The student loan crises has illustrated the dangers of borrowing for education. Millions of students are saddled with thousands of dollars in debts for degrees that are of little value in the workforce. But forgiveness is not the answer, not at least without first addressing the perverse incentives that got here in the first place. We can finance education in a way that eases students’ risk and controls the cost of tuition.
How We Got Here
Student loans have ballooned to become the second-highest form of consumer debt, after mortgages, in the United States. The average student loan debt is some $40,904. Millions of Americans, many in the formative years of their lives, are shackled to a ball and chain of debt that hinders their personal advancement.
It wasn’t always like this. For much of history, higher education was reserved for a privileged few. Classroom seats were limited, and those lucky enough to be admitted had to hold out hope for a scholarship, pay out of pocket, or obtain a loan from a private bank.
By the 1950s, however, it became increasingly evident that the future of work was shifting away from low-skilled labor and toward high-skilled jobs where a college degree would provide a competitive edge. But private loans were hard to come by. Banks were, understandably, unwilling to commit large sums of money toward students who had no credit history, collateral, and very uncertain futures.
The risk was simply too great for lenders, absent some government assistance. For this reason, in 1965, the United States Congress passed the Higher Education Act, that allows banks and private institutions to provide government-subsidized and guaranteed loans to students.
These loans are available to all, with virtually no underwriting. On its face, this sounds like a great thing, as college-educated citizens have higher earning capacity than those who received only a high school education. There are also certainly positive externalities to consider beyond higher income.
The problem is that soon after the passage of the Higher Education Act, the cost of tuition began to rise quickly, outpacing both general inflation and wages. As tuition costs rose, the government raised the maximum allowable loans. When tuition rose again, loan caps were once again raised. Rinse and repeat. The consequence is now are piles of debts on students’ backs.
Spiraling Tuition Costs
While there is no doubt that tuition inflation is a major issue, there is some disagreement as to the cause. If we are to propose a new means of financing education, we need to understand the underlying origins of tuition inflation. Here, two theories dominate.
The first supposed reason for tuition inflation is the State Disinvestment Theory (SDT). The SDT argues that the primary cause of soaring tuition is government funding cutbacks at public universities. It is true, government funding for higher education has been curtailed, especially in the wake of the Great Recession.
The second theory, popularly known as the Bennet Hypothesis, named after Ronald Reagan’s Secretary of Education, William Bennett. In 1987, Bennet wrote (without evidence), "If anything, increases in financial aid in recent years have enabled colleges and universities blithely to raise their tuitions, confident that Federal loan subsidies would help cushion the increase.” In short, he felt that government-backed loans were inflating the cost of education as universities took advantage of this “free” money.
Which theory is correct? As these things go, likely both and neither. There is very little research into the SDT, and what little research exists suggests a loose relationship between government funding and tuition, typically under ten cents for every dollar of allocations. In other words, increased government funding can reduce tuition costs, but only at the margins, and vise versa.
As to the Bennet Hypothesis, the data are mixed. The relationship appears stronger, with some studies finding that tuition rises up to sixty cents for every dollar of additional government-backed loans. It’s not clear, however, that this relationship is necessarily causal. The proliferation of easy student loans may not cause higher tuition, but rather enables it. In reality, both state disinvestment and overzealous lending to students probably contribute to tuition inflation, alongside other variables.
Anecdotally, the Bennet Hypothesis seems to ring more true than the SDT. If tuition increases were primarily due to decreased funding, we would expect that schools would take austerity measures alongside tuition hikes. Yet, we don’t see this play out. On the contrary, to attract students, universities are building ever more lavish dormitories, cafeterias, and recreation centers.
Perhaps more tellingly, the number of non-academic administrative employees at U.S. universities doubled from 1987 to 2012, vastly outpacing the growth in the number of students. If indeed government budget cuts were to blame for higher tuition, it wouldn’t be possible to hire more administrative assistants, VPs, Assistant VPs, Deans…etc. Indeed, in an era where businesses adopted flatter organizations and leaner administrative staff, universities are moving in the opposite direction.
