Terrence J. Thomas
The Initial Proposal
The Basic Structure of Income-Contingent Loans
IN THE UNITED STATES
IN NEW ZEALAND
AND INCOME-CONTINGENT STUDENT LOANS
Education, though an acknowledged
key to productivity growth, is costly. As governments look for ways to
cut their deficits, attempts are being made to shift the costs away from
governments to the students, or the students' parents. One suggestion
has been for income-contingent student loans for higher education. Unlike
conventional loans, which have equal periodic payments, income-contingent
loans are repaid as a proportion of annual income; the payment in any
period will vary with income, so the periodic payments will not be fixed.
Such loans could provide
a substitute for traditional student loans, which have drawbacks for both
the lenders (a high default rate) and borrowers (higher interest rates
because of the high default rates, and the burden of a large debt immediately
after graduation). Income-contingent loans could also replace grant schemes
that involve direct subsidies to students, or could be used in tandem
with a hike in tuition fees at colleges and universities.
This paper discusses first
the earliest proposal for income-contingent student loans and then attempts
in the U.S., Australia and New Zealand to implement the scheme. Finally,
it highlights lessons for Canada and predicts how the system might work
The Initial Proposal
The recognized source for
most income-contingent student loan plans is a 1955 paper "The Government
and Education" by the University of Chicago economist Milton Friedman.(1)
In fact, Friedman had set out the rationale for income-contingent lending
in 1945 in a book on professions in the U.S. he had written with another
economist.(2) The proposal
responded to a concern that someone with the ability and desire to enter
a profession might not be able to finance the necessary training.
Financing might not be forthcoming
because the potential entrant to a profession has no collateral for a
loan; the ability to repay a loan will be based on future income, which
is uncertain. Borrowers who end up with low incomes may default on the
standard loan; borrowers who end up with high incomes pay no more than
the amount of the loan plus accrued interest. Lenders must, therefore,
set a rate of interest that is sufficiently high to cover the losses on
loans to borrowers who default. According to Friedman and Kuznets, that
rate of interest might be too high, higher than the economic return on
an investment in professional training, and might thus shut potential
entrants out of certain professions.
A possible solution was
to allow the potential entrant to sell "stock" in himself; that
is, to agree to repay the lender with a fixed proportion of future earnings.
With such an agreement, a lender's losses from the defaults of those with
low earnings would be balanced by the repayments of those with high earnings.
At the time Friedman and Kuznets were writing, the market for student
loans was certainly underdeveloped, so an income-contingent scheme might
have been attractive to all potential entrants into the professions, even
those who expected high future earnings. As will be discussed below, the
availability of conventional loans can undermine the financial well-being
of an income-contingent scheme.
In the 1955 paper, Friedman
was most concerned with what he considered the inequity of having taxpayers,
many of whom had relatively low incomes, subsidizing the university education
of children from families with relatively high incomes. Moreover, since
a university education would increase earning power, the income gap between
the average taxpayer and the graduate would widen over time.
Friedman's solution was
to tap the increased earning power of graduates to finance university
education, by having a student borrow to cover the cost of his or her
education and repay the loan as a specified fraction of future earnings.
He saw this as an alternative to a fixed money loan. He recognized explicitly
that the more successful graduates (in terms of future earnings) would
repay more than the cost of their education and thus compensate for the
less successful graduates, who would never repay the full amount of the
loan and accrued interest.
Although Friedman's emphasis
has generally been on the private market, he recognized that the high
administrative costs of the plan (for example, the difficulty in obtaining
accurate income statements from borrowers) might prove a rationalization
for government intervention. Under his scheme, the public or private sector
would provide the funds, attracted by the possibility of cross-subsidies
from successful to less successful graduates.
If, because of high monitoring
costs, the force of contract law, and the sanctions available under this
law, could not limit defaults to an acceptable level, Friedman conceded
that the government might use the tax system to collect loan repayments.
Because the income-contingent loans would be available to all students,
there would be no need for government intervention in determining who
An excellent, although now
somewhat dated, survey of income-contingent lending is the 1972 book New
Patterns for College Lending: Income Contingent Loans.(3)
Chapter 3 of this book lists and briefly summarizes several proposals
from the late 1950s and the 1960s. Each of the proposals was theoretical;
it was not until the early 1970s that any universities attempted to put
the theory into practice. Before examining any of the early attempts to
implement income-contingent lending, it is useful to examine the basic
structure of such schemes.
