Failure of the Student Loan Market

A college degree is more than the culmination of learning processes. It is a credential that functions as a good, but in a unique way because it allows the holder to compete more powerfully in the labor market. At the same time, accessing this good requires specific financial instruments in the form of grants, financial aid, awards, federal benefits, and of course, loans. The student loan market, as this essay will show, is a market failure. The supply of college degrees is insufficient compared to the supply of loans for college and costs; there is an information asymmetry with these financial products because many seeking to buy them are not aware of the risks (e.g., the lack of consumer protection, the likelihood that they will not graduate); further, the more loans are sold, the more the value of the good people use them to get (i.e., a college or graduate degree) will decline. All of these factors point to the student loan market as a market failure. Short of dramatic remedies that might make education inaccessible for all but the 1%, one of the best policy-related solutions to this dismal problem might be to make holding a loan less painful for those who are trying to repay it.

Why is the student loan market an issue, and why does it exist in the first place? The ways that Americans finance their postsecondary education hold insight into the answers. As college costs have risen far faster than the rate of inflation (Lieber, 2009), and as the middle class’ buying power has declined, most people have been unable to finance their educations out of their own pockets. For generations, many college students in America have taken on loans to finance college and postgraduate education due not just to the assumption that this will have a positive return on investment (ROI), but also because of the perception that student loan repayment offers a generous tax deduction.

However, as college costs skyrocket (Abel & Deitz, 2014) and jobs evaporate to the point where increasing numbers of people question its value (Taylor et al., 2011), more people are asking questions about student loans and who really benefits. Muddying the water still further is the role of 26 U.S. Code § 221, which stipulates the details that govern the student loan interest deduction, including its maximum deduction and the modest cost-of-living increase that may increase this maximum, in addition to details regarding definitions and the roles of dependents in calculating this deduction (Cornell Law School Legal Information Institute, 2017).

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In general, an individual is eligible for this deduction if, and only if, he or she took out a qualifying educational loan, if they paid interest on the loan (as opposed to fees, principal only, or another arrangement), and if the individual’s modified adjusted gross income (MAGI) is no more than $80,000 if filing as an individual or $160,000 if filing as a married couple (Aranoff, 2015; Internal Revenue Service, 2017). However, these deductions may seem overly modest, given that as of 2013, the average college graduate was leaving school with more than $35,000 of debt (Ellis, 2013). Increasing numbers of people are taking out enormous sums to finance college or graduate school, and fewer are able to pay these off in time, leading to cascading economic problems when they are unable to buy homes, when they put off having children, or in many cases, simply default on the loans.

Information asymmetry is also a critical component of this market and of its failure. Especially for those who are first in their family to attend college, or who otherwise have no personal experience with higher education and its marketing techniques, the appeals of predatory for-profit schools are almost irresistible. These high-pressure schools use sales techniques to get students to agree to attend, helping them apply for loans but failing to give them adequate information about the risks involved (to say nothing of the low value of a for-profit degree). The people selling the loan products have information that the purchasers do not. In some larger theoretical or symbolic sense, the very information asymmetry is something that people want to overcome through their pursuit of a college degree.

Regardless, the student loan crisis is widely considered to be more highly concentrated among those attending two-year schools. Economists have noted that there is a serious potential for an economic crisis to occur if many default on student loans, though the lack of collateralization, as was prevalent in the housing bubble, may contain the damage – but may also nonetheless cause severe declines in middle-class purchasing power (Looney & Yannelis, 2015). The authors of one study stated, “…it is interesting to compare the default out-comes of borrowers who took out subprime mortgages compared with those who took out student loans to attend for-profit colleges. Both types of borrowers tend to have poorer-quality credit records, and the returns to their investments were dependent on macroeconomic factors beyond their control—house prices in the case of subprime mortgages and wage growth in the case of student loans” (Looney & Yannelis, 2015, p. 81). This passage hints at the interconnected nature of mortgages and student loans, including the ways that student loan borrowers are disadvantaged by the situation and by the informational asymmetry.

The repayment systems for student loans, meanwhile, also represent market failures in a strong way. A 2008 paper explored the ways in which various proposed loan forgiveness programs effectively constituted a secondary tax (Dynarski, 2008, pp. 19–20). The author concluded that even though college costs rise and student loan borrowers remain in debt for a very large amount of time, the degree itself is still worthwhile. However, “… there is a mismatch in the timing of the arrival of the benefits of college and its costs, with payments due when earnings are lowest and most variable. Ironically, this mismatch is the very motivation for providing student loans in the first place” (Dynarski, 2008, p. 26). The market failure is apparent from the way that this mismatch occurs, and the ways in which information asymmetry surrounds much of the loan buying process. Dynarski also offers a discussion of the ways that the federal repayment programs such as Pay as You Earn and Income Based Repayment, as well as hypothetical programs such as Pay It Forward (state-based, income-based programs that allow low earners to pay very little while high earners pay much more) constitute taxation, which segues into the larger policy discussion: The student loan interest deduction and the ways in which it can be remedied to better address this market failure.

