Funding undergraduate higher education

• In HEPI’s 20th Anniversary Collection, Dr Mark Corver, Managing Director and co-founder of dataHE, set out the status quo of university funding. Commenting on that piece, he wrote: ‘With the existing system now deep in crisis, policymakers might well find a rapid and bold resetting of the system is worth the risk.’
• This extended piece is his vision for what that resetting may look like.

The funding system for undergraduate teaching in UK universities has drifted into crisis. Bolder changes might now be worth the risk. One option is to recast the system as students investing in their education through an advance of their anticipated higher pay. Graduates would pay much more than now, but for a much shorter time. Universities price courses in terms of this future salary share and share in the financial risks of things not working out. Government provides the infrastructure and working capital, together with targeted tax relief, but with an aligned and broadly self-funding system can be relaxed again about leaving universities to grow opportunities as they see best.

In July 2023 HEPI kindly included in their twentieth anniversary essay collection my analysis of why the UK HE sector could be seen as being in a funding crisis. A real one this time.

It set out how high inflation had ignited the long-smouldering problems in the university funding system for full-time undergraduate teaching. Students not getting the places they want, or resentful of the costs if they do, or increasingly both. Universities being forced to either select on ability to pay, or cut the quality of provision, and often an uneasy mix of both. And governments feeling trapped by uncapped escalating mammoth expenditure coming with a design that manages to combine keeping its considerable generosity well hidden whilst offering no sense of control over what the money buys. After demonstrating that none of the responses available to universities look like they might work, I suggested that the moment when a more comprehensive rethink of how we fund higher education might be worth the risk was fast approaching.

Since July the contours of the 2023 admissions cycle have become clear. They are not encouraging. A further fall in the proportion getting their firm (‘first’) choice, taking this important measure of choice back to levels last seen in the highly constrained 2011 entry year. This playing a part in the key 18 year old university entry rate recording the first year of back to back falls. Young people in England seem to be the focus and there the benchmark measure of widening participation for the sector, the entry rate of young people living in the most-underrepresented areas, has fallen materially for the first time in 25 years.

One of HEPI’s many laudable principles is not to encourage contributions that engage in the easy sport of identifying problems without also putting forward at least an idea for how they could be resolved. I did not think that a few lines alluding to a mix of inefficiencies in the existing design together with some giving of ground from all parties could give a new durable model for the future. To redress that, in this piece I sketch out such a model for changing how we fund higher education for students.

It flows from the earlier analysis in that for each party – students, universities and government – it takes away what they most resent and seeks to give them what they most want. For students it takes away the sense of unfairness from decades of debt made unpayable by interest running ahead of repayments, whilst giving them maximised opportunity to go to the broadest possible range of university places. For universities it removes destructive under-funding and frees them to grow students on academic potential as they judge it. For government it removes the problem of uncontrolled spending and gives them new mechanisms to achieve national policy objectives.

There is no magic in this. High-quality university provision is expensive and must be paid for. Ultimately if the growing numbers of graduates do not bear this cost, then their poorer non-graduate peers do. In gaining market and academic freedoms to grow as they think best, universities must be ready to face the financial consequences if they get it wrong. Governments need to give up the hidden ways the current system is quietly favourable to them, most notably recognising that taking a risk on increasing your human capital is a business investment and should benefit from tax relief accordingly.

In brief, it envisages students making a much higher contribution, but over a much shorter period. This is recast as a share of your future higher earnings, and indeed this share is how courses are priced to the student, and debt vanishes. The higher payment rates are supported by a ‘social dividend’ payment the government and more help than now from employers. Universities get freedom to expand as they see fit with sustainable levels of funding, but not all upfront and some dependent on how their graduates do. Government continues to fund the gap between the immediate cost and future earnings. But it gets a credibly self-funding system that is better aligned to wider economic and social priorities such that it can stop worrying about universities.

One of the inefficiencies of the existing funding model is that it has a single presentation for all audiences. The government-to-universities accounting concepts of fees and real interest, which should be behind the scenes, are front and centre of the language to students. To avoid this, the alternative is sketched from the perspective of each main participants: students, universities, and governments.

Students: An advance of higher pay to invest in yourself

For students, tuition fees, interest and decades of debt disappear. Instead, if you think you will earn more from going to university then you can get a salary advance of your anticipated future higher pay, and use this salary advance to invest in the teaching and living costs needed to get there. Higher pay would be anything over the average of what non-graduates in their early twenties earn (likely currently around £22,000). This threshold is set for incoming student cohorts each year and does not change for the duration of their salary advance, giving certainty as to your side of the deal.

