The problems with income-based repayment

Although you hardly hear anyone talk about it, our country does have an income-based repayment option for federal student loans. Graduates can elect to pay 10% of their discretionary income for 10 years (if in a public service job) or 25 years (if in another kind of job). After that time, their remaining balances are forgiven. So those people who graduate with tons of debt and cannot find a job do have this option available to them, although it appears many are unaware or cannot figure out the system. I do not mean to pile on to some of my prior posts about student debt here, but in all fairness, the existence of this program should militate against the notion that students are getting totally wrecked by debt. Losing 10% of your discretionary income is not fun, but it also should be reasonably livable.

There are a few problems with this program as it is. First, it will suffer from adverse selection problems. This is by design, but still. It has the potential to lose a ton of money, and will necessarily be receiving a subsidy from those paying off their debts in full. Second, once someone has a ton of debt, there is no reason for them not to keep accumulating debt. Got $150k in debt? Why not pile on another graduate degree? It wont cost you anymore in the end. Third, in practice it benefits individuals with high debts more than low debts, but those with high debts tend to also be those with high salaries. As The New America Foundation reports, the big winners of IBR as it is currently set up are those with pricey professional degrees, e.g. law students. And the recent IBR shift from 15% of discretionary income to 10% of discretionary income was a massive windfall for higher-income IBR participants because the lower-income participants were already paying so little even under the 15% rate.

Some of these problems may not be thought of as problems depending on who you are. You might think for instance that the public should commit itself to dedicating social resources to someone who wants to get dozens of PhDs or something. I am not sure that’s a great idea myself, but some might. However, the adverse selection and windfall-to-rich problems will surely be troubling. Is that really what we have in mind for student debt relief? Making sure a lawyer pulling down $130k/year only has to pay $650 dollars a month on her $120k debt? I doubt it. More than that, those lower-income borrowers with lower debt amounts who are paying off their debts in full are necessarily subsidizing that six-figure law graduate with their interest payments. Yikes!

These problems are why I have advocated universal income-based repayment schemes in the past. This gets rid of the adverse selection problem because everyone is made to participate, and you can make the rates on such schemes progressive so that the cross-subsidy runs in the direction it ought to: from higher-income borrowers to lower-income borrowers. Additionally, if you implement the scheme as a tax that rises based on degree attainment, you can clamp down on some of the bad incentives for people to soak up vast amounts of social resources getting degree upon degree that they do not need.

I like the income-based repayment idea generally, but the system we have now is really sub-optimal. It is better than nothing, and I would not say to get rid of it, but it can be vastly improved.