1. Financing higher education: What’s right, what’s wrong, what next? Nicholas Barr and Alison Johnston European Institute Lunchtime Seminar LSE, 12 May 2009

2. Nicholas Barr May 2009 1 Financing higher education: What’s right, what’s wrong, what next? 1What’s right? 2What’s wrong? 3Fixing the problem

3. Nicholas Barr May 2009 2 1 What’s right?

4. Nicholas Barr May 2009 3 1.1 Lessons from economic theory

5. Nicholas Barr May 2009 4 Lesson 1: Competition between universities helps students Does competition work? Yes when consumers are well informed Are consumers well informed? –Students mostly a savvy, streetwise bunch –Much information is available and more can and should be made available –Good information is a central source of quality assurance: On the student experience On teaching On employment outcomes Are all students well informed? No. Information problems for students from poorer backgrounds contribute to debt aversion The same body of theory leads to a very different conclusion for school education

6. Nicholas Barr May 2009 5 Lesson 2: Graduates (not students) should share in the costs of their degree Higher education creates external benefits: Growth, social participation Thus right that society (aka taxpayer) should contribute But also significant private benefits in financial terms, but also in nonmonetary terms, e.g. job satisfaction Thus right that beneficiaries should share some of the costs BUT students generally cannot afford to pay Thus need a way that students can get it free, but graduates repay – loans

7. Nicholas Barr May 2009 6 Lesson 3: Well-designed loans have core characteristics Income-contingent repayments, i.e. calculated as x% of graduate’s earnings For efficiency reasons, to reduce uncertainty For equity reasons, to promote access, since loans have built-in insurance against inability to repay A genuine loan Large enough to cover all fees and realistic living costs; thus higher education free at the point of use An interest rate related to government’s cost of borrowing

8. Nicholas Barr May 2009 7 Loan repayments in the UK (2006 scheme) Bill Tariq Tim Jane Annual earnings £15,000£20,000£30,000£50,000 Income tax (monthly) £161.19£252.86£436.19£945.58 NI contributions (monthly) £91.26£137.10£228.76£274.93 Loan repayments (monthly) £0.00£37.50£112.50£262.50 Low earners make low or no repayments Repayments automatically and instantly track changes in earnings, exactly like income tax and national insurance contributions Loan repayments are generally much smaller than income tax or national insurance contributions

9. Nicholas Barr May 2009 8 1.2 A strategy for financing universities and students

10. Nicholas Barr May 2009 9 Leg 1: paying for universities: deferred variable fees Variable fees Promote quality by bringing in more resources, and by strengthening competition, creating incentives to use those resources efficiently Are fairer than any other method

11. Nicholas Barr May 2009 10 Leg 2: student support: free at the point of use Loans should be Adequate, i.e. large enough to cover all fees and all living costs Universal: all students should be entitled to the full loan As a result Higher education is free at the point of use Students are no longer poor Students are not forced to rely on parental contributions, extensive paid work or expensive credit card debt

12. Nicholas Barr May 2009 11 Leg 3: active measures to promote access Widening participation Raising attainment Improving information/raising aspirations Money measures

13. Nicholas Barr May 2009 12 2 What’s wrong? Two wrong interest rates Zero real rate I.e. interest rate equal to the inflation rate, lower than the rate at which the government borrows This is the rate on UK student loans ‘Commercial’ rate I.e. the rate on individual unsecured loans This is the rate charged on credit cards, bank overdrafts, etc.

14. Nicholas Barr May 2009 13 What is wrong with a blanket interest subsidy? A zero real interest rate Is enormously expensive, at least £1.2 bn per year (roughly 10% of total higher education budget of £12bn) Impedes quality. Student support, being politically salient, crowds out the funding of universities Impedes access. Loans are expensive, therefore rationed and therefore too small Is deeply regressive, the main beneficiaries being successful professionals in mid career

15. Nicholas Barr May 2009 14 Why interest subsidies are regressive An interest subsidy in a conventional loan helps people with low earnings But in the UK student loan scheme Loans have income-contingent repayments There is forgiveness after 25 years These 2 features turn the conventional argument upside down

16. Nicholas Barr May 2009 15 Who benefits from interest subsidies? Students? Low-earning graduates? High earning graduates with low early- career earnings? High earning graduates?

