Issue 123:2017 10 05: Student Loan Groan (Frank O’Nomics)

05 October 2017

Student Loan Groan – There must be a better way.

Forthcoming changes highlight a flawed system.

by Frank O’Nomics

As a way of trying to win back the vote of the younger generation, the proposed capping of the university fees at £9.250 and the raising of the salary trigger for repaying student loans, from £21,000 to £25,000, would appear to have some merit. For those earning less than £25,000 they could have an additional £500 per annum to spend after graduation in 2020, and (according to the Institute of Fiscal Studies) the changes could save middle earning graduates as much as £15,700 over their lifetime.  This is not a small cohort, and it is estimated that 83% of graduates will not have fully repaid their student loans by the time their debts are cleared 30 years after graduation. So what’s not to like? First, these measures do nothing to alleviate the usurious level of interest rates that students are being charged, currently 6.1%.  In addition, the 9% tax on earnings over the trigger puts graduates at the highest marginal tax rate in the world (once you factor in income tax and National Insurance).  For society as a whole, as one starts to engage in a little cost-benefit analysis, it is clear that there are a great many issues with the current, and proposed system of student loan repayments, and a fundamental overhaul is needed.

I will get to some potential ways of improving the system – but first let’s look at the extent of the mess. The problem is that, from an economic point of view, the current regime would appear to offer very little help to any section of society. For the universities the proposed fee cap will quickly start to eat into the real value of their income, causing many to cut back on course provision.  For the taxpayer the costs are potentially enormous. The increase in costs in the provision of higher education could rise by 41%, or more than £2.3bn, per year. For graduates, beyond the obvious benefit to restricting the total of their loan and the near-term increase in disposable income, there remains the prospect of living with a high level of debt for 30 years – which will restrict their ability to buy their own property or to save for their retirement.  A graduate who progresses to earning £60,000 currently pays £3,510 towards their student loan – a sum that would fund an additional mortgage of around £80,000.

The main problems stem from the repeatedly poor assumptions that were made at the outset.  First. The Department of Business and Skills extrapolated from 30 years of graduate income growth and assumed that this would continue, thereby providing an acceptable level of repayments.  This was clearly dubious given the changing nature of the student population, which includes many who earn modest amounts with restricted pay growth, such as nurses and social workers.  Second, they thought that pay growth would be spread evenly across the graduate population – and this was just plain wrong.  Because of its poor logic, the government miscalculated the amount by which it would subsidise the student loan system, the so called RAB (Resource, Accounting and Budgeting) charge. This rate has risen steadily from 31% to an estimated 45% as a result of the proposed changes.  Interestingly, if this subsidy were to rise above 48.6% – not an unrealistic possibility if the prospects for graduate employment deteriorate, then the government would be incurring more costs than it would have done under the old £3,000 university fees scheme!

There are two ways in which the situation may resolve itself.  First, the outlook for graduate pay may improve, thereby reducing the RAB charge, although the trend for wage growth overall does not suggest a more rapid loan repayment rate. The second is an improvement in the discount rate that the Treasury uses to calculate the value of future repayments. If the government could secure long-term funds to back student loans at a very low rate, they could then be more optimistic about the value of future repayments.

Prudent government funding could also have a much more important consequence for the rate at which students are charged interest on their loans. Students have to pay interest of RPI +3% on their loans which, given that the rate is set each September, means that they are currently paying 6.1%.  Other than payday loan deals this looks very expensive. If the government can secure funding at RPI +0.5% then there ought to be scope to improve the rate that students are charged.  How can they do this? Well there could be some money raised via National Savings – where the last Index-linked certificates were withdrawn as they were seen as too generous in paying RPI +0.1%.  The more wholesale solution would be to issue hypothecated government bonds.  Currently index-linked gilts with a 33 year maturity have a negative real yield approaching 1.5% – i.e. investors are receiving 1.5% less than inflation over the life of the bond.  Such negative yields are the product of a desperate need for inflation-linked securities to help fund the future liabilities of pension funds.  There would be huge demand for debt at this rate if it had government backing. Clearly students not paying back their debts is an issue in borrowing sums secured on such debts, but if the government will underwrite them they can surely find a better level to charge students – say somewhere between RPI -1.5% and RPI +3%.

Cutting tuition fees might help students and as a result, the prospect of the government being repaid, but this will not help universities get the funding that they need.  If the government insists on a system where students pay in full for their education, they need to make sure that the interest rate that they pay is not overly burdensome.  There will be many arguments why the rate has had to be high, but most will simply reflect the fact that so many students are likely to effectively default on their debt.  If the government wishes to appeal to younger voters it needs to desist from charging an extortionate interest rate and a high marginal rate of tax.  Merely hoping for a fall in the level of inflation will not work.


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