As student loan debt has grown (currently more than $1.6 trillion in federal loans), it has gotten more attention from the public and Washington. Progressives are pushing for free college and loan forgiveness. While conservatives have rightly criticized the Biden administration’s proposals, they haven’t put forward many alternatives. Unfortunately, one of the few ideas that gets the most attention is income share agreements.
First advocated by Milton Friedman in his famous essay, “The Role of Government in Education,” income share agreements (ISAs) take an equity-based approach to financing college education rather than a debt-based one. Under these agreements, an investor pays for a student’s college education up front in return for a share of the student’s future earnings for a certain number of years. Some income share agreements are already up and running, including Purdue University’s Back a Boiler program.
There is nothing inherently wrong with ISAs. They are consistent with conservative principles, so conservatives certainly shouldn’t oppose them. But income contingent lending (ICL), a close cousin of income share agreements, is a better policy that is both easier and faster to implement. I fear that all the attention devoted to ISAs is distracting from rather than advancing needed reforms.
Like an income share agreement, income contingent lending sets the monthly payment as a share of the borrower’s income. But under ICL, the borrower continues making payments until the loan is fully repaid.
Both ISAs and ICL completely solve the student loan crisis because they ensure that payments are always affordable—if a borrower’s income falls, so does his payment. But relative to income share agreements, income contingent lending has seven big advantages.
First, adverse selection is less of a problem under ICL. Students who expect to have high salaries, such as doctors, would tend to avoid ISAs since they would likely have to repay many multiplies of the cost of their education. Yet these students would not avoid ICL because their higher monthly payments would just result in them paying off their debt faster.
Second, moral hazard is a less of a problem under ICL than under ISAs. With an ISA, once a student graduates, investor and investee interests diverge. Any income that a former student can hide from his investor (or take in fringe benefits rather than salary) is his to keep forever. But under ICL, all hiding income does is allow for more interest to accrue. Thus, there is a less adversarial relationship between student and lender and less fraud under ICL.
Third, as an equity investment, there is no way to refinance an ISA, whereas an ICL can be refinanced. This means that students taking out an ISA benefit from competition only once, when the ISA is first offered. But under ICL, students benefit from continuous competition, and this competition among lenders ensures that students can always benefit from the best possible terms.
Fourth, ISAs suffer from more public relations problems. As an equity investment, they resemble indentured servitude, an unflattering comparison. In contrast, ICL is debt, and society has accepted the legitimacy of debt. ISAs would also need to front-load any expected differences in earnings trajectories, leading to public relations nightmares such as offering women less generous terms than men to compensate for the possibility that they might drop out of the labor force temporarily after childbirth.
Fifth, the legal system is already capable of handling debt. Credit scores, bankruptcy, and court precedent have established reasonable and predictable incentives and tradeoffs regarding debt repayment problems. Such a legal foundation is lacking for ISAs. As one entrepreneur who started and abandoned ISAs noted, “the lack of legal infrastructure around ISAs leads to difficult collections-related issues. You can’t ding somebody’s credit score and there aren’t easy legal paths for collecting. Are you really prepared to go to small claims court? We weren’t.”
Sixth, there is an unnecessary and unfortunate regulatory Sword of Damocles hanging over ISAs. Like my toddler, government regulators are trying to force the square peg that is an ISA into the round hole of existing loan regulations. And just like my toddler, their ill-advised desires won’t stop them from leaving a trail of destruction in their wake out of frustration. For example, the Consumer Financial Protection Bureau recently sanctioned an ISA provider because its product descriptions didn’t include standard loan disclaimers, despite the fact that ISAs are not loans. This is like sanctioning apple sellers because they didn’t include the nutrition label for oranges.
Seventh, ISAs are still in their infancy, whereas ICL is already in use. Even the most well-known ISA providers are struggling to work out the kinks. For example, Purdue University recently stopped enrolling new students in their ISA program. In contrast, there are already several income-driven repayment programs, which have the same basic structure as ICL but with some unnecessary additional features (e.g., forgiving any unpaid balance after 10-25 years depending on the program). The optimal ICL program could be implemented by making a few modifications to the existing income-driven repayment programs, whereas ISAs would require many additional legal and regulatory foundations to be laid.
Overall, while they have captured much of the attention of conservatives worried about the current student loan system, income share agreements are largely a distraction. Rather than pushing for an inferior, impractical solution, conservatives should put their weight behind income contingent lending, which is a better, easier, and faster policy to implement.