The economic value of a law degree

(From September 26, 2008, What is the NPV of a JD? , Posted by Karl Okamoto )

Is law school a good value? That’s the question I ask my students to figure out, hoping to teach them a bit about finance. Using crude numbers, the answer looks like a resounding “yes.” As they say in the investment business, it looks like a “three bagger.” Even if you have to put $230,000 in, you get over $700,00 back!

What crude numbers, you may ask? Well the Wall Street Journal reported recently the median salary for persons holding just a BA has slipped to $47,240, ... Labor Department numbers show the median salary for lawyers at $106,120.

... So, as I say to my students, think of your law degree as an annuity. It represents a payment stream that lasts for a career (say 40 years) that equals the spread between what you would have earned without your law degree versus what you can with it.

Using the median salary numbers, that spread is almost $60,000. Discounted at 8%, the annuity has a present value of over $700,000. The present value of three years of tuition (at $40,000 a year), books and foregone salary (at the median) is about $230,000. So, as your stockbroker used to say about Lehman bonds, a “no brainer!”

(Accounting for taxes:

The salary differential will face a high marginal tax rate. Let's say 50% (future federal upper income marginal tax rates - including social security payments, future state tax rates).

Present after-tax value of annuity: by your base numbers, over $350,000.
The median salary over the three years that is foregone to get a J.D. faces lower current average tax rates; let's say 25%.

This gives an after-tax NPV at 8% of about 98,000.
I believe that the $120,000 in tuition comes out of after tax dollars (I don't think folks get to carry-forward a tuition tax deduction until they're earning again). After-tax NPV at 8% of about $111,000.

Net after-tax NPV of decision to get JD then $140,000. (That's noticably less than the naive method of taking your $700,000, subtracting $230,000 to get $470,000 and then applying a 50% marginal tax rate to get $235,000.))

So what’s all the brouhaha about misleading students about the value of a law school education?
Well, here is where class gets fun.

According to the Department of Labor, the distribution of annual lawyer compensation in 2001 was:
first 10%, less than $45,000;
next 15%, $45-60,000;
next 50%, $61-137,000;
next 15%, 137-145,000;
and top 10%, over $145,000.

Now if you are standing in the ex ante position, i.e., where law school applicants stand, how do you decide what salary statistic to use in your present value model? Might it not be rational to use the “expected value” that comes from this distribution? You might immediately object that we need more data. True, while we can ballpark the first four quintiles, how do we come up with a value for the top 10% contingency? And if we already know (which I do not tell my students) that the “mean” salary was $92,000, isn’t that our answer? Mathematically, yes, but the exercise is revealing.

So much of one’s answer to the question of law school value depends on how you envision the top quintile. So the bi-modal distribution in starting salaries that Bill Henderson has identified has serious implications. The more skewed the distribution, the less helpful means and medians become.

None of my students assumed they would climb atop the Olympus of the AmLaw 100 (funny, I assume a few will). But they revealed a commonly-held notion of “average” incomes that far exceed what the numbers show us is realistic. It appears that my students, as a group, have a very similar notion of what lawyers make on average. Unfortunately, it happens to be more than what at least 90 percent of lawyer actually do earn.