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“Income-Driven” Loan Repayment? Maybe We Should Just Raise Taxes

  • 3 September 2019
  • By Nate Johnson

A guest blog kindly contributed by Nate Johnson, Principal Consultant of Florida-based Postsecondary Analytics

Income-driven or income-contingent student loans and their policy cousins have become popular financing mechanisms for higher education in English-speaking countries over the last few decades. Australia led the way starting in 1989 by essentially building student loan repayment into its tax system. If you take advantage of the government’s offer to pay your tuition, then you agree to pay a higher tax rate after you finish. More recently, England and Wales (but not Scotland or Northern Ireland) have entirely switched from the universally free tuition system that was in place when I was a foreign student at Durham in the late 80s to an entirely tuition-financed model. Now students are asked to pay the full cost of their education, but since most cannot afford it, they do so through loans that they pay back if and when their income permits. (With repayment rates far below 100%, this still left the government as the major subsidizer, but with the neat political advantage when the program began that the cost was some future parliament’s problem.)

Given its decentralized system based on state- and privately-operated institutions, the U.S. has the most baroque approach (or approaches) to income-driven repayment. While the mix of tuition and state support varies widely across the country, the $90+ billion the federal government provides annually in student loans is by far the largest source of financing for postsecondary education, much higher than the support received from state and local governments, and more than three times the amount of federal student grant aid available. But unlike the U.K. or Australian governments, the federal government in the U.S. has (mostly) stayed out of state and institution tuition rate-setting.

The U.S. introduced the first income-based repayment option for a subset of federal loans in 1994 and since then has expanded the program and made the terms more generous to the point that about a third of all borrowers and half of all dollars are now in income-based repayment. In principle, participants are required to repay no more than 10% of their income above a certain threshold, with any remaining forgiven after 20 years. Still, since it requires borrowers to opt in and to annually recertify participation, it probably still fails to reach many of those who would benefit most.

At the same time, the forgiveness provisions are also becoming a hot mess. With interest rates fairly high, the balance forgiven at the end of the payment period could end up being more than the original amount borrowed, and it’s unclear if that would be treated as a windfall of taxable income. And for the large number of people who thought they qualified for a shorter 10-year repayment period in exchange for public service as teachers, prosecutors or other government workers, most are finding out they missed some step in the murky process, which was left largely to loan servicing middlemen whose incentives lie elsewhere. As of March 2019, only about 1.2% of the applications for forgiveness under this provision had been approved.

States and individual institutions have also tried to get into the income-contingency business. A few years ago, when states were still suffering from the budget shortfalls of the Great Recession, there was a rash of “Pay it Forward” proposals to fund current education operating costs with students’ future income. Oregon’s was the most notable of these, but was eventually just too complex for a single state to enact, given how much students move around after graduation.

More recently a handful of colleges, including state-supported Purdue University in Indiana, have started to offer students “Income Share Agreements” in which the university foregoes tuition in exchange for a percentage of students’ future income (higher for English majors, lower for mechanical engineers).

The idea that the cost of students’ education should be linked somehow to their future earnings is intuitively appealing. It solves many problems. There is a time lag between when the money is needed and when people have it that a loan system can bridge. Those who get the expected benefit of higher income pay for the system, while those who didn’t, don’t.

But there is another financing mechanism with the same advantages. It also has less additional paperwork, no need for “servicing” contractors, and fewer opportunities to game the system or fall through the cracks.

It’s the progressive income tax. The vast majority of those in higher tax brackets have directly benefited more from postsecondary education than those in lower brackets. And even the rare individuals with high incomes who did not get college degrees probably have customers or employees who did. Higher average levels of education increase the incomes of entire cities and states, not just the individuals who have them. A progressive income tax is the perfect way to capture enough of that incremental income to keep the system going in a virtuous cycle. There’s no need for elaborate public service forgiveness provisions, since teachers and other government workers generally don’t earn enough to pay the highest marginal rates to begin with.

As states recovered from the recession and as the left wing of the Democratic party gained strength, proposals like Bernie Sanders’s to make four-year college free replaced the wave of more modest and complicated “Pay it Forward” mechanisms earlier in the decade.
Having seen how badly even well-intentioned income-based programs can go awry, I am sympathetic with this movement, but with one big caveat: only if we fund it with a progressive revenue source. It is one thing to propose a free college program at the federal level or in a state like New York, where a progressive income tax could ensure that the costs are borne primarily by those who benefit. It is entirely another in states like Florida or Washington, where education budgets rely heavily on sales taxes or other regressive sources. In states like those, “free college” could end up being yet another wealth transfer to the already-privileged.

But with that caveat, maybe we should just raise taxes.

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