STUDENT FINANCE: REPAYMENT OF GRADUATE DEBT. TWS Policy Paper

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1 STUDENT FINANCE: REPAYMENT OF GRADUATE DEBT TWS Policy Paper Anna Stansbury January

2 BACKGROUND: THE GOVERNMENT S PLANS FOR REPORM The Government s proposal to lift the cap on university tuition fees to 9,000 per year has significantly altered the overall amount graduates will repay after completing university degrees. This makes the way repayment is structured extremely important, to enable graduates to make contributions to the repayment of the loan at an affordable rate, to allow graduates who do not reap large financial rewards from their degrees to pay less, and to ensure that the system is financially sustainable for the government. Under the government s plans, any university or college will be able to charge a graduate contribution of up to 6,000 per year, and certain universities who meet criteria on fair access will be able to charge up to 9,000 per year. Tuition fee loans to cover the full cost of the fee, and maintenance loans, will be available to all full-time and part-time students. In addition, students from families with low and medium incomes will be entitled to grants. Graduates will begin making contributions to tuition costs when they are earning 21,000. Annual repayments will be 9% of income above 21,000, and all outstanding repayments will be written off after 30 years. A real rate of interest will be charged on loan repayments with a progressive taper. Graduates earning below 21,000 will be charged no real rate of interest, and the value of the loan will be uprated in line with RPI 1 inflation. Graduates earning between 21,000 and 41,000 will be charged a tapered real rate of interest, reaching a maximum of RPI + 3%. Graduates earning over 41,000 will be charged a rate of RPI + 3%. Early repayment of loans may be allowed, but with a financial penalty. PROPOSED CHANGES TO THE GOVERNMENT S PLAN The government s plan, as in the current system, links repayment not to the overall size of the debt but to the income of the graduate. This system is progressive and ensures that contributions are affordable for all graduates regardless of income. This report proposes no changes to this principle. Furthermore, this report will establish that the proposed principles of paying 9% of income above a certain level, of paying a real rate of 1 RPI and CPI are the two most common measures of inflation used in the UK. They are measured in different ways: see page 3 of this report for more details. 2

3 interest, and of erasing all remaining debt after thirty years, are also beneficial. However, the following changes will be proposed: i. The income threshold at which contributions begin to be paid should be median earnings, and be updated along with median earnings. ii. The interest rate charged on the loan should be CPI + 3%. The real value of graduates debt should never increase overall. iii. Early repayment should be permitted with no penalty iv. The progressive aspects of the system should be publicised far more clearly. INCOME THRESHOLD AND RATE OF REPAYMENT PROPOSAL: Only those earning above UK median earnings should be liable to make contributions. Contributions will be 9% of any income above that level. Students should pay 9% of any income above a certain income threshold. 9% is the figure that is in use under the current system, and has been proposed both in the Browne report and by the government. It is low enough to be affordable for graduates on low incomes, while ensuring the full value of the loan can be paid off more quickly by those on high incomes. The table below shows the level of weekly contributions from graduates earning incomes between 21,000 and 60,000 per year with an income threshold of 21,000 (i.e. 9% of income above 21,000 per year is paid). When considering the level of contribution relative to disposable income (post-tax income), it can be seen that the system is highly progressive. Annual Gross Weekly Weekly Post-Tax Weekly Contribution as % Earnings Income Income Payment of post-tax income 21, % 25, % 30, % 40, % 50, % 60,000 1, % Columns Annual Earnings, Gross Weekly Income and Weekly Payment are taken from the Browne report. Weekly Post-Tax Income was calculated using the current income tax and National Insurance rates (January 2011). 3

