Is there an implicit subsidy in the HECS debt?

Over at his blog, Andrew Leigh asks whether the OECD was right not to count an implicit subsidy in HECS-HELP in its figures on how much the federal government spends on higher education. The federal goverrnment argues that because the OECD only counts direct subsidy paid to higher education institutions, it understates total spending on higher education. This is a complex issue; I would welcome feedback on my analysis.

There are two possible subsidies in the income contingent loans scheme. There is the writing off of bad debt, about which I have written extensively (pdf). Lending to students that won’t be repaid should be classified as a higher education expense. And there is an interest rate subsidy, because HECS-HELP debts are indexed to inflation, but otherwise no interest rates are charged. There are direct and/or opportunity costs to the federal government in not charging interest on HECS-HELP debt.

Andrew L is questioning the implicit interest rate subsidy point. These are not his words that follow, but the reasoning goes like this:

The real price of going to university is not the advertised maximum student contribution amounts. This is because there is a 20% discount for paying up-front. For example, a year of law subjects is advertised at $8,333. But if you take the 20% discount, the cost is $6,666. Another way of looking at it is that if you don’t pay up-front you incur a surcharge of $1,666, or 25%.

That $1,666 could be looked at as a form of interest on HECS debt. What rate of interest it converts to depends on how long the student takes to repay the debt. Using the ATO report on HECS debtors, and assuming law graduates earn between $50,000 and $100,000 a year while repaying, people in that range repaid an average of $3,300 in 2004-05. At that rate, it would take 2.5 years of work to pay off one year of university debt, which would convert to an interest rate of about 10% on a loan of the real price of $6,666. But if the debtor was in the $35,000 to $50,000 bracket, on the ATO’s data on average it would take 4.3 years of work to repay one year of education, and convert to an interest rate of 5.8%. (There are simplifying assumptions here; for example if there was a real rate of interest it would be compounding on the debt).

From the student’s perspective, there is certainly an implicit interest rate, though one that gets lower the longer he or she takes to repay. Because most students take a while to repay – most law students do 5 year courses, so full-time students probably won’t make any repayments until 5 years after they first incurred debt – typically interest rates would be low, but not zero in real terms as implied by the indexation system.

However, there is a problem with the argument that because students pay an implicit interest rate there is no additional subsidy built into the HECS-HELP scheme. The federal government doesn’t put the $1,666 in our example aside to cover the cost of holding the debt. It pays the full $8,333 to the university (plus its tuition subsidy of $1,643). If the student pays up-front to the university, the federal government pays the $1,666 and the tuition subsidy to the university.

If there is some serious actuarial work behind the up-front discount, it implies that there is an additional subsidy, on top of the tuition subsidy, of at least 25% of the real course price in having somebody defer the cost of their course. Or in other words, it is cheaper for the Commonwealth to write off the $1,666 now by paying it to the university than to lend $8,333 to the student and have it hanging around unpaid for a large number of years, or perhaps never repaid if the student dies, lives overseas, or does not earn very much.

Andrew’s point works, I think, for undergraduate full-fee students who take out a FEE-HELP loan. For them, the university or higher education provider sets a fee. Say it is $10,000 a year. The student incurs a 20% surcharge (not the 25% paid by HECS students, curiously). So their debt to the federal government is $12,000, and it pays $10,000 to the higher education institution. In this example, the government charges $2,000 to cover its expenses, a feature absent from the HECS-HELP system.

Does this invalidate the OECD’s comparisons? In the years in which the Budget was in deficit, the government was borrowing at real interest rates to lend at zero real interest rates. So that was an added expense of higher education not included in official higher education spending. But many OECD countries run budget deficits now, so their borrowing to subsidise higher education directly (rather than lending to students) is also an expense of their higher education policy that would not be caught by the OECD education publications (though there is plently on public debt in other OECD publications). So the OECD understates the public cost of higher education generally, but it is not clear to me that it disproportionately understates Australian expenditure compared to other countries.

In these days of huge surpluses, I’m not sure how we should count the cost of the HECS debt. Is it not the direct cost of interest on government debt, but the opportunity cost of not investing in the various surplus-stashing funds? (Nice irony here – one of these funds is for higher education.) If this is the right way to look at it, a time of good investement returns increases the total (opportunity) cost of higher education to the government.

The OECD comparison is a polemical point. Polemics aside, highlighting how direct higher education subsidy understates the true cost of higher education is worthwhile. If there are only limited funds for higher education, do we want to spend them providing discount interest rates and letting people taking repayment holidays in London and New York?

