The Politics and Economics of Student Debt

Introduction:

Democrats and Republicans have polar opposite views of the severity of the student debt problem and the need for debt relief and changes to student debt policies. Democrats believe current student debt levels are intolerable and favor substantial debt relief or even free higher education. Republicans argue that the current generation of students, like previous generations of students, can and should pay for their education without debt relief.

Neither side of the debate is completely correct. A strong case can be made that unless there are substantive changes to student loans a larger number of households in the current generation of borrowers will experience financial hardships and will be unable to save for retirement.  However, many of the policies offered by the Democrats, including policies implemented by the Biden Administration, will not provide long term improvements are substantially flawed in a number of respects.

·      Many of the debt relief efforts, are executive orders which could be overturned by a future Administration.

·      Many of the relief efforts offered by the Biden Administration, including efforts to fix reporting error on IDR loans are one-time programs, which future Administrations need not offer.

·      The expectation of loan forgiveness combined with the incentives for the debt relief formulas will encourage some students to increase the amount they borrow.

·      Income Driven Repayment loan plans, including the Biden Administration’s SAVE program, will often result in married households paying substantially more in taxes and debt and/or fail to provide timely debt relief.

·      The SAVE IDR loan program does not deal with chronic payment reporting errors preventing timely debt discharges.  (The basic cause of the reporting errors is the inability of loan servicers distinguishing between 0 monthly payment from low income and a $0 monthly payment for refusing to pay a student loan.)

·      The exemption of student debt discharges from federal income tax is set to sunset on January 1, 2026, an issue that can only be dealt with by Congress.

Alternative policies that could provide student debt relief in a more economically efficient way are outlined.  However, the current politically polarized environment is not conducive to the creation of economically viable solutions to the student debt problem. Republicans are oblivious to the extent of the problem and Democrats are oblivious to the problems associated with their proposals.

Financial impacts of higher student debt burdens:

Many Republicans oppose measures that would reduce college debt on grounds the proposals subsidize more affluent highly educated people at that expense of working people who do not pursue higher education.  However, increasingly some education after high school is needed to obtain better jobs.  Most people with some student debt are not highly affluent.

The percent of students entering the workforce with some student debt and the average debt burden is increasing.

·      Average Debt Levels:  The average debt level for a Bachelor’s degree recipient went from $17,900 in 2000/2001 to $29,900 for 2018/2018.   The average debt level for an Associates Degree holder went from $9,600 in 2000/2001 to $19,600 in 2018/2019.  

·      Total Student Debt held by households:  Total student debt held by American households went from $481 billion in 2006 to $1,767 billion in 2023.

Many current workers nearing retirement have not prepared for retirement. 

·      Proportion of older workers with inadequate retirement savings:  An AARP survey found that 1 of 5 people over 50 have no retirement savings and around half worry they will not have enough to last in retirement.

The high level of student debt for workers now entering the workforce is delaying savings for retirement and other financial goals.  This is an especially large problem for people struggling to repay their student loans.

·      Pre-Retirement Disbursements from Retirement Plans:  A recent study found around 18 percent of people with a retirement plan that allowed for cash disbursements had disbursed some funds prior to retirement.  The proportion of people sometimes late on student debt was 6.5 time higher for people disbursing funds prior to retirement than for people who were not disbursing funds prior to retirement.

Many politicians and policy makers favor raising the Social Security benefit eligibility age for younger workers.  Younger households with student debt do not appear capable of responding to this policy change by increasing their saving rate.

Current Policy Proposals:

The most publicized Biden Administration student debt relief effort involving the use of the Heroes Act to discharge up to $20,000 in student debt per borrower because of the Covid pandemic was found to be unconstitutional by the Supreme court.

The Biden Administration has a new broad student-debt relief plan based on the higher education act and has created a new Income Driven Replacement (IDR) loan plan called the Save on a Valuable Education (SAVE) plan.

Comments on the broad debt relief proposal:

The new debt relief plan is based on a different law and is narrower than the previous one rejected by the Supreme court.

Under the new plan, borrowers eligible for assistance include borrowers who now owe more than they have borrowed, people who are eligible for loan dischargers under the IDR, SAVE, or PSLF programs, people who entered debt relief over 20 years ago, borrowers who enrolled in low-financial value programs, and people undergoing financial hardships.