4 The size of weekly contributions can be compared to average household weekly expenditure to establish their affordability. Those in the most difficult positions to repay loans will be single income-earner households with one or more dependents. Average expenditure of households in the 5 th decile 2 group of gross income (between 410 and 520 per week) was , of which for example roughly 11 per week were spent on alcohol and tobacco, 29 per week on restaurants and holiday accommodation, and 49 per week on recreation 3. Weekly contributions on graduate debt for these households, assuming a single graduate income-earner on a salary of between 410 and 520 per week, would be between 50 pence and per week, which is affordable in light of overall expenditure. These would be the households in the most difficult position financially. Concern has also been raised about the squeezed middle of graduate households, those in professions which require degrees but do not necessarily pay highly, such as teaching or nursing. The 8 th decile group of gross income represents income between 796 and 985 per week, equivalent to annual gross household income of 41,392-51,220 (equivalent to two relatively new teacher or nursing salaries per household). Total graduate debt repayments for two graduates would be between 35 and 52 per week, which can be compared to weekly average expenditure of 48 on restaurants and hotels, 73 on recreation, and 26 on clothes. Although it is clear that the debt repayments will not be insignificant, they must be viewed in the context of high household spending on leisure and non-essential items. What should the threshold be? The income threshold should be: i. Clear & understandable ii. Easy to uprate to reflect changing prices and earnings iii. Independent of potential government manipulation iv. High enough to ensure that low-earning graduates are not penalised 2 Households can be divided into ten decile groups according to income. The first decile group is the 10% of households with the lowest incomes; the fifth decile group is the 10% of households between 40% and 50% in the income distriution; the tenth decile group is the 10% of households with the highest incomes. 3 Data is from the Office of National Statistics publication Family Spending: A report on the 2009 Living Costs and Food Survey 4

5 The 21,000 figure chosen by both the Browne report and the government proposals has not been clearly justified. It has also been agreed that it will be uprated annually in line with earnings from April 2016, but the earnings measure that will be used to uprate has not been clarified, and could vary greatly depending on which average is used (e.g. median or arithmetic mean 4 ). This report proposes the use of median earnings as the income threshold above which repayments are made. In 2010, median earnings were very similar to the proposed threshold, at 21, The use of median earnings meets the criteria above. It is clear and easy to understand: if you are earning in the top half of the population, you make contributions towards repayment, and if you are earning in the bottom half of the population, you do not. It is easy to uprate the threshold with median earnings as the level increases each year. The decision on the level of the threshold will be entirely reliant on median earnings statistics, measured every year by the Office of National Statistics, which is impartial, independent of government and reports directly to Parliament. Finally, it seems fair that only those who are earning in the top half of the country s income distribution have to make contributions, as those earning salaries below this may not have reaped any financial reward from their degree. Note: the median graduate salary three years after finishing an undergraduate degree is 23, Few graduates will therefore have to make repayments straight after graduation; but considering that this salary can be expected to increase significantly over the graduate s lifetime, few graduates should consistently earn near or below the median income threshold over their lifetime. 4 The median is the midpoint in a series of data, so median earnings is the earnings of the person in the middle of the income distribution. The arithmetic mean is the sum of all the data, divided by the number of pieces of data, so mean earnings is the sum of all earnings divided by the working population. Mean earnings can be skewed by a small number of very high or very low earners. 5 Gross median annual earnings data, Office of National Statistics 6 Destinations of Leavers from Higher Education Longitudinal Survey, Higher Education Statistics Agency

6 INTEREST RATE PROPOSAL: A real interest rate set to CPI + 3% should be levied on outstanding graduate debt. The real value of graduate debt should never increase: therefore any graduates earning below the income threshold should not be charged interest, and any graduates whose repayments do not, in any year, meet the interest should have the rest of the interest written off. The government proposes to charge a real interest rate 7 on graduate debt, to a maximum of RPI inflation + 3%, slightly higher than the government s borrowing costs. Under the current system, graduate debt has a zero real interest rate: its value increases only with the rate of RPI inflation. EVALUATION: A ZERO REAL INTEREST RATE A real interest rate should be charged on graduate debt. A zero rate is a government subsidy to graduates (as the government is charging less for the debt than its own borrowing costs). This subsidy, under the current system, benefits only high-earning graduates and wealthy students. A zero real interest rate is regressive Graduates on low incomes do not repay the full value of their loans, as any outstanding debt is erased after 25 (30) 8 years. There is no difference to these low-earning graduates between having an interest rate or not, as even if their debt accrues interest, they never repay the full value of the loan, let alone the interest. Graduates on high incomes repay their loan in full, so the total value of their payments is significantly lower without a real interest rate than it would be with one: the rich get an interest rate subsidy while the poor do not. The size of the interest subsidy has been estimated to be 30-35% of the value of all student loans under the current system 9. Regardless of the size of the subsidy, it only benefits the wealthy and is therefore regressive and wasteful. 7 A real interest rate is an interest rate net of inflation, i.e. the total interest rate minus the inflation rate years under the current system, 30 under the proposed system 9 Barr, Nicholas and Alison Johnston, Interest Subsidies on Student Loans: A Better Class of Drain (2010), Centre for the Economics of Education 6

