A quarterly magazine of the IMF

June 2005 , Volume 42, Number 2

Reforms in Britain may provide a useful framework for other countries

Higher education faces problems throughout the world: universities are underfunded, raising worries about quality; student support is inadequate; the proportion of students from disadvantaged backgrounds is lamentably small; and the financing of universities in many countries is regressive, since the money comes from general taxation but the major beneficiaries are from better-off backgrounds.

No longer only a consumption good enjoyed by an elite, tertiary education is an important element in national economic performance and a major determinant of a person´s life chances. Thus, the expansion that is taking place internationally is both necessary and desirable. But higher education is costly, and faces competing imperatives for public spending. Its financing is therefore important and immensely sensitive politically. Despite the problems, widespread agreement exists on two core objectives: strengthening quality and diversity, both for their own sake and for reasons of national economic performance; and improving access, again for both efficiency and equity reasons. If it is not possible to rely wholly on public funding, it is necessary to bring in private finance—but in ways that do not deter students from poor backgrounds. Much of this article addresses that issue. The arguments, though ostensibly about higher education in richer countries, apply more broadly to tertiary education and to developing economies.

What can economic theory teach us?

Economic theory offers a useful perspective for analyzing higher education. First, the days of central planning are gone. Students are potentially well-informed consumers, better able than planners to make choices that conform with their interests and those of the economy. Though that proposition is robust, there is an important exception: people from poorer backgrounds might not be fully informed, emphasizing the need for scholarship finance.

On the supply side, central planning, whether or not it was ever desirable, is no longer feasible. In response to technological change, there are more universities, more students, and vastly greater diversity of subject matter. Thus the myth that all universities are identical and should therefore be funded equally is no longer sustainable. In principle, differential funding could be implemented by an all-knowing central planner, but the problem is too complex for that to be the only mechanism: mass higher education requires a funding system by which institutions can charge different prices to reflect their different costs and missions.

Note that this approach leads to very different conclusions for school education, where the model of the well-informed consumer is less plausible and the case for a more standardized product stronger. The argument for regulated market forces in higher education is not primarily ideological, but rooted in the economics of information.

A second lesson from economic theory is that students should contribute to the cost of their degree. Higher education creates benefits that transcend the individual—benefits in terms of growth, social cohesion, and the transmission of values. Thus, taxpayer subsidies are rightly part of the landscape. However, students also receive significant (often substantial) private benefits. It is therefore both efficient and fair that they bear some of the costs.

The point bears emphasis. Many people argue that tertiary education is a right and should therefore be financed from taxation. However, the fact that something is regarded as a right does not mean that it should be tax-financed. Access to nutrition is a basic right, yet nobody argues that it is wrong to charge for food. The moral imperative is not about instruments (for example, prices) but about outcomes, that is, that a bright person should be able to go to the best school or university irrespective of his or her financial circumstances. In addition, the worldwide collision between expanding tertiary education and fiscal pressures means that reliance on tax finance creates downward pressure on quality. The historical record shows that tax finance has done little to widen access, while, as noted, tax finance is deeply regressive. If it is unfair to ask graduates to pay more of the cost of higher education, it is even more unfair to ask non-graduate taxpayers to do so.

However, most students cannot afford to pay for higher education, leading to the third set of lessons from economic theory—well-designed student loans have essential core characteristics.

• Income-contingent repayments—repayments calculated as x percent of the borrower´s subsequent earnings, collected alongside income tax—protect access because the loan has built-in insurance against inability to repay; and, because repayments are collected alongside income tax, they protect the lender from the risk of making an unsecured loan.
  
  
• Loans should be large enough to cover fees and, at least in richer countries, also realistic living costs, making higher education free at the point of use.
  
  
• Loans should attract an interest rate broadly equal to the government´s cost of borrowing.

The question of interest rates is worth examining. Many countries, including Australia and Britain, offer loans at a zero real interest rate, that is, there is a blanket interest subsidy. This policy, however, does not achieve a single desirable objective. The subsidy is enormously expensive, the resulting shortage of funds being inimical both to quality and access. This point is not fanciful. The communist experience demonstrates that subsidies can easily lead to shortages; in this case, the fiscal cost of the interest subsidy results in loans that are too small—which harms access—and simultaneously crowds out taxpayer support for universities—which harms quality. To make matters worse, interest subsidies are deeply regressive. They do not help students (graduates make repayments, not students). They give relatively little help to low-earning graduates, since unpaid debt is eventually forgiven. They do not help high-earning graduates early in their careers—with income-contingent loans, monthly repayments depend only on earnings; thus interest rates have no effect on monthly repayments, but only on the duration of the loan. Accordingly, the major beneficiaries are successful professionals in mid career, whose loan repayments stop earlier because of the subsidy than would otherwise be the case. This is not the target group that education policymakers had in mind. In contrast, targeted interest subsidies are useful.

