Degrees of debt

The student loans scheme is unsustainable
April 24, 2013
To make student loans affordable, the Treasury "decided that a firm cap had to be placed on student numbers" © Brian Harris/Rex Features

It’s a subject that won’t go away, no matter how much the politicians would like it to. Ten years ago, the Labour government hit big trouble when it tore up a manifesto commitment not to introduce university top-up fees. The Liberal Democrats have yet to recover from the even bigger U-turn that followed their manifesto promise in 2010 to abolish fees altogether. And the next government, whatever its political colour, will also face some very sensitive questions about the funding of higher education.

The reason is that the changes which were rushed through in the closing months of 2010 are unsustainable over the long term. No one wants to discuss the issue today. But sooner rather than later, someone will have to grasp the nettle.

The coalition government came in with one overriding objective, which was to cut the fiscal deficit. And for the Treasury, English universities offered an irresistible get out of jail card. A review of higher education led by John Browne (Lord Browne) was published after the election, proposing a radical new approach. Rather than directing public funding for teaching to the universities by way of subsidies, public support should go instead to students in the form of a generous loan scheme. These loans would support much higher tuition fees, which in turn would compensate universities for the loss of most of their teaching subsidies.

What followed was a case study in political cherry-picking. Browne’s proposals were implemented on a highly selective basis, around a framework which was designed at least in part to give political cover to the Liberal Democrats. The upshot was cuts in teaching subsidies that brought a saving to the exchequer of around £3bn a year. But the long term cost to the taxpayer of supporting the student loans, which was and which remains highly uncertain, would not show up for years.

In the words of Nicholas Barr, a professor of public policy at the London School of Economics, “the changes look like a dodgy public finance initiative: with optimistic assumptions, the numbers look good in the short run but are likely to have a high long-run cost.” To soften the blow of steep rises in tuition fees, the reforms made the repayment terms of student loans much more generous than those of the previous regime. The earnings threshold at which repayments start was raised to £21,000 and indexed to earnings. And any loans not fully repaid after 30 years would be forgiven.

It was clear from the start that under these conditions a good chunk of the loans would never get paid back. Treasury jargon for the long-run cost to the government of the loans that it makes, expressed in real terms, is the “resource accounting and budgeting” (RAB) cost. And in the initial white paper put out by the coalition, the RAB cost was put at 30 per cent—meaning that £3 out of every £10 lent would not be repaid.

One seriously adverse consequence of these arrangements was that in order to make them anything like affordable, the Treasury decided that a firm cap had to be placed on student numbers. Although demand for student places had exceeded supply for years, universities would now face serious financial penalties if they recruited more students than they had been given places to allocate. But two developments have since made the likely RAB cost substantially higher than originally suggested.

The first is that the government wildly underestimated universities’ likely response to the new regime. It proposed a base tuition fee of £6,000, but said that in exceptional circumstances the figure could rise to a maximum of £9,000. In the event, a very large number of institutions went right to the top end of the scale, so that the average fee is now well over £8,000 and rising.

Although a surprise to the government, which had costed the reforms on the expectation of a much lower figure, this was an entirely rational response by the universities. The cost of any bad debt is not their problem: it falls on the taxpayer rather than the institution. The perception of the brand value of a university’s degree is at least partly reflected in its cost. And given the poisonous politics of tuition fees, most universities saw a strong case for pushing up fees as quickly as possible. Higher fees lead to higher loans—and to a higher ultimate cost for the taxpayer.

The second miscalculation pushing up the likely RAB cost arises from the fact that the economy is not recovering at the pace the government had anticipated when it worked out its numbers three years ago. The costs of the scheme are very sensitive to the growth in graduates’ cash earnings: high inflation means more loans get paid back and implies a lower RAB cost.

The assumption in 2010 was that earnings growth would quickly resume the upward path established in the years leading up to the recession, and that the average male graduate would be earning something approaching six figures in today’s money by the end of the 30 year payback period. But that’s not the way things are turning out at all. After several years when earnings have scarcely budged, that high earnings figure now looks completely unrealistic, which in turn means that the likely level of unpaid debts is going to be greater than originally forecast.

