The Tenth Amendment to the United States Constitution reads:

The powers not delegated to the United States by the Constitution, nor prohibited by it to the States, are reserved to the states respectively, or to the people.

Search as one might through the Constitution, one will not find the power to provide for higher education granted to the federal government. Because of that, the federal government should not be providing financial assistance to induce people to obtain higher education. Such activity should be left to the states and to individuals. Thus, one obvious reform would be to simply not reauthorize Higher Education Act. The political reality, however, is that more than 10 million students and their families now rely on some form of federal assistance to pay for their college education, and nearly all colleges and universities base their tuition policy on federal grants and loans. That creates a large constituency for current programs and renders moot any proposal to immediately end all federal financial assistance.

HEA costs taxpayers more than $22 billion per year. For that price, we should expect Congress to be fairly certain of the goals and efficacy of the program. What we do know is that HEA has mushroomed over time, with little consideration of what the legislation is trying to achieve or how the various programs interact with one another. There is ample evidence that the results have been counterproductive to the goal of providing greater access to higher education. Certainly HEA results in higher list price tuitions for all students and higher net tuitions for an unknown number. The extent of the increase in tuition varies by university, student, and time, as demand and supply conditions differ.

The lack of certainty in the results of this program, other than increasing tuition, suggests that rather than expand the current system, Congress should consider a phase-out of federal assistance to higher education over a 12-year time frame. This would allow people who have made decisions under the current system to continue with the same basic structure while the current program is being phased out. It would allow colleges and universities time to respond to the removal of federal government interference in the higher education system.

As the federal government removes itself from student assistance, we should expect several things to happen. First, we would expect sticker tuition prices to decline. Second, the private market would respond to the phaseout of federal assistance. This would likely take three forms: additional private-sector loans, additional private scholarship funds, and perhaps most importantly, the expansion of human capital contracts, which are similar to owning stock in the future earnings of a college graduate.

The private sector is already assuming a greater role in providing student loans. Nonfederal borrowing has increased from 7 percent to 16 percent of education loan volume over the past five years. Nonfederal borrowing reached $11.3 billion in 2003–04, up 39 percent in real terms over the previous year and almost 150 percent in three years. It is quite likely that this market will become more and more developed over time and will be a normal place for students to look for assistance.

It is likely that private assistance for higher education will increase under a phase-out of HEA. Because federal programs affect the private market, one cannot take the current amount of private and institutional financial aid as a measure of what will happen once the federal government has stopped providing direct assistance to students. If the federal system of grants and loans were phased out, some persons who do not now contribute to private grants and loans would be likely to contribute, and others who are already contributing would likely increase their contributions. Although this effect is unlikely to offset federal aid completely, at least some of the reduction in government assistance would be replaced with private-sector assistance.

The most interesting substitute for federal government intervention may be human capital contracts. A human capital contract allows a student to go to the venture capital market and obtain investors in his education. In return for that financing, the student pledges a specific percentage of later income over a specified period of time to be paid to the investor.

Milton Friedman proposed such a contract in his 1955 paper “The Role of Government in Education,” later republished in Capitalism and Freedom.65 Miguel Palacios in his 2002 Cato Policy Analysis “Human Capital Contracts: ‘Equity-like’ Instruments for Financing Higher Education,” provides a detailed analysis of such contracts, their benefits and limitations, and how they would work in practice.66

When fully accepted, human capital contracts would come to be combined by investment funds. Those funds would purchase large numbers of such contracts, allowing the risk of default to be spread over a sufficient number of students that the law of large numbers would generate sufficient profit for the funds to be economically viable. As the market for these contracts developed further, shares in the funds would be traded in the same way that individuals purchase shares in such things as real estate investment trusts. This would create an economically efficient way to finance higher education that would allow students to graduate without having to fear that their future earnings would not be sufficient to pay their student loans.

There are other issues that may limit the extent of this market. For example, the human capital contract may not be useful for situations where a student chooses a high cost college for a low-paying degree. However, this is not a certainty, as markets tend to create the services that consumers desire. Currently one firm, MyRichUncle, offers such contracts. Palacios provides some suggestions for how this market might become further developed. Those suggestions include establishing that such contracts would be enforceable under federal law, amending federal bankruptcy statutes to prevent manipulation of the statutes to abrogate the contracts, and allowing for securitization of the contracts.

CONCLUSION: The federal government spends tens of billions of dollars providing aid to students to attend colleges and universities through a variety of loan, grant, and tax programs. Yet there is ample evidence to suggest that these programs are counterproductive and have the unintended consequence of increasing tuition costs. In addition, federal financing has the potential to threaten the independence of higher education in the United States and, thereby, the independence of political opinion from the federal government.

Congress should reduce or eliminate its intervention in the financing of higher education and instead focus on providing the legal structure that would allow for the creation of human capital contracts. This would result in the most efficient allocation of higher education and preserve the independence of our institutions of higher learning.

This solution is based on an excerpts from an article of the same name, originally published January 25, 2005 at the Cato Institute's website.