The Student Loan Tax
As student loan debt passed the $1 trillion mark, President Obama, speaking at Chapel Hill yesterday, called the upcoming interest rate hike on student loans a tax. He didn’t tell the half of it. Congress’ dirty secret is that the government makes a huge annual profit on student loans. According to the scrupulously nonpartisan Congressional Budget Office, $37 billion will flow IN to Treasury from student loans made this fiscal year at the 3.4% rate (on a net present value basis and net of about $1.5 billion to administer them.) The President’s current dispute with Congressional Republicans is about whether to increase this annual profit next year. The interest rate that students pay on the basic “subsidized” loan is slated to rise from 3.4% this year to 6.8% next year, unless the lower rate is extended by Congress.
How does the government profit from student loans? In two words, yield spread.
What about the credit losses, you ask? While many loans go into default (about 10% projected for 2013 loans), credit losses are relatively modest. The Education Department assumes it will collect between 75% and 80% of defaulted loans (on a discounted NPV basis), using its supercreditor powers, especially wage garnishment and tax refund intercepts. There is no statute of limitations on student loans, and even bankruptcy discharge is difficult. The $37 billion Treasury profit for FY2012 is after allowing for estimated credit losses in the $5 billion range.
Treasury even profits on the loans made by banks and guaranteed by the government, although bank loans are costlier and less efficient than direct loans. Guaranteed student loans generate revenue because the guarantee fees paid by lenders to Uncle Sam greatly exceed losses net of recoveries. In other words, if student loan interest rates were set on a break-even basis, they would be much lower, perhaps around 1.5%, albeit rising as Treasury rates rise. Recently adopted loan forgiveness programs, and the expansion of income-based repayment, may increase the cost (or reduce the profit) of the student loan program in the long run, but so far CBO scores those loan modification costs as minimal.
So what are the President and Congress arguing about? They are arguing about how much of the federal deficit to plug with student loan interest money. The current “baseline” budget assumes that the rate will jump up to 6.8% for 2013 loans, yielding another $30 to $40 billion return to Treasury. Congressional Republicans see the expiration of the rate cut as a given, and any extension as increasing the deficit (by reducing student borrowers’ subsidy to all other federal programs). They are demanding offsetting cuts in other programs before agreeing to keep the rate at 3.4%.
Interest rate policy has huge consequences for the American middle class. Charging an above-cost rate in order to fund Pell grants for low-income students, for example, is justifiable on a theory akin to equity financing of human capital. It is a cross-subsidy from successful college grads to needy college students whose future success is uncertain. A similar case can be made for expanded subsidy and loan forgiveness programs for college graduates in low-paying but socially necessary occupations. On the other hand, the rationale to tax student loan borrowers to fund tax cuts for the wealthy, subsidies for energy and agriculture or other unrelated federal expenditures, is less clear.