Kay L. McLennan

Summary

While guaranteed student loans have grown to be the principle means for student aid in the United States, a wide array of additional student aid programs are funded and even more proposals to expand the mix of programs available. Some of the programs represent an inferior allocation of society’s resources. Further, there are calls for both reforms in the guaranteed student loan program and for greater simplification of student aid in general.

This paper concludes that a better (albeit more radical) approach is to concentrate on only one program that could be enhanced to meet an array of student aid goals. More specifically, expand the use of guaranteed student loans as the only means of federal student financial aid with the addition of a loan forgiveness program tied to national economic goals like expanding the available teaching and information systems work force. Also, tie repayment obligations to future social security payments to eliminate the risk of default on guaranteed loan obligations.

Higher education in the U.S. is often considered to be a private good—the benefits of a college education are excludable (only the individuals receiving the education are rewarded in the labor market) and rival (no or small negative externalities are associated with the pursuit of higher education). Further, the extensive support of higher education by the federal government does not make it a public good. Yet, Baum (1995) notes that while we normally think of externalities as negative, there is every reason to imagine a reverse case where positive externalities accrue to society from the engagement or consumption of certain commodities and this is the case for education. All of society benefits (in terms of higher aggregate income) from the investment in human capital attendant to higher education. In addition, Baum (Ibid.) notes how the notion of incomplete information in the market is relevant where "young people…have no experience with higher education and may underestimate its value."

In keeping with the rationales stated above, the government has chosen to provide student aid as a substantive way of encouraging more citizens to pursue college degrees and equalizing the access to higher education (and its attendant increased earning potential benefits). [In terms of magnitude, the federal government is the most important source of financial assistance for students since they provide about 75 percent of all student aid (see Table 1 below).] Also, where the provision of loans has become the principle means of support for students, the federal government has a role in insuring the provision of credit to an otherwise non credit-worthy group—students (Mankiw, 1986).

Still, where the intended benefits of public funding are to provide wider access to higher education, it is reasonable to ask whether this particular allocation of public funds is being accomplished in the most cost efficient and equitable manner. In turn, this paper provides an overview of the current student aid programs along with an literature-based review of the comparative efficiency and equity attributes of each program, discusses a sampling of the major proposals to expand or change programs and posits conclusions (along with areas in need of further research).

Our present day student aid programs can be traced back to the passage of the Servicemen’s Readjustment Act of 1944 (known as the GI Bill) that was intended as a reward for military service during World War II (Gladieux and King, 1999). In turn, the success of the GI Bill in providing higher educational opportunities for both men and women "who otherwise would not have had the opportunity" led to calls for additional educational support (Ibid.). Yet, it was not until the first Higher Education Act was passed in 1965 that "an explicit federal commitment to equalizing college opportunities for needy students" was formalized (Ibid.). Further, Gladieux and King (1999) report that the magnitude of the amount of student aid grew from about $200 million in 1963 to more than $35 billion in 1995.

However, it is important to note that what began as an initiative to help those students who would have otherwise not gone to college has now gown to include aid for middle class families who could presumably otherwise afford higher education. That is, there has been a "policy drift" where in 1975 almost 80 percent of the aid was in the form of grants or work-study programs for needy students and 20 percent in loan programs, we now see a complete reversal where nearly the same amount—80 percent—of the aid is in the form of loans and only 20 percent is in the form of grants or work-study programs (Gladieux and King, 1999).

Today federal student aid provides for a mixture of programs (see Table 1 below), including guaranteed student loans, direct loans, grants, work study, education tax credits and savings plans (tied to favorable tax treatments).

Table 1: Postsecondary Student Aid, by Major Program (in Millions of Current $)

--Academic Year--

Source: The College Board’s Trends in Student Aid: 1985 to 1995 [as reported by Gladieux (1995)]. (Detail may not add to totals due to rounding.)

Loan guarantees (subsidized and nonsubsidized) have become the principle means of federally supported student aid. Including both subsidized and unsubsidized Stafford Loans, this program area provided $22 billion in guaranteed loan obligations in the academic year 1994-1995. This amount represents about 70 percent of the total federal student aid (excluding specially directed aid). Yet, despite dissatisfaction with the program operation and limitations, it is not likely that this program will be reduced (Murphy and Ark, 1991). That is, Mumper and Ark (1991) posit that the middle class support base for loan guarantees is too wide to allow for any reorientation of student aid back to the original grant program.

