Government Managing Risk

Income Contingent Loans for Social and Economic Progress

Bruce Chapman

• Publisher: Taylor & Francis
• Year: 2006
• eBook ISBN: 9781134444328
• Edition: 1
• Topic: Business
• Subtopic: Business General
• Index: Business

Higher education rates are increasing throughout the Western world, yet at the same time, government budgets face increasing constraints. This has ensured that the importance of student support is recognized in many countries. In recent years there has been a world-wide movement towards the use of income contingent loans (ICL) for higher education. ICLs are now used in six countries following the Australian innovation of 1989, with the governments of many more countries looking very seriously at the model.

This impressive new book by Bruce Chapman analyzes ICLs (particularly their use in supporting students), exploring the experiences of a number of other countries adopting them. Chapman presents analysis of a number of disparate case studies to illustrate how ICLs can aid risk management policy reforming in both progressive and administratively feasible ways.

This book describes, examines and promotes an exciting new role for the public sector as a manager of risk, and argues that ICLs have enormous potential to change the extent and nature of social and economic activities. With the author's experience in the design and implementation of the Australian student financial support schemes, this is a knowledgeable, informative and enlightening book that will be useful to researchers, students and policy-makers alike.

Part I
Income contingent loans for higher education

1 Summary of Part I

Part I examines the basis for, and experience with, income contingent loans (ICLs) for the financing of higher education, recognising that over the last 15 years or so there has been a quiet revolution in approaches internationally to this issue. The most important change has occurred in those countries in which higher education systems had previously been funded almost entirely through taxpayer transfers, that is, without contributions from the direct beneficiaries, graduates. It is now the case that many countries, for the first time for many years, have introduced, or are about to introduce, tuition charges. Examples include New Zealand, Australia and the United Kingdom.

A second and perhaps more significant change concerns the approach adopted with respect to how tuition is to be paid. Specifically, charging reforms in several countries have involved the use of ICLs. The policy allows charges to be paid by graduates conditional on their capacity to pay, and is a profoundly different approach from the traditional fee arrangement involving government guaranteed bank loans.

Chapter 2 considers in detail the conceptual bases important to an understanding of these charging reforms, and begins with an examination of the economic case for student contributions to the costs of higher education. It is argued that students should pay some proportion of the costs, and in essence this case rests importantly on issues of equity and the distributional consequences of alternative financing approaches. It is suggested that there are compelling arguments for taxpayer subsidies, but it is recognised that there is no consensus as to how high these should be.

In this part of the book it is also explained that, left to itself, the higher education system will not be able to deliver either fair or efficient outcomes. Higher education is a market characterised by significant uncertainties for students, and high risks for prospective lenders. For good reasons banks will not be interested in providing loans to help disadvantaged students to cover tuition and with respect to income support needs. Government intervention is therefore necessary.

Chapter 3 examines the costs and benefits of the two major options available to government to solve the so-called capital market failure noted above. The first is the provision of bank loans with a government guarantee, usually to a subset of students, the approach adopted in the US and Canada, as well as other countries. The second policy approach is ICLs.

Government guaranteed bank loans have the significant benefit of removing the risks to the lender of default. They also allow private sector financing of important aspects of the higher education system.

However, it is argued in this chapter that a government guarantee for bank loans does not address other important aspects of the higher education financing process. They are:

1. While the lender is protected from the costs of default by the government guarantee, the borrowers – the students – are not. This means that students taking out bank loans might not be able to meet their repayment obligations and, in an extreme situation, could be declared bankrupt. Such an outcome has a very serious consequence: it necessarily adversely affects the credit reputation of defaulting students, and thus their access to, or the cost of, other loans, such as to finance the purchase of a house.
2. The availability of bank loan assistance is restricted by governments to a subset of prospective students, with the qualification and/or the level of support typically defined by means testing on the basis of family income.¹ A problem with this restriction is that some parents or partners with apparently high incomes might not be prepared to help a prospective student pay tuition or offer income support. In these circumstances the means-testing rule implies that some prospective students face up-front charges and income support problems.
3. Bank loans are characterised by repayments of set amounts over a given time period. This means that a borrower’s ability to meet the repayment obligation in periods of future economic difficulty is not taken into account, and they could experience economic hardships in order to meet these commitments.

This chapter examines in detail the costs and benefits of government guaranteed bank loans compared to ICLs. The defining characteristic of the latter approach is that repayments are required when and only if a student’s future income reaches a given level. That is, if the borrower’s circumstances turn out to be adverse in a particular period, no loan payments are required.

