A Hedge Fund That Has a University
Taxing endowments’ investment income would help higher ed.
By Thomas Gilbert and Christopher Hrdlicka / WALL STREET JOURNAL
Nov. 13, 2017
Whatever you may hear, the Republican tax-reform proposal isn’t an assault on higher education. The House and Senate plans include a new 1.4% excise tax on the net investment income of university endowments, but the levy applies only to private colleges with at least 500 students and endowments of more than $250,000 a student. Schools like Harvard, Yale, Stanford and Princeton—which together hold over $100 billion—are predicting doom. Yet this long-overdue tax will benefit higher education in the end.
Over the past 30 years universities have chased higher returns on their endowments, leading them to take greater risks. Our research shows that more than 75% of the assets in university endowments are now in risky investments: securities, hedge funds and private equity. Think of Harvard as a tax-free hedge fund that happens to have a university.
The proposed levy on investment income—dividends, interest and capital gains—is fundamentally a tax on this risk-taking, not on the endowments themselves. By taxing risk-driven income, the GOP plan doesn’t target higher education. It goes after hedge funds masquerading as university endowments.
When an endowment is invested in safe assets such as bonds, it serves as a rainy-day fund to buffer the risks a university takes in its normal operations: admitting students on scholarship, launching new research laboratories and generally expanding its educational and research missions. Such a safe endowment generates almost no investment income, meaning there would be no tax liability under the GOP proposal.
Instead the tax would fall on large, risky and illiquid funds. Endowments that make such investment decisions cannot effectively protect their schools. During the financial crisis, Harvard’s endowment lost nearly 30% of its value. After failing to sell its private-equity portfolio, the university had to institute drastic hiring and budget freezes.
A large and risky endowment also reveals a university’s poor assessment of its internal investment opportunities, such as scholarships and research. If Harvard and Stanford have educational and research projects that could benefit from additional funds, why put their money at risk in the stock market? Perhaps the answer is that the opportunity to run a tax-free hedge fund is too attractive. In that case, why should taxpayers subsidize their activities?
In colleges’ defense, states have placed perverse restrictions on their ability to use endowments as rainy-day funds. The Uniform Prudent Management of Institutional Funds Act is a law in 49 states that limits the maximum endowment payout rate between 5% and 7% a year. Although well-intentioned, that and earlier restrictions prevent universities from tapping endowments to fill the kind of budget holes they experienced in 2008.
To have the best chance of improving incentives for endowments, the proposed investment tax should be accompanied by a repeal of these payout caps. But it’s a mistake to think that taxing risky investments by university endowments is an attack on academia. Discouraging superwealthy schools from pumping cash into stocks, hedge funds and private equity should lead to increased spending on education and research. Isn’t that the purpose of higher education?
Messrs. Gilbert and Hrdlicka are assistant professors of finance at the University of Washington.
Appeared in the November 14, 2017, print edition.
