The Governor's Dilemna: Can We Afford Public Education?

President Obama met this week with the National Governors Association to discuss, among other things, the impending federal spending cuts and the expansion of existing Medicaid plans that are phasing in this year as part of the Affordable Care Act.  State governors are particularly interested in these topics because they could have such a significant effect on state budgets: Medicaid, which is largely funded through Federal reimbursement, still makes up approximately 9% of total state spending.  The governors are concerned that the Federal government, as part of its goal to reduce the deficit, might find it convenient to push more of the funding responsibility for Medicaid onto the states themselves.  The governors warn that the recent economic downturn has severely weakened state and local fiscal standing, and that any increased burdens from a spending program as large as Medicaid would send them over the edge.  Well, what if there was an even larger spending program that was devouring a quarter of state tax revenue and producing no measurable economic benefits?

Public k-12 education is often put forward as a fundamentally sound economic investment and we are constantly told of how lack of education funding is leaving our children behind their global contemporaries.  However, more and more data is piling up to make us question this long held belief that public education is actually a good economic investment.  Let me first stay that I am huge proponent of education for our youth and that not only did I attend public school my entire life, but my mother was also a teacher in a public school for 15 years.  I make that qualifier because public education is an incredibly sensitive topic in American political discussion and it is not my intention to provoke an ideological debate, but rather to illuminate some alarming trends in the fundamental tenant of public education: that a well educated population is a more productive population and, therefore, public spending on education is a sound economic investment.

There are two alarming trends in public education today: 1) the annual cost of public education per student is rising rapidly; and 2) the median income for an American household is declining rapidly.  Those two trends do not bode well for the economic value of public education spending.  In order to get a more detailed understanding, let’s look at the data:

The figure above plots the real (inflation adjusted) cost of education versus median household income each displayed as a percentage of the year 2000 figure.  There are two key takeaways from this chart: 1) beginning in 1993, America began investing more heavily in public education, but median income increased proportionally to support the increased investment; and 2) starting in 2000, median income began declining but public education investments continued to increase, defying all economic fundamentals.  The reality of the situation is startling: in 2011, Americans earned the same income as they did in 1990 but received 33% more in educational spending.  That is $36,000 more spent per student with no measurable increase in economic productivity.  And that is only at the K-12 level: more Americans than ever are also attending higher education institutions with tuition rates at all-time highs.  Let me stress that point: the cost data above only included k-12 and not higher education, while the income data includes the economic benefits from both high school graduates and college degree holding graduates.  Plus, we are comparing individual education expense to household income when the average household has more than one adult.  And the economics still look bad!  That sounds like trouble, but is public education really a bad investment?

To answer this question, I have put together a pretty simple analysis. My methodology is as follows: for each student “vintage,” I have assumed that they go through a 13 year (k-12) schooling period followed immediately by a 35 year working career (implies a retirement age of ~55).  For every student, I assume that all 13 years of education cost the same amount and that the student’s earnings are equal for each of the 35 years of their career.  In each year, I assume that the public recoups a 15% income tax on all income, which is roughly in line with the expected effective tax rate for a middle income American.  Notably, I assume that this entire tax revenue is dedicated to recouping investment in public education and no other government functions.  Finally, in order to account for the time value of money, I discount each payment at a rate of 3.5%, which is selected to reflect the target real GDP growth in the USA (and globally).  Let me take 1990 vintage for example: education cost for the 1990 vintage student was $8,509 annually or $110,621 for all years k-12.  Using a 3.5% discount rate, the cost of the 1990 vintage’s k-12 education at the time of graduation would be $137,111.  The median income for a person in 1990 was $49,950, so tax revenues each year would be $7,493 or $262,238 over the 35 year working career.  Using a 3.5% discount rate, the value of that tax revenue at the time of graduation would be $149,855, which compares favorably to the cost of education of $137,111.  This would imply a positive investment outcome for the public, all else being equal.  Here is how that same calculation has evolved over the past 20 years:

A key takeaway here is that the investment opportunity turned negative for the public starting roughly in 2002.  That isn’t overly surprising considering we already knew that income growth stalled in 2000 while costs continued to surge, but the magnitude of the losses are pretty staggering: by 2010, the public is losing almost 25% of its investment.  Or put another way, in order to make public education a defensible investment on the same terms as it was in 1990, we would need to reduce the amount we spend on education by 25% back to its 1990 levels.

One final note on this topic is the choice of a 3.5% discount rate.  The discount rate is enormously important in determining whether or not public education (or any government spending, for that matter) is a viable investment.  Many people, particularly congressmen, would argue that we should use the Treasury rate (the rate at which the US government can borrow money) in determining the discount rate for financial decisions such as this.  This view is incorrect in today's global capital markets: we can use the Treasury rate as a proxy for the expected real GDP growth, but not as a fundamental replacement.  In today’s free global capital markets, resources will almost always flow to where they can be most productively put to use.  Resources, in this sense, constitute anything with economic value: monetary savings, commodity goods like coal and oil, as well as human capital in the form of immigration (the most constrained resource in today’s market).  That means that everyone looking to utilize capital (borrowing money, for instance) is governed by the same global cost of capital.  That cost of capital is the expected real (inflation adjusted) growth of global GDP.  Thus, when determining whether an investment is viable or not, we need to be assuming that our cost of capital is the same as our global competitors because that’s how global investors will view it.  This is true whether you are an individual business owner, a corporate CEO or the United States Treasury.  So, in a world where developing economies are growing at rates in excess of 7.0% annually and Germany has consistently delivered growth above 3.5% annual, we cannot be assuming that America will be able to borrow at 2.0% interest forever.