Low interest rates or debt write-offs for people who genuinely don’t benefit financially from their degrees are part of the original design of the HECS system. It was intended to take some of the risk inherent in higher education investment. But other aspects of the system, like not collecting from people overseas, seem to me to be misusing money that could be spent more productively on other higher education-related activities.

16 Responses to “Is there an implicit subsidy in the HECS debt?

  • 1
    Sinclair Davidson
    October 23rd, 2007 19:34

    That’s very complicated. Well done on the explanation. In the end all it really tells us is that international OECD comparisons in this area are worthless. Policy tools are so different as to make comparison difficult to understand.

    Why not reverse the analysis? What is the totality of funds from all sources available to Universities? Then break out funds for teaching and research. Capital is fungible. Does is matter how much the government invests in education per se? Or does it matter that everyone who is capable of undertaking higher education can get an opportunity to do so?

    To be sure the ALP want to invest more in education than the Coalition do. So just say so. Say why. Surely the ALP need to show that there are Australians who want to go to uni, and who are capable of either completing those studies (or even just benefiting from those studies) who are priced out of the system. I am not convinced that they would find such people.

    On another note, it seems to me that having less of a government subsidy is a sign of strength, not weakness.

  • 2
    Andrew Norton
    October 23rd, 2007 20:10

    Sinc – No disagreement from me that OECD comparisons are worthless. The Australian experience demonstrates that the high public investment in some European countries is a waste of taxpayers’ money, which has no positive effect on how much is ultimately spent or who it is spent on. It just drives out private spending. The ALP’s proposals to cut HECS are also pure waste, a wealth transfer to students that achieves no public good.

  • 3
    conrad
    October 23rd, 2007 21:01

    Its not clear to me that high public spending drives out private spending — I think the two are poorly correlated. You can certainly have low public spending and low private spending (like some European countries), and high public spending and high private spending (like the US — indirect subsidies included).

  • 4
    Andrew Norton
    October 23rd, 2007 21:22

    Conrad – With an income-contingent loan system, the Australian experience suggests that public spending is a substitute for private spending, rather than pushing up overall spending. Take the example I have used in this post. The subsidy has been pushed down to $1600 and demand still exceeds supply. It suggests that prior to subsidies being cut they were needlessly high.

  • 5
    conrad
    October 24th, 2007 07:50

    No doubt Andrew, but it isn’t clear to me that saying that will also generalize well is really another thing — there are strong cultural factors. I think that some European governments would be scared that their universities would completely fall to pieces if they started using a system like Australia (people simply wouldn’t pay). For example, I can imagine such a system might work in places like Germany (where I believe they already have some moderate fees in some places –I could be wrong on that), but I’d certainly bet against France (where they don’t). So they are basically in a position of paying for it or going back to the third world, and I know which they’d rather.
    On the flip side, there are large numbers of poor quality education providers in the US that offer undergraduate education not dissimilar to Australia, but that doesn’t stop private education providers existing that charge large fees. This seems to me to show that even high public investment in some places doesn’t satisfy demand. In addition, there is a whole market for high quality education that exists in the US (there is no realy Australian equivalent), despite public subsidies. Again this suggests to me that there is still so much demand that subsidies are not filling it. I think this suggests that public funding only pushes out private funding in limited circumstances — the demand from the population for education is a huge factor, and if it is high enough, then it doesn’t make much difference, since even high may not be high enough.

  • 6
    Andrew Norton
    October 24th, 2007 08:39

    Conrad – I don’t think public subsidies reduce private demand; they would increase it among those who place a low financial value on higher education. What I am saying is that most people interested in higher education place a high financial value on it, and so will pay to get it. From that perspective, public money just replaces private money.

    The European case is partly cultural, but a sharper cost-benefit analysis could come to similar conclusions. Due to very high taxation, the private returns to education in Europe are likely to be lower on average than in the US or Australia. Therefore the maximum level of financially sensible investment in higher education will also be lower.

  • 7
    Andrew Leigh » Blog Archive » Was the OECD right after all?
    October 24th, 2007 09:30

    [...] Andrew Norton (who knows far more about the details of this than me) writes that the university gets the full [...]

  • 8
    Andrew Leigh
    October 24th, 2007 09:30

    Thanks for correcting my error. I’ve amended my post.

