The long-term economic strength of the United States depends on our ability to compete in the world of intellectual capital. Indeed, that is perhaps the last remaining arena where we can hope to win, since we ceded pure wage competition long ago, capital is now as mobile as an e-mail, and scale, which we once had, is no longer our friend. The Chinese middle class already numbers in the hundreds of millions, and last month, more cars were sold in China than in the United States, the first time that has ever happened.
If we are going to improve American intellectual capital, we need to fix how Americans pay for higher education. For too long we have asked students entering college and graduate school to choose one of two unappetizing options: pay astronomical tuition bills upfront or amass enormous debt that demands fixed, sky-high monthly payments the moment they graduate and enter the work force. These options serve as barriers to educational opportunity, since many cannot afford upfront tuition payments or qualify for the needed loans. That also distorts career choices, since for most the obligation to repay loans immediately has reduced the ability to choose socially desirable jobs such as teaching, forcing the pursuit of the highest-paying job regardless of personal or social utility.
Yet there may be a “third way” that eliminates the educational financing problem. Milton Friedman first proposed the following idea, and James Tobin then refined and tried to effectuate it. If two Nobel laureates of decidedly differing worldviews agree, it must be worth at least a quick look. It is, moreover, successful and commonplace in Europe and Australia.
Marketed under the decidedly unappealing name of “income-contingent loans”—how about we call them “smart loans” instead?—the concept is simple: Instead of paying upfront or taking loans with repayment schedules unrelated to income, students would accept an obligation to pay a fixed percentage of their income for a specified period of time, regardless of the income level achieved. Suppose a university charged $40,000 a year in annual tuition. A standard 20-year loan in the amount of $160,000 (40,000 times four) would produce an immediate postgraduate debt obligation of $1,228.50 per month, or $14,742 per year, not sustainable at a salary of $25,000 or anything close to it. Under a smart loan program, the student could pay about 11 percent of his income, with an initial payback of $243 per month, or $2,916 per year, which is feasible at a job paying $25,000. If, after five years, the student’s salary jumped to $100,000, payments would jump accordingly and move up over time as income increases. After 20 years, assuming ordinary income increase, the loan would be paid off.
The smart loan model would permit all students to fund their own educations, guaranteeing that finances would no longer be a barrier to the education our work force needs. It would also free parental savings for other obligations—such as health care—at the same time that it would recognize that the student’s ability to repay will grow over time as income increases through a career. The current system of hitting graduating students with immediately sky-high payment obligations just as they enter the work force is nonsensical. Pegging repayment amounts to income earned is common sense. A student who wanted to teach for several years could do so, with proportionately reduced payments, knowing that when she moved over to a more remunerative job, her payments would jump accordingly.
Yes, this model raises all sorts of complex subsidy issues: Do we let lower-income earners stop repaying after 20 years even if they haven’t repaid in full? Should higher-income earners subsidize lower earners by paying for the full 20 years even if they have repaid their individual debts in full? Should we set a minimum-income threshold, below which no repayment is required? Should we set an annual cap on repayments for exceptionally high earners? Should we make the percentage paid progressive, so as income increases a slightly higher percentage is paid each year?
For those who question the administrative complexities of smart loans, the answer is easy: The IRS can serve as the collection agency, making enforcement almost universal and driving costs down to a negligible level.
Why should we be especially interested in this idea now? Despite all the money for K-12 education in the stimulus package, we are woefully underfunding higher and postgraduate education, and few areas are more important to retooling our economy. And things are only getting worse: College endowments have fallen precipitously, making aid harder to fund. Family savings have taken a huge hit, limiting the capacity to pay upfront and obtain loans. And investments in higher ed have fallen because of state budget crises.
Conservatives like Friedman support the “income contingent” model because they acknowledge that education is a social good that receives inadequate investment. Because it is hard to collateralize an education, unlike a piece of machinery, the market has a hard time funneling as much capital to education as it should, from a societal perspective. For liberals, the allure of the model is that it removes a significant barrier to education for the nonwealthy and it frees employment decisions from the yoke of pure income maximization.
The success of income-contingent loans overseas has prompted sufficient study to provide blueprints for what the domestic models could look like. And the foreign experience also prompted Yale to put in place a small pilot program, which it terminated in 1978. Though unsuccessful for administrative and collection-related reasons, the Yale program did benefit Yale law student Bill Clinton.
Promoting these “smart loans” as a way of making higher education universally available is worth the attention of the Obama administration and Congress.