A no-holds-barred fight has broken out in think tank land. The quarrel is over the claim that the Browne student fees review hit middle income graduates harder than high earners. At stake is Vince Cable’s promise that the system is fair. This is basically an arcane row over discount rates, but let me assure you the politics are important.
In the red corner is the Social Market Foundation, which showed that graduates earning £27,000 will be hit hardest by the Browne reforms. In the blue corner is the Institute for Fiscal Studies, which has mounted a vigorous defence of Browne’s progressive credentials. The IFS analysis basically backs up David Willetts and Vince Cable, who had complained that the SMF failed to account for the “net present value” of payments.
The face-off is as feisty a row as you can ever hope for in wonk-land. But I suspect it is a classic case of the IFS (and Vince Cable) relying on a brilliant, sophisticated model of higher education funding — and completely missing the point.
Most economists will agree on applying a discount rate. (It basically adjusts the value of payments so that they can be compared over time; payments made in the future are less valuable than payments made today.) But economists invariably disagree over its level and whether everyone’s discount rate is the same.
This IFS graph show what a difference it makes (click to enlarge it). Once you apply a blanket discount rate of 2.2 per cent across rich and poor graduates, Browne’s middle class hump disappears and is replaced by a smooth progressive line. Magic.
The trouble is that the “net present value” of payments fails to capture the full range of how people behave. Students and parents are voting with their wallets. Applying one blanket discount rate is misleading because some people’s actions suggest they think otherwise.
Just take the peculiar implications of the Cable/IFS model. Applying a discount rate of 2.2 per cent or over suggests that the most expensive way to pay off your tuition fees is upfront. After all, you’re given a free insurance policy if your income falls below £21K (this is the threshold when payments are made) and the 2.2 per cent real interest rate is still an effective subsidy when compared to commercial loans.
Smart, financially savvy parents would tell their child to take the full loan and put the £30K they would have spent on fees in a savings account.
Yet even Browne and Cable admit that this will be exactly the opposite of what many rich families will do. After all, one of the arguments in favour of tuition fees are that raise money to pay off the deficit quicker than a graduate tax. This passage from the Browne review spells it out:
The introduction of a real interest rate will remove the perverse incentives around loan take up and fee deferral. Families with high household incomes will be more likely to pay upfront voluntarily and graduates with very high earnings will be more likely to choose to make early payments to clear their obligation. Both of these behaviours will ease the cash borrowing requirement for government…
So Browne and Cable are effectively arguing that rich people will act against their own financial interests, making the system even more progressive than even the IFS model suggests. It is a secret fairness ratchet. Who said Vince wasn’t cunning?
Now, I’m not arguing that this system is not progressive. Broadly it is. The big political question is whether the reforms hit middle income families and graduates harder than rich ones. The political sophistry of the discount rate is that it makes appear as if the middle income graduates — who have had the most subsidy removed — actually come out better off than their wealthy peers whose parents paid fees upfront.
The fundamental point is that the removal of the subsidy disproportionately squeezes the middle, whatever discount rate is applied. Even the IFS admitted this last year, before getting lost in the weeds of their own model:
While the savings are fairly uniform across male graduates, slightly more savings are generated from male graduates at lower-to-middle points in the earnings distribution (around the 10th to 30th percentiles). These graduates have earnings such that they do not benefit much or at all from the write-off period, but they do benefit greatly from the interest subsidy. Thus, an increase in interest rates would cause them to be worse off than higher-earning graduates.
The proof of this system will be in how people behave, and whether low and middle income families are put off going to university. That will also be how these reforms are judged at the ballot box. I suspect discount rates won’t give Cable quite the political cover he needs.