The Basic Structure of Income-Contingent Loans
There are several variables
in a model of the income-contingent loan scheme. Some are under the control
of those who set up the scheme, while others are not. The relevant variables
The amount of the loan (L),
The interest rate on the loan (r),
When interest begins to be charged,
The proportion of income (x % of income per year for each $1,000 of
The number of years over which the loan will be repaid (T),
Income stream of those who have taken out the loan, and
Average present value of income stream over the life of the loan (PV).
Hybrids of the conventional
fixed-term loan and the income-contingent loan are possible and would
necessitate changes to the list above. For example, the borrower might
be required to pay some minimum amount each year, no matter what the level
of his or her income. This would add an element to the list above. Alternatively,
the borrower might not have to pay any portion of income until it reached
some minimum level. This would necessitate a modification to number 4
on the list.
The present value is simply
the income stream discounted by the appropriate rate of interest. That
rate is not necessarily the same (in fact, is probably not the same) as
the interest on the loan. Different rates make calculations more unwieldy,
as does the practice, common in student loan programs, of not charging
interest on the loan while the borrower is in school and often not until
some time after the borrower leaves school.
Advocates of income-contingent
student loans have argued that the scheme would be self-financing over
time. With some simplifying assumptions it is possible to represent the
breakeven point as:
xPV = L,
that is, the proportion
of income paid, x, times the present value of the average borrower's income
stream over the life of the loan, PV, equals the amount of the loan, L.
The simplifying assumptions
are: (1) that the entire loan is taken at one time, rather than being
spread over the years spent in school; (2) that interest begins being
charged the moment the loan is taken, rather than at some later date such
as six months after graduation; and (3) that the discount rate and
the rate on the loan are the same. Without these assumptions, the algebra
would be more complicated, but the central formula (xPV=L) would be the
Note that this breakeven
point is defined for the average present value of future income over the
total group of borrowers (or over a subset of the total, such as all those
who borrowed or began repayment in a particular year). For the individual
borrower, the breakeven point is where the present value of the future
income stream is such that an income-contingent loan and a conventional
loan would be equally attractive.
Obviously, in choosing the
proportion of income to be repaid each year if the plan is to be self-financing,
the lenders (either the government, the universities themselves or private
financial institutions) must forecast the income stream of the average
borrower. There are several ways of doing this. One way is to take the
average income stream of past graduates -- either those throughout the
nation or those at a particular university. Another way is to take the
income profiles of graduates who had taken out student loans -- again,
either throughout the nation or at a particular university. If students
of sociology borrow, while students of medicine do not, the forecast should
be based on the income of sociologists rather than of doctors or of a
group made up of both professions.
It does not really matter
what method is used to forecast the average income of graduates. What
is important is that the present value of the income stream used in the
calculation is for the average borrower; some graduates will have
higher incomes and some will have lower incomes. For a plan to be self-financing,
those with above-average incomes must subsidize those with below-average
incomes. The more successful graduates, in other words, will pay more
than the present value of their loans, with the surplus going to pay off
the loans of the less successful graduates. If students know whether they
will have above- or below-average incomes, there is the potential problem
of adverse selection. With adverse selection, students expecting
below-average incomes will opt for income-contingent loans, while students
expecting above-average incomes will opt for conventional loans to avoid
subsidizing the less successful. If students can forecast their future
incomes accurately and act accordingly, the income-contingent loan program
will need an external subsidy (from the university or the government)
to break even; with the subsidy, the income-contingent loan program includes
a grant for at least some of the borrowers.
The attraction of income-contingent
lending depends on imperfect capital markets -- students either cannot
obtain loans at all or can obtain them only at rates that are too high
to make investment in educational economical. When income-contingent lending
was first brought up in the 1940s and 1950s, student lending was certainly
underdeveloped. There are many more student loan programs available now
(even if the market is still far from perfect); thus the terms on alternative
means of borrowing will be important in determining the success of an
IN THE UNITED STATES
Although Friedman's loan
plan was developed as part of a criticism of government-funded higher
education (especially the California system, which then provided "free"
education in the state colleges and universities), the income-contingent
loan plan was first instituted in private schools in the early 1970s.
Yale is the most often cited example, though Duke began a similar loan
program at about the same time. Beginning with the 1971-72 academic year,
Yale offered students the Tuition Postponement Option (TPO) that let loans
be repaid out of future income; the TPO program, which ran from 1972 to
1978, was not a success.
