Financing Higher Education

Answers from the UK

Nicholas Barr, Iain Crawford

• Publisher: Routledge
• Year: 2004
• Topic: Economics
• eBook ISBN:
  9781134280735
• Subtopic: Business General
• Index: Economics

This topical volume tells the story of the UK debate on financing higher education, illustrating a head-on collision between the economic imperatives of student loans and regulated market forces, and the political imperative of 'free' higher education. In telling the story of the partnership of an economist and a political professional, the book offers lessons about both policy design and the politics of reform: of particular relevance to countries which have not yet addressed the issue, including many OECD countries, the more advanced post-communist reforming countries and, increasingly, to middle-income developing countries.

No longer the exclusive province of a small intellectual elite, higher education is a key element in national economic performance. A modern economy needs a high-quality university system, and needs to make it accessible to everyone who can benefit, but mass higher education is expensive, and competes for public funds with pensions and health care, to say nothing of nursery education and schools. How to pay for higher education has thus become a central issue, and Barr and Crawford's book expertly covers the debates and issues involved.

Chapter 1

Higher education in Britain, 1987 to 2004

The spark that generated this book was a 1987 White Paper, Higher Education: Meeting the Challenge (UK Department for Education and Science 1987), which strengthened central government control of universities in England and Wales almost to the point of nationalising them. The problem was never one of academic freedom (as our noisy campaign demonstrates), but of the economic freedom of universities. Our initial motivation was our view that the academic response to the White Paper was supine, and that academics themselves should be taking a lead in reform.

The story since then can be divided into three parts.

• The late 1980s, a time of innovation, saw the passage of the Education Reform Act 1988, which strengthened central planning of higher education, and further legislation which introduced Britain’s first largescale student loan scheme. The chapters in Part 1 argue that central planning was the wrong direction, and that, though it was right to establish loans, the scheme introduced was the wrong one both in terms of design and because it did nothing to improve the funding of higher education.
• It was therefore predictable that funding problems would recur. As a result, the Dearing Committee was set up in 1996 and published its Report in 1997. The chapters in Part 2 discuss this period. Their main argument is that the recommendations of the Dearing Report (flat fees, covered by a better-designed loan) were coherent, albeit cautious, but that the government’s response (income-tested fees unsupported by a loan entitlement) muddied the waters. Once more, an opportunity to solve the problems of higher education finance was lost.
• The chapters in Part 3 discuss a major push by government in the early 2000s, culminating in the 2004 Higher Education Act, which introduced variable fees fully covered by a student loan. The last few chapters take a supportive view of these reforms.

Part 1 Introducing student loans

The landscape in the late 1980s

We started from shared and strongly held views about the ‘What’ of higher education (i.e. its objectives), and the ‘How’ (i.e. the way higher education should best be organised).

The chapters in Part 1 are based round two objectives – expansion and access. In the late 1980s, the UK had one of the lowest participation rates in higher education (about 14 per cent) of any advanced industrial country. Expansion was necessary, first, as a national response to technological innovation, which has increased the demand for highly skilled people and reduced the demand for the less skilled. In addition, alongside broader arguments about personal development, education and training improve a person’s life chances. The argument is not specific to higher education, but applies to post-secondary education more generally.

Improving access to higher education for people from poorer backgrounds, was (and remains) necessary to rectify the strong socio-economic gradient in university attendance, both to enhance social justice and because no country can any longer afford to waste talent.

Our concentration on these objectives in no way denies that universities also have wider purposes. Academic freedom and the pursuit of knowledge are important for their own sake; and universities contribute to the transmission of values, rooted in a country’s history and culture. Research should be pluralist not only within each country but also internationally, not least because the questions asked by researchers and the approaches taken to answering them will differ across countries. Thus the finance of higher education should nurture teaching and research capacity, not only in the USA but also in the wider Europe, Asia and more broadly.

Our second starting point was the view that higher education is not a suitable case for nationalisation. University education is not like school education. First, there is an age gradient in the extent to which participants are well informed. School children, especially young ones, are not well informed, nor necessarily are their parents. These problems are a central reason why the state should provide the bulk of finance for school education and, separately, should be the major provider. The argument crops up throughout the book (for fuller discussion, see Barr 2001a, Ch. 11; 2004). In contrast, consumer choice – and hence market forces – is useful for higher education, where students are generally better informed than any central planner. Second, and reinforcing these arguments, there is a diversity gradient. It is right that, especially at primary level, schools should offer a fairly standard package of knowledge and skills and also – and critically important – attitudes and values (e.g. respect for diverse views).¹ But the older a child gets, the greater the case for diversity to reflect differences in interests and abilities, an argument that is at its strongest in higher education, and is further strengthened by the growing diversity of knowledge.

