Human Capital Contracts Will Do Nothing To Contain College Costs

September 4, 2015

Andrew Kelly and Kevin James, higher education researchers at the American Enterprise Institute and prominent defenders of human capital contracts (ISAs), take issue with my earlier post on that topic, arguing that I “miss the mark.” They argue that ISAs, or selling off a future percentage of your income to pay for college now, would not cause higher education prices to increase because these contracts are significantly different from student loans. They have better incentives for the borrowers and lenders, and private market underwriting is designed to guide students to the best programs.

I didn’t find this convincing when I wrote the first post, but after engaging these arguments more fully I’m absolutely confident that there’s no way ISAs would function the way the authors say they would. There’s no incentive to control costs, the underwriting would be dominated by factors far different than the marginal school choice, and they would disincentivize cost control for students. These would all have consequences.

It’s tough to debate an imaginary private market that will never exist at scale without significant government action because of profound adverse selection issues, but I’ll try to make my arguments generalizable to whatever specific forms this could take—though I’m presuming that the ISA is a profit-seeking, private entity, and I’m only looking at the issue of cost control rather than fairness, opportunity, etc.

It might be good to refresh yourself with the original argument, but to recap: my argument about the New York Federal Reserve paper is that, if borrowing against future income drives higher price inflation, that is a serious problem for attempts to tackle higher education costs that involve making markets more complete. A more complete market involves moving money forward, and whether taking future money and spending it now takes the form of loans or equity doesn’t matter for this effect. Creating a legal infrastructure for ISAs to thrive, moving more money forward, would cause tuition prices to increase.

Now of course student loans and selling human equity isn’t identical. In particular, the distribution of risk and rewards is shared differently among debtors/creditors. The AEI authors are arguing that what makes ISAs unique would actually check costs, or at least not make them any worse. I don’t believe this pans out.

ISAs Have No Incentive to Contain Costs

AEI makes a big point of arguing that ISAs have an incentive to lend to the best schools because schools that add the most value in terms of future income will make them more money. Let’s concede this point for a second.

What they certainly do not have is an incentive to contain costs. Let’s imagine School A and School B, which are identical in terms of their value-add, but A costs $30,000 and B costs $40,000. Let’s say an ISA runs the numbers and decides it will charge you 6 percent of your income to attend A and 8 percent of your income to attend B. At this point the ISA doesn’t care either way.

Remember that the whole point of having the equity rate adjust is to make the ISA indifferent about the choice between School A or School B. The ISA has no incentive to nudge the student away from B. It’ll all fall on the student, as it currently does.

And while it’s tough to imagine how the second-order effects play out, inasmuch as an ISA business model swings for the fences, or wants to capture the upside of extremely high earners in our unequal society, there would be a bias for seeking a higher percentage. This would mean moving more money forward, which would lead to cost inflation.

You Underwrite Income, Not Colleges

Kelly and James put a lot of emphasis on underwriting. Student loans, they argue, do “not underwrite based on the expected value of postsecondary programs, while [an ISA] does.” Because a more valuable program increases the upside, and thus lowers the cost of the ISA, an ISA “channels funding and people toward valuable programs.”

This is not right. An ISA would underwrite based on the expected value of future income, full stop. Differences in postsecondary programs are a determinant of future income, but they are only a minor one. Family income, occupation, race, and gender are going to be much more important to the calculation. Pricing an ISA isn’t about finding the best school; it’s about the overall income package.

Note this graphic from Pew via Matt Bruenig:

It’s complicated to read, but those born in the top 20 percent who don’t have a college degree are two and a half times more likely to end up in the top 20 percent than people born in the bottom 20 percent who do have a college degree. More to the point, the median person born rich without a college degree is around the top 40th percentile of income, while the median person born poor with a college degree is around the 60th.

Which is to say it is very likely when the quants put together the pricing model that a white male born rich who attends a bad school will get significantly better equity pricing than a woman of color born poor who attends a better school, because the former will have a higher expected future income. This expectation of future income is exactly what the contract is meant to price.

We don’t even have to be hypothetical. As a Department of Education report once put it, “Overall, the net contribution of college characteristics to variance in men’s earnings was […] somewhat less than the net effect of background characteristics on earnings.” Men’s family background matters more to expected future incomes than the schools they choose.

This is a major problem for the idea that ISAs would reward the best schools overall. The raw amount of capital wouldn’t be channeled from ISA creditors based on school characteristics, but instead on other individual predictors of future income, especially ones we are born with, that will dominate the price signal.

