Ohio, home state of Kenyon and also a state that some have called “ground zero” in the merit aid arms race that has been sweeping the country. With dozens of private nonprofit colleges and strong public universities competing for a shrinking population of college-age students, nearly all the schools in the state are aggressively using merit aid to attract the students they most desire, and, in many instances, must have to survive.

As chronicled by Elizabeth A. Duffy and Idana Goldberg in their 1997 book, Crafting a Class, the arms race in Ohio began in the 1980s when Ohio Wesleyan University became the first of the state’s liberal arts colleges to institute a merit aid program. The school hoped to lure away more highly qualified students from Ohio’s lower-cost public universities by offering tuition discounts to students with good grades and test scores.

The program helped bring Ohio Wesleyan the results it wanted, at least at first. But its early success soon caught the attention of other private colleges in the state and drove them to respond with their own scholarships. As a result, Ohio Wesleyan found that it had to expand its program significantly just to keep pace. By 1994, the school was providing merit aid to 39 percent of its students.

Once the cycle began, it became harder and harder for even schools opposed to merit aid to resist expanding its use. In the 1970s, for example, Denison University, in Granville, Ohio, had flirted with the idea of starting a merit aid program but rejected it on the grounds that it would trigger a bidding war among the colleges for high-achieving students. “Using such scholarships is likely to lead us into a cut-throat competition with other schools to ‘buy’ talent,” Denison’s Admissions and Financial Aid Council wrote in 1977.

By the late 1980s, however, Denison realized that it could not sit on the sidelines any longer as it lost more and more coveted applicants to other colleges that were aggressively awarding non-need-based aid. Denison thus started a relatively modest program that provided small awards to fewer than 10 percent of its students. When that proved insufficient, it doubled the proportion of students the program served, and increased the size of the awards. After nonetheless missing its enrollment targets by several hundred students, the school expanded the program even further in 1994. On the advice of outside consultants, Denison began providing scholarships of up to $5,000 each to students who graduated in the top half of their high school classes and had SAT scores of at least 1050.

This discounting helped Denison to boost its enrollment and net tuition revenue. “You spend money to make money,” a senior member of Denison’s admissions staff told U.S. News in a 1998 article that described the school’s merit aid program. Since then, the discounting has also helped to raise the average SAT scores of Denison’s freshman class by attracting students who might otherwise have gone to better-known, more prestigious schools. But while no one can be categorically against an institution of higher learning lowering its prices to attract talented, paying students, this particular form of price discrimination has broader and longer-term effects.

At Denison, for example, the school’s lowest-income students now must pay an average net price of nearly $19,000 in tuition. Put another way, even though most of these students are receiving Pell Grants from the federal government, Denison is charging them such high tuition and offering them so little need-based aid that most must take on crippling debts to attend. Should Denison really be offering wealthy students discounts even as it pushes up the prices needy students must pay?

There is also the question of how such competitive discounting affects the solvency of higher education as a whole. For some of Denison’s nearby competitors, like Wittenberg University—a 168-year-old liberal arts college located in Springfield, in southwestern Ohio—the consequences of Ohio’s merit aid arms race have been quite damaging. With an endowment that is about a sixth the size of Denison’s, Wittenberg relies much more heavily on tuition revenue to finance its operations than its wealthier rival. But to keep up with the competition, Wittenberg must discount its tuition significantly, leaving the school less to spend in other important areas related to the school’s academic mission. “It’s hard to compete with free,” Laurie Joyner, Wittenberg’s president, told the Springfield News-Sun last year.

The state’s most exclusive schools, Kenyon and Oberlin, held out the longest against joining the merit aid arms race. Both competed most directly with elite liberal arts colleges in the Northeast that had long forsworn merit aid. But even they could not resist the pressure coming from other institutions in the state that were aggressively using merit aid.

Oberlin, with its progressive history and long-held commitment to social justice, was the last to cave. By the early 1990s, the college’s financial fortunes were flagging. The school was spending an increasing share of its budget on need-based financial aid but was having trouble nailing down a class with the quality of students it was seeking. Oberlin found itself admitting more than two-thirds of the students who applied—an unusually high number for a college of its stature.

Administrators there came to the conclusion that their aid practices were not sustainable. “I suspect that for many students our financial aid offers are less attractive than those of other schools—that our financial aid policy may be a primary cause of our loss of market power,” Alfred MacKay, Oberlin’s acting president, wrote in 1991 in an article that ran in a campus publication, entitled “The College May Need to Change Its Strategy.”

It took another two years for the whole campus to come onboard. In late 1993, following months of intense discussions, the faculty governing body signed off on a plan for the college to start using merit aid to pursue the students it most desired. In addition, the school became “need aware,” meaning that it would no longer ignore a student’s ability to pay when offering admissions.

At the end of the decade, Nancy Dye, Oberlin’s then president, argued that the school had to ramp up its merit aid program even further. According to accounts in the student newspaper of the campus-wide discussions that occurred at the time, some faculty members objected. “What I’m afraid of is that we’ll end up providing a discount to wealthy students and end up with the reputation as the type of ‘country club’ school we swore we’d never be,” Gary Kornblith, a history professor, stated during a general faculty meeting on the president’s proposal.

