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The New Income-Driven Repayment System Could Cause Some Big Problems
As IDR becomes the norm, college and student incentives radically change.
Most of the discourse on Biden’s student debt plan has so far focused on the $10,000 income-tested debt forgiveness. This makes sense as the forgiveness is a splashy short-run policy that is easy to understand. But the plan also includes significant changes to the country’s income-driven repayment (IDR) system that are, in the long-run, far more significant than the debt forgiveness.
The IDR changes are four-fold:
Increase the amount of income not subject to IDR from 150 percent of the federal poverty line to 225 percent of the federal poverty line.
Reduce the interest rate on IDR-enrolled loans to 0 percent.
For undergraduate debt, reduce the IDR rate from 10 percent of income beyond the threshold in (1) to 5 percent of income beyond the threshold in (1).
For IDR-enrolled debts with original loan balances below $12,000, reduce the repayment period from 20 years to 10 years.
For people with who are already using the IDR program, these changes offer a considerable amount of savings without affecting their debt-related decision-making all that much. But, going forward, these new rules could quite radically alter the incentives of colleges and students when it comes to college prices, institutional financial aid, how much debt to take on, and how to approach repayment.
The Gradual Erosion of Price Sensitivity
In the college discourse, it’s fairly common to argue that the expansion of government credit to students has been a major cause of escalating college prices. Analyzed abstractly, this claim never really made much sense. Insofar as debts have to be repaid, people who are buying things on credit still have every incentive to favor lower-price vendors over higher-price vendors. But in practice, for one reason or another, student borrowers do seem to frequently fail to act in a price-sensitive manner, meaning that the availability of student debt probably has enabled the bloating of college costs to some degree.
For most of the history of the student debt program, nearly every borrower had a fairly conventional loan featuring fixed monthly payments based on the loan balance. But in the last decade, this has stopped being the case. In 2010, only 10 percent of student debtors were enrolled in an IDR program, meaning that their repayment was based on a percentage of their income rather than a fixed monthly payment based on their loan balance. By last year, 32 percent student debtors were enrolled in IDR.
Already the percentage of student debtors enrolled in IDR has marched up every year for the last decade. Biden’s four changes to the IDR program should accelerate this rise in IDR enrollments for future students as IDR will become a better deal than conventional repayment for even more student debtors than it is currently.
A student that plans to enroll in IDR has no reason at all to care about the prices colleges are charging. To them, $15,000 of student debt is no different from $100,000 of student debt. For as long as the percentage of students enrolling in IDR remains small and students and colleges are unable to identify in advance who will wind up on IDR and who will not, this lack of price sensitivity among IDR participants is probably not much of a problem. But as IDR becomes the dominant form of repayment, it could become a serious problem.
Imagine if Medicare and Medicaid did not dictate the prices of covered services, but instead reimbursed medical care at whatever price the provider and patient agreed to without any cost-sharing. An IDR-dominant college sector, absent separately-imposed price controls, would be basically the same thing.
Look at the Law Schools
To see how this can play out in practice, consider the Loan Repayment Assistance Programs (LRAPs) that many law schools already have. Law schools provide a good view into this question because law graduates have been enrolling in IDR programs at high numbers for a long time and law schools have some ability to determine who is likely to use an IDR upon graduation and who is not based on the kind of law they plan to go into.
Under the Public Service Loan Forgiveness (PSLF) program, law graduates that go on to work in the public sector, which is a lot of them as the public sector employs many lawyers, only have to pay 10 percent of their discretionary income for 10 years in order to have their debt forgiven.
Law schools figured out many years ago that, for a student who is planning to enroll in PSLF upon graduation, prices and debt loads don’t matter. Ten percent of your discretionary income is ten percent of your discretionary income regardless of what the law school charges you and how much debt you nominally have to take on.
Law schools also realized that they could make the deal even sweeter by setting up LRAPs that give graduates money to cover the the modest repayments required by the PSLF.
The LRAP schemes work as follows:
The school increases their tuition.
The student takes out federal loans to cover the tuition increase.
The school squirrels away the debt-financed tuition increase into an LRAP fund.
The school disburses money from the LRAP fund to cover PSLF repayments.
Through this roundabout process, the law schools effectively use student debt to pay off student debt and make their schools free, at least for these particular students.
Under the IDR scheme proposed by Biden, the regular IDR program will become a little more generous than the current PSLF program that the law schools have so effectively gamed. It’s impossible to say for sure how schools will respond to that, but schools have already shown themselves quite adept at optimizing within the financial aid constraints and not just the law schools.
At some point, it seems like expensive private universities will realize that providing tens of thousands of dollars of need-based discounts to certain borrowers who are likely to wind up in IDR anyways does not make sense and that they should instead charge the maximum amount a student can cover through federal loans. As the law schools show, the surplus generated by that scheme could even be shared a bit with the students via an LRAP.
Even certain public universities may end up reconsidering the wisdom of state-funded tuition subsidies. Tuition subsidies that lower the cost of attendance for public university students that wind up on IDR anyways don’t actually benefit the student. Instead, they are just indirect transfers of money from state governments to the federal government.
Just as schools have new incentives to push debt loads higher in an IDR-dominant world, so do students. Above, I say that, for students planning to enroll in IDR, $15,000 of student debt is no different than $100,000 of student debt. But this is not quite right. A student planning to enroll in IDR actually benefits from taking out the maximum amount of debt possible.
Student loans are initially paid to schools to cover the tuition and fees. But the what’s left after tuition and fees is disbursed as cash to the students, ostensibly to cover living expenses. In a conventional student loan, you have reason to live frugally and take out as little debt as possible. But if you are planning to go on IDR, then your incentives flip and you are leaving money on the table if you don’t take out the maximum loan possible.
Even if you don’t want to spend it living lavishly while in college, you could squirrel away the surplus into a savings account for later use, including for use in making your IDR payments after you graduate. Indeed, this is just a student-administered version of the LRAP scheme discussed above where student debt is used to pay off student debt.
The Need for Price-Setting
I cannot predict the future and different incentives don’t necessarily result in different behavior. But the slow creep of IDR, which will be accelerated by the Biden plan, does at least increase the risk of certain unwanted behaviors by colleges, students, and even state governments.
There are other countries that have IDR-dominant college financing systems, such as Australia. But in Australia, the maximum price a university can charge for a particular course of undergraduate study is directly legislated by the government. If we are going to make the leap into an IDR-dominant college financing system, then we may need the government to also play a much bigger role in setting college prices, something it probably should be doing even before the Biden policy change. Otherwise, we may very well see more unwanted cost bloat beyond what we already have.