Abstract
Prior studies of means-testing in college financial aid formulas have analyzed the disincentives to save attributable to the inclusion of assets in the formulas. Such disincentives are only half of a standard incentives-insurance tradeoff. When income is uncertain, a financial aid formula that conditions aid on assets and income provides insurance against that uncertainty. Using a stochastic, life-cycle model of consumption and labor supply, we show that the insurance value of financial aid is substantial. Compensating families for the loss of the income- and asset-contingent elements of the current formula requires additional aid sufficient to reduce the net cost of attendance by 11 to 22 percent. This compensating variation is net of the negative welfare conse- quences of the disincentives to work and save inherent in the means-testing of financial aid. Replacing just the financial aid tax on assets with a lump sum also reduces welfare.