Under this program, Yale
undergraduates in 1972-73 could borrow up to $1,150; those in Yale's professional
schools could borrow up to $950; any increases in university charges were
to be added to these limits in subsequent years. Borrowers were to repay
4/10ths of 1% of their annual income for every $1,000 of postponed tuition.
Repayments were scheduled to take place over a maximum of 35 years, although
the actual repayment period was expected to be much shorter.
Yale loaned $8 million to
3,602 students under the TPO program. Most of the borrowers were undergraduates
(66% of the total); 9% were from the Graduate School of Arts and Sciences;
6% from the Law School; 4% each from Divinity and Medicine; and the remaining
11% from seven other professional schools.(4)
By the autumn of 1993, 724
borrowers, or just over 20% of the total, had repaid their loans. There
are two ways a borrower can repay the loan before the end of 35 years.
The first is by paying 150% of the initial loan and accrued interest (the
interest rate is set every six months, roughly at Yale's expected borrowing
rate plus 1%). The Tax Reform Act of 1986 reduced the deductibility
of interest on student loans and led some 300 borrowers to buy out of
the TPO program.
The second way a borrower
can repay the loan early is to be part of a cohort (generally all TPO
borrowers who begin repayments in the same year) that repays the aggregate
amount borrowed by the members of the cohort plus accrued interest. An
individual borrower must have repaid at least the principal of the loan
to take advantage of the group termination of the loan. Those participants
with low incomes (under $7,250 in 1972-73) were required to make a minimum
annual payment of $29 for every $1,000 borrowed. By 1988, the experience
with repayments under the TPO program indicated that group pay-offs would
probably occur within 24 to 25 years of the start of repayments.
Looking back on the program
in 1988, an official at Yale concluded that: "(1) the program required
a large amount of start-up capital because of the long period of repayment,
(2) it is complex to administer because of the need for annual determination
of income, heavy counseling and extended repayment and (3) collections
depend heavily upon clear and precise description of the non-conventional
At the time of the program,
Yale intended maintaining existing student aid programs at their current
levels of funding. Retaining these programs increased counselling costs,
because students needed to compare new and old borrowing possibilities
that were quite different in their terms and financial implications. The
TPO program was designed to break even, and not produce a profit for Yale.
But the possibility of having to contribute to participants in the income-contingent
scheme meant that some potential participants in the scheme would have
been better off with an existing aid package.
The TPO experiment was phased
out after the 1977-78 academic year; by then, according to the official
at Yale, "federal programs had been implemented which met the needs
that the experiment was designed to fulfil." It is somewhat ironic
that income-contingent schemes are now being examined to replace existing
Recently, proposals for
an income-contingent student loan program have re-emerged in the U.S.
Two bills were proposed during the 102nd Congress in 1991 --
the Income-Dependent Education Assistance Act (H.R. 2336) and the
Self-Reliance Scholarship Act (H.R. 3050). During the February
1992 hearings on the bills, an academic supporter pointed out that the
bills differed in detail but had three important common elements: (1)
universal eligibility, (2) direct federal funding and (3) income-contingent
repayment. The second element is, of course, at odds with the philosophy
behind Friedman's scheme in that federal government funding replaces private
lending. In addition, reliance on ordinary contract law to limit defaults
would be replaced by the use of the Internal Revenue Service (IRS) to
collect the repayment of the loans.
The idea of using the IRS
to collect loan repayments was opposed by officials from that service,
who criticized the proposal as a "fundamental change in the mission
of the Internal Revenue Service and our role in the lives of taxpayers."
The IRS already collects some non-tax federal debts, including some defaults
on existing student loans through the refund offset program. In 1991,
this program collected over $900 million, which included over $360 million
for defaulted student loans, through the offset of taxpayers' refunds.
During the 1992 hearings,
an official from the IRS pointed out that the income-contingent student
loan proposals would move the IRS from acting as a debt collector of last
resort to being the primary debt collector for federal student loans.
This official also pointed out that the proposal conflicted with IRS attempts
to simplify the tax system. Another witness pointed out that using the
IRS would not reduce defaulting loans to zero, as some graduates would
not have taxable incomes; this witness also pointed out that the program
could lead to additional tax evasion as it provided an added incentive
to under-report income.
