Question

In a paper appearing in the National Tax Journal, titled “The cost of complexity in federal student aid: Lessons from optimal tax theory and behavioral economics”, Susan Dynarski and Judith Scott-Clayton examine the current federal methodology for determining eligibility for financial aid. At the time they wrote, it was true that “The FAFSA, at five pages and 128 questions, is lengthier than Form 1040EZ and Form 1040A. It is comparable to Form 1040 (two pages, with 118 questions).” Why might the complexity of the FAFSA reduce efficiency in the distribution of financial AID?  

Answer 1

The federal system for distributing student financial aid rivals the tax code in its complexity. Both have been a source of frustration and a focus of reform efforts for decades, yet the complexity of the student aid system has received comparatively little attention from economists.

The aid system's treatment of student earnings is deeply flawed, from both an equity and an efficiency standpoint. The aid formula taxes student earnings (over an income protection allowance of $2,550) at a rate of fifty percent. 25 This is a very high tax on students’ work effort, and may serve to discourage work. Further, the tax falls more heavily on low-income students, since both work effort and earnings drop as parental income rises. While 73 percent of students from lower-income families have positive earnings, the figure is 62 percent for students from upper-income families.26 Median student earnings are $2,730 for the lower-income group, as compared to $2,231 for the upper income group.

To isolate the relationship between student earnings and aid, we simulated an approach that keeps the current formula intact except for the tax on student earnings. Relative to the current system, the distributional impact of this change is to increase average Pell Grants by about $500 for those from families with incomes between $15,000 and $45,000, and increase eligibility for subsidized loans by a couple of hundred dollars in the upper income ranges.

Though this might be a desirable change, it is clearly expensive. An approach that would keep costs at their current level, reduce compliance costs, and reward students for working would be to assume that all students contribute a lump sum to their schooling expenses. This does not tax students' work effort on the margin, yet has them contributing to schooling costs.