And it’s not just graduates in low paid jobs who are unlikely to repay their debts in full. Rolls-Royce currently requires its engineering applicants in the UK to have completed at least four years of higher education. Its analysis, based on typical levels of pay progression for its graduate engineers, indicates that a large proportion of them will be paying off their debts through most of their careers, and will still have a sizeable amount left unpaid after 30 years. The company has told the government that it is very concerned about the possible consequences of its changes to higher education funding.

For all these reasons, estimates of the potential RAB cost are rising from the original 30 per cent. The current consensus is somewhere around 33 to 37 per cent—and it’s worth noting that the difference between these two numbers alone works out at around £500m a year.

But some RAB estimates go higher, and there are too many variables to allow for anything like a precise figure. How many European Union students from outside England are likely to repay their loans, given that the money can’t be taken from their income by the UK tax authorities? How many home students might emigrate before the 30 years are up? What are the likely take-up rates for part-time students, who now qualify for loans for the first time?

And will rising income inequality change the way in which earnings growth is distributed among graduates in the future? The Higher Education Policy Institute (Hepi), a think tank, has modelled different scenarios, including one where 75 per cent of the salary increases in the coming years are achieved by the top 20 per cent of earners, and the remaining 25 per cent of increases are spread equally among the rest. On that basis, it reckons the RAB cost would increase by a further 4.2 percentage points. Hepi’s views are more pessimistic than most. But it is hard to quarrel with its conclusion that “the government is implementing a policy about whose cost, on its own admission, it can have no clear idea and which is potentially building up large liabilities for future generations to redeem.”

What is certain is that the size of the student loan book is growing at an accelerating pace. It’s hard to make direct comparisons with private sector institutions. But if you compare the Student Loan Company’s annual rate of lending with the gross mortgage lending of the big British banks, you would find the number well below that of a Lloyds or a Santander, but quite close to the likes of HSBC. In its fiscal sustainability report last summer, the Office for Budget Responsibility estimated that student loan payments would increase net government debt by a peak 6.1 per cent of gross domestic product—or £94bn in today’s money—around the early 2030s, before edging down to 4.4 per cent of GDP by 2061-62 as repayments begin to outweigh new loans. These figures may prove optimistic, since they seem to be based on what now looks like a low average tuition fee. And of course the cash sum of the outstanding loan book would look very much bigger if expressed in nominal terms, rather than in today’s money.

The good news is that the number of student applications appears to be holding up well across all income groups, despite the shock of much higher fees. The loan arrangements must have played a large part in making this resilience possible. What’s not yet clear, though, is whether the accumulation of debt picked up in the course of an undergraduate degree will deter students from moving on to postgraduate studies.

And there is one very worrying exception to this generally steady trend, and that is the collapse in applications from part-time students. The numbers recruited to part-time courses since 2010-11 have fallen by two-fifths for undergraduates and more than a quarter for postgraduates, with serious implications—among other things—for social mobility and the nation’s skills base. This steep fall is unlikely to be just the result of higher fees. The numbers of employer-financed students, especially from the public sector, seem to have dropped sharply. And with household budgets under real pressure, it’s perhaps not surprising that people have been less willing to devote time and money to study. But whatever the precise explanation, this ought to be a matter of real concern to our political leaders.

What the UK needs, and what it hasn’t now got, is a stable system of higher education funding which allows universities to plan ahead for a decade or more, and takes the fixing of tuition fees out of the political maelstrom. It needs a settlement that can be sustained without a cap on numbers, so that higher education can be open to all those who have the talent and wish to benefit from it, and one which removes barriers to access and supports part-time students. And it surely has to recognise that higher education brings a public good to society, as well as private benefits to graduates, and needs to be funded accordingly.

It’s too much to expect any political discussion along these lines with an election just two years away. But there is one lesson at the very least that politicians can learn from the experience of the past 10 years. When the time comes to write their election manifestos, they should think very carefully indeed before making any bold and uncosted promises about university finances.