In order to avoid the problem
of adverse selection, the Self-Reliance Scholarship Act included
floors and ceilings for the repayments. A student who took out a $10,000
loan and agreed to repay the loan with 1 1/2% of future income over
25 years would pay no less than $477 and no more than $1,083 a year; the
amount paid would depend on the ratio of the graduate's income to the
"average for college graduates" (a graduate with less than two-thirds
of the average would pay the minimum, and a graduate with more than one-and-a-half
times the average would pay the maximum).
Neither bill made it through
the committee stage of U.S. legislation, but the idea of income-contingent
student loans is far from dead. At the end of April 1993, President Clinton
unveiled a plan that would change the way Americans pay for college. The
part of the plan that called for a national service program attracted
most of the media's attention; however, another part of the plan called
for an overhaul of the student loan program. The plan contained elements
similar to those found in the two 1991 bills -- direct federal lending
and collection of a percentage of income by the IRS -- but the income-contingent
element was included only as an option. Other options for borrowers included
repaying the loan over ten years with fixed monthly payments, over a longer
period with slightly lower fixed payments, or over a fixed period with
the size of the repayments increasing over the period of the loan.
The U.S. federal government
is heavily involved in the financing of higher education. In the 1992-93
fiscal year, direct spending on post-secondary education by the U.S. federal
government is projected to be $21.3 billion (or 12.4% of total spending
on this level of education). There are many programs that make up the
total for federal initiatives in the field. Two programs, however, dominate
the spending: Pell Grants and Federal Family Education Loans (FFEL). For
the 1992-93 fiscal year, Pell Grants were projected to provide students
with $6.4 billion in aid, while Federal Family Education Loans were projected
to provide $13.6 billion.
Funds for the FFEL program
are provided by private financial institutions, with the federal government
guaranteeing the loans and often providing an interest subsidy while the
student is in school. A large secondary market for student loans has developed.
When students graduate, the banks often sell the loans in this secondary
market. The biggest player in this market is the Student Loan Marketing
Association (often called Sallie Mae), which finances the purchase of
the loans from the banks by selling bonds (backed by the government-guaranteed
Banks and other institutions
involved in the current student lending program vigorously opposed the
new loan plan. In 1992, banks made $13.6 billion in federally insured
student loans, so they have much to lose from direct lending by the federal
government. One observer noted that "lobbying had been intense, with
high-priced lobbyists replacing the more usual scuffed-shoe types seen
on education issues."
In 1992, defaults were estimated
to have cost the federal government about $3 billion; the Department of
Education claims that there has been a significant reduction in defaults
since 1991 and there will be further reductions in the future, because
of changes to the FFEL system introduced in the Higher Education Amendments
of 1992. These reductions in default costs are expected even if the scheme
for income-contingent loans with collection by the IRS is not adopted.
The proposed loan program of direct government lending is intended to
pay for itself, with the reduced number of defaults being an important
source of saving over the current system.
There are two reasons why
the proposed income-contingent student loan package would have a lower
default rate. The first is that the payments would fluctuate with income,
so there would be less financial hardship during the early years after
graduation than with the traditional fixed-payment loans; also, any interruption
in employment would not throw the loan into default. The second reason
for fewer defaults, at least in schemes where repayment is made through
the tax system, is that borrowers could not miss payments on the student
loan as long as they were paying taxes; the borrower would have to evade
taxes to evade repayment of the loan, and evading taxes (by under-reporting
income or by not filing a return) is difficult.
The legislation to institute
direct student lending by the federal government was passed in August
1993 (the legislation to establish the national service program was passed
in September 1993).(5) The
original loan proposal, which would have eliminated private lenders entirely
from the federal student loan program, has been modified considerably.
As a result of a committee compromise, direct government lending will
be introduced gradually. Direct loans will, by law, account for 5% of
total new student loan volume for the 1994-95 academic year; these loans
will increase to at least 60% of the total by the 1998-99 academic year.
Soon after the legislation
passed, a task force was set up to help with the transition to direct
federal student lending and to work out details for the income-contingent
scheme. By mid-November 1993, 105 schools had been selected to take part
in the first year of the direct loan program. Still to be worked out is
the role of the Internal Revenue Service in the collection of repayments.
With the exception of experiments
by some private institutions and a recent ten-school pilot project funded
by the government, the U.S. has little experience with income-contingent
student lending. Since 1989, Australia has had the Higher Education Contribution
Scheme (HECS), which is open to all students pursuing higher education
and which is linked to the tax system.