The share of the anticipated higher salary becomes the currency in which different university courses are priced. So, you can choose between a university offering a three-year first degree at a 25 per cent share of those future higher earnings, or another course that requires 40 per cent. You form your own view of what is the best value for you. If a university wants a student there is nothing in the system to deter them recruiting you, so choice and opportunity are maximised. Money for living costs could be advanced in a similar way.

The share of higher salary advanced for fees and living costs would be very much higher than the 9 per cent loan repayment rate now. You only repay the salary advance if you earn more than non-graduate peers, so it has the chance of being seen as fair. But the arrangements need to favour graduates in other ways to make the change acceptable as a package. First, the much higher rate is offset by the duration to repay the salary advance being very much lower than the current debt arrangements. Say, 10 years full-time employment. This removes the oppressive feeling of repayment periods stretching for 40 years. For 18-year-old entrants, it gets the deductions behind them by their early thirties. This would typically be before the change to working patterns associated with starting a family, which inevitably weakens the economics of the existing loan arrangements.

Another favourable change for graduates is when they start to repay their salary advance, they find that the government also starts paying them a monthly tax-free ‘social dividend’. This is only if they are working in the UK and is positioned as representing their share of the wider national economic and social return on their investment. This would be highly visible (ideally paid directly into bank accounts) and substantial, averaging across graduates to something like an extra 5-10 per cent or so on take-home pay. For some working in areas of high policy importance to the government, perhaps healthcare, teaching or in certain parts of the country, the social dividend might be higher if the government wanted. Behind the scenes the social dividend is – in aggregate – simply the tax relief on the repayments. It could of course be applied in that way. But this construction probably has higher political and social yield. Graduates’ knowledge of whether loan repayments come from pre- or post-tax income seems weak (so a payroll change would not likely bring political credit), and it offers a ready framework for incentivising non-financial objectives.

Graduates could get further support from employers being able to make salary advance redemptions on behalf of their staff. To encourage this, these are treated like employer pension contributions, not incurring employers NI and deductible as a cost against Corporation Tax. Many employers of graduates might well choose to fully clear the salary advance after a fixed period of years as a tax-efficient way to attract and retain staff, benefiting graduates and government alike. Some might question why employers are not asked to contribute directly. But this overlooks that, through the higher salaries, they are already effectively paying the entire cost and attempts to go further would risk counterproductive incentives for graduates and employers alike.

For graduates the proportion of their salary advance that is still outstanding can be checked at any time, so 90 per cent or 50 per cent say. Importantly, each time a graduate repays the salary advance this figure encouragingly goes down, never up (as now). Like in the current system, repayments stop once the full salary advance is paid back. As the system parameters are set so that almost all graduates will find they repay their salary advance before their 10-year period is up, write-offs are exceptional by design. With no interest you only ever pay back what you took as an advance, appealing to that sense of intrinsic ‘fairness’ that is needed for system to gain acceptance. If a graduate wants to pay back their salary advance early, they can request the outstanding nominal balance and do so, and there is no reason not to encourage this. But otherwise, the accounting cash value of the outstanding salary advance is not visible, because it does not need to be. For the student the negative language of debt and interest has gone.

Universities: restored resource, market signals, shared risk

Although the accounting cash numbers are hidden from the student, they are necessarily very real for universities and the government. The government sets the link between the salary advance share and the price the university gets for delivering the course. A university pricing a course at a lower share of say 20 per cent of higher salary might then have a fee of £9,000 each year. If it sets the price at 30 per cent of the higher salary advance, then the annual fee might be £12,000. The scheme commits to annually indexing these fees, with graduate pay perhaps the most sensible choice, for a decade or so. Long enough to give strategic clarity for investment in provision and accommodation.

This restores unit funding for UK students to economic levels and gives confidence to grow. But there are two other changes which necessarily counterbalance this strong outcome for universities. Firstly, the university does not get all of the money at once. For lower-price courses it might get paid 90 per cent of the price upfront. But where the university thinks its course is high value and sets a higher price that upfront figure is lower. Say, 60 per cent upfront.

The balance is made up by the university sharing in the salary advance repayments once the student has graduated. If a university gets 60 per cent upfront from the government, then it would get 40 per cent of the stream of repayments its graduates go on to make. Universities would get a share of the social dividend payments too. It would then clearly matter to universities that graduates are both successful and making useful contributions to the UK economy as the government sees it. With this strong passive alignment governments can spend less time regulating and let universities get on with what they are good at.

Perhaps surprisingly subjecting tuition fees to VAT could be beneficial to making the overall scheme work. This might seem obtuse. Not least because the fee is being charged to government in the first instance. Though ultimately, the graduate pays the VAT through their salary advance repayments. But adding it means that the students repay more than the non-VAT cost of their course. This margin gives the government funding headroom to provide beneficial simplicity elsewhere in the scheme – for instance, not applying interest to the outstanding salary advance – whilst not perhaps being seen as punitively unusual by students.

