Predictions that £9,000 fees would deter young people from poorer backgrounds from applying to university simply didn’t come true. In fact, the current system is even more progressive than the one it replaced.
But the problem is that the system works almost by accident. We have a capped graduate tax in all but name. Eye-watering fees and so-called “usurious” interest rates ensure that the graduates who benefit most from university pay a larger share of the costs. As three-quarters of graduates never fully pay off their loan and have their debts written off, cutting tuition fees or capping interest rates would primarily benefit higher-earners.
When the Coalition Government lifted the cap on tuition fees to £9,000, they didn’t anticipate that amount to become the norm. Instead they assumed competition would mean only the very best institutions could charge fees that high. But as most students don’t expect to pay off the full cost of their loan, there is little incentive to shop around for cheaper courses.
We did get the promised price differentiation, it’s just not visible. While Oxbridge graduates are likely to end up paying back the full £9,000, graduates from less prestigious institutions will pay back much less. Worse still, each institution receives the full £9,000 per year regardless of whether or not they produce graduates capable of paying back their loans.
The valiant efforts of MoneySavingExpert Martin Lewis notwithstanding, it’s no surprise that the electorate thinks that cutting fees or capping interest rates would only benefit the best-off. The surprise success of Jeremy Corbyn on the back of a pledge to scrap tuition fees has increased pressure to change things.
Tinkering around the edges won’t work. Theresa May’s announcement of a rise in the repayment threshold and a tuition fee freeze received a muted response. The political calculus simply does not add up and the Conservatives cannot outbid Corbyn’s proposal to scrap fees altogether.
The upcoming review of higher education funding provides the opportunity to go back to first principles and deliver a system that works and, just as importantly, the public understands.
In the 1950s Milton Friedman observed that we cannot finance investments in human capital (e.g. a university education) in the same way we finance investments in physical capital (e.g. machinery). Unlike physical investments where the lender can count on realising at least part of the investment by selling the underlying physical asset, there is no way of clawing back any of the investment if a student defaults on their loan.
The problem is compounded by the fact that, even though the average expected return on a university education may be high, there’s a lot of variance between students that cannot be known in advance. Students differ in ability, work-ethic, and good fortune, as a result many loans would never be repaid in full. To compensate for this risk, lenders would demand high interest rates making the loans unattractive to prospective graduates.
One way to get around this problem would be for the state to subsidise higher education, either by offering low-interest loans or paying a share of the cost of tuition. But this is far from ideal. Under this approach non-graduates face higher tax burdens to fund the education of graduates who will eventually earn more than them and to keep spending down student numbers would need to be capped.
Equity, not debt, is the solution
Friedman had a better idea: use the same mechanism we use to finance other risky investments where lending is too risky — equity. Just as Silicon Valley startups with next to no physical assets are able to finance growth by selling a stake in the company’s future profits, students should fund tuition by selling a stake in their future earnings. Friedman envisioned lenders recouping more than their individual investment on high-earners compensating any losses from low-earning graduates.
This may sound far-fetched, but it’s already happening in the private sector. Education startup Lambda School offers intensive six-month software engineering courses with no-upfront costs. To fund the programme, they take 13 per cent of student’s salary (up to $30,000) for two years after the course is over and once the graduate has been placed in a high-paying job. The upside for the student is that if the course doesn’t pay off they’re not burdened with large debts.
There are potential pitfalls. There would be significant administrative costs to track each graduate’s income. As a result, the graduate equity industry may tend towards natural monopoly. The system would find it hard to co-exist with existing subsidised loans, the graduates with the best earning prospects will prefer loans to equity and vice versa. There may also be legal risks; such arrangements may fall foul of existing laws to prevent exploitation.
These obstacles can be overcome. The Government should take advantage of the earnings data it already collects for tax purposes, replace the current student loan system, and offer a line of credit in return for taking a stake in the future earnings of graduates.
Jeb Bush’s Presidential Run may have fell flat, but his equity-based student finance proposal deserves to outlive his campaign. As described by the Brookings Institution: “Students would pay one per cent of their income for 25 years for each $10,000 that they access to pay for their college educations. There is no interest and total payments are capped at 1.75 times the original amount borrowed.”
Specific numbers aside, Jeb’s plan is economically identical to our current system, save for one fact: it makes sense. This proposal gets around the pesky perception problem. Students would no longer carry the psychological burden of debt. Arcane arguments about the progressiveness of high interest rates would not be needed. This system would even be slightly more progressive than the status quo.
But progressiveness shouldn’t be the only aim. Income inequality is best dealt with directly through broad-based taxes and cash transfers. The point of tying contributions to earnings is to insure against the risk that a degree doesn’t pay-off.
Professor Nicholas Barr, the architect of the shift to income-contingent loans, has argued against moving towards a graduate tax on the grounds that variable fees support competition and the risk that funding decisions would be politicised. Yet the predicted price competition never arrived and funding decisions such as May’s move to cap fees are still in the hands of Ministers.
We need to tie funding to outcomes
Moving to a transparently equity-based system would not solve every problem. Under Jeb’s plan institutions would still have an incentive to charge excessive fees as they do under the status quo.
Rationalising the parts of the system that work is a necessary first step, but reform should go further, we need to fix the parts that don’t.
Beyond opaque graduate employment and salary statistics, universities lack an incentive to make their graduates employable. As Lambda School co-founder Austen Allred puts it “we need to align the incentives of the school with the incentives of the student.”
In the long run, graduates should repay the cost of their education directly to the university.
If funding was tied directly to student outcomes, institutions would scrap pointless degrees with poor job prospects, protecting students and the taxpayer alike.
Institutions unable to produce workers capable of repaying their loan would shrink, better-run organisations would take them over, and, in rare cases, they would simply go bust.
Politicians may wince at the idea, but in competitive markets firms must be allowed to fail to free-up space and capital for new entrants.
