With the new academic year in full swing, college students and their parents might be wondering how tuition costs have gotten so out of control. In 2015, the average tuition at a private, nonprofit four-year college was $32,405, up significantly from $10,088 (in inflation-adjusted 2015 dollars) 30 years prior, according to the College Board.
Many college students will be financing their skyrocketing tuition through debt, adding to the existing $1.3 trillion in total student loans outstanding in the United States. On average, the 2015 college graduate who has student debt will have to pay back slightly more than $35,000, and future college graduates can expect student-loan indebtedness to increase.
The challenge with government-funded student debt is not only its repayment mechanism of high-interest fixed rates but also that it leads to what economists call a “principal-agent problem” — a lack of accountability on the part of the principal agent (in this case, colleges). A recent study by researchers at the Federal Reserve Bank of New York found that colleges that become eligible for federal student-loan funding hike their tuition rate almost immediately after approval. To keep tuition affordable, colleges that accept government-backed federal loans should agree to reforms that require them to share financial risk with the government.
But wholescale student-loan reform is not something that Mitch Daniels, the former governor of Indiana and the current president of Purdue University, is waiting for. He has undertaken an experiment that, if embraced on a national level, could potentially halt and reverse the trend of soaring student debt. More than 100 students entering their third and fourth years at Purdue are financing their education loans via the school’s new “Back A Boiler” program (“Boilermakers” is the nickname for Purdue’s sports team, students, and alumni), an income-sharing agreement (ISA) in which the student pledges a portion of his future salary in exchange for funding.
The average Purdue student enrolled in an ISA will receive $13,789 in funding from the Purdue Research Foundation, promising to pay it back as a small, constant percentage of his income in the six to ten years after graduation. Payments don’t begin until a student obtains a job. In essence, Purdue’s ISAs give recent graduates, many with uncertain work prospects, some relief from the high-interest fixed rates associated with federally backed student debt.
One novel feature of ISAs is that the repayment rate is linked to the income-earning prospects of the student’s college major — those with prospects for higher-paying jobs have lower repayment rates over shorter terms than do those likely to find lower-paying work. A computer-science major at Purdue, for instance, will pay 2.57 percent of post-graduate pre-tax income over 7.3 years for $10,000 of tuition paid through an ISA, while an English major will pay 4.52 percent of his post-grad pre-tax income over 9.7 years for the same amount of tuition.
This has led some critics to predict that lower-earning majors would probably not get funded by investors in a private ISA market. Purdue counters this charge by noting that no student major is ineligible for ISA funding. More than 60 majors at Purdue are represented in the group of students receiving it.
Another plus: The average repayment rates for Purdue’s ISAs are lower than those of most federal student loans. For this reason, ISAs cannot be dismissed as “usury” or as “indentured servitude” — as some leftists have called them — without applying the same label to government loans. Furthermore, Purdue caps its ISA repayment rate at 15 percent of total post-grad pre-tax income.
If this program were scaled to the national level, the differences in ISA repayment rates over time might motivate students to choose majors with better post-college prospects. And ISA financing options might make college accessible to individuals who otherwise could not afford it and who might be scared off by the specter of accumulating student debt.
ISAs are not a new concept. Economists Milton Friedman and Simon Kuznets were among the first to champion equity investments in education: In their 1954 book Income from Independent Professional Practice, they proposed that individuals be able to sell “stock” in themselves. In recent years, the concept has been taken up by analysts in education-policy circles, especially after several small-scale ISA experiments in the private sector by start-ups such as Lumni, an education-oriented investment company co-founded in 2002 by Vanderbilt economist Miguel Palacios and entrepreneur Felipe Vergara. During their presidential campaigns, both Jeb Bush and Marco Rubio advocated national implementation of ISAs. Purdue’s Back A Boiler ISA program, which funds more than a hundred students, is the largest of its kind in North America to be tested at a single post-secondary institution.
For equity investments in education to go mainstream in the private market, investors will need confidence that legal mechanisms are in place to ensure recourse should enrollees fail to make payments. For instance, legal clarity could be provided to make ISAs non-dischargeable in bankruptcy nationwide, much like private student loans, which have been non-dischargeable since 2005.
This challenge for ISAs spurred Rubio and Tom Petri, a Republican congressman from Wisconsin, to introduce legislation in 2014 that would provide legal clarity for private-market ISAs, including protections to ensure that investors’ repayment rates are not so high that they bankrupt employed students or discourage unemployed students from working — the bill achieves this by placing a limit on the fraction of a student’s income that can be paid to investors. It also requires a minimum-income exemption of $10,000, a maximum repayment period of 30 years, and an aggregate limit of no more than 15 percent of an individual’s income committed to ISAs (the same as the limit set by Purdue in its Back A Boiler program). Additionally, the legislation would give flexibility to investors who might want to extend the repayment term in the event that the borrower fell below the $10,000 income threshold because he spent unsalaried time in graduate school.
Potential investors in ISAs will also need to have a better sense of the rates of return associated with them and how the rates differ by college major. As Back A Boiler students graduate from Purdue and begin making payments, more data will become available.
Another unknown is whether ISAs will cause the same types of labor-market distortions that taxation creates, given that ISAs are essentially an agreement to receive college funding in return for paying a flat income-tax rate (to the investor). ISAs might create moral hazard, for instance, by weakening students’ incentive to work hard or find a job quickly after college. Purdue’s experiment will provide some answers. If there is no evidence of such distortions, investors might be reassured that using data on post-graduate incomes by major to set ISA repayment rates is an appropriate way to price such agreements and earn some return.
Brian Edelman, the chief operating officer of Purdue Research Foundation and Back A Boiler’s project manager, says he expects it could be three to five years before Purdue can accurately determine whether the payment obligations of students in the program are being fulfilled.
Over the past few months, Purdue has received inquiries from other universities that are interested in exploring ISAs as an alternative to federal student loans. If Purdue’s ISA experiment sows the seeds for reform of national higher-education financing or if other schools begin their own ISA programs, many more students will find college affordable.
– Mr. Hartley is an economics contributor to Forbes and an MBA candidate at the Wharton School of the University of Pennsylvania.