Benje Patterson has a prisoners’ dilemma. He says it is not right for Govt to excessively subsidise the educated middle class when others in society are truly needy. Your view?

Benje Patterson has a prisoners’ dilemma. He says it is not right for Govt to excessively subsidise the educated middle class when others in society are truly needy. Your view?

By Benje Patterson*

I was recently completing my online tax return on the IRD’s website and happened to glance across at my student loan balance.

Although this sizeable hangover from my student days is typically the least of my worries, seeing this large stock of debt next to my name did make me pause for a second.

In light of the recent raising of mandatory student loan repayment rates and removal of voluntary repayment bonuses, it occurred to me that I should reassess whether my current repayment strategy is still optimal.

The issue of optimal student loan repayment strategies has been a pet project of mine ever since my student days.

As a student of finance and economics, I quickly put theory into practise and set to work leveraging up my student lifestyle by working the margin between interest-free student loan money and higher real rates of return available on bank deposits, bonds, and shares.

Although I was in the fortunate position of not needing much in the way of a student loan, I still borrowed as much as I could to exploit this free lunch.

Upon entering the workforce, my thoughts then turned to minimising the proportion of the real value of my outstanding student loan that I would return to the government.

In a 2011 Dominion Post article, I concluded that to achieve this goal, under the then system of zero interest and 10% voluntary repayment bonuses, I should “…make the minimum required repayments for now, but in a number of years’ time repay the remaining balance of the loan in full with a single voluntary repayment. At any point in time, a voluntary repayment is only logical if the compounded return from investing the money is less than the 10% voluntary repayment bonus”.

Recent changes to the scheme

Following this type of minimum repayment strategy has worked well for me and many other student loan borrowers over recent years, but our common exploitation of the student loan scheme has cost the government (and ultimately other taxpayers) hundreds of millions of dollars per year.

In light of this significant cost, at a time when the government is determined to get its books back in order, it is not surprising that policy initiatives have recently been introduced to try and limit the ability of borrowers to exploit the student loan system.

In April, the government raised the mandatory repayment rate for earnings over $19,084 per annum from 10% to 12%, and removed the 10% bonus for voluntary repayments over $500.

The first of these policies was designed to speed up underlying repayment rates, while the latter was aimed at removing a loophole for exploiting the scheme.

It seems that some borrowers had been exploiting the voluntary repayment bonuses to such an extent, that they were borrowing and repaying money within a tax year simply to be gifted a cut of the funds by way of the repayment bonus system.

But the new policies didn’t have much of an effect

However, even after these attempts by the government to improve the student loan repayment system, the scheme remains flawed.

Raising the mandatory repayment rate has forced an increase in the underlying speed of repayments, but the complete removal of the voluntary repayment bonus has taken away the incentive to make voluntary lump-sum repayments towards the end of the loan holding period.

After factoring in these changes to the scheme, the most rational strategy for a New Zealand-based student loan holder is to make only the minimum required repayments throughout the loan holding period and let inflation erode away the value of the remaining debt.

This strategy is rational for the borrower because it minimises the proportion of the real value of the student loan that they end up repaying.

Just what is wrong with the student loan system?

The underlying problem with student loans is that they remain interest-free and, as a result, there is no incentive for borrowers to make additional repayments on top of what is required.

In its current form, the student loan scheme is middle class welfare – effectively boiling down to a backhand subsidy to those in society with the highest earning potential.

Rather than being a true means of funding an education, interest-free student loans remain a loophole for the tertiary educated to exploit.

You may say that this type of exploitation is selfish, and I agree with you – it is!  But the problem is that the scheme is designed in such a way that individual incentives are simply not aligned with what is best for society.

At a personal level, I exploit the scheme because I don’t want to see others making a buck that I can’t, but at a societal level, I realise that these selfish actions in aggregate are costly to other taxpayers.

This type of stalemate is known to economists as a ”prisoners’ dilemma” and can only be solved by the introduction of a mechanism that aligns private interests with those of society.

How could private interests be aligned with those of society?

The first-best solution for aligning what’s best for the individual, with what’s best for society, would be the reintroduction of interest on student loans.

Under this first-best policy, the decision to enter tertiary education would become more of an investment decision, where the reward of a higher future salary was balanced against the interest expense of additional debt.

If student loans were interest bearing then borrowers would be incentivised to borrow no more than was necessary and to repay the loan as quickly as reasonably possible.

In this situation, the student loan scheme’s cost to the taxpayer would be minimised, because not only would the stock of student loan debt be smaller to begin with, but the inclusion of interest would preserve the real value of the debt repayments.

Unfortunately, however, the reintroduction of interest on student loans is off the table at present. Although the policy is more efficient than the status quo, the government does not want to run the risk of upsetting a large cross-section of voters – particularly when next year’s election looks set to be a close battle.

