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Taxes, Subsidies, and Knowledge: A Reply to Professor Oei

In this article, Professor Simkovic responds to critiques of The Knowledge Tax. The Knowledge Tax is available here: http://ssrn.com/abstract=2551567.Topics covered include: substitutability of other investments for higher education; supply-side subsidies and the margin of investment; non-taxation of foregone earnings; subsidy incidences; information costs.In The Knowledge Tax, I argued that federal taxes and subsidies in aggregate likely disadvantage investments in higher education relative to other investments. When it comes to investments in higher education, the tax rates are higher and the tax base is larger.The purpose of The Knowledge Tax is not to assert that the only explanation for underinvestment in higher education is differences in tax treatment and subsidies. Rather, The Knowledge Tax highlights that a simple neoclassical model can explain much of the observed data, and that a simple and under-explored explanation is credibly at least one important driver. An economic model can remove higher education policy from the realm of anecdotes and narrow interest group politics, and situate higher education in broader conversations about efficiency (relative to alternatives), investment, and economic growth.As Professor Shu-Yi Oei’s response highlights, even demonstrating that higher education is at a disadvantage relative to other investments would be a substantial contribution to the scholarly literature. Demonstrating such a disadvantage would shift the policy question from whether we should subsidize higher education to how we should counter anti-education policies embedded in the tax system. Particular taxes and subsidies can best be understood within a broader context. Neoclassical models are useful not because they fully capture reality, but because they simplify it. Simplification makes analysis and prediction inexpensive while explaining enough of reality to be relevant. To be useful, a model sometimes need only make predictions that are likely to be directionally correct. I. Substitutes for Higher Education: The Knowledge Tax suggests that tax disadvantages to higher education could lead to substitution away from investments in higher education and toward other investments. Professor Oei questions whether it is appropriate to compare tax rates on higher education with tax rates on investments that are taxed more favorably, and whether it is appropriate to assume substitution effects between higher education and tax-favored investments. Investments do not have to be direct substitutes for the taxation of one to affect the level of investment in the other. Through a chain of indirect connections, incentives and decisions at one point in the capital market can affect returns and investment levels at another seemingly unconnected point. In other words, an assumption of an efficient capital market is often useful shorthand for describing the aggregate effects of policies, even if it is not necessarily literally true at a more granular level.II. Supply-Side Subsidies and the Margin of Investment: The Knowledge Tax considered higher education tax expenditures as well as federal subsidies such as Pell Grants. In aggregate, even after taking these subsidies into account, the tax treatment of higher education appears to be disadvantageous compared to many other investments. Professor Oei raises an important question: whether comprehensively integrating all subsidies as well as taxes into the analysis changes the conclusion that investments in higher education are disadvantaged. Subsidies are most important to the analysis if they operate on the margin where investment decisions are made — that is, if the dollar value of the subsidy changes with a dollar increase or decrease in investment in higher education at the current level of investment. Much of US public spending on higher education comes from state governments supporting state institutions. These subsidies probably do not scale proportionately with increased marginal demand for higher education. The public may subsidize investments that compete with higher education as much as, if not more than, it subsidizes higher education. Healthcare and the military are each a larger share of federal outlays than higher educationIII. Nontaxation of Forgone Earnings: In The Knowledge Tax, I addressed the claim that higher education is tax advantaged because forgone earnings are not taxed. This critique targets one of the two prongs of the argument in The Knowledge Tax — nondeductibility of costs and the larger tax base for higher education — but does not address the second prong of higher tax rates.Investments in human capital are heterogeneous with respect to the relative importance of forgone earnings (in other words, time) and cash outlays for tuition and the like (in other words, money). Forgone earnings are the primary cost of apprenticeships, PhDs, and on-the-job-training, in which trainees accept low wages in return for valuable training. By contrast, non-deductible tuition fees and book purchases are the primary cost of high-end bachelor’s degrees, professional degrees, and terminal master’s degrees. I intentionally focused on formal, tuition-funded higher education in The Knowledge Tax — rather than human capital writ large — because formal higher education is the form of human capital investment for which the case for distortionary taxation is strongest, and which has well-documented unusually high returns.IV. Subsidy Incidences: While it is difficult to accurately estimate subsidy incidences, the equation in The Knowledge Tax demonstrates that, under reasonable assumptions about the levels of tax-and-subsidy disadvantages, tax disadvantages could explain a large portion of the difference in returns between higher education and other investments. The explanation is simple and fits the data and economic theory reasonably well.V. Information Costs as Rising Marginal Costs: The neoclassical model assumes rising marginal costs and declining marginal returns to investment. In the absence of taxation, investment should cease just before the point at which marginal costs exceed marginal returns. Taxation and subsidies can move the margin, because decisionmakers focus on private benefits and costs, not social benefits and costs.Oei discusses information problems — some students lacking adequate information about the value of higher education. These problems can be understood as raising marginal costs.