But Dye won the day, in part, by stressing the need for the school to keep up with its rivals. “Colleges like Wooster and Denison are trying to use the current financial aid market as a way of upgrading the quality of students by offering substantial amounts of aid,” she said. “We do compete with them, despite what some people think.”

Meanwhile Kenyon, having held out as long as it could, now finds that not only must it offer substantial aid to affluent students, but these students and their families have come to view such aid as an entitlement. Mid-April is the time of year that Jennifer Delahunty, Kenyon’s dean of admissions and financial aid, dreads the most. That’s because sitting on her desk every April is a very large pile of appeals from students Kenyon has accepted but whose families want the college to at least match the financial aide packages they have received from competing schools. “You know how there was the age of the enlightenment?” the blunt-speaking Delahunty asks. “Well, this is the age of entitlement, in the sense that ‘XYZ school gave me a merit scholarship, why don’t you?’ ”

Delahunty acknowledges that colleges have helped encourage this sense of entitlement by giving out awards that are not tied to actual need, and that Kenyon is an active participant in the arms race. But while Kenyon is experimenting with cutting back on merit scholarships, there seems to be no way for the school to disarm unilaterally. “Kenyon, Wooster, Oberlin, and Denison are all going after the same group of kids both in the Midwest and nationally, and we’re all trying to stand out,” Delahunty says.

So, increasingly, are public institutions, both in Ohio and across the country. Declining government support and institutional status-seeking have worked hand in hand to encourage state colleges and universities to join the same merit aid arms race as their private counterparts.

Miami University in Oxford, Ohio, provides a good example. Michael S. Kabbaz, Miami’s indefatigable associate vice president of enrollment management, is on a mission to make the school into a “destination institution” for out-of-state students who are at the top of their class and whose families can afford to pay full freight. To capture the attention of these students, the public university offers many of them hefty amounts of merit aid.

“I come to work every day realizing that if we’re not out there being much more aggressive in attracting these great students, they have options virtually anywhere in the country,” says Kabbaz.

Increasingly, Miami’s focus is on competing nationally against Big Ten schools, like Indiana University, for top students. This goal may seem far flung from the traditional mission of public universities. But given the fiscal realities Miami is facing, Kabbaz sees no alternative to the approach he is pursuing.

Over the last five years, the state of Ohio has slashed spending per student at its public universities by nearly 30 percent. Back in the 1970s, state appropriations covered about three-quarters of Miami University’s annual budget. Today, it accounts for only 11 percent. The school now relies on tuition revenues to cover 55 percent of its budget.

“We can’t control what the state has in store for us over the next ten, fifteen, twenty years,” Kabbaz says. “But we can develop alternative revenue sources so we are able to sustain whatever comes down from the state.”

These issues came to a head for the university in 2009. In addition to the state budget cuts, the school suffered a major financial blow when it missed its enrollment target by 350 students. “That created urgency for the university,” Kabbaz says. “The university said that this could never happen again.”

It was at this point that the university’s “nonresidency strategy” came into focus. The Strategic Priorities Task Force—convened by Miami’s president, David C. Hodge, and made up of faculty and administrators—urged the school to significantly expand its out-of-state recruiting. The committee warned that a failure to do so would be harmful to the institution because of the state budget cuts and Ohio’s shrinking college-age population.

“Widening our reach in enrollment will not be easy, nor will it be accomplished without significant investments in our capability to recruit, attract, and retain students less familiar with Miami’s reputation for excellence,” the task force wrote. “Even so, it is necessary for our future prosperity.”

In the years since, the school has placed recruiters in affluent areas of the country, including Connecticut, northern Virginia, and San Diego. Today, nearly 40 percent of Miami’s students come from outside of Ohio.

The institution also established automatic scholarships for both in-state and out-of-state students who achieve high standardized test scores and good grades. For example, students who have SAT scores of at least 1400 in critical reading and math and have earned a cumulative grade point average of 3.70 are eligible for half-tuition or full-tuition scholarships for four years. About 70 percent of the school’s students receive some sort of scholarship through the program.

Supplementing these efforts, Kabbaz has created the Academic Scholars Program, in which the highest-achieving students receive more-generous aid awards than they would get through the school’s main merit scholarship program. The university also offers these students special academic opportunities, such as personalized mentorships with top faculty, participation in funded research projects, and guaranteed internships.

All in all, Miami University provided $44 million in institutional aid this year, with two-thirds of it going to non-need-based aid. According to data that the school has provided to the College Board, the university was only able to meet the full financial need of about 17 percent of the student aid recipients on its campus in the 2011-12 academic year. Meanwhile, 22 percent of freshmen had no financial need and received merit scholarships that year, with an average award of about $6,500.

Miami’s stress on market positioning and revenue maximization through the use of strategic tuition discounting or price discrimination is now quite typical of public universities. Indeed, public university presidents appear to be even more resistant to the idea of giving up non-need-based aid than their private college peers. According to the Inside Higher Ed survey, 71 percent of public four-year colleges said they wouldn’t eliminate merit aid even if their competitors did so. In comparison, only 48 percent of private college leaders disagreed or strongly disagreed with the idea.

