Invest in People with Income Contingent Loans

by on March 9, 2010 at 7:30 am in Economics, Education | Permalink

Three entrepreneurs are offering a share of their life’s income in exchange for cash upfront and have banded together to form the Thrust Fund, an online marketplace for such personal investments.

Kjerstin Erickson, a 26-year-old Stanford graduate who founded a non-profit called FORGE that rebuilds community services in Sub-Saharan African refugee camps, is offering 6 percent of her life’s income for $600,000.

(quoted here).  A closer look reveals that this is more of clever marketing play to interest donors in supporting a philanthropy.  What, for example, does Kjerstin want do with the money? She writes:

Some people may think that it's crazy to give up a percentage of your income for the sake of scaling a nonprofit venture. But to me, it makes perfect sense.

Well it does make perfect sense for Kjerstin but not so much for a profit-seeking investor (moreover any income would be taxed twice, a problem with equity financing in general but especially so here without corporate tax breaks.)  Investing in just one entrepreneur is also risky – why not subdivide the investment and invest in many?

Jeff at Cheap Talk raises a larger but closely related issue, "Why don’t we replace student loans with student shares?" In fact, Milton Friedman advocated income contingent loans in 1955. 

The counterpart for education would be to "buy" a share in an individual's earning prospects: to advance him the funds needed to finance his training on condition that he agree to pay the lender a specified fraction of his future earnings. In this way, a lender would get back more than his initial investment from relatively successful individuals, which would compensate for the failure to recoup his original investment from the unsuccessful. There seems no legal obstacle to private contracts of this kind, even though they are economically equivalent to the purchase of a share in an individual's earning capacity and thus to partial slavery

…One way to do this is to have government engage in equity investment in human beings of the kind described above. …The individual would agree in return to pay to the government in each future year x per cent of his earnings in excess of y dollars for each $1,000 that he gets in this way. This payment could easily be combined with payment of income tax and so involve a minimum of additional administrative expense. The base sum, $y, should be set equal to estimated average–or perhaps modal–earnings without the specialized training; the fraction of earnings paid, x, should be calculated so as to make the whole project self-financing.

Another Nobelist of a more liberal stripe, James Tobin, helped to implement an income-contingent tuition program at Yale in the 1970s.  Alas, the program was terminated largely due to rent-seeking when many Yale graduates become so successful that the repayment amounts became substantial and the nouveau riche chose to default (also here).

Bill Clinton later tried to take the idea national but it didn't get very far in the United States.  (Not coincidentally Clinton had been a beneficiary of the Yale program.)

Australia, however, implemented an income contingent loan program in 1989. Australian students don't pay anything for university when they attend but once their
income reaches a certain threshold they are charged through the income tax system.  Many other countries are experimenting with income contingent loans.    

Hat tip to Alexander Ooms.

anon March 9, 2010 at 8:04 am

Putting a $10 million present valuation on the future earnings of a nonprofit employee? I think I (and everyone else who prefers to make money rather than lose it) will pass.

One thing I fear will doom this sort of market is the endowment effect – that sellers will fail to discount and there will be a fundamental disconnect between what sellers expect (which probably is based on a non-discounted sky-high optimistic valuation) and what buyers would expect (something comparable in pricing to a variable annuity).

Of course, one of the worst things about this is that the marginal tax rates start becoming ridiculously high once you sell any appreciable portion of yourself. With total marginal rates well over 50% in many areas, an additional 6-10% of your income, whether after-tax or otherwise, likely makes the appeal of being a stay at home parent (or other generator of non-taxed imputed income) overwhelming.

Presumably the answer to the last concern, at least, is to structure this as a contingent debt instrument that could somehow allow the individual to deduct the payments, which would be difficult to structure, though probably the appropriate treatment.

mike March 9, 2010 at 8:38 am

William Yu and Don Salyards wrote about this here:

http://www3.interscience.wiley.com/journal/121406658/abstract?CRETRY=1&SRETRY=0

Can’t find an ungated version.

Bill March 9, 2010 at 8:50 am

How about taking shares of soon to be foreclosed houses, loaning to the soon to be foreclosed person, and sharing any gain from the sale if the owner stays on the property for five or more years.