  • 9
    Rajat Sood
    October 25th, 2007 11:51

    Andrew, I am no finance expert, but I am not sure if your analysis is right. Consider the following example: The cost of tuition is $10k pa. Let’s say that the government funds half of that directly and bills students for the other $5k, offering them a CPI-indexed HECS loan to fund the payment. Assuming that this loan is issued at below-market interest rates, the net present value (NPV) of that loan (being the value that the loan would sell for in the market) is less than its face value of $5k – say, it’s NPV is $4k. Therefore, the total government contribution is $6k. By contrast, let’s say that the government pays the whole $10k itself and the student pays nothing. The Government then issues a bond with a face value of $10k paying a market-based coupon rate. Assuming interest rates do not change, that bond will be purchased at and trade at (ie have an NPV) of $10k. Therefore, the government’s contribution remains at $10k. Hence, the failure to take account of the below-market rate loan overstates the difference in the funding levels. Any thoughts?

    On the opportunity cost of government spending, I agree that the return on the surplus-stashing funds is an appropriate measure. Although this will vary over time, we can use long-term averages, or perhaps use the Future Fund’s objective of about 5% real as an indicator. This is pretty high and would torpedo the case for most government spending initiatives. It also raises an interesting question about the use of “social” discount rates in areas like the global warming debate. Stern and co used real discount rates of about 1.5%. If we made all decisions on that basis, the government would be chewing my food for me. Conversely, if we used 5% real, you wouldn’t lift a finger to stop global warming. Of course, this is simplistic in that climate change raises inter-generational issues not present elsewhere, but the implications of different discount rates are profound.

  • 10
    Andrew Norton
    October 25th, 2007 13:52

    Rajat – Isn’t that $4K NPV the value of the loan to the government, whereas what I am looking at is the cost of the government’s own borrowings in the finance markets? Say both governments are in deficit. They will both have to borrow $10,000 to finance their higher education spending for that student, and pay interest each year on that $10,000. That interest should be counted as a higher education expense.

    In the case of the government with the HECS system, the cost will be partially offset by the indexation of the HECS debt of $5K (let’s assume the debt will be fully repaid).

    In this example, direct subsidy undercounts the expense of higher ed in both cases, but by more in the country without a HECS system.

  • 11
    Rajat Sood
    October 25th, 2007 14:50

    Andrew, I’m a bit confused, probably because I’m not sure exactly what the OECD report does and what the Government has claimed. I assumed that the OECD did not count government spending reflecting students’ HECS liabilities as government spending. However, I gather from what you’re saying that the OECD counts as government spending the entire cost of tuition paid by the government at the outset of the tuition period? How does the OECD then account for graduates’ actual and expected HECS repayments?

  • 12
    Andrew Norton
    October 25th, 2007 15:39

    Rajat – The OECD counts HECS as private expenditure. In that sense, their figures understate how much cash goes from the government to the universities. But as most of this will be recovered, it is lending rather than spending.

  • 13
    Rajat Sood
    October 25th, 2007 16:08

    Andrew, let me make sure I understand. Say that a course costs $10k to provide. I then assume that the government pays $5k directly to the university as “higher ed expenditure” and pays the other $5k to the university on behalf of the student, for which the student is liable to the government (ie the student’s ‘HECS’ debt). If what you’re saying is that the OECD does not count the second $5k as government spending, then I think my original point stands – this $5k is not fully recovered from students because it is lent at below-market interest rates (this ignores the bad debts issue). In other words, the amount attributed as private expenditure is overstated – it should be $4k rather than 5k.
    On the other hand, if the OECD counts the full course costs ($10k) as government spending but subtracts actual HECS debt repayments by students in any given year, then perhaps that is fair enough because those repayments already reflect the below-market interest rates being charged.

  • 14
    Andrew Norton
    October 25th, 2007 16:32

    Rajat – The OECD only counts the first $5K as government spending.

  • 15
    Rajat Sood
    October 25th, 2007 16:54

    Then I would say that the criticism of the OECD report is apposite. The way I see it is that the government spends $10k on higher education and, in order to fund that expenditure, issues a bond with a face value of $10k that pays the market interest rate. Then (in exchange for her education), the student notionally gives a bond to the government with a face value of $5k. However, this bond pays a below-market interest rate and thus is only worth $4k in the market (ie NPV($5k below-market rate bond)=NPV($4k market rate bond)). The government is left with a net $6k bond outstanding, which pays the market interest rate. However, it sounds like the OECD assumes that the government only contributes $5k. By contrast, if the government paid the entire $10k cost itself, it would issue a $10k bond paying the market interest rate. Therefore, while there is a $5k difference in the nominal government contribution, there is only a $4k difference in the present value government contribution.
    Where are the finance gurus when you need them??

  • 16
    cba
    October 26th, 2007 21:37

    Rajat – I agree with you. counting interest used to finance a past expenditure is double counting.

    the question of the right discount rate in the stern report is also interesting. if we assume global warming will ultimately cause a massive shock to welfare with positive probabilty then there is no reason the discount rate couldn’t be negative (at least less than the risk free rate)