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Today’s Student Loan Recipients are Tomorrow’s Economic Elite

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Today’s Student Loan Recipients are Tomorrow’s Economic Elite

May 10, 2012

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President Obama recently took to college universities and late night talk shows to tout his plan to keep student loan interest rates fixed at 3.4%. As e21 has noted previously, since 2008 the Federal Government has effectively socialized the student loan market by enacting laws to eliminate private lender participation in administering Federal loans. As a consequence, student loans owned by the Federal Government have grown from $111 billion at the end of 2008 to $425 billion (L. 106) as of December 31, 2011, a compound annualized growth rate of 56%. With a 9% default rate among borrowers in the most recent cohort and no collateral to cushion default severities (there are added protections in bankruptcy), the program’s interest rate would be insufficient to cover expected credit losses at today’s default rates.* Yet there is no appetite among elected officials for scaling back government involvement.

Despite the widespread agreement on extension of current policy, President Obama has focused on the issue to highlight tax policy and his own biography. By so doing, however, the President has revealed the incoherence of his broader approach to economic policy. On the one hand, President Obama wishes to present himself as one of the fortunate few who should have to pay more in taxes so the government can provide greater, or ongoing, loan subsidies to prospective college students. At the same time, the President references his own experience as a one-time recipient of student loans to argue for lessening the financial burden on prospective recipients. But, the President can’t have it both ways. The President is financially successful precisely because he is well-educated. If he can personally pay more in income taxes to defray the cost of the government’s student loans, he most certainly could pay the interest and principal balance on the loans he took out to finance his education.

The broader point is that income and educational attainment in America are highly correlated. Individuals have a strong financial incentive to gain additional education because the present value of the increase in lifetime earnings exceeds the cost of tuition. Subsidies to encourage prospective students to enroll in college are therefore not necessary and very likely counterproductive. Moreover, the notion that the costs of education subsidies can be pushed off onto “the rich” through higher taxes is fatuous, since the best educated are also the ones likely to be in the highest income tax brackets. To be sure, there are well-off families who pay for their children’s college (and graduate) education. But the progressive income tax (and the President’s rhetoric) does not distinguish between those with rich parents. Well-educated, financially successful households pay higher tax rates no matter how they financed their degrees. The only tax-related benefit for households who financed their advanced degrees with loans is the student loan interest deduction, but this provision is irrelevant for those facing the highest marginal tax rates because it phases out at $150,000 in income for joint tax filers.

Income and Educational Attainment

According to the most recent data from the Bureau of Labor Statistics (BLS), the median weekly earnings for college graduates in 2012 is 1.6-times that for workers whose highest degree was high school. The median worker with an advanced degree earns 2.1-times as much as the median high school graduate. Table 1 provides the differences in median weekly earnings by level of educational attainment for workers in 2012. The correlation is nearly perfect: each additional step on the educational attainment ladder adds an additional 33% to the median worker’s weekly earnings, on average.

median weekly earnings by educational attainment

Some could argue that the median may understate the impact of education since some industrious college drop-outs actually do quite well financially. While Bill Gates is the most famous example, many people can anecdotally reference someone they know who’s done well with little-to-no education. Table 2 below provides the same comparison as Table 1 but instead of using the median (50th percentile) in each distribution, it uses the 90th percentile.

The figures above provide the average weekly income necessary for a person in each educational cohort to qualify for that group’s top 10%. The differential actually grows relative to the median: the college graduate at the 90th percentile earns 1.8-times more than the high school graduate at the 90th percentile. Similarly, the worker with the advanced degree at the 90th percentile makes 2.2-times more per week than the high school grad at the 90th percentile. Thus, the distributions are largely the same shape, with the variation in college graduate’s income even greater than for high school-educated workers.

Over a lifetime, the increase in weekly income can be substantial. A 2002 Census Bureau study found that the average lifetime earnings of a Bachelor’s degree holder was 75% more than the lifetime earnings of a high school graduate. A follow-on study by researchers at Georgetown University found that the premium on a college education had increased to 84%, on average. If the education acquired through student loans dramatically increases the student’s lifetime earnings, the would-be student has every necessary financial incentive to take out the necessary loans. If the net present value of the investment is positive – and loans to pay for a bachelor’s degree at an in-state institution appears to be for all but those with the most extreme discount rates – then the expense of the investment itself is unimportant. For example, would you prefer a $50,000 investment that returned nothing, or a more “expensive” $500,000 investment that increased the present value of lifetime earnings by $750,000? In the first case, the net present value is -$50,000 while in the other it is +$250,000.

The economy benefits when more people attain greater levels of education (or skills) because the resulting increase in human capital increases productivity, living standards, and competitiveness. So it’s reasonable to think that education is something that should be subsidized if the individual did not have a strong financial incentive to do what is in society’s interest. Subsidies for renewable energy, for example, are generally premised on the idea that utilities and other energy consumers have a financial incentive to consume lower-cost fuels with higher emissions. Absent the subsidy for wind energy, for example, it would be in utilities’ interest to invest in more coal-fired plants, which, presumably, is not in society’s interest. Given the data on weekly and lifetime earnings disparities, it appears to be difficult to argue that would-be college students have a financial incentive to stay out of school.

Rather than focus on college generally, it might make more sense to focus on subsidies for education in areas that deliver an outsized impact to the economy, like engineering and sciences. But as the annual 2011 BLS occupation wage summary makes clear, these are precisely the jobs with the highest median weekly earnings. College degrees in subject areas that are likely to generate the greatest returns for society are also the degrees that are most likely to boost a graduate’s income. As a result, it is difficult to make a case for even these kinds of targeted subsidies.

With no externality or market failure to correct, the case for subsidized student loans seems to rest on the cost of college tuition and the fact that it has grown faster than the rate of inflation for many decades. But why should anyone believe the cost of tuition is exogenous to government subsidies? That is, why do we take the cost of college as given and then design policies to address rising costs rather than wonder whether the policies themselves are partly responsible for the inflation?

Imagine a favorite area restaurant that grew so popular that the prices of its menu items grew well in excess of inflation. If the government provided cash and loan subsidies to help patrons of the restaurant finance their meals, the net effect on affordability would probably be nil, as the restaurant’s owners would likely respond by raising prices. By relaxing patrons’ budget constraints but doing nothing to control costs, the policy would simply increase demand for a good that’s already in fixed supply, which is clearly a recipe for inflation.

The effect of cash and loan subsidies for higher education are unlikely to be any different. Colleges and universities have simply responded to the subsidies through increased tuition and housing costs. While the share of the population with college degrees has increased to a high of 30%, college completion rates have fallen as the increase in enrollment has not been matched by a similar increase in graduates. The student loan program appears to have stimulated enrollments, without a corresponding increase in graduates. This leaves households in the worst position of all, with the added debt associated with student loans but no degree to show for them. Yet, this outcome is entirely consistent with subsidies that eliminate the link between spending and household budget constraints.

Society does not need to subsidize the economic elite. Yet policies to defray the cost of interest rates on student loans do exactly that. Perhaps the policies could be tolerated if the taxes and subsidies netted out to zero, but the net impact is to increase tuition costs and lower completion rates, which leaves many households with added debt but no degree to show for it.

*This subclause was added after the commentary was first published.

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