As the aggregate American student debt burden continues to scale new peaks and the budget lifetime default rate on subsidized Stafford loans stands at 19.4%, policymakers have begun to devise alternatives to the existing system of loan-based tuition financing. Among these, Republican presidential candidate Marco Rubio’s proposal to permit students to fund their studies via income-share agreements merits special notice.
Income-share agreements, otherwise known as human capital contracts, were originally conceptualized by economist Milton Friedman as a way to mitigate the risk introduced into student loans by the wide variation in returns to college education. In his 1955 essay “The Role of Government in Education,” Friedman wrote that a mutually beneficial alternative arrangement would see an investor “advance [a student] the funds needed to finance his training on condition that he agree to pay the lender a specified fraction of his future earnings.” The borrower would not face financial ruin if his college wage premium should prove to be less than he had initially projected. Conversely, the lender would see considerable upside from the possibility of the student’s earnings exceeding expectations and repayments outpacing the lender’s initial investment.
Income-share agreements (ISAs) have been seized upon by a variety of organizations as a compelling strategy for increasing the level of human capital investment. Miguel Palacios, of the libertarian Cato Institute, favours such arrangements, describing them as effective instruments that reduce repayment uncertainty for borrowers and default risk for lenders. Simultaneously they also incorporate an implicit subsidy for low-earning graduates in the form of greater returns derived from students who repay more than they had borrowed. The Economist is also sympathetic to ISAs, though it believes that an ideal system of tuition financing would also incorporate debt to mitigate the moral hazard associated with a purely income-based repayment plan.
Support for ISAs is not limited to libertarian institutions. In Oregon, Bill 3472 passed the Democratic-dominated State House and Senate unanimously and was signed into law on July 29, 2013. The bill called for the state’s Higher Education Coordinating Commission to conduct a study into the development of a “Pay It Back” program, similar to what Friedman proposed, that would constitute a state-run income-share program. As of the time of writing, a bill permitting the implementation of a pilot program is being considered by the Oregon House Ways and Means Committee.
Despite bipartisan support for income-share agreements, there are significant obstacles to effective implementation that must be surmounted before ISAs may constitute viable alternative to student loans. Chief among these is the problem of adverse selection. If certain students expect to pursue unusually remunerative careers upon graduation, they will have little incentive to fund their tuition with an ISA, opting instead for traditional student loans. Investors will then be left solely with students who intend to pursue less financially-rewarding careers.
Miguel Palacio, Tonio DeSorrento and Andrew Kelly expect that investors would be able to price ISAs appropriately to reduce disincentives for students entering lucrative fields. They do not, however, explain a mechanism for mitigating the information asymmetry inherent to such agreements: only the borrowers are aware of their future career intentions. For example, investors would be unable to know with any degree of certainty whether a student pursuing a mathematics degree intends to work as a highly-paid quantitative analyst or as a teacher for comparatively less compensation. Those who intend on pursuing the former career would be less likely to opt for an ISA.
These predictions are borne out by empirical data. Yale’s Tuition Postponement Option, which was designed by Nobel Laureate James Tobin and ran from 1971 to 1978, placed 3300 students into a series of cohorts. Members of each group paid four percent of their income per year for every $1000 borrowed until the cohort’s collective tuition had been repaid. The program was widely perceived to be a failure. High-earning graduates bought themselves out early for 150% of their loan amount, plus interest. As a result, the remaining debt was divided among a smaller, lower-income cohort. Final payments were made in 2001, three decades after the first loans were offered.
Income-share agreements may prove to be an attractive alternative to traditional loans for students who face significant uncertainty regarding their future ability to repay debts. However, a large-scale rollout of an ISA program should not begin until issues regarding adverse selection have been resolved. A pilot program incorporating students hailing from a wide range of demographic groups would provide policymakers with important empirical information regarding the effectiveness of ISAs.