This analysis simultaneously argues for state school education and against central planning of higher education. Our advocacy of regulated market forces in higher education is thus rooted in the economics of information, not in ideology. We both strongly support state school education and the National Health Service.

Our initial premise was that denationalising universities meant that they would have to become less dependent on public funding. Various sources of private finance (discussed in Chapter 7), include family support, contributions from employers and university endowments. But it was – and remains – our view that the only large-scale and sustainable source of income for universities derives from their core services, teaching and research. We focused particularly on the former, for which the logic of denationalisation was clear:

• To increase their independence, universities would need to be able to earn money by charging fees.
• But a requirement to pay fees from family resources would unquestionably harm access, a non-negotiable objective for us both.
• Thus fees would have to be covered by a student loan, but loans with mortgage-type repayments would themselves harm access.
• What was needed, therefore, was a system of loans with income-contingent repayments (i.e. repayments calculated as x% of earnings until the loan had been repaid). As discussed in the first (Barr 1987) edition of The Economics of the Welfare State (see the extract in Chapter 2), the major advantages of income-contingent loans are twofold: they protect individuals from a heavy repayment burden during times of low earnings, thus minimising deterrents to access; and, if well designed, they ensure that a high fraction of total borrowing is repaid.

As well as assisting the autonomy of universities, the case for student loans emerged also from chronic underfunding of higher education as a whole – a recurring theme in subsequent chapters.

Our early work therefore included fees as part of the overall strategy, but concentrated on designing a student loan scheme, which (1) had income-contingent repayments, (2) was easy to administer and (3) did not substantially raise public spending, any increase being an anathema at a time when the Thatcher administration was in its pomp.

Chapter 2 1987 Income-contingent loans: a central theme

We have argued for many years, and others before us (Friedman 1955; Peacock and Wiseman 1962; Prest 1962; Glennerster et al. 1968) that student loans should have income-contingent repayments collected alongside income tax or social security contributions, until the borrower has repaid what he or she borrowed. Since the point is fundamental and one of the two central themes of this book, it is worth explaining why (for fuller discussion see Barr 2001a, Ch. 12).

A conventional loan is a useful benchmark. The loan (say to buy a house) will have a fixed duration (say 25 years) and a positive interest rate. Monthly repayments are determined by three variables: the size of the loan, its duration and the interest rate. Other than adjustments because of changes in the interest rate, monthly repayments are fixed.

Buying a house is a relatively low-risk activity:

1. The buyer generally knows what he is buying, having lived in a house all his life.
2. The house is unlikely to fall down.
3. The real value of the house will generally increase.
4. If income falls, making repayments problematic, he has the option to sell the house.
5. Because the house acts as security for the loan, he can get a loan on good terms.

For all these reasons, the private sector provides home loans, with little role for the state beyond regulating financial markets.

The contrast with lending to finance a university degree is sharp. First, though many students are well informed, those from poor backgrounds might not be, potentially violating (1) in the list above. In addition, borrowers face risk and uncertainty, which arise because (2), (3) and (4), though true for housing, are less true for investment in skills. A qualification can ‘fall down’, because a borrower may fail his exams, and thus ends up liable for loan repayments, but without the qualification that would have led to increased earnings from which to make those repayments. Second, even well-informed students face risk: though the average private return to investment in human capital is positive, there is considerable variation about that average. In addition, even the private benefits of education are hard to quantify, so that the borrower faces uncertainty as well as risk about the return to a particular qualification. Third (element (4)), someone who has borrowed to pay for a qualification and subsequently has low earnings and high repayments does not have the option to sell the qualification, further increasing the borrower’s exposure to risk.

Lenders also face uncertainty. If I borrow to buy a house, the house acts as security. If I fail to repay, the lender can repossess the house, sell it and take what is owed. Loans are thus available on good terms. An analogous arrangement with human capital would allow the lender, if I default, to repossess my brain, sell it and take what is owed. Since that is not an option, lenders for human capital have no security: they face uncertainty about whether I will acquire the qualification, and whether my subsequent earnings will allow me to repay. Because there is no security, adverse selection is a second problem, since the borrower is better informed than the lender whether he or she aspires to a career in accountancy (a ‘good’ risk from the lender’s point of view) or in acting.

The resulting inefficiencies are major. On the demand side, (1) some borrowers, particularly from disadvantaged backgrounds, may be badly informed about the value of a degree, not least because of a lack of family university experience, and (2) all borrowers face risk and uncertainty, both about the return to their investment and because they cannot sell the qualification should their income turn out subsequently to be low. The resulting borrowing will be inefficiently low.