Also, where financing higher education costs through student loans has grown so dramatically in the aggregate, the question arises concerning whether there is some financial recklessness on the part of students or their families that is driving the increased demand (King, 1996). However, one only needs to examine how rapidly college costs are rising coupled with how large a percent of the average middle-class income average college costs are to determine that the need is genuine. Dramatically higher costs for higher education are evident in how between 1983 and 1994, "the cost in current dollars of attending private four-year universities increased by 94 percent, from $10,243 to $19,884; at private four-year colleges by 88 percent, from $7,849 to $14,732; at public four-year universities by 76 percent, from $3,899 to $6,862; 74 percent at public four-year colleges , from $3,518 to $6,109; and 44 percent at public two year colleges, from $2,807 to $4,039 (Nettles, 1995). Further, according to Frase (1995), "[i]n 1993, the average charges for tuition, room and board were about $5,800 for public institutions of higher education (for an in-state student) and $15,800 at a private institution" and "[t]hese charges represented 14 percent and 39 percent, respectively, of median family income (for families with children aged six to 17)." In conclusion, "borrowing is a perfectly reasonable way to finance this investment [in human capital]" (Hauptman, 1995).

However, the guaranteed student loan program has come under a great deal of criticism primarily for the high rate of defaults. The finding means that the unsubsidized loans are still subsidized on the basis of the high default rates attendant to this type of loan. Yet, this subsidy (along with default rates) can be lowered (or eliminated) by the simple tying of loan repayment to social security payments (Hanushek, 1989).

Initiated in 1994 on a trial and/or phased in basis, direct loans provided a little over $1.7 billion in loans during the 1994-95 academic year (Gladieux, 1995). The funding level for this program during the 1994-1995 academic year totaled $1.7 billion or only 5 percent of the total federal support (excluding specially directed aid).

At present, the Department of Education (1999) claims that for every $100 loaned, direct loans are $18 less expensive for the federal government than guaranteed loans. However, conservative groups and congressional members are opposed to this type of loan on the grounds that the financial capital used in the program will be raised by additional federal borrowing (versus the channeling of private funds to education) and how this program requires the hiring of additional staff at the Department of Education (Spalding, 1995).

While the original means of means of student aid provided by the federal government, these awards have diminished both in terms of the percent of the total dollar amount of aid made available and in terms of the percentage of the amount of college costs covered. That is, as reported by Breneman and Galloway (1995) "the value of the maximum Pell Grant as a percentage of college costs has shrunk from a 1975 high of 78 percent of the cost of a four-year public institution to 37 percent in 1993, and from 39 percent of the cost of a four-year private institution to 13 percent in 1993." In turn, the shift in student aid away from grants to loans as well as the decline in the real value of financial aid have failed to narrow the gap between the percentage of black versus white students that attend college (Carnoy, Winter, 1994-1995 and Hauptman, 1995).

While not a large program in terms of the funding level—$760 million dollars were provided for this type of assistance in the 1994-1995 academic year--according to Hauptman (1995), this program is particularly popular with "many members of Congress who hark back to the time when they worked their way through college." Also, of particular importance is how this program is only suited for students in good academic standing. In other words, any students in need of remedial help with their studies would be better served by one of the loan programs (Ibid.).

Presently there are two types of tax credits available to offset qualifying tuition and related expenses. More specifically, the Hope credit can be claimed in an amount up to $1,500 annually for each student (but only for 2 years for each student). The second type of credit is termed a lifetime learning credit of up to $1,000 for qualified tuition and related expenses.

Both types of credit are generally considered to be an inferior form of support owing to the regressivity and market distortion attendant to this type of initiative. (Regressivity refers to how higher income groups benefit more than lower income groups and market distortions refer to the decrease in the efficiency of the economy as a result of people changing their behavior to avoid paying taxes.)

At the present time there are several incentive options for saving for a child’s higher education. First, an educational IRA can be established that allows fund earnings to grow tax-free. However, the contributions to this type educational savings fund are limited to $500 a year and adjusted gross incomes of less than $160,000 for joint filers and $110,000 for single taxpayers.

The second option is to set up an account in the child’s name (gifts to children of $10,000 per year for a single taxpayer and $20,000 per year for joint filers are allowed). In turn, the tax on this type of account will be at the child’s lower rate of 15 percent for ordinary income and 10 percent for capital gains. Yet, the child will gain control of the account when they come of age and may decide to use the money for purchases other than higher education.

In addition to the regressivity and market distortion attendant to the advantageous tax treatment, increased savings might lead to the undesirable result of what is termed "the paradox of thrift." For example, if a large number of individuals decides to increase their level of savings, there will be an accompanying reduction in consumption. In turn, production will be adjusted downward and total income will fall. In other words, total savings may fall because of the fall in income even though each person saves a larger fraction of their income. (Note: While the subject of under what circumstances the paradox of thrift applies has been the subject of much debate, its inclusion here is meant to illustrate how it is often not a simple matter of what is beneficial for one person will automatically be beneficial for the whole economy.)