7 A zero real interest rate encourages excess loans and enables wealthy students to make a profit Students who are able to pay tuition fees and maintenance upfront upon entering university have an incentive to take out fee and maintenance loans regardless. They can invest both the maintenance loan (paid directly to them) and the funds that would have been used to pay tuition fees, earning a real interest rate on them, and then repay both loans with no interest, making a profit from the government subsidy. A zero real interest rate limits the amount of loans available As loans are subsidised, the government makes a loss on each loan. The total loss the government can incur is limited and therefore the number of loans is limited. Reducing the government subsidy to student loans by charging interest would enable loans for other students such as part-time students and postgraduates to be provided, as in the government proposal. EVALUATION: A MARKET INTEREST RATE Charging the market interest rate would eliminate the problem of encouraging excess loans and enabling profit-making; it would also enable the government to make more loans. However, it would allow the government to make a profit on the average loan rather than break even on it, which may be undesirable on equity grounds. Also, the lowest-risk students (i.e. those likely to make the highest lifetime earnings) could opt for market loans from the private sector rather than government, thus depriving the student loan system of the highest contributors, making it more expensive and more difficult to subsidise low earning graduates and students. The optimal solution is charging a rate between the market rate and a zero rate. This allows the government to break even on many loans (rather than subsidising them), freeing more government funds to subsidise lower-income students and graduates than would otherwise be available. CHOOSING THE INTEREST RATE The government proposes charging a rate of RPI inflation + 3% for graduates earning over 41,000. For graduates earning between 21,000 and 41,000, the proposal is to increase the interest rate from RPI to RPI+3% on a sliding scale. This paper suggests using a rate of CPI+3%, with interest write-off rather than a sliding scale of interest rates. 7

8 The two measures of inflation, RPI and CPI, cover different living costs. The main differences: RPI covers housing costs and UK households expenditure abroad, and excludes the changes in the cost of living for the highest earners; while CPI covers the cost of certain financial services and includes the expenditure of foreign households in the UK. The main difference is accounted for by housing costs, especially mortgage interest payments: as such, RPI is usually higher than CPI in periods of economic growth when the housing market booms and interest rates are high, and lower in downturns. Overall RPI is usually higher. CPI should be chosen over RPI for two reasons: CPI is a better measure of the average changing costs of consumption RPI is highly affected by changing interest rates for mortgage payments. Using RPI rather than CPI would artificially inflate the graduate debt interest rate, as rising interest rates would push up RPI inflation, which in turn would push up graduate interest rates. Secondly, most graduates become homeowners at some point with mortgages that are likely to track RPI for their interest rates, so if RPI were to rise faster than CPI, graduates would be hit both by rising mortgage repayments and a rise in the value of their graduate debt. Secondly, RPI is prone to far more regional variation than CPI, as a result of the significant regional differences in the rate of change of housing costs. Using RPI over CPI would unfairly punish those who live in areas with below average housing costs growth, and vice versa. CPI is consistent with the government s other policies on inflation The government s official measure of inflation is CPI. It is not only the measure used to target inflation, but also to uprate pensions and state benefits as of It would not only be inconsistent for the government to use RPI for graduate debt and CPI for benefits; it would also be perceived to be deeply unfair as RPI is usually higher than CPI therefore the government would be receiving money at a high interest rate, and paying it out at a low rate. This perception could be highly damaging. The difference between using RPI and CPI as the measure of inflation is not negligible. Between 1988 and 2010, the CPI estimates inflation as having been 84%, while the RPI estimates inflation as having been 109%. The value of an outstanding student loan over 8