The resulting strategy

The theory suggests a three-part strategy:

Element 1, deferred variable fees: Universities are financed from a mix of taxation and tuition fees. Each university sets its fees, which are covered by a loan entitlement. Variable tuition fees are controversial in Europe, although less so in Central and Eastern Europe, and are taken for granted in the United States and many countries in Asia. Fees give universities more resources to improve quality and, through competition, help improve the efficiency with which those resources are used. That is not an argument for law-of-the-jungle competition but for regulated markets. Counterintuitively, variable fees are also fairer since they reduce the regressivity of a system based on tax finance.

The obvious argument against fees is that they deter students from poor backgrounds. That is true of up-front fees, but not when students go to university free and make a contribution only after they have graduated. This brings us to the second part of the strategy.

Element 2, income-contingent loans: Student support is provided through a loan with income-contingent repayments. The loan entitlement should be large enough to cover fees and, in richer countries, living costs, with an interest rate broadly equal to the government´s cost of borrowing.

If loans cover fees, the package closely resembles "free" higher education. Students pay nothing at the time they go to university. Part of the cost is paid through taxation and part through their subsequent income-contingent repayments. From the viewpoint of the graduate, the latter differ from tax in only two ways: they are paid only by people who have been to university, and they do not go on forever. Thus, income-contingent loans are logically equivalent to free higher education financed by an income-related graduate contribution.

The viewpoint from the ministry of finance is somewhat different. Though loans eventually bring in private resources, a loan scheme, by definition, has up-front costs because it lends the money first and receives repayments later. It is therefore useful to distinguish the fiscal costs of loans (that is, money that is never repaid, for example because of an interest subsidy) from the cash flow costs, which relate to money that is eventually repaid. Fiscal costs are a major concern in all countries; and in poorer countries, the cash-flow costs are also a major concern. Ideally, it should be possible to meet those costs by borrowing from the private sector, but—particularly in a developing country—private lenders will charge a substantial risk premium unless there is a government guarantee; and if there is a government guarantee, the loans will be classified as public. Potential solutions exist in this highly technical area, but require considerable care in design.

Element 3, active measures to promote access: The first two elements free up resources to finance the third—active measures to promote access. There are two causes of exclusion: financial poverty and information poverty. Any strategy for access must address both. Financial measures include scholarships. Information poverty is inadequately emphasized. Action to inform school children and raise their aspirations is critical. The saddest impediment to access is someone who has never even thought of going to university. Moreover, students who are badly informed about the costs and benefits of higher education will be reluctant to borrow—this is the group for whom taxpayer support is essential. Finally, problems of access cannot be solved entirely within higher education. More resources are needed earlier in the system, not least because of the growing evidence that the roots of exclusion lie in early childhood.

Reforms in Britain

Reforms in 1998 brought in income-contingent loans, for which loud cheers. Beyond that, however, the system in Britain had serious problems:

• central planning continued, with controls over student numbers and fees;
  
  
• fees were introduced, set by the central government and the same for all subjects at all universities; and there was no loan to cover fees, making them an up-front charge;
  
  
• loans were too small to cover living costs, let alone fees, and incorporated a blanket interest subsidy; and
  
  
• the reforms abolished the previous system of tax-financed student support.

The reforms enacted in 2004 address most of these problems and broadly conform with the three-part strategy above, offering a useful framework for other countries.

Tuition fees. From 2006, the reforms replace the up-front flat fee with a variable fee between £0 and £3,000 per year. Students can pay the fee up-front or can take out a loan, in which case the student loans administration pays the fee directly to the university, whose financial position is therefore broadly independent of how students choose to pay their fees. This is a regulated market, notably through the imposition of a maximum level of fees. As discussed earlier, variable fees improve efficiency. They are also fairer: they reduce the regressivity of tax finance, and they are directly fairer, in that students do not have to pay the same fee at a small local institution as at an internationally famous one.

