Do Business Cycles Affect State Appropriations to Higher Education?

• Author: Humphreys, Brad R.

Brad R. Humphreys [*]

Spending on higher education constitutes an important and increasing portion of state government spending and a major source of operating funds at public institutions of higher education. Anecdotal evidence suggests that state appropriations are subject to cyclical variation. An analysis of state appropriations to higher education, enrollment in two- and four-year public colleges and universities, and state-specific measures of the business cycle for all 50 states over the period 1969-1994 shows that state appropriations to higher education are highly sensitive to changes in the business cycle. A 1% change in real per capita income was, on average, associated with a 1.39% change in real state appropriations per full-time equivalent student enrolled. This implied decline in state government funding, coupled with the increase in enrollment in higher education during recessions reported by Betts and McFarland (1995), suggest that public institutions of higher education may experience fiscal stress during econom ic downturns. These results also suggest that state legislators and education policymakers should reconsider their higher education funding policies during recessions in order to allow public colleges and universities to provide dislocated workers with access to quality education and training during these periods.

1. Introduction and Motivation

   Business cycles affect higher education in a number of important ways. Anecdotal evidence from college admissions officers and administrators, as well as empirical evidence on the behavior of students and institutions of higher education, suggest that enrollment in higher education is countercylical. For example, Betts and McFarland (1995) recently showed that enrollments in community colleges are highly responsive to changes in local labor market conditions. These authors found a 1% increase in the unemployment rate among all adults associated with a 4% increase in enrollment at community colleges in a large panel of community colleges across the United States. Leslie and Ramey (1986) found a similar relationship between economic conditions and enrollment using data aggregated to the regional level.

   This paper examines the relationship between state appropriations to higher education and state-specific measures of business cycle conditions in order to better understand the effects of the business cycle on government funding of higher education. [1] I further investigate the relationship between the business cycle and state government appropriations to higher education reported by Betts and McFarland (1995) and Leslie and Ramey (1986). Both of these studies aggregated state and local government appropriations to higher education to the regional and national level. While data aggregated to the regional and national levels are readily available, decisions about government funding to higher education are made at the state and local levels, and these decisions may be affected more by local economic conditions than by aggregate economic conditions. If the timing of turning points in the business cycle varies across states, then aggregating government appropriations data across states may obscure important sta te-specific phenomena.

   Most research has focused on the effects of economic conditions on demand for higher education. One notable exception is Leslie and Ramey (1986), who examined the relationship between enrollment, business cycles, and state appropriations to higher education using regional appropriations and enrollment data and a national measure of business cycle conditions. That study found a procyclical relationship between the NBER coincident index and regional-level government appropriations to higher education. For one region, the estimated elasticity of appropriations with respect to changes in the coincident index was three, suggesting that a 1% change in the NBER coincident index was associated with a 3% change in appropriations to higher education in that region. This study also highlighted the complex relationship between state funding for higher education, enrollment, and business cycle conditions by documenting a statistically significant relationship between enrollment and state appropriations at the regional le vel, although they found that the appropriations--enrollment relationship weakened after 1977.

   Betts and McFarland (1995) also describe, in an informal way using aggregate data, a procyclical relationship between the business cycle and funding for higher education. These authors report that aggregate state and local government appropriations to higher education fell in the years 1971, 1975, 1980-1982 as well as in several years in the early 1990s; all of these years are either coincident with, or immediately following, years when the NBER Dating Committee has identified a cyclical downturn in the economy. The transmission mechanism linking business cycles and government appropriations to higher education during recessionary periods seems clear: recessions reduce tax revenues; state and local governments, most of which operate under legally required balanced budget restrictions, reduce appropriations to institutions of higher education, as well as other types of expenditures, in order to balance their budgets.

   Betts and McFarland point out that these cyclical patterns of government support for higher education may place tremendous financial pressure on institutions of higher education during economic downturns, because the cuts in government funding happen at the same time enrollments are increasing. These financial crises affect community colleges because the open admissions policies of these institutions make them attractive to unemployed workers displaced by the recession. Public four-year institutions of higher education may also be adversely affected because these institutions typically rely on government appropriations to offset a large fraction of their operating and general expenditures.

   An alternative explanation for rising enrollments and declining government appropriations discussed by Betts and McFarland is increasing returns to scale. If institutions of higher education operate at levels of enrollment where there are economies of scale, then these institutions could lower average operating costs by increasing enrollments that could in turn lead to lower government appropriations. In the case of community colleges, Betts and McFarland report that interviews with community college presidents revealed that these institutions operate at or above capacity nearly all of the time and that increases in enrollments were typically associated with increases in average operating costs. In the case of four-year colleges, the existing empirical evidence suggests that most institutions of higher education operate at enrollment levels where there are constant returns to scale, indicating that increases in enrollment would not lead to decreases in average operating costs, although there is a great deal of disagreement in this extensive literature. However, recent research in Getz, Sigfried, and Zhang (1991) and Koshal and Koshal (1999) find no evidence of increasing returns to scale in institutions of higher education. This evidence makes it unlikely that increasing returns to scale can explain the behavior of government appropriations to higher education during periods of rising enrollments.

   The results presented in this paper suggest that state appropriations to higher education are quite sensitive to business cycles. The estimated elasticity of state appropriations per Mi-time equivalent (FTE) student is 1.39, suggesting that a 1% change in real personal income per capita is associated with a 1.39% change in real appropriations per FTE. Further, after accounting for the countercyclical behavior of enrollments, it appears that real appropriations fall more during recessionary years than they rise during expansionary years.

2. Empirical Methodology and Data

   The financing of higher education takes place in a complex, dynamic setting. Institutions of higher education raise revenues from tuition and fees, grants from all levels of government, research support from public and private grantors, and other sources. Revenues generated from tuition and fees depend on enrollment, which in turn depends on complex decisions made by households. Government appropriations to higher education are determined by legislators and bureaucrats who have complex objectives and agendas.

   Considerable variation exists in the process by which states determine the funding of public higher education. The National Association of State Budget Officers (1996) surveyed states in order to document this process. Based on the results of this survey, the processes by which states decide on appropriations to higher education appear to be idiosyncratic. Few patterns emerge. Eleven states reported operating on a biennial budget cycle, and initial budget requests originated from a variety of sources. Institutions made the initial budget request in 12 states; higher education regulatory bodies like boards of regents or boards of higher education made the initial budget request in 15 states; state budget offices made the initial budget request in five states; the governor made the initial budget request in six states. The remaining states were not included in the survey. In each case, the budgeting process involved oversight by many other areas of state government. Several states reported that the governor ex ercised line-item veto power over appropriations to higher education.

   "Formula-based funding" represents one commonly reported feature of the budgeting process. [2] Initiated in Texas shortly after the second World War, funding formulas were used in 16 states in 1964. By 1992, 33 states reported using some sort of funding formula as part of the budget process. However, this increase in the use of formulas has not been a process of steady...