The inconvenient truth about Philip Hammond's budgetary plans

While everyone's worrying about Brexit, the real impact of tuition fees on the public finances is being misreported

March 20, 2019
Chancellor of the Exchequer Philip Hammond delivers his Spring Statement to the House of Commons ©PA
Chancellor of the Exchequer Philip Hammond delivers his Spring Statement to the House of Commons ©PA

Overshadowed by last week’s tumultuous Brexit votes, Philip Hammond had some good news to report in his March 13th spring statement. Provided that Britain does leave the EU in an orderly fashion there will now be a “deal dividend” of close to £27 billion. That handy stash of public money will become available in 2020-21 as the budget deficit falls comfortably below the Treasury’s target for that year. But there is an awkward caveat, which the chancellor failed to mention to MPs. A new way of accounting for student loans in the public finances will wipe out nearly half of his booty.

Galvanised by critical reports from two parliamentary committees, the Office for National Statistics (ONS) is poised to call time on the current flawed way in which student finance is captured in the public accounts. Such are its deficiencies that the Office for Budgetary Responsibility (OBR), which provides independent scrutiny of the public finances, said last year that the method was fostering “fiscal illusions.”

The smoke and mirrors are possible because of the way that student loans are recorded. When a student takes out a loan, the government finances the lending by itself borrowing. That is picked up in the cash-based figures for the stock of public debt. However, the expense in funding students does not show up in the budget deficit—the annual difference between spending and revenue—which is based on accruals (recording as far as possible transactions when the underlying activity occurs rather than when cash changes hands). And it is the budget deficit rather than debt that is the headline fiscal number and the main target measure for the chancellor as he seeks to reduce and eventually eliminate it.

The rationale for excluding the expense of providing student loans from the budget deficit is that the transaction is strictly financial: the government borrows to acquire an asset in the form of the loans. But when it comes to the interest charged on the loans, this is included in the budget deficit even though it is not paid but “capitalised,” by increasing the amount that students owe. This notional revenue decreases the budget deficit, further flattering it.

This approach would be appropriate if the government were providing conventional loans. But it is not doing that. Students are liable to repay the loans for 30 years after they have graduated, at which point any outstanding arrears are written off. They make the repayments only if they can afford to do so, by earning more than a threshold that currently stands at £25,000 a year (above which they pay 9 per cent).

The system is in effect a graduate tax paid in full by only a minority, reckoned by the Department for Education to be just 30 per cent of English full-time students starting their courses in 2017-18. As tuition fees have risen to their current cap of  £9,250 a year, the shortfall in the overall system has become large. The OBR estimated last year that the students starting in 2017-18 would eventually repay less than 40 per cent of their total loans and capitalised interest.

Eventually that ugly reality, as opposed to the alluring illusion of student finance, will affect the budget deficit. But that will not occur until the loans and capitalised interest are written off three decades later, when the subsidy is finally recognised. Even more remarkably, the government can dodge that collision with reality altogether by selling tranches of the loan book to the markets. Even though such sales recognise big losses—student loans with an outstanding face value of £3.5 billion were sold in December 2017 for £1.7 billion—the write-offs do not show up in the budget deficit.

The ONS’s reform, due to take effect in September, will strip away the fiscal illusions by acknowledging the reality of student finance: that it combines loans to those who can repay them and grants to those who will be unable to pay back some or all of the debt they have incurred. Crucially, the grants component will be treated as current expenditure when the loans are made rather than when they are written off three decades later. Receipts will be lower to reflect the fact that a lot of interest will in fact never be paid. Altogether, the new approach will add around £12 billion—0.5 per cent of GDP—to the deficit, as currently measured, according to a preliminary estimate from the OBR.

Will it matter as and when the deficit turns out to be bigger than currently reported? Hammond could argue that nothing has substantively changed and retain his full bounty of £27 billion by raising his deficit target for 2020-21 to take account of the adjustment. But in practice the headline numbers mesmerise everyone. The Treasury was happy to countenance a big expansion of university finance when it did nothing to blemish its scorecard in reducing the deficit. It will take a sterner view once the actual costs show up in the budget deficit.

Compared with the sturm und drang of Brexit, the misreporting of the real impact of student loans on the public finances might seem arcane. Tellingly, no MP raised the issue in the truncated debate on the spring statement. Yet the sorry saga matters. Whatever the original case for student loans in supporting universities and extending participation in higher education, the fiscal figures should faithfully reflect their genuine impact on the public finances rather than providing a distorted mirror.