With the costs of higher education rising and almost a third of the outstanding $1.2 trillion in student debt in default, it’s time for imaginative solutions. One of the more promising ideas comes from Oregon, where the state senate this summer passed a bipartisan bill to test a new system called “Pay It Forward, Pay It Back.”
Students attending public universities in the state would pay no tuition at all. Instead, they would commit to repaying 3% of their income for the next 20 years into a fund that would support the next generation of students.
The idea is attracting attention. Stephen Sweeney, president of the New Jersey state senate, has proposed a similar concept for his state, and U.S. Sen. Jeff Merkley (D., Ore.) says he will soon introduce a bill proposing the same “pay it forward” concept for federal student loans.
Income-based loan repayments are a promising idea, but lawmakers should proceed with caution. On the positive side, borrowers don’t generally default on loans because they’re irresponsible. They simply have times in their life, perhaps after losing a job, when they can’t afford to pay. Income-based repayments sidestep the problem: When you earn less, you pay less. When you earn more, you pay more. And by design, these loans are always affordable.
Given these advantages, what’s not to like about “pay it forward” plans? If they are not done right, the answer is “much.”
The first issue is that a pure pay-it-forward model allows schools to avoid coming to terms with the rising costs of higher education and student debt. Universities have little incentive to keep either of them under control as they benefit from an overly generous lender—the U.S. government. Students today take on debt for degrees that are unlikely to offer the earning potential necessary to repay their loans. Pay it forward does nothing to encourage students to focus in areas with high earning potential, such as engineering and computer science.
The pay-it-forward model also transfers a rising share of education costs to higher-income earners. While it might sound appealing to ask high earners to pay more for their education, there’s a hitch.
The income prediction model that my company Upstart has developed suggests that, under the Oregon plan, the top quartile of earners from Oregon State University would pay at least 2.5 times what the lowest quartile would pay for the same education. But students who are likely to be high earners will be less likely to participate in a pay-it-forward program. Other opportunities for financing their education such as a conventional student loan are a better deal. The end result could be what economists call “adverse selection.” With few or no high earners paying forward to the next generation, pay-it-forward funds could end up like underfunded pensions.
There is a better market-based approach that can better align interests and incentives of students and schools. Instead of a blanket repayment rate—such as Oregon’s 3%—why not let students earn discounts from that loan rate by choosing majors with strong career prospects? Or by studying hard to get the grades that will attract potential employers? Employers—and not only investment banks and consultancies—pay attention to the college transcripts of job applicants. GE, the country’s eighth-largest employer, requires a minimum GPA of 3.0 for all applicants to its entry-level leadership programs.
We know how much mechanical engineers from the University of Michigan earn, so why not take these market signals into consideration? Students would be properly motivated to pursue degrees that provide a strong economic future. And colleges would have some accountability for the quality and value of their degrees.
Schools that want to attract the best students would be forced to better align the cost of their degrees with their earning potential. For careers such as teaching that have a large public benefit without the monetary payoff, it would be smarter to subsidize the degrees required for these fields.
Pay it forward is undoubtedly appealing. But a market-based approach would help students choose the institutions and programs that will serve them best, and undertake one of the largest financial obligations of their lives.
A version of this article appeared October 4, 2013, on page A23 in the U.S. edition of The Wall Street Journal, with the headline: How the Market Can Rein in Tuition.