income contingent loans

Invest in People with Income Contingent Loans

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.

Income Share Agreements

Mitch Daniels, former Governor of Indiana and now President of Purdue University, writes about income share agreements in the Washington Post:

In an ISA, a student borrows nothing but rather has his or her education supported by an investor, in return for a contract to pay a specified percentage of income for a fixed number of years after graduation. Rates and time vary with the discipline of the degree achieved and the amount of tuition assistance the student obtained.

An ISA is dramatically more student-friendly than a loan. All the risk shifts from the student to the investing entity; if a career starts slowly, or not at all, the student’s obligation drops or goes to zero. Think of an ISA as equity instead of debt, or as working one’s way through college — after college.

An excellent point. If you watch Shark Tank the entrepreneurs are always wary about debt because debt puts all the risk on them and requires fixed payments regardless. Yet when it comes to financing the venture of one’s own life suddenly equity becomes akin to slavery and debt bondage becomes freedom! It’s very peculiar.

Another advantage of ISAs is that they provide feedback. Is the university willing to educate you for free in return for a share of future earnings? That’s a good signal!

ISAs have emerged principally in response to the wreckage of the federal student debt system but they also represent an opportunity for higher education to address another legitimate criticism: that it accepts no accountability for its results. As the lead investor of the two funds Purdue has raised to date, our university is expressing confidence that its graduates are ready for the world of work.

Check out Lambda School. “We invest in you. Pay nothing until you get a job making over $50,000.”

At Purdue, the university I lead, hundreds of students have such contracts in place, and other colleges large and small are joining the ISA movement. Beyond traditional higher education, coding academies and other skill-specific schools are making the same offer: Study for free, and pay us back after you get the good job we are confident you’ll land.

Although the very nature of ISAs protects the participant, early adopters such as Purdue have built in safeguards. A user-friendly computer simulator provides quick, transparent comparisons with various public and private loan options. No investee pays anything for the first six months after graduation or until annual income exceeds $20,000. For those graduates who get off to fast career starts, a ceiling of 250 percent of the dollars that purchased their education limits total repayment.

I’ve been writing about income-contingent loans for years. Milton Friedman was an early advocate. It’s good to see forward movement.

Venture Capital to Buy Equity in Purdue Students

Danielle Douglas-Gabriel at the WashPost writes that Purdue is going to run an experiment with income contingent loans.

This week, Purdue University [partnered]…with Vemo Education, a Reston-based financial services firm, to explore the use of income-share agreements, or ISAs, to help students pay for college.

Through its research foundation, the school plans to create ISA funds that its students can tap to pay for tuition, room and board. In return, students would pay a percentage of their earnings after graduation for a set number of years, replenishing the fund for future investments.

The Federal government already offers an income based repayment program for student loans but private plans would likely be more flexible and generate more useful information.

Douglas-Gabriel makes a useful point:

Say a student agrees to pay five percent of her income for five years on a $10,000 agreement. If that student lands a $60,000 job after graduation, she could pay $15,000 by the time the contract is up, more if she gets raises along the way. Yet if that same graduate loses her job during that time, she wouldn’t be forced to find the money to pay.

But then concludes with an odd criticism:

Either way students would have to be pretty informed about the earning potential in their field before signing up.

What the example illustrates, however, is that being unlucky or uninformed is less damaging with an income share agreement than with a traditional loan. Loans have the greatest burden when a student overestimates their potential earnings and is poorer than expected. Thus, the loan offers no relief when relief is most needed. In contrast, payments under an income share agreement fall when income falls. An ISA does cost more than a loan when a student underestimates their potential earnings but in this case the student is richer than expected and can easily bear the extra burden. Thus, ISAs offer income insurance.

Douglas-Gabriel also writes:

Some observers worry that students pursuing profitable degrees in engineering or business would get better repayment terms than those studying to become nurses or teachers.

Actually, that is part of the point. An ISA is about improving idiosyncratic risk sharing. To the extent that engineers are reliably expected to earn more than nurses, they should pay a smaller share of their income so the total payment for an education is about the same for both engineers and nurses (fyi, business is not a profitable degree).

Indeed, one of the prospective benefits of ISAs is that differences in prices will better reveal which are the degrees, programs and schools that most generate value-added.

Hat tip: Kevin James.

Addendum: See previous MR posts on this topic.

Zingales on Education Equity

Luigi Zingales has a good op-ed on education in today’s NYTimes:

… scholars like me…work in the least competitive and most subsidized industry of all: higher education.

We criticize predatory loans by mortgage brokers, when student loans can be just as abusive. To avoid the next credit bubble and debt crisis, we need to eliminate government subsidies and link tuition financing to the incomes of college graduates…Just as subsidies for homeownership have increased the price of houses, so have education subsidies contributed to the soaring price of college.

…These subsidies also distort the credit market. Since the government guarantees student loans, lenders have no incentive to lend wisely. All the burden of making the right decision falls on the borrowers. Unfortunately, 18-year-olds aren’t particularly good at judging the profitability of an investment…

Last but not least, these subsidized loans keep afloat colleges that do not add much value for their students, preventing people from accumulating useful skills.

Instead of subsidies Zingales, drawing a page from Milton Friedman, proposes income-contingent loans.

Investors could finance students’ education with equity rather than debt. In exchange for their capital, the investors would receive a fraction of a student’s future income — or, even better, a fraction of the increase in her income that derives from college attendance. (This increase can be easily calculated as the difference between the actual income and the average income of high school graduates in the same area.)

As I wrote about earlier, Bill Clinton received a loan like this from Yale’s law school and later created a national program but it didn’t get very far (although Obama wants to expand the 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.

Lumni is a private organization, started by economist Miguel Palacios (here is his book and Cato paper on human capital contracts), that is funding loans like this right now.

One point that Zingales doesn’t examine is adverse selection – an income-contingent loan will appeal most to people who want careers with low-income prospects, say in the non-profit sector. (Redistribution of this type was one of the reasons for the Yale law school program.) Thus, the program works best when incomes differ due to luck. My guess is that the adverse-selection problem can be handled if education venture capitalists are left free to price.

Assorted links

Incorporated Men and Women

In my post on The Unincorporated Man “framing” writes:

Instead of saying that a corporation can own shares in your income, how about saying it is like a loan that you wont get into trouble ever paying back, but will have to pay more if you become rich.

Exactly. In fact, I have written about income-contingent loans before and how one of them got Bill Clinton through college. At the PSD blog Ryan Hahn also points to Lumni, a new firm that is investing in human capital in the developing world:

Lumni designs, markets and manages “Human capital funds”, an innovative investment vehicle for financing education. Students agree to pay a fixed percentage of their individual incomes for a predetermined number of months after graduation. The arrangement traspases part of the risk of investing in education from the student to the investor, who is in a better position to diversify it.

Lumni is the brainchild of economics professor Miguel Palacios.  Here is his book and Cato paper on human capital contracts.