Jonathan Falk March 9, 2010 at 9:13 am

Slocum: That’s exactly what happened at Yale. It wasn’t so much rent-seeking as Alex pointed out, but there was pooling which adverse selection killed. All the students in the arts took the TPO (as it was then known) while the future investment bankers and lawyers failed to sign up. A given year’s TPO was pooled, and the amount owed grew every year as the revenues failed to match the interest owed and negative amortization kicked in. By the late ’90s, my wife, having faithfully made her contributions every year, still owed about six times what she originally borrowed, and we finally paid it off in a lump sum as the real death spiral began.

Alex Tabarrok March 9, 2010 at 9:39 am

Adverse selection could be a problem in equilibrium but for the Yale program the problem was not that the investment bankers didn’t sign up but that they signed up and then defaulted when they had to pay big bucks.

“Each borrower had to continue paying until the debt of their entire graduating class was repaid. The program unraveled when high-earning graduates realized they would have to repay far more than they had borrowed, subsidizing not only students in low-paying professions, but the 15 percent of graduates who were deadbeats. Few students realized how many classmates would renege on the loans.”

http://www.bc.edu/bc_org/avp/soe/cihe/newsletter/News27/text002.htm

See also here

http://www.slate.com/id/1000326/

Andrew March 9, 2010 at 9:40 am

Right off, as noted, rewarding people as a percentage versus a set amount is going to encourage people to earn lower absolute numbers and thus is going to shift university seats toward lower ROI majors, which if investors/lenders assume a historical rate of return they will either be disappointed or cause a default. That’s the math problem. The qualitative problem is that we already have too much college for no productivity careers. It is really funny to me that we make gradeschool kids do stuff they hate while school is free, then we encourage college kids to “follow their passion” when school (not to mention the opportunity cost) is something that they will have to pay back out of earnings.

Allan March 9, 2010 at 10:01 am

Wait a second. Why rely on private investment for this? Why not just …

Have the government pay for higher education and have a higher marginal tax?

Seems to me like the proposed scheme is just a taxation mechanism run by private sources instead of the government (perpetual repayment and all).

The government is certainly more efficient in doing this (fewer deadbeats and fewer reneging on loan obligations).

Slocum March 9, 2010 at 10:06 am

“How is this any different from corporate finance? Business leaders who see substantial upside in their firms will prefer to raise debt capital. Those with less optimistic outlooks will be more willing to offer additional equity.”

It’s very different. Bad corporate risks are charged high rates or denied loans entirely. Or, alternately, they have to sell a larger fraction of the company to raise a given amount of capital. But in this case, there’s no opportunity to charge higher rates for poor risks. What percent of future income would you demand to in exchange for providing, say, $200K+ for 4 years at an Ivy League institution for…an early childhood education major? You’d want a very high percentage (actually, if you were sensible, you’d probably be unwilling to make the deal at all) — but a basic feature of these plans is a fixed percentage of income regardless of the characteristics of the student or the intended major, so there’s no opportunity to price risk.

mattmc March 9, 2010 at 10:30 am

Income contingent loans seem totally stupid to me, as presented here. We have the opposite problem to some degree, people getting heavily subsidized university education and choosing to study unprofitable subjects, say Medieval Literature, with our money. Perhaps a better scheme would be to only pay for studies in subjects that are deemed to be under-subscribed, and only pay the subsidy in the event of a successful graduation. I can definitely see how my company could do this, by identifying and sponsoring prospective students and then paying for their education in return for a few years of labor after they graduate with useful skills.

PeterW March 9, 2010 at 10:33 am

The easiest way to avoid adverse selection would be to make the loans contingent on certain decisions (you’d have to keep taking those financial engineering classes, for example) that correlate with being on money-track careers. This way investors would only invest in those with the most “useful” careers.

Interestingly the market signal would also provide objective evidence of what characteristics correlate with high future earnings.

Andrew March 9, 2010 at 10:43 am

Harvard Business School rejected Warren Buffett.

I just re-learned this today and thought it was at least tangentially interesting.

Think about that, the allegedly best admissions entity missed the greatest business prodigy of all time, probably due to over-thinking what they thought they were good at.

And people think the rest of the education system is probably fine, or at least too good to make major changes.

