Separating Student Aid and Student Debt

Americans currently owe about $1.5 trillion in student debt. Issuance of student loans has risen drastically in recent decades, and as a college degree becomes increasingly important, the loans look to continue to be a part of many young Americans’ economic lives. In this article, I examine existing answers to two main questions: why student debt has risen so much, and whether or for whom the returns to education justify this level of borrowing.

Borrowing for education has more than doubled in the last 20 years, from $42.6 billion for the 1995–96 school year to $106.8 billion in 2015–16, although that figure has fallen from the $124.2 billion peak in 2010–11 (all reported values in 2015 dollars). Almost all this credit—over 90 percent of total borrowing in most years—is issued by the federal government. Thus we must understand the federal government in addition to two other players to get a handle on the question of student debt: students and their families, and colleges. Many observers argue that the government should not be in the student loan business at all, but the current system is sufficiently entrenched that for this article I will focus on the effects of current practice and on reforms within the general framework of the federal aid system.

The large amount of loans does not necessarily mean college is a bad investment. If a college degree gives a large boost to lifetime earnings potential, then it may be worthwhile for students to take out substantial loans.

We can also study what happens to federal aid money. To the extent these loans are subsidized, they act as a transfer from taxpayers to someone in higher education. Two critical questions in evaluating policy, then, are how much of the gain from subsidized loans is captured by colleges versus students, and overall what happens to students who use this aid money.

Loan Availability and the Rising Cost of College
College tuition has risen over the same period as student debt, in large part because colleges are able to raise prices in response to expanded aid programs. I recently spotlighted in the AIER blog a 2015 New York Fed staff report that found colleges are able to raise tuition in response to increases in Pell Grants and subsidized student loans to the point where colleges reap 55–65 percent of the gains from these programs. Other researchers have produced estimates that make similar points.

In a 2015 paper, Gordon and Hedlund model the market for higher education in order to estimate how much of the increase in the sticker price of college is due to various factors. They broadly divide these into three channels, which they call supply-side, demand-side and macroeconomic factors. The supply-side factors represent rising input costs for colleges due to less funding from state and local governments as well as increased costs of administration or student activities, the demand-side factors are primarily increased funds and lower out-of-pocket costs to students from expansions in grants and subsidized loans, and the main macroeconomic factor is the rising wage premium for college-educated workers in the labor market. Of course, the latter could also be classified on the demand side, but the authors’ nomenclature preserves a useful distinction between increased demand from direct subsidies and that from labor market conditions.

They find that the expansions in student aid have been primarily responsible for the rising cost of college. In their model, the supply-side factors hardly play any role compared to the other two. Even the predicted rise in tuition from the increasing earnings premium from a college degree is only about one-fourth the size of the increase in tuition due to government aid. These numbers are remarkable. They suggest that government is indirectly responsible for up to three-fourths of the explosion in college costs—and all the while politicians on both sides of the aisle insist on the need for affordable higher education.

In a 2014 study, Cellini and Goldin reach similar conclusions while studying the for-profit college sector. Interestingly, these results are mostly about two-year programs, a different side of the issue than what Gordon and Hedlund address. They show that for-profit institutions that are eligible to participate in federal aid programs through Title IV cost about 78 percent more than comparable instructional programs at ineligible for-profit schools. The obvious confounder is that qualifying institutions might just be a lot better, but the authors make a strong effort to show their estimate is robust to this possibility. They control for occupational licensing pass rates of students (for example, in cosmetology programs) and also compare not only one school’s tuition to another’s, but tuition at the same institution and field of study before and after a program qualified for Title IV aid. Their results aren’t a smoking gun, but they are an additional piece of evidence that federal subsidies are largely captured by educational institutions.

The focus on for-profit schools is important. A 2015 study found that “most of the increase in [student loan] default is associated with borrowers at for-profit schools, 2-year institutions, and certain other nonselective institutions.... Decomposition analysis indicates that changes in the characteristics of borrowers and the institutions they attended are associated with much of the doubling in default rates between 2000 and 2011.” Most large for-profit institutions get the overwhelming majority of their revenue from federal funds. The Obama administration increased regulations monitoring for-profit colleges, but to have the federal government fund the industry with one hand and discipline it with the other cannot be optimal. Matthew McGuire, in a 2012 article, phrased this nicely as the creation of a market for “subprime education,” with federal aid programs failing to fulfill the desire to provide equal college access as some students get saddled with increasing debt obligations yet do not see corresponding earnings gains.