17. Nicholas Barr May 2009 16 3 Fixing the problem

18. Nicholas Barr May 2009 17 What should be done? The blanket interest subsidy should be replaced by targeted interest subsidies The default interest rate should be related to the government’s cost of borrowing Targeted interest subsidies should prevent real debt rising for People with low earnings People with caring responsibilities Use at least part of the savings for policies that really widen participation

19. Nicholas Barr May 2009 18 Specific policies to increase repayments Higher monthly repayments Increased duration of repayments

20. Nicholas Barr May 2009 19 Specific policies to increase repayments Option 1: Higher monthly repayments Repayment rate: 10%, 11% and 12% Repayment threshold: £13,000 and £10,000 Option 2: Longer repayment 1: charge a real rate of interest equal to the government borrowing rate New Zealand variant system: annual unpaid interest is forgiven Option 3: Hybrid system 1%, 2% and 3% interest rate coupled with 10%, 11% and 12% repayment rates Option 4: Longer repayment 2: an extra n years

21. Nicholas Barr May 2009 20 Calculation of interest subsidies Use an average graduate real salary path, calculated from the Institute of Fiscal Studies Starting salary £20,000 Assume that the Government borrows at a 3% real interest rate Students graduate with SLC debt of £25,126 Based on these assumptions, we estimate the current interest subsidy to be 28% of the loan, or £7,040 per average graduate

22. Nicholas Barr May 2009 21 Results: Options 1-3 Higher monthly repayments by changing the repayment formula is not highly effective (20% of the subsidy remains even under the most stringent conditions modeled) Combining higher monthly repayments (changed repayment formula) with longer duration (charging a positive real interest rate) provides more significant reductions

23. Nicholas Barr May 2009 22 Interest Subsidy Per Average Graduate (% of Total Loan) 1% real interest Rate 2% real interest rate 3% real interest rate 9% repayment Rate 20 (£5,030) 11 (£2,760) 2 (£500) 10% repayment Rate 19 (£4,770) 10 (£2,610) 1 (£330) 11% repayment Rate 18 (£4,520) 10 (£2,450) 1 (£230) 12% repayment rate 17 (£4,270) 9 (£2,260) 1 (£180)

24. Nicholas Barr May 2009 23 Results: Option 4 Progressive repayment extension: individuals who repay their loan in less than 10, 15 or 20 years, have an additional 3, 2, 1 years of repayment, respectively Has political and administrative advantages not present in other options Reduces the interest subsidy to approximately 7% of the original loan (for the average graduate) If the average graduate pays an additional 3 years instead of 2, the loan subsidy is completely eliminated

25. Nicholas Barr May 2009 24 References Vidha Alakeson (2005), Too Much, Too Late: Life chances and spending on education and training, London: Social Market Foundation. Nicholas Barr (2002), ‘A way to make universities universal’, Financial Times, 22 November 2002, p. 21, downloadable from www.econ.lse.ac.uk/staff/nb Nicholas Barr (2004),‘Variable fees are the fairer route to quality’, Financial Times, 30 March 2004, p. 21 downloadable from www.econ.lse.ac.uk/staff/nb Nicholas Barr (2004), The Economics of the Welfare State, 4 th edn, OUP Nicholas Barr (2004), ‘Higher education funding’, Oxford Review of Economic Policy, Vol. 20, No. 2, Summer, pp. 264-283. Nicholas Barr and Iain Crawford (2003), ‘Myth or magic’, Guardian, 2 December 2003, pp. 20-21, downloadable from www.econ.lse.ac.uk/staff/nb Nicholas Barr and Iain Crawford, Financing Higher Education: Answers from the UK, Routledge, 2005. Nicholas Barr and Alison Johnston (2009), ‘Interest subsidies on student loans’, in progress OECD (2008), Tertiary Education for the Knowledge Society, Volume 1: Special Features: Governance, Funding, Quality and Volume 2: Special Features: Equity, Innovation, Labour Market, Internationalisation, Paris: OECD.