Loans versus grants for university education

It has been suggested that the British system of paying grants (i.e. gifts) out of tax revenues to students to finance their university education should be abolished and replaced by loans. One reason (see Farmer and Barrel, 1982) is the failure of the grants system to remove all financial barriers to university attendance, partly because inequalities in school education cause a disproportionately high attrition rate among children from disadvantaged backgrounds, and partly because of the grants system itself. The latter reason sounds paradoxical. The argument is that the reduction in the real value of the student maintenance grant by nearly 20 per cent between 1963 and 1982 eroded the differential between the grant and juvenile earnings (which rose substantially); and that the means-tested parental contribution caused disproportionate problems for working-class students, and probably also for women. Both factors tended to reduce working-class applications (i.e. demand) to universities. Additionally, on the supply side, grants are costly, and university places therefore rationed by controls on public spending. These problems, it is argued, would be ameliorated by a system of loans.

The following discussion does not look at any specific proposals […], but sets out in turn the general way in which loans operate; some examples from other countries; and the issues which divide their supporters and opponents. Under most loan schemes, actual or proposed, university education remains partially subsidised, either through low (or zero) fees and/or by a residual grant to all students or, in some schemes, only to students from disadvantaged backgrounds. The loan can come from the state (as in Sweden), or predominantly from private lenders such as banks or universities themselves (as in the USA), either with or without a state loan guarantee. Repayment can follow two generic models: the 'mortgage repayment' model (i.e. the individual repays what he/she has borrowed, plus interest); or the 'graduate tax' model (Glennerster, Merrett and Wilson, 1968), in which the individual pays a surcharge on income tax (i.e. repayments are related not to the size of the loan but to eventual income).

Thus the price of the loan can be commercial (rarely), or at a subsidised interest rate (usually), or income-related (often). The essence of the loans strategy is that individuals pay for the private benefits of their university education, but are subsidised to the extent of the external benefit conferred on others. This is a valid approach to efficient resource allocation only where inter alia consumers have perfect information about the long-run value of education, and where capital markets are perfect. Loans bring about the latter condition; whether the first holds sufficiently is one of the central issues in the loans versus grants debate.

Loans systems of different types work well in a number of countries. Farmer and Barrell (1982) cite two schemes of particular interest: the Swedish system, which is a large state scheme in a country with a socialist tradition (see OECD, 1980 and 1981), and a much smaller private scheme run by Yale University (see Nerlove, 1972 and 1975). The original Swedish system consisted of a grant topped up by a loan. In 1964 it was decided to switch the emphasis towards loans by the simple expedient of freezing the nominal value of the grant and allowing its real value to be eroded gradually by inflation. By 1978 the grant covered just over 10 per cent of the total cost of a university education. It was topped up with a loan from the state, available to all qualified high-school students; an element of positive discrimination was later built in; repayments are income-related. Under the Yale scheme students were grouped into cohorts; each cohort was jointly responsible for repaying its loan, and repayments were income-related so that those with below-average earnings after they left university repaid less than they borrowed, and vice versa. The resulting system was self-financing and generally experienced low default rates. One of its most interesting features is that it provides a form of group insurance, so that individuals who are poor or unemployed after leaving university are not burdened by large debts.

The issues which divide supporters and opponents of loan schemes are varied, complex and sometimes contradictory. A number of efficiency issues arise. First, what is the effect of loans on the quantity of university education consumed? It is argued that grants distort the individual decision to acquire a university education by making it too cheap, thereby (in the absence of a budget constraint limiting the number of university places) causing overconsumption. A subsidy may well be justified if university education creates external benefits but, so long as private benefits are positive, this is no argument for a 100 per cent subsidy; and if the screening hypothesis is true there might be no efficiency justification for any subsidy at all. Loan schemes, it is argued, avoid the tendency to overconsumption associated with grants. A logically incompatible view is that loans avoid underconsumption. Farmer and Barrell (1982) argue that the expense of the grants system has kept the university sector below its optimal size. Loans, they argue, relax the budget constraint, and so enable an expansion of university education at no additional public cost. Other writers argue that loans, by reducing public expenditure, enable taxes to be reduced with beneficial incentive effects. It should be noted, however, that a public loan scheme, even if self-financing in the long run, is likely to increase public spending in the short term, when the state will be issuing many loans and receiving few repayments.

A second set of issues concerns consumer sovereignty. Some writers argue that the need to repay loans would give students undue encouragement to take 'vocational' subjects. The US and Swedish experience lends little support to this view. It is also argued that students who finance their own education through loans are likely to be more assertive in demanding the kinds of courses they want, including more flexible opportunities for part-time study than currently exist at British universities.

A third efficiency (and equity) issue concerns the possibility that loans create a disincentive to women to acquire a university education, i.e. that women graduates burdened by repayments bring a 'negative dowry' upon marriage. Since women on average spend fewer years in the labour force than men they might be more reluctant to take out loans. This problem would be solved if repayments were income-related, 1 so long as the income in question was that of the woman herself rather than the joint income of husband and wife.

Loan schemes have two undoubted equity advantages: they solve the inequities arising from capital market imperfections; and they avoid the regressivity of the grants system resulting from differential consumption of university education by social class […]. A third, and controversial, equity issue is whether loans contribute more than grants to equality of opportunity. Farmer and Barrell argue from a socialist perspective that loans, by making it possible for the university system to expand, open up opportunities for students from disadvantaged backgrounds, partly because more places in total would be available, and also because students no longer depend on parental contributions if they are not eligible for a full grant. Though this might have efficiency implications.

But it does not follow that working-class take-up of university education would necessarily increase. The need to repay loans, even if repayments are income-related, and even if the loans are available on generous terms to students from poor families, might well increase inequality of university attendance by social class. It requires considerable optimism about one's future to take out a loan which, even if no tuition fees are charged, would amount at least to £7500 for a first degree. It might be advisable to introduce any UK scheme gradually, along Swedish lines, by freezing the nominal value of the current grant and allowing students to top it up with a loan as inflation eroded its real value (for a recent UK proposal see Glennerster and Le Grand, 1984).

Source: Financing Higher Education: Answers from the UK