Returns on Investing in Education
This brings the discussion back to wage returns to higher education and the composition of students who are helped more or less by the availability of federal aid. Over two-thirds of recent graduates have debt, and the average amount is around $30,000 among those for whom the amount is greater than zero. For the average bachelor’s degree holder, this is a lot but not necessarily a life-altering amount of debt. Even conservative estimates of the wage premium imply it is a good investment. There are also some subgroups whose borrowing behavior may be less worrisome. For several reasons, much of the increase in borrowing was by wealthier families. One reason is the expansion of availability of unsubsidized Stafford loans. Another is lower-than-expected college savings due to the Great Recession and the housing crisis. However, if people are now back on their feet and loan values grew to relax credit constraints that only arose during the Great Recession, that may not be a large or persistent concern.

One useful paper that tackles the issue of returns to education in broad strokes is a 2014 report by Jaison Abel and Richard Deitz of the Federal Reserve Bank of New York. They show that the college wage premium, the ratio of average wages of college graduates to those of high school graduates, has increased slightly over time. They show that even after accounting for rising tuition prices and forgone income for the time in school, college remains a highly positive investment. They show this is true both for four-year bachelor’s degrees and two-year associate’s degrees.

However, this is a very aggregated view, and the authors are clear there are important things they do not consider. The most important is adjusting for individual ability. Most students who go on to earn college degrees were good students in high school and may have skills that would be rewarded in the labor market regardless of college. This is not to say that college does not help these students, or that there are not many talented individuals who do not choose to attend college. It only means that in comparing the overall wages of college graduates to high school graduates, we must take into account that these groups are formed by individual choices and that the difference in their lifetime income is due partially to their college education and partially to differences in characteristics that have nothing to do with college.

College graduates differ from one another in important ways. Two readily apparent reasons are that not all colleges are the same, and not all college majors are the same. Abel and Deitz look a little bit at the college major premium and show higher wage premia for STEM majors. Abel and Deitz use Current Population Survey and American Community Survey data that do not contain specific college information, but other economists have shown a positive wage effect on attending a more selective college. Student debt may be a reasonable investment on average, but it is riskier for people who attend less selective institutions, who attend two-year or for-profit colleges, or who do not enroll in STEM majors. These groups have a lot of overlap with the pool of students most likely to lean on financial aid.

Debt and College Completion
The most at-risk group of students are those who do not complete college. One reasonable lens to think about the problems with student debt is that it intensifies the existing problem of low college graduation rates. A 2016 Department of Education report finds that only 60 percent of first-time undergraduate enrollees graduate within six years. Non-completers do take on less average debt than graduates, but nearly half of students who do not finish their degree take on at least $10,000 in debt, and 13 percent take on over $27,000. Student debt is obviously a special concern for the two in five students who do not even have a degree to show for it. Why are dropout rates so high?

A 2010 study found that declines in college completion rates are partially due to lower average academic preparation of matriculants, but more of the decline is due to a higher percentage of students enrolling in less selective institutions. That study’s data considered changes between the 1970s and 1990s, but the rise of for-profit institutions and expansions of federal aid have likely only strengthened the changes they found. This is particularly important because there is strong evidence, as I wrote in an old AIER blog post, that students and their families are sensitive to new information in making college decisions.

This has been shown in a variety of contexts. In a 2015 study, Hoxby and Turner show that high-achieving low-income students, when provided personalized information about net prices and student outcomes, are more likely to apply to and attend selective colleges. These colleges often have generous need-based financial aid, and net costs to qualified low-income students there are lower than at less selective colleges. Wiswall and Zafar show that college students substantially revise earnings expectations—and sometimes intended major—after being provided publicly available information about the distribution of earnings.

