English student loans are a weirdly designed tax

Despite being called ‘tuition fees’, the system of financing university education in England operates more like an extra income tax on graduates. For most students, the government pays universities up front, and then charges the student an additional 9% of any income above a threshold of £25,725 a year along with income tax and national insurance. I have always been a bit puzzled by the branding of the system as ‘fees and loans’, which hides the fact that students pay nothing up front, and emphasises the ‘debt’ they take on. In fact, the majority of students are not expected to fully repay the cost of their tuition, with the government writing the debt off if not repaid after 30 years. I suspect this is why this week’s Augar review recommends calling it a ‘graduate contribution’ instead.

However, student loan repayments are unlike ordinary income tax in two respects. First, the total amount any person can pay is capped by the total value of their tuition fees, maintenance loans and the interest accrued on these. As soon as this is paid off, the government stops collecting money. The effect of this is to ensure that the richest people end up paying a smaller share of their lifetime income than others who pay off their loans in full. It is like if the government created a rule that nobody was charged more than £20,000 in income tax: those earning £100,000 a year would pay 20% of their income, but those earning £1,000,000 would pay 2% of their income (obviously the numbers are less extreme in the case of student loans, but hopefully the point is clear). Indeed, because richer people tend to pay off their student loans earlier, accruing less interest, they end up paying less than those who pay off their loans later (but still more than the poorest, whose loans are written off).

Second, student loan repayments look like a hypothecated tax. Hypothecation means that there are restrictions on how the funds generated from a particular tax may be spent. For example, revenue from the recent tax on sugary beverages were hypothecated to be spent on sport in schools. The separation of the student loans system from general taxation creates at least the impression that the money is hypothecated to fund universities.

Hypothecation tends to be unpopular among economists because there is no reason to expect that the revenue generated by a hypothecated tax will equal the amount needed to be spent on whatever it is hypothecated for. If revenues are low, services may be cut back for no good reason. If revenues are high, it might lead to unnecessary and wasteful spending. Yet this is clearly not how the student loan system operates. It is not self-financing: the amount that the government pays out to universities is independent of how much it generates from student loan repayments. The student loan system might be called fictional hypothecation: in the same way as national insurance contributions are supposed to pay for pensions and benefits, but actually just go into general taxation, student loan repayments end up in much the same place.

Why does the government bother with the pretence of fictional hypothecation? I suspect three reasons. First, for accounting reasons. Funding universities directly is seen as public spending – this is bad because it increases the deficit. At least initially, ‘loaning’ money to students to pay for universities was not treated as spending and didn’t increase the deficit (…until the debt has to be written off in 30 years’ time, but that is some other government’s problem). However, last December the Office for National Statistics changed this approach and started counting the expected write-offs of loans made today as public spending, increasing the deficit overnight by £12 billion.

Second, for public relations. A 9% income tax hike is pretty steep and potentially unpopular, whereas ‘loan repayments’ sound fairer and more reasonable.

Third, hypothecation ties the government’s hands. This is another reason why economists tend to dislike hypothecation: because it prevents governments redirecting hypothecated funds to more pressing issues if they emerge. Yet this is also what proponents of tuition fees like about them – Nicholas Barr argues that if universities are funded from general taxation “higher education will lose in the political battle to more urgent and politically salient public spending priorities, including nursery and school education, health care and spending on pensions”, leading to underfunding of universities. This suggests that the tuition fee system is a self-commitment device: the government guarantees universities a certain amount of funding per student because it doesn’t trust itself to fund them properly in discretionary annual budgets.

Thinking about university finance as an oddly designed supplementary income tax leads us to think about the whole purpose of the system in a different way. The notions that tuition fees are an accounting trick, a public relations exercise or a self-commitment device don’t seem to feature much in the debate. If they did, we might be more likely to draw parallels with the private finance initiative, which seemed like a clever way to fund investment without increasing public spending, but whose circuity led to inefficiency. Or to link the government’s apparent success in drawing the sting of tax rises and tying itself in to spending commitments to calls for a hypothecated NHS tax. The implications, for good or bad, go far beyond higher education policy.

One comment

  1. Wow this is an amazingly profound insight about students. Kudos to you!

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