Under HECS, Australian students
are expected to contribute to their higher education. In 1989, the contribution
for "each year of equivalent full-time study" was set at $1,800Aus.
($1Aus then equalled about $0.94Can); at that time, the cost of providing
the education was about $9,000Aus. A student's contribution could be made
at the start of the year, in which case a 15% discount was given. Alternatively,
the student could defer payment until his or her income reached a threshold
level, at which time the contribution would be repaid as percentage of
income. (Strictly speaking, the student need not graduate to begin repaying
the contribution; students who fail are still liable to repay, and students
begin repaying whenever their incomes exceed the threshold.)
Repayment is through the
Australian tax system. In 1989, the accumulated HECS debt was to be repaid
at the following rates:
1% of taxable income between
$22,000 and $24,999,
2% of taxable income between
$25,000 and $34,999, and
3% of taxable income of
$35,000 or more.
The thresholds are indexed
each year to reflect increases in the cost of living. Additional payments
may be made at any time to reduce the accumulated HECS debt.
Whether taking out a HECS
loan is a good idea depends on how quickly a student expects to repay
the loan. The implicit interest rate on the HECS loan comprises a margin
for inflation, which is covered by the indexation of the loan, and a real
component, which is a function of the 15% discount on immediate payment
of the contribution and the number of years it takes to repay the loan.
The faster the loan is repaid, the higher the implicit rate of interest
(and the greater incentive to use some alternative source of funds to
obtain the 15% discount).
Unfortunately, the income-contingent
student loan scheme has not been in place long enough to provide data
on some aspects of the scheme, especially the default rate. In 1992, the
government announced a scheme that would replace some grants with interest-free
loans, which provoked violent protests from students.
IN NEW ZEALAND
In 1992, the New Zealand
government established the Student Loan Scheme, which allowed citizens
or permanent residents who were taking approved courses and who had an
acceptable academic record to borrow from the government. Eligibility
for the loan does not depend on age, ability to pay, credit-worthiness,
or parents' or spouse's income; however, a bankrupt under New Zealand
law cannot borrow money, so a student who was a bankrupt would be unable
to take out a student loan.
The maximum amount available
in 1992 to any student through the loan scheme would be equal to compulsory
enrolment fees, course-related costs up to $1,000NZ ($1NZ is currently
about $0.64Can), a living allowance up to $4,500 and the $50 administration
fee. A Ministry of Education pamphlet uses $1,000 as an example of a compulsory
fee, so a typical maximum for the annual loan would be $6,550. The Government,
through a Student Loan Manager, sets up a loan account for each student,
who may use it to draw up to the allowable maximum.
Following is a summary of
the terms and conditions of the loan contract (the summary is from a New
Zealand Ministry of Education pamphlet "1992 Student Loan Scheme"):
To receive a loan you
will have to sign a contract. This is a legally binding agreement between
you and the Government. Your tertiary institution will sign the contract
on behalf of the Government.
Simple interest will accrue
daily on your loan account. There are two components to the interest
charge: real interest [which the pamphlet defines rather idiosyncratically
as the interest rate that "reflects how much it costs the Government
to borrow."] and the interest adjustment rate [which is an adjustment
for inflation]. These have been set at 6% and 2.2% until 31 March
You will be charged an
administration fee of $50 when you make your first draw down. Interest
is also charged on the administration fee.
The repayment has been
set initially at 10 cents in the dollar for every dollar earned above
the income threshold of $12,670 pa. If in any year that you do not draw
a loan [or] your repayment amount is not enough to meet the real interest,
the difference between your repayment amount and the real interest will
be written off by the Government. This provision applies to New Zealand
resident taxpayers only.
As was the case in the Australian
scheme and the recent proposals in the U.S., repayments by those no longer
in school in New Zealand are made through the government tax collector
(the Inland Revenue Department). While at school, a student may make a
payment to the Student Loan Manager and thus reduce the principal that
will later be repaid through the tax system.
