The Student Loan Tax

Johnathan Lott

As summer comes, a new class of graduates will be entering America’s job markets.  Entering, though, may not be the right word.  Although no official statistics state how many recent graduates have jobs, anecdotal evidence indicates that the answer falls in the range of “not very many.”

 

The lack of jobs, however, is not the only thing that makes the Class of 2011 unique.  They’re saddled with debt.  The Wall Street Journal reported on Monday that the average graduate held nearly $23,000 in debt – up 8% from last year and up nearly 50% from ten years prior.

Plenty of factors are behind this.  Skyrocketing tuition at universities is the go-to response.  A lack of need-based aid due to lower charitable giving in a down economy is another good guess.

But there is a more devious reason for the debt.  The federal government is behind it.

And no, that’s not just a conspiracy theory.  After last year’s federal takeover of student loans, the federal government now controls the vast majority of all student loans and disburses them directly to students.

This is a departure from the long-standing system in which the federal government allowed banks to make educational loans that were backed by the federal government.  This wasn’t a perfect system, but it allowed students with little or bad credit to get loans for their education.  And the banks at least had an incentive to manage their lending and work on collections with their debtors.

Private lenders are still free to make student loans.  And they do, usually at lower rates.  Federal loans for graduate students ranged from 6.8 to 7.9 percent last year, at a time when interest rates across the board are a historic low.

But students rarely take advantage of these, because they’re told not to.  Financial aid offices decry any loan that isn’t federal as “risky” and “dangerous.”  They tell their students to go instead to the federal government, who will guarantee them as much money as they want, no matter how useless their degree or what their plan to pay it back.

And herein lies the problem with the federal loan system.  Anyone can get a loan for any reason.  Education is generally a good thing, sure, but a degree is a major commitment in time, cost, and opportunity cost.  This is especially true for graduate degrees.

Yet people take federal loans as if they were candy.  “Everything will be better once I have the degree,” many think, although that often isn’t true.  Such is the case with the man who graduated from a bottom-tier law school with no job prospects and $250,000 in debt.  To make it even more heinous, federal loans are not dischargeable by bankruptcy.  You have to pay back the money, even if it takes you your entire life.

The government does back up its loans with an “income-based repayment plan (or IBR),” which means a debtor will never contribute more than 15% of his income to his loan repayments.  This policy is also great for public interest (and, thus, government) employees, who will have the remainder of their loans forgiven after ten years at the taxpayers’ expense.  But it is a trap for private-sector employees.  IBR has a built-in “tax bomb” after 25 years, whereby the loan is “forgiven” but you have to pay income tax on the difference.  For a $300,000 debt payment, this simply is impossible.  Bankruptcy ensues.

So if the federal government charges outrageous interest rates on loans that are not dischargeable, where does all the money go?  Right back to the Fed.  The difference in federal and private interest rates essentially equates to a “student loan tax” that the government adds to its own coffers.

Granted, there are some costs along the way: the cost of the thousands of unemployed grads who cannot possibly make good on their loans. The cost of sending the collection agencies after them.  And the cost of forgiving the loans of new federal employees who make more money than their counterparts in the private sector.

But a tax is a tax.  The government has found a new way to make money.  It guarantees funding to students for any degree they want, regardless of how much and whether they can pay it back.  And who wouldn’t turn down “free” cash?

The problem is, students really do view it as free cash.  And their mistake stays with them, sometimes for the rest of their lives.