Universities face a moral conundrum

The Australian student loan system is over 30 years old, yet it still produces startling surprises. The recent revelation of an unnamed university graduate grappling with a staggering student loan of $737,000 is a stark illustration. The amount of time this student must have spent in higher education is as bewildering as the figure itself. The amount is so astronomical it seems less like a sensible investment in education and more like someone's telephone number.

How did someone accumulate such a colossal debt? One contributing factor was loan availability. In its original incarnation, there were no limits to the amount students could borrow. Students who decide to spend their lives studying could add thousands to their accumulated debt every year. Combined with periodic loan indexation (to account for inflation), some graduates have run up enormous debts. The government has since imposed limits on student loans, which make it impossible for individuals to accumulate such considerable debts in future. However, as the total number of university students keeps increasing, their collective debt continues to explode. The amount owed is now more than $70 billion, almost four times higher than the national credit card debt.

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Accumulating such mountainous debts may seem crazy, but from students' viewpoint, such borrowing is entirely rational. After all, the government (on behalf of taxpayers) is taking all the risk. If post-university life goes well, graduates get high-paying jobs and steadily whittle down their student debt. Conversely, if graduates' earnings fail to reach the threshold for repayment, the burden shifts to the collective shoulders of taxpayers, including those who have never set foot in a university. In a real-world example of "heads I win, tails you lose," graduates get to keep any gains from studying while the taxpayer absorbs any losses.

And the subsidies do not end there. The government borrows money at market interest rates to fund student loans but does not charge students a real (post-inflation) interest rate. Thus, even wealthy graduates-bankers, surgeons and lawyers-are subsidised by taxpayers.

Imagine offering loans to stock market speculators on terms similar to student loans. If the speculators make a killing, they repay their loans and keep any profits. If their investments collapse, the taxpayer covers their losses. Who wouldn't accept such a deal?

Keeping speculative gains while shifting losses to others encourages a type of risk-taking known to economists as "moral hazard." It not only affects students and graduates, but it also affects universities. Universities pocket tuition fees regardless of whether or not graduates repay their loans, thus presenting educational institutions with a moral conundrum. Even if loan repayment seems unlikely, they may be tempted to admit marginal students and provide them with mediocre teaching because universities keep students' fees even if they drop out or fail to benefit economically from their studies. Instead of steering applicants towards judicious financial choices related to their education, universities are incentivised to encourage everyone, even those who barely struggled through high school, to attend.

To summarise, moral hazard creates perverse incentives for both students and universities. Although many graduates fail to find jobs that correspond to their qualifications and never make enough money to repay their loans, students keep borrowing because the taxpayer picks up the cost of their unpaid loans. Half the population has never had the privilege of higher education, yet they find themselves bearing the brunt of outstanding student loans.

The social costs of these perverse incentives are enormous. Marginal students who wind up in jobs that do not match their credentials become disenchanted, unhappy, and unproductive. Meanwhile, non-graduates, who would be happy in these jobs, are frozen out because employers increasingly require university degrees. Degree requirements for jobs that formerly did not require them and the perverse incentives of the student loan system have combined to blight the life chances of those who never made it to university. Without any change, student debt will continue to mount, large amounts of capital will be misallocated, and social mobility will remain stalled. It is time for a policy reset.

In my recent report, "Degree Inflation: Undermining the Value of Higher Education" (published by the Centre for Independent Studies), I propose several ways to rebalance the risk of non-repayment of student loans. Instead of a burden born mainly by taxpayers, students and universities should share the risk of non-repayment. To see how this can be done, let's start with students.

Under the current student loan regime, the loan charge equals the rate of inflation, which is less than the government pays to borrow the money. The difference between the government's borrowing costs and inflation is a subsidy to graduates paid for by taxpayers. The result is deeply unfair. Those who do not have the opportunity to study at a university subsidise the education of professionals who make more than they do. (Economist Nick Barr described this arrangement as "Taxing beer to pay for champagne.")

Politicians justify this inequity by claiming that these subsidies allow students from low-income backgrounds to access higher education. This argument would make sense if student loans were like mortgages; an interest rate subsidy would lower monthly repayments. Student loans are different. They are like taxes. The repayments of income-contingent loans are calculated as a per cent of income, not the amount borrowed. Charging graduates a real interest rate adds to the amount of time it takes to repay their loans but makes no difference to their monthly payments.

Charging a real interest rate would result in considerable savings for taxpayers, allowing the government to make more generous loans to those who need them. Instead of providing lawyers, doctors, and other high-paid professionals with interest subsidies, students who struggle economically could borrow living costs in addition to tuition fees. Charging an interest rate set at the government's cost of borrowing would not completely eliminate moral hazard, but it would rebalance the risk of non-repayment from taxpayers to graduates.

Rebalancing risk also means removing the perverse incentive for universities to admit students who are likely to drop out or, if they manage to scrape through their course, never earn enough to repay their loans. Quotas on new students would encourage universities to limit their intake to better-prepared students, but they are politically difficult to implement. Governments are reluctant to be seen as restricting access to higher education. Indeed, the current government wants universities to enrol even more students.

Another approach would encourage the university regulator to enforce its legal obligation to ensure that "students have the academic preparation … and no known limitations that would be expected to impede their progression and completion." Judging from the attrition rates, some universities seem to be flaunting these requirements.

In addition, universities could share the risk of non-repayment. The government has proposed a possible mechanism for sharing the risk. That is, universities with high attrition rates will receive a funding cut. A good idea, but the proposed amounts involved are tiny. A university with many dropouts would lose less than one per cent of the funding for those students. Such a minor penalty will not change university behaviour.

Making universities absorb a significant portion of a dropout's tuition would send a stronger message, but it may lead them to lower standards and pass everyone. It would also be technically challenging to require universities to retrospectively absorb some or all the losses currently covered by taxpayers. A much easier way to discourage universities from admitting poorly prepared students and failing to provide them with remedial teaching is to give universities a role in the student loan process.

Specifically, universities could be mandated to underwrite student loans and shoulder the burden of those that are never repaid. This measure would tie the financial health of universities directly to their graduates' employment outcomes, thus encouraging universities to adopt judicious admissions policies, prioritise top-notch teaching, and dissuade students from reckless borrowing.

Navigating the labyrinth of student debt and income-contingent loans is a complex exercise of balancing incentives and consequences. It calls for careful thinking about fairness, accountability, and the delicate balance between individual ambition and societal responsibility. As Australia wrestles with these challenging issues, the $737,000 student debt tale stands as a powerful testament to the fact that moral hazard can insidiously infiltrate unexpected corners, trapping both students and institutions in a web of financial and ethical uncertainty. Urgent intervention is essential to reduce moral hazard and lay the foundation for a more equitable and accountable higher education system.