In the context of the recent presidential election campaigns, two different strategies for aid to student emerged from the opposing democrats and republicans. First, the republicans propose the funding of Pell grants up the maximum $5,100 for the first year of college (benefits low income families). In addition, middle-income families would be able to save up to $5,000 a year in a tax-advantaged account to pay for educational expenses. Further, there are numerous references to how republicans would like to eliminate the direct loan program.

Similarly, the democrats call for increased Pell grants (an amount is not specified) and would provide as much as $2,800 in tax relief for up to $10,000 of college tuition expenses. Also, families could save as much as $2,500 in tax-advantaged accounts to pay for educational or job training expenses.

 Table 2: The Efficiency and Equity Considerations Relevant to Current and Proposed Student Aid Programs

( ) Indicates proposed program.

Federally financed student aid channels financial resources into the critical area of the educationally-based development of human capital in our economy. In turn, there is an analytical rationale for continuing and even expanding the amount of student aid available. In terms in what form the support should be provided, the literature and analysis included in this paper includes the following findings.

Grants represent the most efficient allocation of resources to students and additionally fulfill the objective of targeting low income students and families. Yet, this student aid program does not have a broad base of support.

Guaranteed student loans have become the principle means of federally supported student aid. In turn, the middle-class support base for this type of loan is quite entrenched (Mumper and Ark, 1991). Also, where it has been suggested that the increasing use of nonsubsidized loan guarantees by middle-class families represents a selfish disregard for the savings needed to finance their children’s higher education, one only needed to examine how rapidly college costs are rising coupled with how large a percent of the average middle-class income college costs are to determine that the need is genuine. Yet, this type of loan guarantee entails a large cost owing to high default rates. Still, this important criticism could be eliminated by the simple tying of loan obligations to future social security payments (Hanushek, 1989).

Direct loans are considered to be less costly than guaranteed loans (U.S. Department of Education, November 1999). However, conservative interests are opposed to this type of loan on the grounds that the financial capital used in the program will be raised by additional federal borrowing (versus the channeling of private funds to education) and requires additional staff at the Department of Education.

Work-study programs do target low income students and families but they distort economic incentives by mandating employment. In addition, this type of program is limited in the preferred application to students of good academic standing.

Savings plans (tied to advantageous tax treatment) decrease the efficiency of the economy as a result of people changing their behavior to avoid paying taxes. In addition, with savings plans there is always the risk of the "paradox of thrift" which leads to even less savings in the aggregate despite greater individual thrift. Finally, this type of program cannot help the low income families that do not have excess income to save. The finding also applies to minority middle-class families that live on the economic margin and do not have enough income to fund savings plans.

Tuition tax credits and deductions as well as a job training tax credit all entail substantive distortions (as detailed above: as a result of the economic inefficiency related to the changed behavior). More importantly, all advantageous tax treatment schemes are regressive and therefore benefit higher income groups more than lower income groups.

In turn, a synthesis of these findings along with the notion that extensive borrowing is both needed by lower and middle income families as well as a perfectly reasonable way to finance an investment in human capital (Hauptman, 1995), points towards the maintenance and/or expansion of guaranteed student loans as the principle means of support for students. [An additional consideration in the recommendation of just one loan program relates to continued calls for the simplification of federal student aid (Hauptman, 1995).] This program has a broad base of support and could be modified to satisfy the calls for decreasing the amount of loan defaults and channeling more aid toward low income students and families. The virtual elimination of loan defaults could be accomplished by the garnishing of social security payments in the event of a default. In terms of channeling more aid to the individuals that would not go to college without full funding from an outside source, the subsidized Stafford loan program could be continued with the expanded provision of a loan forgiveness in exchange for National Service. National Service types of loan forgiveness are not new (Hauptman, 1995) but could be modified to appeal to a wider number of student borrowers. First, in addition to the previous designated forms of national and community service envisioned as an alternative to loan repayment, the modified program could include different types of occupations where labor shortages currently exist. For example, if a student borrower would elect service over repayment, they could choice a specified period of employment as say a teacher or information service technician in an economically disadvantaged region of the country.

Further, the issue of whether direct loans are in fact less costly than loan guarantees is an area in need of further research. More specifically, a new comparison needs to be made of whether direct loans are still cheaper when compared to loan guarantees that have an almost zero rate of defaults (in keeping with the social security pay out garnishing plan proposed above). (Note: The notion of deficit financing advanced as an argument against direct loans is rejected on the grounds that there is every reason to expect the program could be financed from current revenues.)

Finally, the savings plans, advantageous tax treatment for tuition or training payments and work study programs are all rejected on the grounds of entailing either too substantive market distortions and/or favoring higher versus lower income students.

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