Because of the widespread perception that student loan debt is good debt, and because of the ways that this tax code provision is built on some complex assumptions about supply and demand, it is clear that there is a market failure. The deduction assumes that the supply of college graduates will be smaller than the supply. It assumes that the cost of living will only increase modestly, and critically, it does not calculate the increases in college costs or the ways that they far outpace inflation. In other words, it assumes that the demand for college loans will outpace the supply of people taking them out and repaying, when the opposite is true. It also assumes that the economic demand for college graduates will be higher than the supply, to the point where incentivizing people to get an education is necessary to get highly skilled workers. However, the economy is no longer in need of these credentials, or perhaps college has become so watered-down that people with degrees are seldom finding the kinds of jobs they dreamed of. In any case, many people with college or even advanced degrees are not experiencing the return on investment that they had anticipated.

At present, the student loan interest deduction is generally capped at $2,500 annually (Internal Revenue Service, 2017). For those who are repaying very significant loans, including for graduate school, professional school, or simply for attending high-cost, predatory schools, this deduction does not make a significant difference. More people than one may initially believe struggle with student loans of $100,000 or more (Kantrowitz, 2012), so the tiny tax deduction is often laughable. Especially because of the market failure that has itself promoted the situation, the government should intervene to increase the tax deduction. The mismatch between the good and its benefits facilitates the market failure of the student loan interest deduction (Dynarski, 2008, p. 26). Even for those who have a modest amount of student loans and for whom the interest deduction would be significant, an informational asymmetry means that many who qualify for this deduction do not even take it, since around 19% are not even aware of what deductions they might quality for (Student Loan Hero, 2016).

Revising the system so that, for example, student loan interest and principal are both deductible, could reduce the failure of the market. Improving information about student loans, as well as how to take advantage of the tax deduction, could also go a long way towards reducing the information asymmetry that dominates the market. The failure of the labor market to adequately absorb college graduates, especially with wages that cause their debts to decrease over time, combined with the informational asymmetry that disadvantages some people more than others, means that there is a serious issue; one potential remedy would be to improve the student loan interest deduction.

The student loan system is a market failure, and the tax deduction has also failed to live up to promises because of the temporal mismatch. It has failed to account for the realities of college costs, the realities of the labor market, and the realities of economic life for young people. The policy is a market failure and needs to be changed. Some ways to improve it could be to increase the maximum deduction, to increase the MAGI ceiling at which the deduction is phased out, or to implement widespread loan forgiveness since doing so might add more liquidity to the consumer economy, which would in turn help the economy to grow. Forcing colleges and universities to guarantee student loans could also be another solution to the problem of student debt, ensuring that widespread debt default has less of an effect on the overall economy than it did during the housing bubble. 

References

Abel, J. R., & Deitz, R. (2014). Do the Benefits of College Still Outweigh the Costs? Current Issues in Economics and Finance, 20(3), 1–12. https://doi.org/DOI: ,

Aranoff, A. (2015). Student Loan Interest Deduction: What You Need to Know | HuffPost. Retrieved October 17, 2017, from https://www.huffingtonpost.com/aryea-aranoff/student-loan-interest-ded_b_7486888.html

Cornell Law School Legal Information Institute. (2017). 26 U.S. Code § 221 – Interest on education loans | US Law | LII / Legal Information Institute. Retrieved October 16, 2017, from https://www.law.cornell.edu/uscode/text/26/221

Dynarski, S. M. (2008). An Economist’s Perspective on Student Loans in the United States (No. 5579). Munich.

Ellis, B. (2013). Class of 2013 grads average $35,200 in loans, credit card debt. Retrieved November 1, 2017, from http://money.cnn.com/2013/05/17/pf/college/student-debt/

Internal Revenue Service. (2017). Topic No. 456 Student Loan Interest Deduction. Retrieved October 15, 2017, from https://www.irs.gov/taxtopics/tc450/tc456

Kantrowitz, M. (2012). Who Graduates College with Six-Figure Student Loan Debt ? Washington.

Lieber, R. (2009, September 5). Why College Costs Rise, Even in a Recession. The New York Times, p. B1.

Looney, A., & Yannelis, C. (2015). A crisis in student loans?: How changes in the characteristics of borrowers and in the institutions they attended contributed to rising loan defaults. Brookings Papers on Economic Activity, (Fall), 1–89. https://doi.org/10.1353/eca.2015.0003

Student Loan Hero. (2016). 19% of Americans Don’t Know What Student Loan Tax Benefits They Can Claim. Retrieved November 1, 2017, from https://studentloanhero.com/press/19-percent-americans-dont-know-student-loan-tax-benefits/

Taylor, P., Parker, K., Fry, R., Cohn, D., Wang, W., Velasco, G., & Dockterman, D. Is College Worth It ? (2011).