A critical theme of this book explored in Chapter 3 is that ICLs have two important benefits compared to government guaranteed bank loans, and they are both related to the risk reduction for borrowers inherent in having debt obligations being met on the basis of capacity to pay. This results in insurance, providing both default protection and consumption smoothing.

Chapter 3 also points out that there are several different forms of ICL, and the conceptual bases and implications of these are examined. It is argued that an ICL in which risks are shared with taxpayers, the so-called ‘risk-sharing ICL’, has the highest potential to deliver social and economic benefits.

Chapter 4 considers in detail the 1989 to 2004 experience associated with the most researched risk-sharing ICL for higher education, Australia’s Higher Education Contribution Scheme (HECS). HECS was introduced as a different way of collecting tuition, to substitute for in part the total taxpayer-financed system. At the time of its introduction it was highly controversial, considered by some to be unworkable, and by others to have a strong potential to harm the access of the relatively disadvantaged to the system. The evidence summarised in Chapter 4 suggests that the arrangement has worked as hoped.

Chapter 4 explains that HECS, or perhaps more generally the introduction of tuition charges, delivered considerable revenue to the Australian government, and this facilitated a considerable expansion in the number of public sector university places. The nature of, and changes to, HECS parameters are described and considerable effort is given to a review of its effects, particularly with respect to the potential for consumption smoothing and concerning both equity and access.

As well, from a range of different surveys and statistical tests, it is reported that HECS has had no adverse consequences for either equity or the access of the disadvantaged. This might be because international enrolment patterns in higher education are generally insensitive to the design of tuition charge and loan characteristics. There is some evidence, however, that in the period when the first income threshold of repayment was very low, 1997–2004, HECS might have had a adverse effect on tax compliance, but the extent of this problem in empirical terms is small. The chapter reports that HECS seems to be inexpensive to administer.

Chapter 5 explores in less detail the international debate and experience in a range of other risk-sharing ICL applications, or suggested policies, for higher education financing. It is apparent from this discussion that there is a very critical public policy issue related to the successful adoption of ICLs for higher education, which is that a particular set of institutional requirements is essential for their efficient implementation. While several administrative conditions are required for the collection of any type of loan for tuition or student income support, ICL schemes have an additional criterion: it is necessary to know, efficiently and with accuracy, the future incomes of former students. It is suggested that countries without administrative structures that cannot provide this are unlikely to be well suited to the adoption of ICLs.

Note

1 In the US, for example, the household income of young people defines the borrowing amounts available. In the Student Loan programme in Canada, students from relatively high income household backgrounds are ineligible for any assistance.

2 Paying for higher education

2.1 Introduction

This chapter examines the essential issues surrounding the responsibility and incidence of the financing of public sector higher education. The questions addressed are:

1. Is there a case for taxpayers to subsidise tuition?
2. What contribution to costs should be borne by taxpayers?
3. What is the case for a student charge?
4. Should student charges differ between courses?
5. Is there a case for government to subsidise student income support?
6. Should government intervene in the process?

Mainstream economic theory provides a framework that suggests that governments should contribute a proportion of the direct costs of higher education, but it remains clear that the precise level of the subsidy cannot be determined on the basis of existing empirical evidence. There is a case for students to be charged tuition (to reflect course costs), and this is both supported empirically and reinforced from an equity perspective. Further, given the nature of student higher education investment costs, it seems apparent that governments should subsidise, or at least be involved in the provision of, income support as well as tuition. Critically, it is argued in what follows that there is a strong case for government intervention in the higher education financing process, beyond the role of subsidies. This important point sets the scene for Chapter 3 which provides an analysis of the relative merits of an income contingent loan approach to higher education financing.

2.2 Economic issues related to taxpayer subsidies

Background

The conventional way of analysing efficiency issues with respect to public expenditure uses a proposition, well known in welfare economics, known as ‘allocative efficiency’, and what now follows is an informal description of this approach. A more formal exposition is provided in the Appendix at the end of this chapter.

The mainstream economics framework starts with the presumption that resources are in limited supply, and that the major conceptual issues are concerned with allocating these scarce resources in a way that maximises their production potential. This perspective focuses on the extent to which governments should subsidise activities in order to influence resource allocations, and is informed by notions of both private and societal costs and benefits. The private costs and benefits are considered in Section 2.3, and what now follows examines the decision-making issues from the perspective of government.

