One of the eternal debates in higher education policy is the validity of the Bennett Hypothesis, first stated by William Bennett (President Reagan’s Secretary of Education) in 1987:

“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. In 1978, subsidies became available to a greatly expanded number of students. In 1980, college tuitions began rising year after year at a rate that exceeded inflation. Federal student aid policies do not cause college price inflation, but there is little doubt that they help make it possible.”

Does the availability of federal financial aid give colleges an incentive to keep hiking tuition? I wrote about the existing research on the Bennett Hypothesis last fall, which has been one of the most-read posts in my three years of blogging. At that time, I concluded that although it’s quite possible that federal financial aid is associated with increased tuition, it was hard to draw a solid conclusion given data limitations and the fact that nearly all students can receive federal financial aid—limiting the ability to draw causal inferences.

But two recent studies have pushed the research frontier forward by estimating the relationship between small changes in federal aid and colleges’ pricing strategy. The first is a job market paper by Christopher Lau, a recent economics PhD graduate from Northwestern. Using a rather complicated analytic strategy (read the methods section and see for yourself!), he estimated that for-profit colleges captured approximately 57 cents of each additional dollar of federal grant aid and 51 cents of each additional dollar of federal loan aid. Community colleges captured a smaller portion of federal aid dollars (37% of grant aid and 25% of loan aid), which is unsurprising given that the maximum Pell Grant is larger than community college tuition in nearly all states. Additionally, states often limit the amount that public colleges can increase tuition, reducing the opportunity for strategic behavior.

The second examination of the Bennett Hypothesis is a newly released report from three economists at the New York Fed. They used increases to federal subsidized and unsubsidized loan limits in 2007 as well as maximum Pell Grant awards to see whether colleges responded by increasing tuition. They found that colleges did increase posted tuition (not necessarily net tuition) at a higher rate after loan limits increased, with the magnitude being approximately 55 cents for each dollar of additional Pell Grant aid and 65 cents for each dollar of subsidized loan aid. These effects were largest for the most expensive private nonprofit colleges, where the maximum amount of federal loans ($5,500 for a first-year student) only covers a small portion of tuition.

An even more interesting finding from the Fed paper is that shareholders in for-profit colleges responded favorably to the passage of legislation that increased federal financial aid amounts. They concluded that across three pieces of legislation, the cumulative increase in stock prices was about 10% above what would have been expected without an increase. Given the high (at the time) public valuations of large publicly traded for-profits, this represented a large increase in valuation. It is also worth noting that because for-profits have to get at least 10% of their revenue from non-federal sources or veteran’s benefits, some colleges may have had to increase tuition in order for students to take out private loans to stay clear of the so-called ‘90/10’ rule.

Both of these papers have some major limitations. Most notably, they are unable to account for whether students took out less in PLUS or private loans when subsidized loans and Pell Grants increased and do not look at net tuition after grant aid. However, these represent some of the best evidence of there being some truth to the Bennett Hypothesis for the most expensive colleges. But does this lend credence to the claim that tuition will become much less expensive if the federal government got out of the student aid business? As a researcher, I urge caution with that interpretation for two reasons. First, these studies only tell us what happens when more aid goes into the system. The relationship may not hold when less aid comes in. Second, these findings are based on relatively small changes in aid—often less than $1,000. These ‘local’ effects may not hold for a larger change.

[Cross-posted at Kelchen on Education]

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Robert Kelchen, a professor of education at the University of Tennessee, Knoxville, is data manager of the Washington Monthly college guide.