Comment One:  The use of debt discharge rewards people who may have prioritizing spending and other savings goals over repaying their student loans.  A person who chose to reduce 401(k) contributions to repay their student loans more quickly will feel foolish or angry if this proposal is enacted. The adoption of a rule guaranteeing debt relief after 20 years would likely incentivize many people who currently have student debt or will have student debt in the future from repaying their loans.  However, debt relief cannot be guaranteed because the program can be canceled by a future administration.

Comment Two:  The wording in the White House document on cancelling debt for people eligible for IDR loan programs including people not enrolled in IDR loan programs is confusing.

“Automatically canceling debt for borrowers eligible for loan forgiveness under SAVE, PSLF, closed school discharge, or other forgiveness programs but not enrolled”

What is the purpose of the provision of forgiving student debt for people who are not enrolled in an IDR program?  Would the promise of a complete discharge of any outstanding balance of the loan at the maturity of the loan create an incentive for people to stop payments on the loan?

It may make sense to provide some student debt relief for people who have unpaid balances at the maturity of the loan, but a complete discharge discourages repayment and encourages students to borrow more.

Comment Three:  The executive order can be rescinded by a future Administration and any decision to provide debt relief by auditing loan servicers or by granting assistance to defrauded students would be made by the Administration in power.

Comments on the SAVE Program:

Income Driven Repayment loan programs are commonly used by student borrowers with limited income who would have trouble covering the full payment on a traditional student loan. advantages of IDR loans for struggling borrowers.   IDR loans link monthly payments to income and allow for a complete discharge of the outstanding balance on the loan after the required number of payments.

The Biden Administrations’ SAVE program makes several changes to IDR loans that will substantially reduce borrower payments including

·      Increase in protected income for loan payments from 150 percent of federal poverty line to 225 percent of the federal poverty line.

·      Elimination of all interest charges when no interest is due to because of low income.

·      Allow married filing separate borrowers to exclude spouse’s income for loan payment calculation,

·      Cut payment rate on loans from 10 percent of income to 5 percent of income starting in 2024.

·      Reduce number of years for a loan discharge for smaller loan amounts.  (Students with initial loan balances less than $12,000 could receive a loan discharge after 10 years of payments.  Each additional $1,000 borrowed results in an additional year of delay to discharge eligibility up to a cap of 20 or 25 years.)

The SAVE rule includes new procedures designed to reduce pitfalls preventing loan discharges.  These new procedures include:

• Automatic enrollment for people who provide access to federal tax returns even without payment within 75 days.

• Access to IDR program for some borrowers in default.

• IDR credit for some borrowers in deferment but additional payments for some other borrowers in deferment.

• Some credits for borrowers in deferment.

Comment One:  The increase in the amount of income protected from loan payments and the elimination of additional interest charges when IDR payments do not cover the amount of interest due will both make the monthly payment more affordable when the household has a low level of income.

Comment Two:   The rule allowing married couples who file separate returns to exclude the spouse’s income on the IDR loan application will usually increase taxes offsetting any temporary reduction in loan payments. 

Many student borrowers who choose an IDR loan program when they are single and fresh out of school find that the IDR loan program is unaffordable once their household income is increased either due to a promotion or marriage.  A person who leaves the IDR program because of increases in household income from marriage might want to reenter if household income falls due to a divorce.

The SAVE modifications do not alter the tendency for the suitability of the IDR program to change with marital status.

Also, family size in the SAVE program for people filing separate returns does not include the spouse.  This reduction in family size will partially offset the exclusion of the spouse’s income in the monthly payment calculation.

Go to this Q&A in Financial Decisions to learn more about how the SAVE program impacts taxes for married separate return filers.

Comment Three:  In the past, relatively few IDR borrowers have received a timely discharge on their IDR loans.   The existing evidence on the effectiveness of IDR loan comes from the Public Service Loan Forgiveness Loans (PSLF), which are tied to IDR loans.  Go here for some statistics.

• Around 2.15 percent of Public Service Loan Forgiveness applications processed since November 2020, were accepted.

• Only around 6.7 percent of eligible student borrowers applied for loan forgiveness.

• Around 30 percent of denied claims are due to incomplete paperwork.

Comment Four:  The Biden Administration has prioritized fixing problems caused by incorrect counts of student loan payments as discussed here.    However, the recent announcement is not the first announced attempt of a programs to facilitate more accurate counting of IDR loan payments.

Legislation mentioned here was enacted in 2019.