Andrew March 9, 2010 at 10:53 am

“economically equivalent to the purchase of a share in an individual’s earning capacity and thus to partial slavery”

Economists are funny if they think that is slavery. Slavery involves whips. In a non-sexy way.

tom March 9, 2010 at 10:58 am

1. Isn’t our whole income tax system already like this? I can’t justify my very high tax rate on the services I receive now. I can only think of it as my ‘angel’ invested in me by allowing me to grow up here, so he gets 30% of everything I make up to a certain level, then 50% of everything above that.

2. How would you get an enforceable mortgage on future income to stop the “Dean Martin” (or I would say “Producers”) problem that Steven Landsburg mentions above? We have lien registries for real estate, cars & other personal property, etc…, but not for personal income. We’d need a new US Treasury lien registry!

3. Would these be dischargeable in bankruptcy? Normal school loans often aren’t. But these would almost have to be, since they could be such an anchor on people trying to get a fresh start.

4. These interests would also need to be on all credit reports since they have the effect of reducing income above a certain amount.

5. This is fun to talk about but insane in our world, where we nearly destroyed the relatively simple business of home loans because of decades of making them tools of public policy. Imagine the mayhem Congress would create in trying to ‘fix’ these investments.

Cody L. Custis March 9, 2010 at 11:19 am

As far as concerns of a portion of future income being a bad investment, lifetime income is Nassim Taleb classic black swan territory with an exponential distribution. It’s very difficult to tell which incoming freshmen will have massive income, dwarfing their peers. One of the most successful individuals associated with the University of Montana is Jeff Ament, a drop out who went on to play bass guitar for the band Pearl Jam.
There is also an information problem. College freshmen who start in ‘high income’ majors such as engineering might switch to less stressful majors, or drop out entirely. The professions which are associated with very high median income, such as lawyers, doctors, and economists, require graduate degrees. The point that I am making is that one can make a much better prediction of an individual’s lifetime income after four years of college, rather than the beginning of college. One still cannot predict mean income because of extreme successes, but one at least has an idea where to find the median.

Jonathan Falk March 9, 2010 at 11:39 am

Sorry I meant also see Willem Buiter, http://eprints.lse.ac.uk/847/1/tobin.pdf at pages 11-12

jeff ely March 9, 2010 at 12:45 pm

The incentive-dampening effect may be an feature, not a bug. See my comment here.
http://cheeptalk.wordpress.com/2010/03/08/shes-selling-equity/#comment-3450

Daniel Horowitz March 9, 2010 at 4:32 pm

The Thrust Fund was catalyzed by Rafe Furst’s post on Investing in Superstars. http://emergentfool.com/2009/10/30/investing-in-superstars/

monsieur Jean March 9, 2010 at 5:46 pm

That is also a idea developed in a French novel (can’t find an English translation): Les Actifs corporels de Bernard Mourad. What happens when, at last, everybody could be IPOed… Highly recommended.

http://www.amazon.fr/actifs-corporels-Bernard-Mourad/dp/2709627809/ref=sr_1_1?ie=UTF8&s=books&qid=1268174050&sr=8-1

Patrick March 9, 2010 at 6:35 pm

Actually, the income is probably effectively alienated or alternatively derived on trust (ie not derived at all) and thus not subject to income tax.

Andy March 9, 2010 at 8:43 pm

Why wouldn’t the rate just be based on major/SAT score/GPA/etc, presumably at the end of your graduation. If you don’t graduate then you have to repay the money.

This would get rid of some of the adverse selection. a 4.0 CS major would have to pay a much smaller percent of income than a 2.0 English major.

Jacqueline March 10, 2010 at 12:34 am

Regular student loans already have income contingent repayment with any remaining balance forgiven after 25 years: http://www.finaid.org/loans/icr.phtml

tom March 10, 2010 at 11:51 am

Jacqueline’s link above on the US government program is real. I didn’t realize how well established the ‘minus’ side of income contingent loans was here.

I couldn’t find numbers showing how many loans are covered by this today. It looks like it started within the past 3-5 years. But it seems very broad and it seems to allow large reductions in payments and eventual forgiveness based on AGI.

It seems strange that the only testing is based on income, which can be a pretty weak measure of ability to pay. I would have guessed they would require more complete means-testing. It is a welfare program.

NoBill March 10, 2010 at 2:19 pm

The Boston Fed just published a working paper on this topic:
http://www.bos.frb.org/economic/wp/wp2010/wp1001.htm

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