The Debt Commission and Higher-Education Policy

The co-chairs of the National Commission on Fiscal Responsibility and Reform have issued a set of proposals for long-run reduction in the federal deficit. Of central importance—but not highlighted in many of the brief reports on the recommendations—is that the Commission explicitly recognizes that the proposals must not “disrupt a fragile economic recovery.” In other words, they should not be implemented immediately. Given political realities, we probably don’t have to worry about that happening anyway.

The Commission also states a strong commitment to the principles of protecting the truly disadvantaged and of investing in “education, infrastructure, and high-value R&D. We applaud this critical distinction between consumption and investment. Failure to strengthen our nation’s investment in education—like failure to strengthen our infrastructure—would diminish our future prospects in direct opposition to the goals of the Commission.

But this does not mean that all spending in these areas should be sacrosanct. If advocates for education refuse to distinguish between those expenditures that have a significant positive impact on educational opportunities and outcomes and those that represent less efficient use of federal funds,  they hurt the cause more than they help it.

The Commission proposes eliminating the in-school interest subsidy on federal student loans. The Rethinking Student Aid study group, which the two of us co-chaired, made a similar proposal in its report on comprehensive reform of the federal student aid system issued in September 2008. A critical difference is that we recommended using the savings to strengthen protection for student borrowers through the Income-Based Repayment plan for Stafford Loans and other critical components of the student aid system—not for deficit reduction. Nonetheless, the Commission is correct to single out this element of the student-aid system as a target for cuts.

Students with documented financial need are eligible for subsidized Stafford Loans, for which the government pays the interest while the student is in school, for six months after the student leaves school, and during qualifying periods of deferment. Students without documented financial need and those who have borrowed the maximum amount of subsidized loans for which they are eligible can borrow unsubsidized Stafford Loans, on which the interest accrues while they are in school and during other periods of non-payment.

This policy might be a good one if subsidized loans consistently went to the students who have the most difficulty paying for college and the most difficulty repaying their student loans and if this group of students could count on getting all the subsidized loans they need so interest would not accrue on any of their federal loans while they are in school. However, neither of these conditions holds. In 2009-10, about 70 percent of Stafford Loan borrowers used a combination of subsidized and unsubsidized loans. Only 17 percent relied only on subsidized loans. Because the limit on total annual Stafford borrowing is higher than the limit on subsidized borrowing—regardless of a student’s financial circumstances—the existence of the two programs increasingly complicates the system without providing meaningful relief to students.

Even if pre-college circumstances were the only relevant measure, the Stafford Loan system would not be doing a good job of targeting its subsidies. This results partly from allowing cost of attendance to enter into the eligibility criteria. Students who qualify for the subsidy at high-priced institutions may have significantly higher incomes than many who do not qualify because they attend lower-price institutions. In addition, students who are in school for the longest time—those who go to graduate school—benefit most and they rarely either come from the lowest-income families or end up with the lowest earnings.

But most important, financial circumstances before college are not the primary determinant of borrowers’ ability to repay their loans. For any given debt and earnings levels, borrowers from low-income families are most likely to struggle with their loans, but this reality does not mean that borrowers from middle- and upper-income families are immune from repayment difficulties.  In the current economy, examples of students from relatively affluent backgrounds with strong academic credentials who find themselves unemployed or employed in low-wage jobs are easy to find. And many of those students will find that their parents are now in no position to help.

Students have little understanding of the difference between subsidized and unsubsidized loans (or, unfortunately, of the difference between federal and private loans). What they do understand is their payments once they leave school. A student who borrows $5,000 a year for four years at 3.4 percent interest would owe $20,000 with in-school subsidies and face monthly payments of about $197. The same borrowing without the in-school subsidy would lead to a debt of about $21,800 and monthly payments of about $214.

The real issue, no matter whether the debt results directly from borrowing or from accrued interest, is whether the borrower can afford the monthly payments. And only a better-subsidized Income-Based repayment program can address this issue.

The subsidized Stafford Loan program introduces unneeded complexity into the student aid system. Students cannot predict their eligibility for subsidized loans, which depends on a combination of the arcane federal need-analysis formula and the cost of attendance at the institution at which they are enrolled. Removing the in-school subsidy and would eliminate the need to evaluate family financial circumstances in allocating Stafford loans and would allow students to know their loan eligibility in advance.

A considerable amount of evidence supports the idea that grant aid increases educational attainment, particularly when the aid is easy to understand and to access. Federal student loans and the repayment protections that accompany them are a vital supplement to grant aid, providing the liquidity many students need to continue their education. But there is no evidence that the in-school interest subsidy has a measurable impact on educational outcomes.  There are in our view much better ways to invest the estimated potential $5-billion in savings. We would much prefer to see those dollars directed to important areas like early childhood education, elementary and secondary schools, or more effective subsidies to college students instead of protecting this questionable use of our scarce resources.