9 Interest Rate those 22 years would have been over 20% higher under the RPI-based interest rate than under the CPI-based rate. The graph below shows the interest rates that would have been used at RPI + 3% and at CPI + 3% since It is clear to see that the CPI rate tends to be lower. Possible Interest Rates 9.00% 8.00% 7.00% 6.00% 5.00% 4.00% 3.00% 2.00% 1.00% 0.00% Year RPI + 3% CPI + 3% ADJUSTING THE INTEREST RATE FOR LOW EARNERS It is in the interests of fairness to ensure that the real value of student debt will not rise. The real value of the debt of those who are, in any year, earning below median income should be uprated only by CPI inflation. The size of annual contributions made is irrespective of the interest rate as it is purely based on percentage of income earned. The interest rate acts only to increase the value of outstanding debt. Therefore those whose annual contributions do not meet the cost of the real interest rate (3%) should have the rest of the interest for that year written off, and the value of the debt should be only uprated by CPI inflation. In this way, the real value of their debt will remain constant (as in the Browne report proposal). This has a similar effect to the government s proposal of a sliding scale of interest rates, but it is simpler both to administer (for the government) and understand (for the graduate). An example: in a particular year the outstanding debt is 30,000, CPI is 3% and the graduate is earning 30,000. The graduate s annual contribution, calculated by earnings, is 810. The total interest on the debt is 1,800 (CPI inflation 3% + the real interest rate 3%). 900 of this is inflation, and 900 is the real interest due. The graduate pays 810 of the real interest, and the remaining 90 is written off. The value of the debt increases only by inflation to 30,900 (so its real value remains constant). 9

10 The interest write-off can be justified not only on the grounds of fairness and simplicity, but also on the grounds of economic efficiency as it ensures continuity in the marginal tax rate. Although the real interest rate charged on the debt is constant at 3%, the writeoff effectively means that for low earners, a lower real interest rate is charged. In the above example, the real interest rate paid by the graduate earning 30,000 with 30,000 of outstanding debt is 2.7% as the remaining 0.3% is written off. For a graduate earning 25,000 with 30,000 of outstanding debt, the real interest paid would be 1.4%. The effective real interest rate therefore increases gradually as incomes increase. Increasing the real interest rate as incomes increase effectively increases the marginal income tax rate, and a higher marginal income tax rate can reduce incentives to work as the earnings gained from each extra hour of work are reduced. Increasing the marginal tax rate gradually as income increases minimises these distortions. In contrast, if the real interest rate were to jump, say from 0% to 3%, at a particular income threshold, the marginal tax rate would also jump by that same amount, creating distortions. Under the calculations of both the government 10 and the Institute for Fiscal Studies 11, of graduates repaying average debt of 30,000 (based on a university fee of roughly 7,000), the 60% earning the lowest lifetime incomes will not repay the full original value of their loan, regardless of any interest accrued. Therefore, the interest rate will not affect them. Over the loan repayment period, the average earnings of those at the cut-off, i.e. those who will repay more than the full original value of their loan, would be roughly 50, Concerns as to whether the interest rate will adversely affect this group are justified, but as this group reflects very high-income earners in comparison with both graduates and the total adult population, the effect of beginning to pay interest will not be significant in context of their absolute level of income. The most important effect of the interest write-off will be twofold: firstly, to protect those who will earn highly over the course of their career, but have some low earning years (e.g. while caring for children); and secondly to protect graduates from the psychological impact of seeing the real value of debt rise, which may cause concerns over repayment issues even if in the future it will not have to be repaid. 10 The government student and graduate finance proposals, Department for Business, Innovation and Skills 11 Dearden, Lorraine, Haroon Chowdry and Gill Wyness, Government proposals for higher education would squeeze high earners less and cost the taxpayers more, Institute for Fiscal Studies 12 See 11 above 10

