Why Endowments of Educational Institutions Shouldn't be Taxed

In the Tax Cuts and Jobs Act of 2017, Congress enacted the “endowment tax”—a tax on the “net investment income” from the endowments of some private colleges and universities. This essay briefly describes the tax, points out some of its defects, and considers whether Congress could expand the taxation of educational institutions, as the Trump administration has proposed.

The Tax

The statutory language can be obscure—this is the Internal Revenue Code, after all—but the basics (putting aside computational difficulties) are simple. The 1.4 percent tax applies to the net investment income of any private educational institution

(1) with 500 or more tuition-paying students during the year (calculated on a full-time equivalent basis), more than half of whom are in the U.S.; and

(2) if, at the end of the prior year, the fair market value of the institution’s assets that weren’t used directly in carrying out its exempt educational purposes was at least $500,000 per student.

That latter requirement refers to endowments, as that term is ordinarily understood—that is, investments—and doesn’t include, for example, the value of buildings and land used for educational purposes.

Those requirements make the tax inapplicable to most schools. According to Phillip Levine of the Brookings Institution, in 2021 only 33 private institutions were subject to the tax. (The total tax paid was $68 million.) Levine compiled a list of 38 institutions that, in 2021-2022, had endowments that exceeded the $500,000 per student threshold. The list mostly includes major research universities and elite liberal arts colleges.

Investment advisor Don Kramer reports that the number of taxed institutions had increased to 58 in 2023, and the total amount collected had risen to $380 million. That’s still chump change in the federal budget, but the liability isn’t chump change for affected schools. According to a 2020 article in Inside Higher Education, Stanford’s estimated tax liability for 2019 was $42.9 million, and Harvard’s was $37.7 million. That’s enough to make university officials pay attention. (I know, I know. The reported data on the incidence of the tax aren’t perfectly consistent. Please cut me some slack.)

Elite institutions were the target of the tax—those with large endowments that are building up tax-free rather than being spent on educational services and doing research. Indeed, some tax proponents have said that well-to-do colleges effectively operate tax-free hedge funds. In 2015, tax professor Victor Fleischer wrote in the New York Times that “instead of holding down tuition or expanding faculty research, endowments are hoarding money.”

The fact that the tax raises little revenue is, therefore, beside the point. The congressional intention was to change behavior.

The Negatives of the Tax

The endowment tax has many problems, including the following.

1. The small number of colleges currently paying the tax is a misleading measure of its effects. The compliance costs—doing the calculations and the planning to ensure that the tax doesn’t apply—or at least is minimized—can be staggering. (Think of the cost of planning to avoid the estate tax.) If the goal is to get colleges to devote more resources to education and research, does it make sense to require them to spend more on tax professionals? As a tax lawyer, I’m inclined to say Yes, but in my capacity as a citizen, I think that’s a terrible incentive.

2. The dollar figures in the statute aren’t indexed for inflation, which means that, as time goes on (and assuming Congress doesn’t modify the statute), more schools will become liable for the tax—unless they take remedial action. That also means spending more on planning.

3. The tax is an example of what in tax circles is called a “cliff effect” (not a good thing). The tax is inapplicable if the fair market value of investment assets is $499,999 per student. But if that figure goes up by one dollar per student, BOOM, the tax may apply in full force.

4. In form, colleges pay the tax, just as corporations pay the corporate income tax. But everyone except Bernie Sanders knows that the economic burden of corporate tax is borne by some combination of investors, employees, and customers—not the targeted corporations, which are legal fictions. Economist Douglas Holtz-Eakin has similarly argued that “in the near-term, the students and university employees will bear the brunt of the [endowment] tax.” Is that desirable?

5. The endowment tax may look like a tax on income, but it’s not. The base of the tax is only net investment income, which is determined in much the same way as for private foundations. (The details are blessedly beyond the scope of this essay, but the term includes capital gain as well as interest and dividend income, less the expenses of earning that income.) The fact that expenses associated with providing educational services almost certainly exceed revenue from those services doesn’t matter. When all income and expenses are considered, the tax can apply to institutions that lose money during the year.

6. The tax undercuts the appropriate goal of building endowments to provide for the inevitable years in which investment markets crater. (The National Association of College and University Business Officers reported that colleges had a negative 8 percent return on endowments for fiscal year 2022.) An endowment helps to get a school through the down years. Being stuck with tax liability simply because there is net investment income in a particular year doesn’t help in doing that.

The Endowment Tax in the Future

Is the endowment tax the camel’s nose under the tent? Could Congress (with the backing of the administration) go even further and impose a tax on the value of a college’s endowment, not just the net investment income—or the value of a college’s property more generally? Could Congress change the definition of “applicable educational institution” so that more colleges would be subject to the tax? Could Congress dramatically increase the tax rate? The answer to those questions is probably Yes. There is no applicable limiting principle in the Constitution. Congress called the endowment tax an “excise”—correctly, I think—and the Constitution requires only that excises apply to the same base and at the same rate from state to state. The endowment tax meets that uniformity requirement, and so would those possible extensions of the tax.

But there is a serious issue here, one with constitutional overtones: for some officials, the endowment tax has an ideological underpinning. Donald Trump and J.D. Vance have spoken to expand the tax, using it to attack “wokeness” in higher education. The president has proposed the creation of a free online, woke-free “university” to be funded by an expanded tax on university endowments. (Other parts of the president’s agenda are similarly motivated.) In 2023, then-Senator Vance proposed legislation to increase the endowment tax rate from 1.4 percent to 35 percent for private universities with at least $10 billion in investment assets. In introducing his bill, Vance referred to taxpayers’ “mass subsidy . . . that has metastasized into the most corrupt, and one of the most politically hostile organizations in the U.S.—and that is elite colleges.”

The goal of the administration is clear: to attack institutions it views as filled with “Marxist maniacs” (the president’s phrase) and “the enemy” (then-Senator Vance’s characterization).

I defer to no one in my dislike of wokeness, but it’s a bad idea to have the federal government attacking educational institutions for permitting disfavored views. If a college is nothing but a platform for political indoctrination, challenge its tax-exempt status. But despite what you may have read, no elite university is tainted with wokeness from top to bottom. Yes, even departments in the hard sciences and engineering have overdone wokeness in hiring and promotions, but it’s hard to see how a course in physics or a research lab is going to be excessively woke.

In any event, the idea that an institution should be taxed because politicians think it’s too woke should make all who care about academic freedom nervous. (We should be similarly nervous about any proposed federal mandates requiring wokeness.) I’ll leave to First Amendment scholars the question of whether an anti-wokeness motivation for a tax violates the Constitution. But, even if constitutional, it’s not something Congress should do.

Of course, the government can appropriately consider an institution’s disregard of legal requirements—such as those affecting preferences in hiring and promotion—in making awards and imposing penalties. But that doesn’t mean a general animus against wokeness can justify a federal tax.

A final point: The Supreme Court concluded in 2012, in the first Obamacare case, that penalties aren’t taxes. If the endowment “tax” is intended to penalize arguably bad behavior, maybe we should stop using the language of taxation to justify it. Let’s call it what it is and then argue about its legitimacy.

Erik M. Jensen is the Coleman P. Burke Professor Emeritus of Law at Case Western Reserve University.