The problem is accentuated on the supply side. Lenders face uncertainty about the riskiness of an applicant and therefore charge a risk premium. A risk premium assessed by a well-informed lender is efficient (e.g. higher car insurance premiums for bad drivers). But lenders are not well informed about an applicant for a student loan. Thus risk premiums will be inefficiently high, further reducing the amount of borrowing. Additionally, lenders face incentives to cherry-pick, i.e. to find ways of lending only to the best risks, analogous to incentives to cream skimming that face private medical insurers. One way to do so is to lend only to students who can provide security, for example, a home-owning parent. Once more, the resulting borrowing will be inefficiently low.

Conventional loans are also inequitable. The various efficiency problems impact most on people from poorer backgrounds, women and ethnic minorities, who may be less well-informed about the benefits of a qualification and therefore less prepared to risk a loan. In addition, these groups tend to have a less well-established credit record. They are therefore less tempting to lenders and thus likely to be on the wrong end of cherry-picking.

Income-contingent repayments exactly address these problems. Designed explicitly for that purpose, they have a profound effect on higher education finance in ways that are still not widely understood. Graduates with low earnings make low or no repayments; and people who never earn much do not repay. Separately, a larger loan (or a higher interest rate) has no effect on monthly repayments, which depend only on the person’s monthly income. Instead, a person with a larger loan will repay for longer.

Chapter 2 (originally published in the first (1987) edition of The Economics of the Welfare State) was Barr’s first piece of writing about loans. At the time it appeared to have had little impact. But it later transpired that it had had a significant influence on the Wran Committee in Australia, which introduced their Higher Education Contribution Scheme in 1989. The scheme included the first large-scale scheme of income-contingent loans with repayments collected by the tax authorities, which became an important weapon against British civil servants, some of whom cast doubt on the practicality of our proposals.²

Chapter 3 1988 Setting universities free from central planning: a second central theme

The issue in 1988 was how to fund universities without central planning. Barnes and Barr (1988), from which Chapter 3 is drawn, was our unofficial attempt to draft the relevant White Paper, hence the book’s subtitle ‘The Alternative White Paper’.

The first edition of The Economics of the Welfare State argued against vouchers for school education on both efficiency and equity grounds. John Barnes’s proposal for what, in essence, was a voucher scheme for higher education therefore initially provoked suspicion. The writing in Chapter 3, however, shows a growing realisation that the analysis which argues against vouchers for school education simultaneously supports the approach for higher education for reasons which the chapter sets out:

• Information. Students are well informed, or potentially well informed; even before the Internet considerable information was available about different degrees and (in contrast with health care) prospective students have time to seek advice and to ponder their options.
• Competition. Vouchers (called bursaries in Chapter 3) are compatible with more or less competitive regimes. With a completely hands-off approach, universities attracting large numbers would flourish, those unable to do so would go to the wall. At the other extreme, governments could determine the number of vouchers for each subject and university, mimicking pure central planning. Thus the mechanism allows public policy to determine the degree of competition, including vouchers tied to particular universities or particular subjects. The mechanism is also compatible with different fee regimes: ‘Finally, and of considerable importance, is the issue of whether institutions are completely free to set their own fee levels, whether fees may vary only within a given range, or whether fee levels will be centrally established for all institutions . . .’ (this volume, p. 35), a paragraph that foreshadows the fierce debates about fee variability in 2004, discussed in Chapter 15.
• Redistribution. Vouchers can be designed to be strongly redistributive, for example paying larger vouchers to students from disadvantaged backgrounds. The idea is articulated more fully by Le Grand (1989).

The argument against central planning as a suitable mechanism for higher education – the second fundamental element in our strategy – is worth spelling out in more detail. Again, it is helpful initially to take a contrary case as a starting point. Consider the following stylised facts about health care: consumers are imperfectly informed because health care is a highly technical subject; treatment frequently results not from choice but because of an external event, such as breaking a leg; and when treatment is needed, there is often limited choice about its type. Much of the efficiency case for publicly organised health care is based on these facts. With food, the story is different. We are generally well informed about what we like and its costs, hence we can do our own shopping. And though food is a necessity, there is considerable choice over how we meet those needs. These technical differences explain why we ensure access to health care by giving it to people (largely) free; with food, in contrast, we ensure that elderly people have access to nutrition by paying them a pension and allowing them to buy their own food at market prices.

Within this stylised context, the question is whether education is more like food or more like health care. School education is more like health care: small children are not well informed; the need for education is externally imposed by legal compulsion so that it is consumed by all young people; and, especially for younger children, the range of choice over curriculum is properly constrained. There are also equity issues if middleclass parents are able to do better for thei...

Table of contents

• Cover Page
• Title Page
• Copyright Page
• Iain Crawford
• Foreword
• Preface
• Copyright acknowledgements
• Chapter 1
• Part 1 Introducing student loans
• Part 2 The chickens come home to roost
• Part 3 Shifting tectonic plates
• Part 4 Onwards and outwards