Colleges Aren’t as Rich as They Look

The assault began five years ago when Congress enacted a 1.4% excise tax on the investment income of nonprofit universities. As opponents feared at the time, the 2017 tax has proved the opening salvo in an attack on college endowments. The federal government jumped into the mix last year, with Republican Sen.

Tom Cotton

introducing the Ivory Tower Tax Act, which would add a 1% tax on the fair-market value of the largest private endowments as well as a 30% tax on “undistributed excess endowment earnings.” Several bills have also been introduced in the House that would raise the taxes paid by our best-resourced universities and expand the tax to a broader group of schools.

Aiding these assaults are misleading arguments, the most prominent of which come from Canadian writer

Malcolm Gladwell,

author of the bestselling 2000 book “The Tipping Point.” In his newsletter, Oh, MG, Mr. Gladwell suggests that some of America’s leading research universities have such large endowments that they could finance themselves perpetually simply by spending their endowment’s earnings. Using Princeton as an example, Mr. Gladwell notes that over the past few decades the school has earned about a 10% yearly average return. It spends only 5% each year. Simply spend the other 5%, Mr. Gladwell says, and there would be enough money for the university to pay its bills and educate all of its students free of charge, in perpetuity. Mr. Gladwell’s argument was picked up and repeated in the newsletter Axios Finish Line, which is widely read in Washington.

There are at least three problems with Mr. Gladwell’s argument.

First, using its expectations for returns and inflation, Princeton has adopted a spending rule that allows it to spend a bit more than 5% a year on average. Other universities have used similar calculations to ensure their endowments can ride out the inevitable bear markets, when stocks produce negative returns. All this is done to ensure that the real value of the endowment is preserved and that spending can rise each year at the rate of inflation. Only then can the educational opportunities available to faculty and students today still be available 50 years from now.

A second problem with Mr. Gladwell’s analysis is that the approximately 10% endowment returns earned in recent decades are unlikely to continue. In the early 1980s, yields on the safest U.S. Treasury long-term bonds were about 10%. Valuations of stocks, real estate and other assets were at historic lows. In subsequent decades, interest rates fell to near zero and valuations for all types of equities soared until the start of this year. All this enhanced past returns sharply. But at the valuation levels for both debt and equity instruments today, it is completely unrealistic to project the same returns in the years ahead. The already-released endowment-return reports for 2021-22 among some universities have proved consistently negative.

A third problem is Mr. Gladwell’s implicit assumption that no future investments will be required to fulfill the university’s basic mission of providing cutting-edge research and useful teaching. Entirely new fields of inquiry have been developed, necessitating the creation of new academic departments with new faculty and facilities. In recent decades disparate fields, from molecular biology and genomics to quantum computing, have required investments in new laboratories and new faculty.

As for helping students, our elite educational institutions already provide substantial scholarship aid. If one is concerned about maintaining a society in which all young people can pursue their dreams of economic advancement, educational achievement is a critical necessity. Universities use their endowments to make their educations affordable. At Princeton more than 61% of undergraduates are on need-based financial aid. The average scholarship exceeds the tuition price. No student needs to take out a student loan, and next year Princeton will eliminate the student-earnings contribution—meaning that students will no longer be expected to hold summer or term-time jobs to pay for their education. The endowment makes all of this possible.

Our institutions of higher education have been engines of innovation, fostering upward mobility and helping to demonstrate that the American dream isn’t dead. Increased taxation and ill-considered criticism are inconsistent with the social and economic interests of the country.

Mr. Malkiel is author of “A Random Walk Down Wall Street,” whose 50th anniversary edition is forthcoming in 2023.