Taking income contingent loans to the world

At least eight countries around the world have adopted versions of Australia’s Higher Education Contribution Scheme. Known as HECS, the scheme requires students to pay some of the cost of their degrees and the remainder through a government loan.

HECS was introduced in 1989 by the Australian government and is a process whereby the loan is repaid through the tax system, depending on the participant’s income. This arrangement is known as an income contingent loan, or ICL.

ICLs differ critically from ‘normal’ loans in that repayments occur if and only when the debtor’s income reaches a given level. And if it doesn’t ever reach this level, then no payments are ever required.

Global spread of ICLs

In the years since its introduction, other countries have adopted similar student loan schemes. There is even an ICL bill currently under bipartisan consideration in the US Congress.

ICLs are now the student loan mechanism in Australia, New Zealand, Ethiopia, England, Hungary, South Africa and South Korea, with most countries providing finance for both tuition fees and to cover living costs.

Interest rate subsidies are usually the norm. It is generally agreed that these policies have worked effectively in equity, efficiency and administrative senses.

While HECS was considered to be a creative innovation, applauded in the main for its political sophistication, no-one at the time foresaw the potential of ICLs to transform the debate concerning the economic and social policy landscape.

There was no appreciation of the possibility that contingent loan financing could provide a model for far-reaching renovations to the nature and form of public policy – yet in the eyes of some contemporary social scientists such a possibility is close to being realised.

Using ICLs in other fields

My colleagues, Dr Tim Higgins and Professor Joseph Stiglitz, and I have been investigating the potential of ICLs and the intellectual, conceptual and empirical bases of contingent financing.

Applied ICL research is not novel. Indeed, over the last 25 years, economists and other social scientists have taken the basic template of Australia’s education ICL and applied it to a plethora of different social and economic arenas.

Our research, and the work of others featured in our new book Income Contingent Loans: Theory, practice and prospects*, suggest there are a few key features which mark out a successful design for ICLs.

The first is understanding that the public sector has a monopoly by law with respect to knowing citizens’ incomes through the internal revenue service, the tax office – so it is natural that governments take jurisdiction over ICL policies.

These arrangements deliver the insurance benefits of reducing repayment difficulties and providing protection against default in policy areas often characterised by market failure – which very obviously exists with university financing because of students’ lack of collateral.

Schemes of this type can also involve equity and this takes the form of human capital contracts. In this latter approach those assisted agree to repay a set percentage of their incomes for a given period, with the present value of repayment rising with lifetime income. There can also be hybrid schemes, combining attractive aspects of both arrangements.

If loans are not income contingent, many students will face considerable repayment burdens in terms of economic hardship and some will experience difficulty servicing their loans and may default. This problem led to the collapse of the Chilean loan system following student protests.

Developing nations face problems

The difficulty most developing countries have in adopting an ICL scheme is the lack of an effective collection mechanism because this approach to higher education financing usually requires a comprehensive and efficient income tax system.

Design issues aside, where could ICLs be used beyond higher education? Research suggests a range of other potential applications, including financing extensions of paid parental leave; recompensing poor countries for skilled migrant emigration; legal aid for civil disputes; a profit-contingent loan arrangement for research and development for small and medium enterprises; the payment of low-level criminal fines; and out-of-pocket healthcare costs.

The diversity of potential applications suggests that ICLs could well have appeal as a new way to think about the role of government.

Of course, enthusiasm for the take up of ICLs has to be tempered by the political and economic realities of government lending in a loan environment dominated by the banking industry. But the prospect for substantial benefits to people’s lives, in terms of both transactional efficiencies and equity, makes these opportunities worth pursuing.

Improvements in the functioning of markets through the use of carefully designed income contingent instruments have the potential to lead to large welfare gains. Careful framing of the benefits to the public, to politicians and to policy-makers, will be critical for this kind of reform.

* The book Income Contingent Loans: Theory, practice and prospects is published by Palgrave Macmillan, Houndmills, Basingstoke, Hampshire, UK; New York, USA. This article first appeared in Advance magazine and in Policy Forum, the magazine and website of the Asia and the Pacific Policy Society.

Professor Bruce Chapman is director of policy impact at the Crawford School of Public Policy, Australian National University. He designed the Higher Education Contribution Scheme which was adopted by the federal government in 1989.