At schools such as Pennsylvania State, in-state students attending the university’s flagship campus in University Park pay about $16,000 in tuition and fees annually. Yet despite the fact that Penn State spends nearly $14 million a year on institutional aid, its lowest-income in-state students pay an average net price of nearly $17,000. At the same time, about 6 percent of the school’s first-time freshmen received an average of $3,800 in so-called merit aid in the 2010-11 school year. Institutions of higher learning used to complement the government’s efforts to promote equal opportunity by using their financial aid resources to open the doors to the neediest students. But those days appear to be in the past.

For several decades, starting in the 1950s, groups of private colleges worked together to try to prevent bidding wars from breaking out over much-sought-after students. By the 1970s, as many as 150 colleges across the country were meeting with their competitors to compare the aid awards they were offering to students.

The most famous of these was the Overlap Group, which was made up of twenty-three elite private colleges, including all of the members of the Ivy League, the Massachusetts Institute of Technology (MIT), and a number of highly selective liberal arts colleges in New England. These schools essentially agreed to determine the appropriate aid award for every student admitted to more than one of the institutions. According to the colleges involved, these arrangements were meant to ensure that students could choose among the institutions without cost being a significant factor, and that the colleges could reserve their aid dollars for the neediest students.

In the view of the U.S. Department of Justice, however, these discussions had a much different purpose: price fixing. In 1991, the Justice Department filed a lawsuit against the members of the Overlap Group, charging that they had violated the Sherman Antitrust Act “by illegally conspiring to restrain price competition for financial aid” to prospective students. To get the Justice Department to drop its suit, the eight Ivy League colleges quickly capitulated, signing a consent decree in which they agreed to end their discussions. (MIT, which was the only school to fight the lawsuit, eventually reached its own settlement with the government.) The Ivy League’s action convinced other private college groups to disband as well.

In 1994, former members of the Overlap Group persuaded Congress to pass a bill allowing certain private colleges to hold meetings to discuss general institutional aid policies and to refine the formula the institutions use for measuring a student’s need. The schools are forbidden, however, from negotiating individual students’ aid awards. And participation in these discussions is limited to a small and ever-shrinking number of colleges: those that are completely “need blind,” meaning that they never take a family’s income into consideration when admitting students.

Nugent and the other private college presidents with whom she’s working argue that Congress must revise the law to allow a much wider group of institutions to participate in these types of discussions. “Allowing conversation about financial aid priorities and policies among schools could catalyze the creation of a better system,” says Tori Haring-Smith, the president of Washington & Jefferson College in Pennsylvania, who has been actively involved in the campaign.

But even if a much greater number of colleges were given the opportunity to work together to try to stem the merit aid arms race, would they want to?

The signs are not encouraging. A recent survey by Inside Higher Ed asked 841 college presidents whether “they would eliminate non-need-based aid if their competitors also agreed to do so.” The results: only a quarter of the respondents agreed or strongly agreed with the idea, while nearly 60 percent made clear that they are not interested in changing their practices.

At the very least, we should consider whether so-called merit aid is a form of price discrimination that ought to be illegal, since it is both unfair and inefficient. While it may help some individual schools to maximize their own revenues or attract more desirable students at the expense of other institutions, it does nothing to improve either the quality or the financing of higher education as a whole and may well make both worse. When a kid is lured from going to Oberlin to going to Denison by a $5,000 “merit” scholarship, that does not make him or her more or less meritorious. Nor does it change in any obvious way how well such a student will do in college or life. But that $5,000 cannot now be spent on another student who, though he or she may have higher grades and scores, cannot afford to go to either school, or perhaps to any school at all. Meanwhile, if both Oberlin and Denison, and a lot of other fine schools like them, go broke by engaging in competitive cycles of discounting to wealthy students, how does that serve any social purpose?

Short of banning the practice of offering the biggest tuition discounts to those best able to pay, the federal government needs to scrutinize institutions that both enroll few low-income students and charge them high net prices. To prevent such institutions from using public dollars as a substitute for offering their own aid to financially needy students, or as a means of financing discounts for affluent students, they should be required to match at least a share of the Pell dollars they receive.

At the same time, however, we can’t lose sight of the root cause of the problem. Between stagnating or declining real wages and relentlessly rising tuition costs, an ever-rising share of the population, including most of the middle class, requires financial assistance to have equal access to higher education. Getting a $5,000 discount on a $40,000 tuition bill hardly leaves most middle-class families able to afford college without taking on debts they should not, and is all the more cruel when the list price has been inflated by $5,000 just as a sales gimmick.

The explosion of student debt that occurred over the last generation masked the problem for a while, but has proved unsustainable. A large part of the answer (much easier said than done, of course) is to drive down tuition costs through improvements in efficiency. But we cannot pretend that it is possible to reverse the growing trend toward inequality and diminished upward mobility as long as more and more institutions of higher learning, including public universities, face a growing imperative to maximize tuition revenues at the expense of other values.

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Stephen Burd is a senior policy analyst in the Education Policy Program at the New America Foundation.