President Biden announced a previous “one-time” PSLF waiver and “one-time” IDR waiver.  The PSLF waiver lasted from October 2021 to October 2022 and the IDR waiver time frame was originally April 2022 to December 2023.   The previously announced IDR waiver described here looks identical to this one. 

The low on-time discharge rate for IDR loans occurs because many students don’t make all payments on time, loan servicers make errors, and it is difficult to distinguish between a $0 monthly IDR payment due to low income and a $0 payment from neglecting to pay.  The Biden Administration proposals does not address these problems.

The Biden Administration projects that this initiative will provide relief to 804,000 IDR borrowers.  The jury is still out on whether the debt relief will occur.  A future Administration may not prioritize this problem.

Comment Five:  Implications of tax rules on loan discharges.

The IRS routinely considers most loan discharges to be taxable income.  However, there are exceptions.

·      The amount forgiven on PSLF loans is not taxable.

·      The American Rescue Plan temporarily exempted IDR loan discharges from federal tax but unless this exception is eliminated discharges occurring after January 1, 2026 will be fully taxed.

There are advantages and disadvantages associated with the taxation of student loan discharges.  The tax of the amount of the loan forgiven reduces costs for the taxpayer but could create a liquidity problem for the student borrower with a large tax bill.  The tax on the amount of the loan that is discharged will, all else equal, be positively related to the amount borrowed, hence the reinstatement of the tax will reduce the incentive for students to increase the amount they borrow.

Modifications of the rules governing the taxation of loan discharges require congressional action.  It is likely the temporary exemption of tax on the amount of the loan discharge will be phased out if the Republicans get control of either branch of Congress. 

Alternative Student Debt Relief Proposals:

Proposal One:  Modifications of IDR loan contracts

·       Provide periodic partial discharges of student loans, after every 24 verified payments,

·       Partial discharge would perhaps be 20 percent of the 24 monthly payments,

·       Establish a non-zero minimum monthly payment on all IDR loans.

·       Limit discharge at the maturity of the loan to 50 percent of the outstanding balance.

·       Undischarged loan balance will be restructured into a new short-term zero interest rate loan administered by the IRS through the tax form.

Advantages of proposed changes to IDR contracts:

·       The quicker partial discharge gives borrowers an incentive to make payments on time to maximize debt relief.

·       The quicker partial discharge reveals potential problems with the recording of loan payments earlier.  Currently, payment problems are not revealed until maturity when the borrower apples for the complete loan discharge.

·       The non-zero monthly payments provides the borrower and the loan servicer proof of payment.  Currently, loan servicers are unable to distinguish between people who are making a zero monthly payment because of low income and people making a zero payment because they are evading their responsibility to repay their loan.

·       The limitation of the final discharge to 50 percent of the outstanding loan balance will cause borrowers with larger loans to have a higher debt at maturity than borrowers with lower debt, thereby, reducing the incentive for students to increase the amount they borrow or delay repayment.

·       The use of tax authorities for collection efforts will increase payments even though the interest rate is zero.

Proposal Two: Modification of standard loan contracts

·       Set interest rate on outstanding student loan balances to 0 percent when the loan reaches maturity date.

·       Treat unpaid student loan balances after the maturity of the student loan as a tax obligation spread over 3 to 5 years.

Advantages of proposed changes:

·      The initial choice between IDR and standard student loans is made when students start repayment and have little knowledge about their future income.  This change to the standard loan contract will provide some debt relief to student borrowers who initially chose a standard loan but had problems repaying the loan to low levels of lifetime income.

·      The proposal would offer some debt relief to borrowers who leave the IDR loan program when they marry because the change in marital status will increase either their monthly loan payment, their annual taxes or both. 

·      This change will reduce the number of older people who have their Social Security checks garnished because of outstanding student loan obligations.

·      The proposal creates an incentive for borrowers to select a standard student loan contract instead of an income driven loan contract.  

·      Under the modified student loan contract, the borrower with a larger loan will always repay more than the borrower with the smaller loan over the lifetime of the loan.  

·      The use of the IRS to collect unpaid balances of the zero interest loan at maturity will increase repayment to taxpayers and spread out payments to borrowers.

Concluding Remarks: Reducing student debt burdens to households who cannot repay their student loans and save for retirement in a way that it is fair to other borrowers and to taxpayers is not rocket science.  The achievement of this goal requires a desire for people to analyze the actual financial situation impacting many student borrowers and the incentives created by their policy proposals rather than be driven by their ideological viewpoints.