Forward-Looking Means-Testing with a

Student Loan Tax Credit

Thomas J. KaneHarvard Graduate School of

EducationNovember, 2005

Context

• State budgets will continue to be constrained. (Medicaid.)

• Even if there is progress in restraining college costs, tuition likely to continue to increase.

• Additional spending through Pell Grant problematic: high implicit tax rates, increasing middle class eligibility, discretionary program.

Key issue:

With rising use of student loans, how do we minimize the burden on families?

“[T]here is clearly here an imperfection of the market that has led to underinvestment in human capital and that justifies government intervention…”

-Milton Friedman, 1955Two problems:

1. No indentured servitude.

2. Risk.

Earnings of 25-34 Year Olds Working Full-Timeby Educational Attainment

0% 5% 10% 15% 20%

$5,000

$10,000

$15,000

$20,000

$25,000

$30,000

$35,000

$40,000

$45,000

$50,000

$55,000

$60,000

$65,000

$70,000

$75,000

$80,000

$85,000

$90,000

$95,000

$100,000

> $100,000

High School Diploma Only Bachelor's Degree

Median for

BA Degree

Median for

HS Diploma

Economic returns to higher education are high, but

variable“A . . . complication is introduced by the inappropriateness of fixed money loans to finance investment in training. Such an investment necessarily involves much risk. The average expected return may be high, but there is wide variation about the average.”

--Milton Friedman, 1955

Balancing the risk associated with post-college

earnings• Long history of interest in income contingency.

(Milton Friedman, Sen. Edward Kennedy, President Ronald Reagan, Robert Reischauer, etc.)

• ICR in Direct Loan Program (helpful but inadequate).

• Broader implementation: Australia, New Zealand, United Kingdom– 10% or less of income above a threshold.– Collected through the income tax system.

Possible U.S. Version:

• Borrowers continue to make payments on their loans (direct or guaranteed). No need to create new loan origination or repayment system.

• Borrower receives a refundable tax credit for loan payments exceeding 10% of income above $10,000.

• Lenders report total principal and interest payments to the borrower and to the IRS.

Additional assumptions

• Undergraduate borrowing only.

• 10-year assumed repayment period (borrowers may continue to take advantage of existing flexible repayment options).

• Borrower or spouse must be working to receive credit.

Assumptions:Loan Balance $20,000Income Growth 4%Discount Rate 5.80%Annual Payment $2,944 (10 year schedule)

AGI At Graduation

CurrentICR

ProposedTax Credit

CurrentICR

ProposedTax Credit

CurrentICR

ProposedTax Credit

15000 $1,086 $500 300 120 $6,380 $16,16320000 $1,764 $1,000 300 120 $1,117 $11,78325000 $1,996 $1,500 232 120 $0 $7,40330000 $2,199 $2,000 193 120 $0 $3,30835000 $2,359 $2,500 168 120 $0 $82940000 $2,529 $2,943 149 120 $0 $0

Illustrative Calculation of Value of ICR and Proposed Credit

NPV of Federal Subsidy

Over 25 YearsMonth of Last

Payment

First YearLoan Payments

Minus Tax Credit

Estimated Cost

• Preliminary estimate:– $7.3 billion– Estimated 87% of benefit goes to tax filers

with incomes below $40,000.

• Current higher education tax provisions (Hope, Lifetime Learning, Loan Interest, and Tuition Deduction): $8.8 billion in 2005

• Consider replacing current array with a student loan credit.

Parameters for Program Design

• Percentage of income.

• Level of income threshold.

• Eligible loans (e.g. graduate school).

• Assumed repayment period.

• Principal & interest vs. interest-only.

Potential benefits

• Current loan programs and borrower repayment options can remain the same.

• Repayment burdens eased.• Potentially aids in career choice, particularly low-

wage, public service careers.• Potentially lessens debt aversion.• Broader tax base for means-tested federal education

benefits: Forward-looking means-testing over career, rather than backward-looking evaluation of a single year of student/parent income.

• Universal benefit: Valued by middle and higher income parents concerned about their child’s ability to pay.

Benefits relative to current higher education

tax credits• Easier to administer for government; less

reporting for schools.

• No confusing interactions among federal financial aid and tax credit programs.

• No net cost to the government if student loan tax credit replaces current credits.

• Better targeted according to need.