The pamphlet gives several
examples of repayments at different income levels. The repayment rate
is 10% of income above the threshold level; because there is a positive
threshold level, the actual percentage of total income going to repayment
of the student loan increases with income. The following are the four
income levels used in the pamphlet with the percentage of total income
going to repayment in parentheses: $15,000 (1.6%), $20,000 (3.7%), $40,000
(6.8%) and $60,000 (7.9%). According to an official at the New Zealand
High Commission in Ottawa, the average wage in New Zealand is about $30,000;
at this income level, the repayment would take 5.8% of total income. The
Government has reserved the right to review the repayment percentage;
at the current rate of 10% for repayment, according to the pamphlet: "It
is estimated that the majority of the loans will be repaid within a 15
As was the case with the
Australian scheme, it is too early to have any useful results from the
New Zealand experience with income-contingent student loans.
AND INCOME-CONTINGENT STUDENT LOANS
The Canadian government,
through the Department of Human Resources Development (formerly the Secretary
of State), currently operates the Canada Student Loans Program (CSLP)
to make post-secondary education more accessible to those in need; Quebec
and the Northwest Territories manage their own programs.(6)
CSLP was established in 1964 and is the federal government's largest program
of assistance to students. The program provides guarantees for loans made
by private financial institutions, an interest subsidy while students
are in school and some possible interest relief to borrowers who become
unable to repay the loan without financial hardship.
Loans made under CSLP are
not meant to cover all costs of higher education. In 1991-92, 247,044
full-time students negotiated CSLP loans for a total value of $742 million;
the average value of a loan for a full-time student was $3,003. The big
five Canadian banks made about 93% of all the loans.
There has been considerable
concern with CSLP, especially the government's liability for defaults,
and attempts are currently under way to change the program. According
to one source, the Department of the Secretary of State "estimates
that claims paid to the banks by the government have averaged 5.2% a year
of outstanding loans."(7)
In his 1992 report, however, the Auditor General of Canada estimated the
claim rate for Canada Student Loans as 13.8%. The "claim rate"
is "net claims paid plus collection cost as a percentage of total
loans made since the program inception," but does not include subsequent
recoveries, which would almost halve this claim rate. Since the program
began, an estimated $7.6 billion has been lent; the Department expects
another $4 billion to be lent in the next five years.
Changing to an income-contingent
loan program would, obviously, involve a radical shift in the federal
government's assistance to students. If the new program did not have eligibility
criteria, the government would probably have to come up with more than
$4 billion over the next five years. If the loan scheme became an important
source of university financing rather than a supplement to other sources
of funds, the cost to the government would be even greater. The cost to
the Canadian government could, therefore, be $1-$2 billion a year in the
early years of the program. Over time, the program could pay for itself;
however, it could be a constant drain on the government purse if only
those with low expected earnings took out these loans or if there was
a sharp increase in interest rates so the fixed proportion of a graduate's
income became an insufficient repayment of the loan and accrued interest.
Any attempt to use Revenue
Canada to collect the loan repayments would also involve a radical shift
in the student loan program and in the functioning of Revenue Canada.
Tax returns would become more complicated, and there would be immediate
costs to Revenue Canada. These costs might be paid, however, perhaps several
times over, by a lowering of defaults on student loans. No precise estimates
of the costs or benefits in this area are possible.
One way of gauging how practical
a program of income-contingent student lending might be is to see what
proportion of income would go to repaying the loan if the program were
designed to be self-financing. This is the approach taken in a recent
paper on income-contingent student loans in the U.S.(8)
According to the authors: "If we suppose a participant borrows $25,000,
the required supplementary tax rate to repay the loan would be 17.75 percent
over 10 years or 7 percent over 25 years, again assuming no adverse selection."
tax rate" is the proportion of income taken to repay the loan (x
in the formula given earlier); if this tax rate is to be comparable to
common tax rates, of course, the income base used in the loan repayment
must be the borrower's taxable income. Use of the tax system for social
policy, therefore, will affect the repayments of income-contingent loans
(and possibly the setting of x in future years).
The Krueger-Bowen paper
also points out that the supplementary tax rate would be higher for women,
if the scheme allowed for the historically lower post-graduate earnings
of women. The figure of 7 % over 25 years to pay back a loan of $25,000
was based on average earnings of men and women; if the calculation were
based on the average earnings of women, the supplementary tax rate for
women would become 12.5%; if the calculation were based on the average
earnings of men, the supplementary tax rate for men would become 5.75%.
Again, these figures do not include any adjustment for adverse selection.