Economic agents require full information to make the most efficient decisions, and prospective college students do not appear to make fully informed decisions. Uncertainty about the individualized difference between colleges’ sticker prices and true net prices, the availability of federal loans at a given college, and how likely students are to succeed at an individual institution in their desired course of study and get a suitable job afterward are all factors that complicate a student’s college decision.

Potential Directions for Student Aid
This leads us to two ends student aid reform must accomplish: it must sever the link by which student aid flows straight into college endowments by increasing prices for all students, and it must help clarify students’ understanding of the marketplace, or at least not complicate it. One model, as mentioned at the top of the article, is for the government to step aside entirely and let students and colleges make decisions on their own, but in this section I will turn my attention instead to proposed incremental changes that may help.

One good example of the need for simplification is the Free Application for Student Aid form, required by any student who wishes to be considered for federal aid. There have been constant calls to make the FAFSA simpler and shorter. Progress has been made, but there is still room for improvement. For example, the 2017–18 school year is set to be the first in which the FAFSA is required to be filled out with “prior-prior year” income information, which means students will have all the information required to fill out the form earlier. This change had been supported by a variety of organizations and a bipartisan group of senators. However, reducing the administrative burden and increasing certainty for college students and their families can go even further.

As early as 2008, an independent commission recommended the government simplify the application for financial aid in four major ways. First, they recommended that Pell Grant eligibility be determined entirely by adjusted gross income and family size. The loss of precision would be more than offset by the gain in simplicity. Second, they recommended that because this information is already collected by the IRS, the IRS should share this information directly with the Department of Education, thus eliminating the need for the FAFSA at all. Since then, these agencies have collaborated to offer an online option for students and their families to fill in some of the FAFSA directly from tax data, which is a step in this direction. However, this tool is offline for the current academic year due to concerns about identity thieves accessing tax data through FAFSA logins – another good reason not to require families to provide the same financial information twice. Third, they recommended that all families with children younger than college age be told the size of the Pell Grant they would be eligible for if the child was college-aged, possibly along with other state-specific college aid and pricing information. Fourth, they recommended ending subsidized Stafford loans, arguing that any dollars flowing to students eligible for these loans are more efficiently spent in increasing Pell Grants or in sharing repayment risk with students through income-based repayment plans.

There is a lot to like about these recommendations. The simplification of the system, like many common tax reform proposals, would eliminate a lot of compliance costs. This is especially important in the case of college aid because the difficulty of navigating the financial aid system for students is inversely related to the quality of their high school and the number of family and friends they know who have gone through the process. In other words, the burden falls worst on students the program most intends to help. The other benefit, as the discussed recent research on information interventions has confirmed, is that adding Pell Grant information to tax return mailings or other official correspondence can help students and their families start learning about college aid and costs sooner.

Their other recommendations were to better align colleges’ incentives. One proposal was to replace campus-based student aid programs such as Perkins loans and federal work-study programs with block grants to colleges, with the amounts of these block grants based on how many Pell-eligible students enrolled and, critically, progressed and graduated. These funds could also depend on gainful employment outcomes. This would incentivize schools not just to compete to enroll students and get the federal aid dollars that come with them, but to increase retention rates.

This proposal could potentially achieve many of the aims of recent reforms and regulations in a more intuitive manner. As we have seen, a body of research shows that colleges, especially less selective and for-profit colleges, capture a lot of the economic gains from federal aid dispersed through grants and loans. This capture, along with low graduation rates, is the primary driver of the explosion in student debt and especially in defaults. The proposal ties schools’ incentives more strongly to the graduation outcomes of eligible students, emphasizing retention a little more and enrollment a little less. This is a more efficient and transparent way than the current system of indirectly funding many colleges through student loans and then trying to monitor ex post whether they have been dishonest in recruiting students or ineffective at placing them in the labor market.

The key balancing act for policy makers is to promote access to and incentives for higher education without building a bubble in tuition and “subprime education.” Most researchers have found that college education is still, on average, a good investment, so student loans may be a rational choice for most people. However, the explosion in debt appears to have raised prices but not graduation rates, the opposite of any reasonable policy maker’s intent. To the extent government agencies will remain involved in helping constituents attend college, information interventions, grants or tax credits, and campus-based programs may be more appropriate tools than a continually expanding subsidized student loan program.