Economic theory suggests that government subsidies should reflect the value to the society of an activity, above and beyond the advantages for the individual of that activity. These additional social benefits are known as ‘externalities’ or spillovers. In understanding the externalities from higher education it is useful to distinguish the various components of expenditure into research, community benefits and teaching. Given our focus on tuition charges, what follows considers the last of these.

The nature of higher education externalities

Critical issues for policy concern the nature of social benefits and their likely size, given that economic theory suggests that the latter should determine level of government subsidy. With respect to government subsidies the significant issues are what, and how valuable, are higher education externalities?

The externalities from higher education have been argued traditionally to include, among other things: reduced criminal activity, more informed public debate, better informed judgements with respect to health and more sophisticated voting behaviour. However, the value of these particular externalities is likely to be small and debatable relative to the externality effect of higher education on economic growth. Since the early 1960s it has been argued that in a world of rapidly changing information more highly educated workers have an advantage in adapting to different environments, in ‘dealing with disequilibria’ – the capacity to adjust to unanticipated shocks (Schultz 1975; Huffman 1974; Fane 1975; Wozniak 1987).¹

Related issues have emerged in so-called new growth theory, which stresses the role of endogenous technical change, and the interdependencies between knowledge, innovation and human capital investments. However, the role of higher education with respect to productivity growth is highly complex, with educational improvements seen to facilitate technological progress, which is the engine of growth.

There are several (highly related) ways education is seen to impact on technological change:

• high levels of formal education are necessary for the successful introduction of capital equipment (Bartel and Lichtenberg 1987),
• the above connection encourages physical capital investments (McMahon 1999),
• during periods in which a population is undergoing increases in education there will be an effective increase in the size of the labour force, so long as education raises productivity (Barro 1991) and
• education disseminates information and through this adds to growth because death does not result in knowledge loss (Lucas 1988).

These notions have received wide acceptance in the economics research community. However, the consensus with respect to the conceptual importance of these factors, and the likely role of higher education for them, has not been matched with agreement concerning their empirical significance.

The value of high education externalities

Measuring the impact of higher education on economic growth is not straightforward. An important reason is that the impact of education on the skills of the labour force will be determined by both its quantity (that is, higher graduation rates) and its quality (that is, the amount of knowledge imparted at any given schooling level). Given data availability most analyses focus on the former.

The role in economic growth of both the quality and quantity of education internationally are compared in Hanushek and Kimko (2000). They test the extent to which educational quality as measured by standardised scores for mathematical and scientific literacy has contributed to economic growth differences averaged over 30 years across 139 countries. The test results are compared with the effect of changes in schooling quantities (as measured by the number of years of schooling).

They found that increases in workforce quality have a profound influence on economic growth. For example, on average a one standard deviation increase in test scores adds about 1 per cent to a country’s GDP per capita annual growth rate, which is arguably a very high impact. By contrast, increases in the quantity of schooling required to match this growth rate change seem to be very much higher: to achieve a 1 per cent increase in the annual growth rate of a country’s GDP per capita requires, on average, that workers had nine additional years of education.

The Hanushek and Kimko analysis does not address the sources of labour force quality, that is, in their context, the determinants of test scores. It is very possible that these have been correlated over time with rising school participation rates. As well, there is little direct role played here with respect to higher education. To argue that the Hanushek and Kimko result supports the role of higher education as a direct growth determinant requires a link between higher education and labour quality, an issue that was not tested.

Barro and Sala-I-Martin (1995), Gemmel (1996) and McMahon (1999) attempt to measure the direct role of education on economic growth. The former finds that a one standard deviation increase in the ratio of public education outlays to GDP of the order of 0.3 percentage points, with relatively high effects from the tertiary education sector. For the UK, Gemmel finds that a 15 percentage point increase in educational enrolments leads to just over half a percentage point higher rate of productivity growth. These broad results are supported in Englebrecht (2003), which emphasises in particular the positive role of human capital as a catalyst to technological diffusion.

A different way to think about this issue is presented in Chapman and Chia (1989). Their exercise suggests that under certain (and limiting) assumptions, it is possible to estimate what implicit value is given to the spillovers from higher education from particular levels of government subsidy. Assuming that a government provides marginal subsidies to higher education in such a way as to maximise the net social benefits of the activity, breaking down the costs and benefits of the ...

Table of contents

• Cover Page
• Title Page
• Copyright Page
• Figures
• Tables
• Contributors
• Preface
• Abbreviations
• Introduction
• Part I Income Contingent Loans for Higher Education
• Part II Income Contingent Loans for Public Policy
• Part III Income Contingent Loans for Public Policy
• Epilogue
• References