An Idea Whose Time Has Come? | Eastern North Carolina Now

    Publisher's note: The John William Pope Center for Education Policy provides a treasure trove of information suggesting the better path forward in regards to North Carolina's number one issue - public education. Public education, at all levels, requires a significant amount of funding from our state government, and all one hundred North Carolina counties, so it is essential that leaders effecting education policy get it right, and know that concerned entities, like the John William Pope Center, will be minding their progress to do so. We welcome the John William Pope Center for Education Policy to our growing readership, and expect our readers to learn all they can to do their part in this wise endeavor to better educate our People.

    The author of this post is George Leef.

Equity funding for college students is attracting attention, but can't work as long as we have easy government loans.

    In his 1955 paper "The Role of Government in Education," Milton Friedman suggested the idea of equity contracts to finance college education. Friedman thought that loans were not the appropriate means of financing education. He argued that the better way was to advance the needed funds for college to qualified students, who would repay a percentage of their earnings for an agreed-upon number of years.

    That is, instead of students borrowing money for college that must be repaid with interest, investors pay for their education and later recoup their investment (perhaps making a profit but nothing is guaranteed) as the student makes payments based on his or her earnings.

    Moreover—and this will probably surprise many people—Friedman argued that the federal government was the best "investor." He thought that the costs of administering equity contracts would be too high for persons or groups in the private sector.

    The concept of equity investment in students' education (previously called human capital contracts) has never caught on. The main reason is that the federal government began student loan programs back in the early 1970s and those programs mushroomed. With student loans easy and affordable, there was little chance for alternative finance systems to develop.

    Friedman's aversion to student loans has proven to be entirely justified by events. Politicians, eager to project a "pro-education" image, kept making college loans (as well as grants) more appealing. As the notion spread that college was a sure-fire investment worth borrowing great amounts, the numbers of students taking out loans for college grew, as did their average level of debt.

    Kelli Space, who wrote about the prodigious debt she racked up in pursuit of her sociology degree, is something of a poster-child for the danger of using loans to finance education, especially when the lender is the government and therefore indifferent to risk. Default rates on student loans are at historic highs, and rising.

    Thus, it is certainly time for another look at the equity investment idea. A new paper published by the American Enterprise Institute, "Investing in Value, Sharing Risk" by Miguel Palacios, Tonio DeSorrento, and Andrew Kelly, makes a strong case for what the authors call Income Share Agreements (ISAs).

    They argue that ISAs have several important virtues.

    First, they would improve the efficiency of our higher education system by channeling students into high-quality, low-cost educational programs.

    ISAs would do that because those who advance the money for students will be interested in making a profit, or at least not squandering their money. Because students would not be entitled to ISA funding but would instead have to strive to convince those who run the programs that they are worth taking a chance on, the focus of college education would change dramatically.

    Whereas the current student loan system indiscriminately helps students to accumulate college credits, ISAs would be offered only if the funders could foresee a probable benefit from the student's education. Investors won't put their limited funds behind students unless they seem likely to succeed after graduation, so ISAs would sensibly discriminate against ill-prepared, unfocused students who just seem to be looking for an easy degree.

    Second, ISAs would benefit students who don't find high-paying jobs soon after graduating. Because repayment would be based on their earnings, the severe difficulty that many graduates now find themselves facing—large loan bills due at a time when they have little income—would be eliminated.

    No doubt that sounds very appealing to students who are aware of the bind that many others, like Kelli Space, have found themselves in. But the apparently gentle, income-based repayment nature of the ISA contract only applies to those who manage to get one.

    In the pool of accepted students, some of them will probably have unexpectedly low earnings to start, just as some will have unexpectedly high earnings. The crucial point, however, is that students with poor prospects are not apt to get ISA funding in the first place. Few of them will "benefit" from the protection of easy payments because investors won't put their money behind students unless they show promise.

    Third, ISAs will open up space for educational innovations that currently have trouble gaining traction because they are not federally accredited. Currently federal student aid can only go to students enrolled in schools accredited by a select few accrediting bodies. There would be no such restriction on ISAs, which would do their own "accrediting" to decide whether an educational program appears good enough to merit risking money on a student.

    Undoubtedly, many schools that are accredited (and especially dubious departments within them) would never be deemed worth risking a nickel on, while innovative programs that appear to add human capital would quickly get attention. As ISAs develop, managers would steer students away from accredited programs where they would probably be wasting their time (and investors' money) and into ones that have good records.

    All right—if this is such a good idea, why hasn't it taken off before now?

    The authors explain that there are legal obstacles to ISAs at present, writing, "Although a small but growing number of firms are testing this market, legal uncertainty has made it very difficult for any kind of market to develop on a larger scale." They set forth four areas in which legislation is necessary (or would at least be helpful) to facilitate the growth of ISAs.

    I don't want to go into detail on those, but must register concern about their idea that ISAs need "ownership by a regulator." Federal regulation might frighten off prospective market entrants who know that regulation has often been used as a sword rather than the shield the authors envision. A president beholden to the education establishment might choose to appoint people to this agency who would promulgate rules meant to slow or stop the growth of ISAs if they were drawing too many students away from traditional college programs.

    Regulation might facilitate the growth of ISAs, but it might also strangle the idea.

    The main problem I have with the paper is that the authors see ISAs as existing side-by-side with the current student aid system. I doubt that would work well. Our public policy aim should be to get the federal government out of financing (and subsidizing) higher education, a mistake that has caused college costs to soar while luring into college many students who are not prepared for or interested in a real college education. (Examples are the heavy "partiers" Karen Weiss wrote about in her recent book Party School.)

    As long as the federal government makes substantial amounts of money available to almost anyone who wants to give college a shot, the benefits that the market discipline ISAs give will be greatly diluted.

    With the current loan caps, any student can borrow enough to cover most of the cost of attending a state university. Why would the academically marginal student who merely wants an easy, generic degree bother with the difficulties of applying to an ISA firm (which might be more daunting than applying for a mortgage) when government money is available just for the asking?

    There is just one reason why such students might think twice about government loans, namely that their repayment terms can be harsh, as the authors acknowledge. Students worried about having to meet their loan obligations when they might have little income would see the ISA option favorably.

    But the authors also advocate changing the loan system so that all students would get the benefit of income-based repayment (IBR). Moving to IBR (which Senator Rubio also favors) removes the biggest negative (from students' point of view) from the current loan system. If we want to break our bad habit of encouraging everyone to go to college with easy federal money, we shouldn't make that system more attractive.

    In that 1955 paper, Friedman argued for an equity funding system, but he also said that the efficiencies it would bring would be lost unless it were the only form of government financing. That makes good sense today. The ISA concept is sound, but won't grow much as long as it has to compete with the government.