With this first-best policy solution ruled out, we are forced to consider less efficient solutions.

In this world, we are unable to tackle the underlying problems of distorted incentives (that leave people borrowing too much), but at least we can attempt to further speed up repayments in a way that is fair and reduces the cost of the scheme to the government.

One example of a second-best solution would be the introduction of progressive student loan repayment rates.

At present, student loan holders make flat-rate repayments of 12% of income over $19,084. However, repayment rates could be made more progressive, in the same way that marginal income tax rates increase as you climb into higher income tax brackets.

Although some loan holders would complain upon seeing their take-home pay reduced by a progressive repayment rate policy, at least the government could bill the policy as being fair and targeted at those with the greatest ability to pay. After all, additional repayments would only be levied on higher earning student loan holders, and these people only reached where they are today with the assistance of heavily subsidised student loans.

And if these loan holders still complain – then let them.

It is not right for the government to continue excessively subsidising the educated middle class when there are others in society who are truly needy and would benefit greatly from a little additional support.

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Benje Patterson is an economist at Infometrics. You can contact him here »

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16 Comments

We're stuck with the current system, it's politically impossible to change. Which is a shame since interest free students loans was an election bribe in more properous times.
 
I think the repayment rate is about right. A progressive student loan repayment rate would make it tough - if I get a $1 payrise today, I already see less than 50c in my bank account.

Nowhere to you actually make the case that it is a specific "middle-class" subsidy, rather than a "people getting educated" subsidy that is disproportionately used by the middle-class (since they lack the wealthy family to inherit from, and have the desire for improvement, education is seen as the method in the belief that society is a meritocracy) but also benefits others. My wife was the first person in her family to get a degree (even now, decades later she is still only one of around 3).
Fiddling with the interest rates strikes me as a efficent in the small scale, inefficent at a society scale solution. In reality, basically everyone earning a lot is either benefitting from their degree, or benefitting from other people having degrees (either through employing them or catering to them). Just raise the top tax rate a little if you want to capture back the benefits that acrue to everyone involved. This also means all the time spent on student loan optimisation strategies could be put to other activities.

Yes, yes , yes!
Progressive taxation is the far more sensible approach to take.
Student loans are an terrible invention designed to break down the social contract. To atomise us and to break down the political voice of students and all citizens.
Debt is a brilliant way to silence the population.  So load up the peasants with debt and then they will be silent and docile.
Anyway if you really believe that the individual should pay for their education then make them start paying at 5, after all it is the early years that matter most.
If you really thought about what we are actually here for in any meaningful sense at all , it is to raise our young. That is it. Education is a key part of that. Our society is required to do this, breaking this down and convincing some twit that because they have a loan they did it all by themselves and therefore owe nothing to the society they come from is the end game of this wicked policy

The issue is for those of us that took an OE in our 20's.
My loan at end of study was $35K. Started paying it back then went to mate's 25th in Copenhagen and ended up working and travelling for the next 3 years.
if I look at my interest added portion of my SL these days... another 30K has been added in interest. Even though I've made $20,000 in repayments, my balance is still at $35K.
I now have a mortgage, one young child an another on the way. My partner is on maternity leave so we're a one-income house. 12%of my income now goes to my student loan- I have no problem with this.
But how is taxing me ever harder going improve the situation, Benje? Or would you rather I become one of the " truly needy (who) would benefit greatly from a little additional support...."
 

That is a dilemma
We all make choices as we progress through life
What you describe is the dilemma you and your mate face now and for some time into the future
What you don't explain are the decisions and choices you made
You undertook an OE knowing you had a debt of $35,000
By spending available funds on the OE instead of paying down the debt is tantamount to using the SL to fund the OE. That was a choice.
Remaining overseas with a debt hanging over your head was another economic choice
The decision to couple up with an outstanding debt is another economic choice
The decision on the part of your partner to couple up with a mate who is in debt is another
However your mate may consider you are a much more worldly wise person and worth it
The decision on both your parts to breed while you have an outstanding debt is another
Now you draw the conclusion that life is tough and hard to pay off the debt.
Can you explain your decision making processes and the trade-offs

Agreed, when you have a unsecured $35k debt, this is an EMERGENCY and it should  be paid off before you go partying or paying other people make your coffee. With some application, you could have cleared  this debt in a couple of years. Same rule applies to credit card debt.

Better yet - why is the government in the business of providing education loans anyway?
 
Happy for the government to provide tertiary education scholarships (for fees) based not on social class (i.e. ability to pay or not to pay) but rather based on merit (i.e. ability to add value to society through such higher education).  Scholarships need not be paid back, unless the recipient fails to pass/qualify through fault of their own.
 
Let the private sector lending institutions provide loans for those not qualifying for scholarships who want to seek a higher education.
 