11 REPAYMENT TIME SPAN PROPOSAL: Outstanding debt should be eradicated after 30 years. Early repayment should be permitted with no penalties. The government proposal increases the time span for repaying debt from 25 to 30 years. After 30 years, any outstanding debt is eradicated. This is indeed a long time, and should be considered with concern; however, the rewards of a university degree should pay back over the course of a whole career, therefore it makes financial sense to structure the costs of the degree over a similar time span. It must be acknowledged that the graduates who reaped the most reward from their degrees financially will have repaid all debt before the 30 years is up; whereas those who reaped the smallest reward financially will continue making contributions for 30 years. Therefore, it is those who reaped the least reward from their degrees who will continue repayments the longest; although it is also important to note that under the proposed system, the lowest earning 20-30% of graduates will pay back less than under the current system, according to the calculations of the government 13 and the IFS 14. The government proposals suggest that early repayment of student loans, if allowed at all, will be penalised by charging a penalty rate (for example 5%) on repayments over a certain amount or from high-income earners. The reason for doing so is that by repaying early, high earners will avoid interest payments on future contributions, so the government loses funds it would have earned if early repayment were prohibited. Penalising early repayment allows the government to recoup (or even make a profit from) some of the interest income that it would lose in the event of early repayment. However, the basis upon which this is proposed is flawed. The central premise of the graduate debt system is that individuals (who can afford to) should pay the cost of their degree. Whether graduates are able to repay after 28 years or 2 years should be irrelevant if a graduate has been lucky or hard-working enough to earn enough to repay their loans early, this should be permitted and encouraged. It should be noted that, with a real interest rate charged, it is unlikely that students from wealthy families will take out tuition 13 See 10 above 14 See 11 above 11

12 fee loans and maintenance loans therefore the graduates wishing to make early repayments are most likely to be those from middle- or low-income backgrounds who worked hard to get high-salary jobs, or saved money on mid-salary jobs in order to repay early. It is true that some graduates may be lucky enough to receive a windfall just after graduation and therefore be able to repay all their graduate debt without interest, and this may be considered unfair (as it was due to luck). Yet a student who receives a similar windfall just before entering university will not take out student loans at all, and therefore will not have to pay interest. Penalising the first person in comparison to the second, simply for the timing of his/her luck, seems nonsensical and unfair. These cases will not anyway be the norm: early repayment is most likely to occur not through luck alone but through entry into high-paying jobs, achieved at least partly through hard work. Although early repayment would cost the government income in terms of lost interest, prohibiting or penalising early repayment undermines the principle that the system is in place simply to charge graduates for the cost of their degree, and not to penalise the hard-working or thrifty. REPAYMENTS: PUBLICISING THE TRUTH PROPOSAL: The progressive aspects of the system should be publicised far more clearly; the government should make every effort to use accurate terminology and prevent misleading information being spread. Whether unconscious or deliberate, the portrayal of the government and Browne report proposals in the public sphere has been highly misleading. The National Union of Students website writes, for example: It will push all of the costs of higher education onto students shoulders The only thing that students and their families could expect is higher debts. Many news articles on the topic 15 fail to mention the progressive provisions such as the fact that roughly 20% of students can expect to repay less than they currently do and fail to explain that the loan is not conventional debt, in that 15 For example the BBC: 12

13 contributions are linked only to affordability. Most major opponents to the system, including the Labour Party and the National Union of Students, propose a graduate tax. Yet the way the proposed system works has all the benefits of a graduate tax, in that it is taken in a progressive way as a percentage of earnings above a certain threshold, it is spread across all graduates, and the better off pay far more. Its advantage over a tax is that it is capped, so there is a maximum amount a graduate will pay for their education. This enables students to make an informed decision upon entering university about its advantages and disadvantages, as the student knows the maximum financial liability they can incur (whereas with a tax, the maximum liability is unlimited, and governments can alter tax rates at will in effect, retrospectively raising the price of higher education after the graduates have received it). There should be a mass campaign by the government to publicise these advantages of the system, outlined above. Currently, the terminology of debt repayment and student debt is used. This misrepresents the nature of the system and serves only to cause concern amongst poorer prospective students that they will be burdened with an obligation to repay the full amount of their student loan with interest. This is not the case. The system obliges graduates (rather than students) to make an annual contribution dependent on their earnings for that year and the amount of their outstanding loan. Contributions better reflects the income-linked nature of the payments, and the fact that there is no obligation to repay the full value of the loan if earnings are low, while graduate contributions better reflects the fact that it is only upon graduation that contributions need to be made. While the detail of the system itself is the most essential aspect to publicise, the use of more appropriate terminology as recommended above would also help people to understand better the nature of the system. It is imperative that the government counter these misconceptions about the nature of the repayment system if it is not to deter poorer students from entering university. 13