Making a Bigger Mess of Student Loans

The John William Pope Center for Higher Education Policy

Federal student aid programs abound in examples that demonstrate a point economists often make: government policies almost always have undesirable consequences that weren’t anticipated, or if they were didn’t matter much to the politicians.

At the time they were begun, during President Johnson’s “Great Society” years and shortly thereafter, hardly anyone forecast that they would result in huge increases in the cost of going to college. Decades later, it is evident that they have.

Now that college is far more expensive and many students are borrowing huge sums to afford their degrees, politicians are tinkering with the system to solve the “student debt crisis.”

Two programs meant to ease the burden on students are Income-Based-Repayment (IBR) and Public Service Loan Forgiveness (PSLF). I wrote about them back in May and these programs are rapidly expanding, adding to the ever-accumulating federal debt.

To briefly recap, the idea behind IBR is that since some students have a difficult financial struggle with their payments because of their low earnings after college, their repayment schedule should depend on their income level. IBR caps repayments at 10 percent of their discretionary income and if, after 20 years of payments whatever balance remains is forgiven. (That is to say, the loss is covered by the taxpayers.)

If that sounds like vicarious generosity by the politicians, it’s just a minnow compared with the barricuda of PSLF, the loan forgiveness program. That program lets students who happen to go to work in “public service” jobs pay their loans for only ten years before the balance is wiped out. Because many of the jobs that qualify for PSLF require postgraduate education, the debts that the taxpayers must eat are far higher.

A recent study by Jason Delisle and Alexander Holt of the New America Foundation, Public Service Loan Forgiveness: Big Benefits, Bad Incentives carefully investigates the impact of Uncle Sam’s generosity on the behavior of students and institutions of higher education. Their work reveals how the perverse incentives built into these programs subsidize waste and create “reverse Robin Hood” effects.

Delisle and Holt find that the people who learn how to game this system can get much of their education, especially graduate degrees, at little or no cost to themselves. Furthermore, the beneficiaries are apt to be individuals who land government jobs that pay quite well.

And there’s more perversity here: Schools that sell the degrees that are likely to be  free will capitalize on that by increasing their cost. Why not, since the government will wipe out the debt that students incur? Therefore, the net effect of these programs will be a transfer of money from taxpayers to well-off individuals and the institutions where they received their credentials.

I doubt that many Americans would regard that as sensible or fair.

Key to the analysis by Delisle and Holt is what they call the ZMCT: zero marginal cost threshold. That is the point at which, assuming that the student takes full advantage of the government’s easy repayment plans, all further educational borrowing will be forgiven.

For example, someone who earns a law degree and then gets a job as a lawyer (for any unit of government, or working for a non-profit entity) and earns the median wage for lawyers his age, reaches ZMCT at about $54,000. All borrowing beyond that will be covered by the taxpayers, so there is no reason to economize, to use one’s own resources, or to work to offset some of the cost.

Delisle and Holt write, “The ZMCT equates to only about one year’s tuition and living expenses, implying that the remaining two years of costs could be borne completely by the government.”

Lawyers who work for government are often paid pretty well. Delisle and Holt calculate that such a person could benefit from loan forgiveness to the tune of roughly $100,000.

Even if you wouldn’t go as far as Shakespeare’s character Dick the Butcher in Henry VI, who exhorts the crowd to “kill all the lawyers,” you probably don’t like the idea of giving those who go to expensive law schools and accumulate lots of debt a gift of $100,000 after ten years on the job. That’s the effect of Uncle Sam’s generosity, though.

Another graduate degree the authors looked at was the master’s in education. Teachers earn less than lawyers usually do, so the ZMCT is lower: $16,500 for those at the 50th percentile. Therefore, a student who borrows more than that amount to the get that degree is just adding to the taxpayers’ burden. (In most states, an educational MA leads to an automatic pay increase even though there is no evidence that the degree improves teaching effectiveness, as this Brookings study concluded.)

The government’s vicarious generosity toward teachers who get this dubious credential squanders taxpayer money in a way that subsidizes teachers, as well as the colleges and universities that offer those degrees.

And just like every other government program that dispenses benefits, people and institutions learn how to “game the system” with the loan repayment programs. In his earlier paper entitled Beware Savvy Borrowers Using Income-Based Repayment, Delisle pointed out that law schools whose students are likely to pursue careers that qualify them for the “public service” advantage are pitching that to students. “Georgetown Law, whose students leave school with an average of $146,000 in federal loans, holds a seminar for its students on the benefits of IBR,” he writes. The seminar “coaches students on the benefits of increasing retirement savings to reduce their Adjusted Gross Incomes, thereby reducing their loan payments and increasing the amount of debt that is forgiven.”

Delisle and Holt also observe that consultants are already advising people on how to maximize their benefits under IBR and PSLF. For instance, a firm called The Advantage Group advertises that it can help college graduates “reduce student loan payments and forgive tens, even hundreds of thousands of dollars.” Such services are beneficial to the graduates who can reduce their payments, but that merely transfers the cost to taxpayers.

I tip my hat to Delisle and Holt for their sharp analytical work. They’ve identified the bad incentives that IBR and PSLF create, artificially stimulating demand for some degrees, making students less price sensitive and less inclined to rely on earnings or savings to pay for them, and changing both personal and institutional behavior so as to optimize benefits.

Where I part company with them when it comes to the best solution. They urge Congress to reform these programs, continuing them but eliminating their bad effects. In my view, however, both IBR and PSLF should be eliminated entirely.

PSLF should be eliminated because there is no reason whatever for the government to favor people who take jobs in “public service” (which, incidentally, the authors show covers 25 percent of all employment) rather than jobs in the for-profit sector. Non-profit work is neither underpaid nor more virtuous than for-profit employment.

IBR should be eliminated because it encourages Americans to ignore the poor cost-benefit ratio for many individuals and many college programs. Lending large amounts of money to students with the understanding, “If you have trouble paying it back, don’t worry because we will adjust to your ability to pay,” encourages bad decision-making.

If banks had to lend money to new businesses under similar terms—“Don’t worry about profitability because we’ll lower your payments if you aren’t doing well”—you can see what would happen. We would have lots of ill-conceived new companies wastefully absorbing capital and resources.

That is what IBR does for the decisions many young Americans make about college. They’re encouraged to adopt a breezy “Hey, why not give it a shot?” attitude instead of thinking responsibly about the balance of costs and benefits.

Until we get the government out of the student loan business entirely, the best policy would be for all students to be treated the same, required to pay back the full cost of their borrowings.

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