College debt: Battling the unintended results of policy proposals

The United States has a $1.3 trillion student debt crisis, and income-driven repayment plans are the primary method to address it.

The federal government offers at least four versions of these plans. Student loans are typically amortized for 10-year repayment. When borrowers cannot afford normal repayment, income-driven plans lower monthly payments to 10 percent to 20 percent of discretionary income. This extends repayment timelines, but unpaid balances are forgiven after typically 20 or 25 years. However, negative amortization can increase financing costs, and loan forgiveness can create significant phantom tax liabilities for struggling borrowers, because forgiven amounts are taxed as income.

A more controversial approach to existing debt is letting borrowers refinance at low interest rates. Democrats generally support lowering interest rates on loans, while many Republicans oppose it.

IDR is optimal only for borrowers who truly cannot meet their repayment schedules, while unconditional refinancing is suboptimal for taxpayers. Regarding solutions to future debt, Republican Donald Trump hasn’t released a formal plan, though he has said the government shouldn’t profit from student loans, a position shared by Democrats Hillary Clinton and Bernie Sanders.

Republican Marco Rubio had championed a debt alternative conceived by Milton Friedman in which private firms finance students by purchasing their future revenue for a set number of years. This idea is problematic because it creates incentives that reduce access to higher education and discriminates.

▪ First, it makes it attractive for investors to finance the safest and most lucrative students and degrees. For example, STEM graduates would be more attractive for investors as they typically enjoy higher and less variable earnings. Likewise, inasmuch as there’s a gender wage gap (and maternity-related employment downtime) male students may be more attractive to financiers than females. This could aggravate biases and reduce access.

▪ Second, it may deprive federal loan programs of the financially strongest borrowers without a correlating reduction in debt financing of “less desirable” students. Since the government will likely continue originating student loans, this policy would less likely create a “market correction” than enable venture capitalists to pluck the best prospects from the federal debtor pool, increasing taxpayer risk and expense and making conventional debt more expensive.

▪ Third, it reduces the value proposition of higher education to purely financial terms.

Democratic solutions to student debt generally focus on subsidies, theoretically paid by the wealthy. Although Democratic proposals sound great to the progressively minded, they pose more challenges than making the 1 percent pay for them.

Not just tuition

Clinton and Sanders’ free tuition proposals – at public schools – may be misleading. Tuition is only part of total cost of attendance of public institutions. For 2016-2017, UNC-Chapel Hill in-state tuition and fees were about 35 percent of the total cost, at N.C. State University roughly 39 percent and at N.C. Central approximately 33 percent. Free tuition could reduce, though not eliminate, student costs for public students.

Moreover, passing this expense to the government may not decrease costs as much as expected. Easy access to federal credit has increased tuition. If that’s true, then why wouldn’t direct federal subsidies encourage public institutions to increase tuition more or exploit other revenue sources such as new fees and housing? Alternatively, schools may turn toward lower cost options such as online courses, which may have much lower completion rates than traditional methods.

Total subsidization of public school tuition would also distort the relative price between public and private schools, which are already struggling. Unable to compete on price, enrollment at less elite private schools would diminish as more students choose public school. This financial pressure would likely cause private institution failures and consolidations. Meanwhile, public schools would struggle to increase capacity, with potentially negative effects on educational quality.

Free tuition could spell trouble for many of North Carolina’s 35 private colleges attended by 54,000 in-state students. Elite institutions like Duke and Wake Forest would be fine, but smaller schools – especially those already struggling like St. Augustine’s and Shaw in Raleigh – may not fare so well.

This story was originally published June 10, 2016 at 5:03 PM with the headline "College debt: Battling the unintended results of policy proposals."