Marginal School Choice Isn’t a Major Determinant of Future Income

Students themselves might be able to discern between schools because they can compare the rates they’ll get. This isn’t the choice between Harvard and a state college, which is obvious; it’s the choice between, say, two similar state colleges. Wouldn’t a person gravitate to the school that offers the best reward? But there’s genuinely little evidence that the marginal school choice is a major determinant of future incomes, certainly not enough for the quants to measure.

There’s an interesting finding, argued by Stacy Dale and Alan Krueger, that which school you go to matters less than which schools accepted you. This means that equity prices won’t be capable of doing the kind of granular sorting of schools at the margins that the ISA proponents argue they will. If you got accepted to schools A and B that are similar in selectiveness, the expected value of your future income won’t vary enough to change incentives.

Now we do know that selectivity makes a difference. (Jordan Weissmann summarized this literature.) But do we need to create a giant financial market to tell us that it is better to go to an Ivy League school than a state college for future earnings? And, for our narrow question of cost control, to the extent that people don’t know this—and many do not—wouldn’t this additional information cause them to move more money forward?

Occupation is also an important determinant, and ISAs could fund majors associated with more profitable occupations.[1] But there you’d have such an adverse selection problem I have difficulty seeing it work. Why not major in business or engineering if you want to do social work, so you can lock in a cheaper rate and then go do a low-paying job? Many people don’t do the work their degrees are associated with, and that doesn’t seem like a societal problem.

Students Already Have This Now, With a More Salient Measure

Either way, it falls to the student to handle cost control. But it already falls to the student to handle this, and they are unable to do it. AEI makes a big deal of the fact that student loans don’t adjust the interest rate based on risks, and that students could adjust their decisions based on the equity rate of ISAs.

But students are already adjusting one of the most important parts of their student loan package: the balance. Many people don’t go to the most expensive school they could in order to hold down student loan balances and minimize their risks of financial distress.

Quick: How much would you sell 5 percent of your future earnings for? I… have no idea. And I used to do a lot wacky financial modeling. I could guess, but it would be just that, a guess.[2] It is easier (though perhaps not easy) to figure out if I could afford a $30,000 loan. Whenever I’ve talked with people about student debt, they will, if they trust me, share the loan balance. What they can’t usually do is tell me their interest rates. It’s not a salient feature of the loan.

Note that it’s this salience of a feature of debt that generally causes people to act, and replacing loans with ISAs would likely reduce the salience that can control costs. A loan balance is scary in a way 5 percent vs. 10 percent of future earnings is not. This cuts in several different directions. If people feel the student loan balance as a constraint in a way they wouldn’t with an equivalent equity percentage, that means they would move more money forward with ISAs. Inasmuch as children are bad at predicting future outcomes, they could easily sell a higher rate of equity than is reasonable, which would lead to moving more money forward. What happens when a dumb kid sells 60 percent of his or her equity to a predatory program?[3]

The Downside Risk Contains Costs

Let me spell that out more bluntly: There’s a lot of talk about aligning incentives, but what we are really doing is shuffling incentives, moving the downside from students to private markets. And right now students facing the downside is a major factor in limiting the amount of money being moved forward.

The idea that students should be borrowing more if it means completing their education comes up quite often in these debates. It’s why we should feel sorry about those with too little debt, as a recent New York Times piece put it. The threat of financial stress is a major pressure on aggregate borrowing. Removing it by insulating students from downside risk will cause students to move more money forward. Indeed, these credit constraints on student loans are part of the critique of student loans that ISA literature brings up. This isn’t a value judgment either way (I’m not a fan of the implications), but just an acknowledgment that widespread acceptance of ISAs would reduce students’ incentive to contain school costs, and the ISAs don’t have one.

If college as a whole is underfunded due to credit market imperfections, ISAs will cause prices to rise. All the talk of information and incentives do not change this. There needs to be a more serious plan to control costs, and using public education as a public option is a much better solution than giving more resources to the already rich and selective.

[1] Sometimes people suggest student loans should be priced by majors, e.g. this paper. But isn’t the point of having a labor market to channel this information through salaries? Why do we assume it is failing, and why do we think the government or hedge fund quants can better guess the labor demand decades out using central planner-style modeling?
[2] For all the endless hype, are there a lot of examples of people actually executing an ISA? I’d love to see a contract to see how they handle what is included in income. Is a percentage of capital market income claimed by an ISA? Business ownership income? Inheritances? EITC?
[3] You’ll be happy to note that Kelly is against any kind of usury regulation and bankruptcy protections for ISAs. That would interfere with the market. The thing where he describes building a joint government–creditor surveillance state, where the IRS uses its extensive power to consistently feed all of your personal information to debt collectors in real time to assess the earnings they need to collect? That’s just normal for markets.