Transforming the Way We Finance Higher Education

In my various posts this week, I've focused on some of the problems that afflict our current system for financing higher education.  The new approach I've suggested would ensure that every American could pay for college on the basis of income-contingent federal loans. 

A comprehensive income-contingent-lending (ICL) program would transform the way we finance education and training in this country, much as social security transformed the way we finance retirement. In fact, such a program might be thought of, roughly, as social security in reverse. Instead of paying-in over one’s working life to finance retirement (i.e., once one’s human capital is depleted), an ICL program would allow a young person to build human capital up front and then spread the cost over his or her working life. Like social security, an ICL program would allow Americans to cover risks they couldn’t otherwise cover on their own, and it would take advantage of the withholding system to simplify and streamline administration.

The ultimate investment we can make as a society is an investment in the education of our young people. Sadly, our existing system for financing higher education is hopelessly inefficient and complex – and this, at a time when the benefits of higher education have never been more clear. We can do better. A comprehensive ICL program would be like a GI bill for everyone, but one that would also pay for itself over the long term. Social security transformed retirement by changing the way we finance it. It’s time we do the same for education.

 

Precedents for Income-Contingent Lending, at Home and Abroad

Earlier this week, I suggested that we consider a new system of income-contingent lending (ICL) to ensure that every American can cover the cost of higher education.  Surprisingly, the notion of income-contingent lending, now viewed as a liberal idea, was originally conceived by a well-known conservative economist. Milton Friedman suggested a federal ICL-style program to help finance professional education as early as 1945, and he extended the proposal ten years later to cover virtually all higher education.

In Friedman’s view, the market system on its own produced “underinvestment in human capital” as a result of “an imperfection in the capital market.” Private lending for investment in human capital (education) was far riskier than for investment in physical capital (plant and equipment) because the former could not be collateralized – i.e., because slavery was prohibited. The government, however, could effectively collateralize human capital given its power to tax future earnings. As a result, a federal ICL program would, in Friedman’s words, “make capital more widely available [to students] and would thereby do much to make equality of opportunity a reality, to diminish inequalities of income and wealth, and to promote the full use of our human resources.”[1]

The economist (and Kennedy advisor) James Tobin not only supported the idea of income-contingent lending, he actually helped put such a system in place at Yale University in the early 1970s. Yale’s Tuition Postponement Option obligated borrowers to pay 0.4% of their adjusted gross income, for up to 35 years (or until their cohort had repaid its debt in full), on each $1000 of tuition postponed (borrowed). The repayment schedule included both a minimum ($29 per $1000 borrowed) and a maximum (150% of principal, scaled up year by year according to a variable interest rate). The program was ultimately terminated in 1978, in large part because of problems with collection and unexpectedly high payments required of high-income graduates. Still, the program offers important clues about how best to structure a federal ICL program. It also helped many students from low-income families afford a Yale education, including one particular Yale law student named Bill Clinton.

In fact, it was probably no coincidence that as President,Clinton initially favored an income-contingent approach in reforming the nation’s system of financial aid. Yet his ICL proposal faced strong opposition from private lenders. In the end, the watered-down version of an ICL plan that President Clinton signed into law in 1993 was so weak that it had barely any effect on student borrowing and has gone largely unnoticed.

The ICL idea was employed with considerably greater success – and fanfare – abroad. Beginning in the late 1980s, a number of countries adopted ICL programs to help cover university tuition, including Australia (1989), New Zealand (1992), and the United Kingdom (1997).[2] Although many of these programs appear to be working well, it is doubtful that any would be directly transferable to the United States, given substantial differences in country context. Most of the foreign programs, for example, exhibit only a weak market orientation – in most cases charging no interest on loans. The sums involved are also much smaller than they would be here, since the U.S. is effectively in a league of its own with respect to tuition levels. Still, the spread of income-contingent lending overseas is important, reflecting the broad appeal of the idea and providing a solid empirical basis for determining the best ways to structure a program here at home.

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[1] In fact, Friedman’s proposal went further than the one I outlined in my last post, since Friedman's plan would have required students to repay to the federal government a fixed percentage of their future income indefinitely, rather than simply to repay their own individual loans. He characterized this as an equity arrangement (instead of debt), whereby the government would “’buy’ a share in an individual’s earning prospects.” To simplify administration, he recommended that “the appropriate unit of government to make funds available is the Federal government….” See Milton Friedman, “The Role of Government in Education,” in Economics and the Public Interest, ed. Robert A. Solo (New Brunswick: Rutgers University Press, 1955).

[2] This paragraph draws on Yael Shavit, “Promoting Equal Access to Higher Education: the Past and Future of Income Contingent Loans,” unpublished draft, January 2007. While program details vary from country to country, Australia’s program is reasonably typical: students can borrow up to the cost of tuition and, after graduation, pay 4-8 percent of their income each year until the principal (adjusted for inflation) is fully repaid. No payment is required in any year in which the borrower’s income falls below a threshold level, which currently stands at about AU$38,000 (approximately US$30,000).

Promoting Investment in Education through Income-Contingent Lending

In yesterday’s post, I identified a number of problems with our current system for financing higher education, and I promised that I would suggest a new approach.

The option I think we should strongly consider is to ensure that every American can finance college or graduate-school tuition (or the cost of job training) with a special income-contingent federal loan. The loan would have an extended term (up to 30 years, like a mortgage) and would defer or potentially forgive interest payments for any year in which the recipient’s household income fell below a pre-specified trigger.

Income-contingent lending for education is certainly not a new idea. In the past, its intellectual champions included both Milton Friedman and James Tobin, two Nobel laureates in economics from opposite ends of the political spectrum. Among politicians, key supporters have included Congressman Thomas Petri, Republican from Wisconsin, and former Senator Bill Bradley, Democrat from New Jersey. The idea has broad appeal because it addresses an important weakness in our market system.

Just as limited liability law encourages investment in financial capital, an income-contingent-loan program would encourage investment in human capital by limiting the investor’s downside risk. In my view, it would represent a vital – and ultimately self-financing – policy innovation for the information age.

In Need of a New Approach for Financing Higher Education

Over the course of this week, I want to discuss student loans, including the inadequacies of the existing system for financing higher education and a potential strategy for improving it.
 
As I see it, the current patchwork of programs for covering college tuition makes little sense. The system is maddeningly complex. What’s worse, it does a poor job of managing risk and assessing need, and it actually discourages household saving. Most student loans, moreover, require borrowers to bear the heaviest burden when their earning power is lowest. For such a major lifetime expense, it is imperative that we do better.

I’ll suggest an alternative approach in my next post. First, though, I want to focus on the nature of the problem we need to solve.