This is helpful but there are two other strategic advantages to consider bringing tuition fees into a more business-like VAT framework. Currently the VAT treatment of education means that efficiencies from setting up shared services, or subcontracting specialised activities, are disincentivised compared to doing it in-house. Being able to take neutral choices here, free from VAT-related biases, could be more efficient. Overall the balancing effect of VAT on input costs and potential efficiencies would reduce the effective cost of this change for universities. Secondly, VAT would also naturally be levied on tuition fees paid by international students. Government would then have a new source of revenue from such students, which it could notionally view as offsetting any indirect costs they might bring. The policy environment for serving international students might well be more consistently supportive as a result.

With real fee income for home students restored to realistic levels, there is also an opportunity to consider equalising fees for international students for most courses. This could help reassure UK students that only academic factors drive admissions decisions between potential students. And to reassure international students that their fees are good value and not unduly inflated by the need to cross-subsidise other areas. It is possible that this fee equalisation might raise concerns that demand for UK university courses was being fuelled not by their intrinsic merit but more by post-graduation work visas they supported. If so, perhaps the simplest way to prevent this worry is by setting a fee for any such post-graduation visa entitlements that reflects the presumed value of this benefit, and is paid to the government directly.

Government: contained costs and new policy levers

The central gain for governments is that the higher education system becomes essentially self-funding. It is hard to be sure without access to the right data (the long time series of SLC data being the best source), but 30-50% or so of the higher pay should be sufficient to cover the nominal money advanced within the shorter payment period. Governments then can let universities grow and see student opportunities expand, with only limited bridging funding for universities to worry about, not endlessly growing expenditure. It could also probably implement this quickly and cheaply, building on the impressive and underrated infrastructure that underpins the existing payroll-based deductions. A way of recording through whether employment is full-time or not would be needed, but this could be of substantial information and planning value to government more widely.

Having an evidently self-funding system is probably necessary but not sufficient for governments to feel relaxed again about university numbers growing. But the passive incentives in the proposed system address areas governments often worry about, making it easier for them to support rising numbers. With effective price signals for the first time – your salary advance share choice has clear consequences, adding to a debt you are not going to pay off does not – then governments might feel there was the functioning market mechanism for value they have always wanted. Universities risk-sharing in the post-graduation prospects of their students might similarly reassure governments that they would properly consider whether courses were value-generating. If they were not. If universities grew so enthusiastically in aggregate that more graduates were produced than the economy could maintain a pay premium for, the system would automatically correct. There may be types of provision where it is agreed that their value is not reflected in achieved salaries, either because of the nature of the study or the nature of the students, and these would need explicit support. But these would be controlled exceptions.

Through the social dividend the government potentially gains a powerful and efficient policy tool. If it was felt politically acceptable to vary the dividend rate by employer, profession, or geography, governments get a fast-acting tool to shape the economy. Since universities also get a share of the social dividend, governments can assume that universities would be efficiently attuned to their policy objectives.

As with students and universities, not everything would be a gain for government. Importantly it is providing tax relief on the salary advance repayments. Indirectly, through the social dividend (which is imagined to be set to be in aggregate as the tax relief on repayments), and directly through the employer repayment treatment. Treasury has understandably long resisted treating tax revenues from the higher earnings of graduates as part of the equation for higher education funding. But it arguably makes sense to treat education as an investment in this way, and without it, graduates would have exceptionally high marginal tax rates. A boost for the Treasury here is that it creates a strong incentive it creates for graduates to contribute their skills to the UK (where they would get the dividend and employer support) rather than elsewhere where they would not. More generally, officials would want to be careful that with the advance repayments and various other payroll deductions there was still a sufficient incentive to seek higher salaries.

Not applying interest to the outstanding salary advance is another cost for government, albeit designed to be somewhat offset by the VAT changes. As is the government taking on the related inflation risk of the repayments being worth much less in real terms. But arguably this inflation risk sits better with Treasury rather than, through index-linked interest, teenagers. Interest, and seeing the outstanding debt grow and grow after painfully made repayments, causes graduates much distress and resentment. The higher interest rate environment is only just starting to take effect on student loans, and it is likely to intensify the sense of unfairness there. Giving ground here removes that before governments are forced into it anyway.

Funding higher education is a deep and increasingly large problem of importance to both young people and the wider economy. This proposal imagines making a set of substantial changes to get to a durable solution. Although mostly developments of existing models, change on this scale would no doubt carry large risks. But with universities being one of the UK’s relatively few world-class strategic assets, and the consequences of under-funded places hitting young people, letting the current funding crisis drift on is perhaps risker still.