Loans. The 2004 reforms improved the system by extending loans to cover tuition fees and by increasing the loan for living costs. They also raise the threshold at which loan repayments start: from 2006, graduates will repay 9 percent of earnings above £15,000 per year (the previous threshold was £10,000).

From the student´s perspective, the situation is little different from the days of "free" higher education: her fees are paid on her behalf, and money is paid into her bank account to cover living costs. From the graduate´s perspective, there is an additional payroll deduction, alongside income tax and social security contributions until the loan is repaid.

In one important respect, however, the loan arrangements conform with neither theory nor best practice—the 2004 reforms continue the interest subsidy.

Action to promote access. The 2004 Act restored grants (income-tested scholarships). From 2005, students from poor backgrounds will be entitled to a grant of £2,700 per year, in addition to a loan. The intention is that no student from a poor background will be worse-off because of the reforms. In addition, there is help for people with low earnings after graduation—any loan not repaid after 25 years will be written off. And 10 percent of the loan of new teachers in shortage subjects is written off for each year in the state system.

The Act also brings in an Access Regulator—another aspect of a regulated market—whose task is to ensure that universities have satisfactory plans to widen access. Those plans can include scholarships for students from poor backgrounds, and outreach to schools to improve the information available to schoolchildren.

These arrangements, which come fully into effect in 2006, bring in additional resources and strengthen competition, both of which contribute to quality, and redistribute from better- to worse-off, contributing to access. That does not, however, mean that the scheme is perfect. Some commentators argue that the cap on fees is too low. This is a balancing act. If fees are liberalized too rapidly, the delicate political balance may not hold, but if fees are kept too low for too long, most universities will charge the maximum, approximating a system of flat fees, reintroducing central planning by the back door. The major continuing problem with loans is the expensive and regressive interest subsidy. That said, there is much in the U.K. reforms that other countries could usefully emulate.

The greatest challenge

Economic theory and practical experience offer solutions to avoidable problems, such as:

a) unsustainable public spending;
b) public spending that is hijacked by the middle class;
c) loans absent, or badly designed, so that they bring in few, if any, extra resources;
d) economic constraints on universities, which reduce incentives for efficiency; and
e) specific design features that are costly (interest subsidies), administratively demanding (income testing), or both.

These are widespread, though (b) and (d) are less of a problem in countries with variable fees.

The three elements in the strategy above—deferred variable fees, income-contingent loans, and active measures to promote access—are applicable to any country that can collect income tax, and hence student loan repayments, effectively. They offer a benchmark against which countries can assess future policy directions (see box).

For developing countries, however, a challenge that haunts commentators is how to design a loan that mimics income-contingent repayments when there is a large informal sector and only limited capacity to collect income tax. This is, perhaps, the greatest challenge of all.

If the necessary prerequisites are not in place, the wrong option is to instigate a large-scale loan scheme and assume that things will somehow turn out right. What other options might be available?

• finance higher education out of taxation on a small scale (say 1 percent of GDP) to provide good quality higher education for a few students, or lower quality for more students;
  
  
• rely on private finance, accepting that this will restrict access to students whose families can afford to pay and, perhaps, a small number on scholarships;
  
  
• introduce a small-scale loan scheme, accepting that it will have a high default rate and high administrative costs;
  
  
• use taxpayer resources to pay for (say) two years of university education, leaving the rest to private finance; and
  
  
• use development assistance to ease the trade-offs between the previous methods.

The disadvantages of private finance or a premature loan scheme are clear. It may be that the last two options, designed as a package, offer the best short-run use of limited public finance and, by avoiding a loan scheme that becomes discredited, leave open the option of introducing loans once institutional capacity allows. At that stage, the existence of an effective mechanism for collecting repayments opens up the possibility of raising part of the start-up costs from nongovernmental sources, including international financial organizations and commercial lenders.

Complementarity of education

The arguments about tuition fees and the analysis of income-contingent loans apply to tertiary education more broadly. And tertiary education should be seen also in the broader context of education over the course of a person´s life. Growing evidence points to the complementarity of different levels of education: tertiary education is more productive if it rests on a solid foundation of high-quality early education, and early education is more productive if it is reinforced by secondary and tertiary education. Thus the challenge is to finance tertiary education in ways that promote quality and avoid crowding out primary and secondary education.