As far as borrowing to fund living costs - again, not a government responsibility. However, I would note that if a Guaranteed Minimum Income were established, students could use this to fund living costs - thereby avoiding additional borrowing.
 
Trades training (apprenticeships) should be a separate policy matter altogether.

Kate: Your idea about the private sector is fine in theory, but if privatised educational loan providers used the same risk profiling criteria as banks, most students wouldn't be elegible. Plus a private sector providing loans would need auditing to avoid any sharky behaviour. I just don't see the advantage, apart from ideology.
 
As far as I can see, the government provides loans as a service to citizens and permanent residents so that they can better themselves. That's part of the social contract between citizens/residents and their government. What would be the social cost of having a majority with only high-school education and no chance of getting a loan from a private provider when we are constantly being exerted to 'upgrade', 'upskill', and so forth?
 
Of course there's pork in the current system (dodgy courses with NZQA accreditation), but you don't throw the baby out with the bathwater because of that. NZQA should be doing tougher audits to solve that problem.

 "That is a dilemma."
I'm sorry, what, exactly, is the dilemma? I'm MORE THAN HAPPY to pay my loan off, as I have been doing the past 7 years since I returned to the country. 
Some of you have obviously never had a student loan.

This whole issue is actually - Reynold's Law, which is glossed here.
 
The Law says:
 
"“The government decides to try to increase the middle class by subsidizing things that middle class people have: If middle-class people go to college and own homes, then surely if more people go to college and own homes, we’ll have more middle-class people. But homeownership and college aren’t causes of middle-class status, they’re markers for possessing the kinds of traits — self-discipline, the ability to defer gratification, etc. — that let you enter, and stay, in the middle class. Subsidizing the markers doesn’t produce the traits; if anything, it undermines them."
 
Higher education bubble.....
 

The numbers I've seen are that education gives a big boost to social mobility (people improving their lot) if it is a society open to people improving their lot. If it is a society were most wealth and power is inherited, then education doesn't do much to increase the number of middle class.

Why whack the middle classes on this one.  Plenty of the underbelly are exploiting student loans to the max. 
Long term unemployed are very happy to sign up for very second rate courses, with very little indication they will move off benefits or ever repay one little bit.  Courses run by supposedly respectable institutions, and Wananga etc all.
How about long term beneficiries, with long term drug habits,  signing up for "Diving Instructors" courses.  With a stay in the Pacific Islands as part of the deal.   Thankfully that one has been squeezed down a bit.
 

I am sure there are a few pacific island holidays and their ilk being taken. However for someone that lives in the hinterlands of NZ I have seen great things happen for the great unwashed having been educated. Many hold their heads high having partaken and gained in educating themselves. It may be in some oblique weird and useless course. But that empowered some to go further, and try harder. The Wananga etc may have seemed a waste of money, but for many it has opened their eyes and given them a future. 

Oh, it's been much, much more widespread than that.
 
Evening Surf Classes (NI, East Coast)
CoolIT (Christchurch Polytechnic)
Ski Field work (Greymouth)
 
These are all essentially worthless, yet attracted per-EFTS Gubmint munny to the tune of $4-6K per warm body (or registration mark thereof) per annum.  Rort went on for years.
 
Question to ask is:
 
How many actually helped??  (I have no doubt that some lives were indeed turned around.  Not saying they weren't)
 
At what cost?
 
It's like the First Homes scheme put up by Labour in the early 00's.
 
Pitch:  $100K guaranteed loan if ya can fog a mirror.
 
How many helped?  Around 2,000 warm bodies.
 
Cost to the economy?  

  • Every single house price anywhere in NZ(fairly much) increased by, spookily enough, $100K.   
  • Great dollops of CG trousered by existing homeowners.   Untaxed.  
  • A high proportion of said house value increases were promptly treated as an ATM by owners - more debt, more to pay back.  Lotta ppl still climbing the sides of That hole. 
  • The beginning of the now-complete chop at the First Rung on the Housing Ladder.

Unintended Consequences......small beginnings, wunnerful Good Intentions....

I remember hearing about Cool IT, various conflicts of interest with a private company supplying the materials that did not fit into any official Qualifications framework. That case really established that the government should only be involved with education that meets NZQA standards, otherwise it becomes a ripoff magnet.
I've never heard of the surfing case (or for that matter the ski field one (I didn't know they had ski fields near Greymouth)), do you have a citation?
 

Tertiary education should be free. After all education up to high school is, so why suddenly magically is it user pays after that?
 
It used to be free.
 
Keep it to the professional fields - medicine, law, engineering, sciences, humanities.
 
No more Security Industry Training Diplomas Level 3 or Internationally Recognised Bar Tending Certificates. Industry should be doing the necessary training instead of dodging it   via employee personal debt.