This system isn’t working. We need a way to enable students to get an education without exacerbating unsustainable tuition inflation, or weighing down the future generation with an anchor it can never lift.
A Simple Solution
Before diving into the solution, we have to differentiate between universal “general education,” that all citizens should be required to have, and higher education, that specializes and deepens the knowledge base of a select number of individuals. We have proposed adopting a voucher based system for general education, but this is not suited to higher education.
Some have suggested that we make college education “free” by dialing up government subsidies. This is hardly a solution at all, as it merely shifts the cost of education by redistributing it among the entire population. Furthermore, it is unlikely to restrain tuition inflation, it may indeed worsen it.
Even worse, free college would blur the aforementioned distinction between general education and higher education. College degrees would lose their meaning and value as they became almost ubiquitous.
A better alternative to loans and direct subsidies was proposed by Nobel Prize winning economist Milton Friedman, in his 1955 paper entitled “The Role of Government in Education.” Friedman thought, perhaps foresaw, that loans were not the optimal means of financing higher education. He argued instead for using equity in the form of Income Sharing Agreements, or ISAs.
Instead of borrowing money for their education, students would seek the backing of investors who would finance their education in exchange for receiving a defined percentage of their disposable income after they graduate, hence the name “income sharing agreement.”
ISAs could be structured any number of ways, with total payment caps, time limitations, and even “buyout” options, where a student could buy out of their ISA early. Unlike a loan, there is no principle or interest to pay. Crucially, the risk on the investor, not the student. The investor may profit, or may not. A student may ultimately pay more or less than they would have with a loan, but they would never be burdened with a payment they couldn’t afford.
ISAs offer several advantages over the current loan system:
They preserve equality as all students have an equal opportunity to obtain an ISA
Because risk in on the investor, they would channel students only toward high-quality and low cost degree programs, curtailing tuition inflation.
Because payments are tied to income, graduates who are jobless or making poverty wages, would owe nothing. They would never have a payment they couldn’t afford.
They offer flexibility. An ISA can be structured any number of ways to suit the investor/student needs. Unlike a one-size fits all loan.
ISA investors have a strong incentive to aid students after they graduate, setting up career counseling services, arranging internship opportunities…etc
After writing this, I learned of one potential downside of ISAs: adverse selection. Student’s know themselves better than investors do. Students who know they will have high earning capacity will tend not to sign up for an ISA, understanding that they will pay more in the long run. Meanwhile, students who know they have lower earning potential, will have a tendency to take full advantage of ISA financing.
ISAs could become a bad investment if too many of the latter group sign up relative to the former. This is the same problem we find in health insurance. The people who want health insurance are those who know that they are going to use it. This is a challenge, but is not insurmountable.
To prevent adverse selection, all students who are admitted to a university program should be automatically signed up into a basic ISA plan. Tuition payments made outside the ISA will be subject to a VAT tax, while payments made toward the ISA will be tax-deductible. This ensures that even high earning students gain a potential benefit from an ISA and that they won't jump out of the risk pool.
How It Works
In practice, high school students would get scores, akin to credit scores, that determine their risk level and areas of competence. These scores would be used by investors to determine if, and how, they might invest in that student’s education.
Universities themselves might become the largest investors, as they already have the mechanisms in place to pick and choose which students they want. Importantly, the existence of ISAs would realign incentives; universities would no longer be able to take their loan money and shove students out the door. They would be properly incentivized to control costs and provide a worthwhile education and career services for their students. This incentive simply doesn’t exist today.
Investors could hold onto their investments, or, as often happens in the finance world, they could package a variety of ISAs from students in different fields and risk levels into securities that could be traded on the market. ISAs could even form part of your retirement portfolio, and therein lies their poetic beauty. ISAs provide a mechanism by which we invest in the future of the young, to bring a dignified retirement to the old.
Some might find the notion of scoring and trading children’s futures, like stocks or bonds, to be inhuman and cold. We disagree, what is inhuman is the current system, a system that indiscriminately doles out loans to hope-filled students, only to leave them with worthless degrees and a pile of debt.