Krueger and Bowen suggest,
however, that: "Because of adverse selection, the average program
participant will probably have lower earnings than the average eligible
person in the population." Accordingly, they adjusted their calculations
so that the average person with an income-contingent loan would have "earnings
equal to that of a worker occupying the 25th percentile of the earnings
distribution." The results are startling, especially when men and
women are treated separately. For men and women together the supplementary
tax rate jumps to 21% for a $25,000 loan to be repaid over 25 years (44.25%
if repaid over 10 years); for men as a group the supplementary tax rate
is 10.75%; for women it is a staggering 68.5%.
Several comments must be
made. First, note that this a supplementary tax rate that must be added
on to the regular tax rate to calculate the total tax burden facing the
borrower of an income-contingent loan. Women borrowers -- assuming the
calculations by Krueger and Bowen are reasonably accurate -- could end
up with overall marginal tax rates of more than 100%. This would certainly
discourage women from entering the labour force.
There is, of course, the
question of the legality of having different repayment rates for men and
for women. Different rates are certainly politically unpalatable and would
possibly be found to be unconstitutional: on the surface, the different
rates would violate section 15 of the Canadian Charter of Rights and
Freedoms, which prohibits discrimination on the basis of gender, although
a counter argument could be made, in line with section 1 of the Charter,
that there is a sound economic reason for the different rates. There would
undoubtedly be a court case if an income-contingent scheme were set up
with different rates for men and women.
If having different rates
for men and women was found to be unconstitutional, the income-contingent
loan scheme could founder on the problem of adverse selection. The problem
would be aggravated, moreover, if private lenders created instruments
appealing to students likely to have above-average incomes.
If an income-contingent
loan scheme becomes a source of financing students likely to have relatively
low future incomes, the government could be faced with the need to provide
large subsidies for the scheme (or with the need to set high supplementary
tax rates for those using it). Given the current fiscal difficulties for
all levels of government, providing the initial funding for an income-contingent
lending scheme would pose another problem.
There are obviously many
varieties of income-contingent student loan, although all share the basic
element first set out by Friedman in 1955 -- repayment based on a proportion
of a student's future income. Early advocates of the scheme saw it as
a means of reducing the role of government in higher education. Schemes
now in operation in Australia and New Zealand, however, involve direct
government loans and the use of government tax collectors to process the
repayments. The scheme about to begin in the U.S. involves direct government
lending, although the role of the tax system in the program has not yet
been worked out. Unfortunately, none of the current schemes has been in
operation long enough to generate useful data on the benefits of income-contingent
In theory, such lending
has many good points. It avoids placing large financial burdens on new
graduates by allowing them, in effect, to sell shares in themselves (with
the returns on these shares varying with future income) rather than finance
their education with fixed interest debt. Thus, repayment of an income-contingent
loan varies with the returns to the investment in education.
A move to income-contingent
lending in Canada, however, would have immediate implications for the
government's financial requirements. The annual subsidy for such a scheme
could be significant if adverse selection became prevalent. Moreover,
attempts to avoid adverse selection could run into constitutional challenges.
The paper was included as a chapter in Robert A. Solo (ed.), Economics
and the Public Interest, Rutgers University Press, 1955 and revised
as a chapter in Friedman's Capitalism and Freedom, University of
Chicago Press, 1962.
Milton Friedman and Simon Kuznets, Income From Independent Professional
Practice, National Bureau of Economic Research, New York, 1945, p.
90 and 20.
D. Bruce Johnstone, New Patterns for College Lending: Income-contingent
Loans, Columbia University Press, New York, 1972.
Because of recent U.S. interest in income-contingent student lending,
the Financial Aid Director at Yale University prepared a note in 1988
(updated in 1993) explaining Yale's experience with such lending. The
information on Yale in this paper is taken from the note and from an appendix
in the Johnstone book cited above.
The Student Loan Reform Act of 1993 was passed in August 1993 as
part of the Omnibus Budget Reconciliation Act of 1993. The National
and Community Trust Act of 1993 was passed in September 1993.
Two useful references for this section are: Marc Leman, Post-Secondary
Education: The Role of the Federal Government, Library of Parliament,
Background Paper, BP-140E, February 1986 and Odette Madore, Post-Secondary
Education: An Imperative for Canada's Future, Library of Parliament,
Background Paper, BP-319E, November 1992.
Globe and Mail (Toronto), 11 March 1993.
Alan B. Krueger and William G. Bowen, "Income-Contingent College
Loans," Journal of Economic Perspectives, Volume 7, Number
3 (Summer 1993), p. 193-201. The article is a useful introduction to income-contingent