A smarter way to solve the student debt problem

Blanket loan forgiveness less effective than helping those who need it most, research suggests

Editor’s Note: This piece was written by Constantine Yannelis, an assistant professor of finance at the University of Chicago Booth School of Business, and shared by Chicago Booth Review. The essay is based on testimony Yannelis submitted to the U.S. Senate Committee on Banking, Housing, and Urban Affairs’ Subcommittee on Economic Policy in April 2021.

Education is the single highest-return investment most Americans will make, so getting our system of higher-education finance right is fundamentally important for U.S. households and the economy.

A key point in the student-loan debate is that the outcomes of borrowers vary widely. Undeniably, a significant number of borrowers are struggling, and are sympathetic candidates for some kind of relief. Student-loan balances have surged over the past decades. According to the New York Fed, last year student loans had the highest delinquency rate of any form of household debt.

Most student borrowers end up as higher earners who do not have difficulties repaying their loans. A college education is, in the vast majority of cases in America, a ticket to success and a high-paying job. Of those who struggle to repay their loans, a large portion attended a relatively small number of institutions—predominantly for-profit colleges.

The core of the problem in the student-loan market lies in a misalignment of incentives for students, schools, and the government. This misalignment comes from the fact that borrowers use government loans to pay tuition to schools. If borrowers end up getting poor jobs, and they default on their loans, schools are not on the hook—taxpayers pay the costs. How do we address this incentive problem? There are many options, but one of the most commonly proposed solutions is universal loan forgiveness.

Various forms of blanket student-loan cancellation have been suggested, but all are extremely regressive, helping higher-income borrowers more than lower-income ones. This is primarily because people who go to college tend to earn more than those who do not go to college, and people who spend more on their college education—such as those who attend medical and law schools—tend to earn more than those who spend less on their college education, such as dropouts or associate’s degree holders.

My own research with Sylvain Catherine of the University of Pennsylvania demonstrates that most of the benefits of a universal-loan-cancellation policy in the United States would accrue to high-income individuals, those in the top 20 percent of the earnings distribution, who would receive six to eight times as much debt relief as individuals in the bottom 20 percent of the earnings distribution. These basic patterns are true for capped forgiveness policies that limit forgiveness up to $10,000 or $50,000 as well.

Another problem with capped student-loan forgiveness is that many struggling borrowers will still face difficulties. A small number of borrowers have large balances and low incomes. Policies forgiving $10,000 or $50,000 in debt will leave their significant problems unaddressed.

While income phaseouts—policies that limit or cut off relief for people above a certain income threshold—make forgiveness less regressive, they are blunt instruments and lead to many individuals who earn large amounts over their lives, such as medical residents and judicial clerks, receiving substantial loan forgiveness.

A fact that is often missed in the policy debate is that we already have a progressive student-loan forgiveness program, and that is income-driven repayment.

If policy makers want to make sure that funds get into the hands of borrowers at the bottom of the income distribution in a progressive way, blanket student-loan forgiveness does not accomplish this goal. Rather, the policy primarily benefits high earners.

While I am convinced from my own research that student-loan forgiveness is regressive, this is also the consensus of economists. The Initiative on Global Markets at Chicago Booth asked a panel of prominent economists to weigh in on this statement: “Having the government issue additional debt to pay off current outstanding loans would be net regressive.” The panel included economists from leading institutions from both the left and the right. The results of the survey were telling. Not a single economist disagreed with the idea that student-loan forgiveness is regressive. This is because the facts are clear—to borrow a phrase commonly used, “The science is settled”—student-loan forgiveness is a regressive policy that mostly benefits upper-income and upper-middle-class individuals.

Another facet of this policy issue is the effect of student-loan forgiveness on racial inequality. One of the most distressing failures of the federal loan program is the high default rates and significant loan burdens on Black borrowers. And student debt has been implicated as a contributor to the Black-white wealth gap. However, the data show that student debt is not a primary driver of the wealth gap, and student-loan forgiveness would make little progress closing the gap but at great expense. The average wealth of a white family is $171,000, while the average wealth of a Black family is $17,150. The racial wealth gap is thus approximately $153,850. According to our paper, which uses data from the Survey of Consumer Finances, and not taking into account the present value of the loan, the average white family holds $6,157 in student debt, while the average Black family holds $10,630. These numbers are unconditional on holding any student debt.

Thus, if all student loans were forgiven, the racial wealth gap would shrink from $153,850 to $149,377. The loan-cancellation policy would cost about $1.7 trillion and only shrink the racial wealth gap by about 3 percent. Surely there are much more effective ways to invest $1.7 trillion if the goal of policy makers is to close the racial wealth gap. For example, targeted, means-tested social-insurance programs are far more likely to benefit Black Americans relative to student-loan forgiveness. For most American families, their largest asset is their home, so increasing property values and homeownership among Black Americans would also likely do much more to close the racial wealth gap. Still, the racial income gap is the primary driver of the wealth gap; wealth is ultimately driven by earnings and workers’ skills—what economists call human capital. In sum, forgiving student-loan debt is a costly way to close a very small portion of the Black-white wealth gap.

How can we provide relief to borrowers who need it, while avoiding making large payments to well-off individuals? There are a number of policy options for legislators to consider. One is to bring back bankruptcy protection for student-loan borrowers.

Another option is expanding the use of income-driven repayment. A fact that is often missed in the policy debate is that we already have a progressive student-loan forgiveness program, and that is income-driven repayment (IDR). IDR plans link payments to income: borrowers typically pay 10–15 percent of their income above 150 percent of the federal poverty line. Depending on the plan, after 20 or 25 years, remaining balances are forgiven. Thus, if borrowers earn below 150 percent of the poverty line, as low-income individuals, they never pay anything, and the debt is forgiven. If borrowers earn low amounts above 150 percent of the poverty line, they make some payments and receive partial forgiveness. If borrowers earn a high income, they fully repay their loan. Put simply, higher-income people pay more and lower-income people pay less. IDR is thus a progressive policy.

IDR plans provide relief to struggling borrowers who face adverse life events or are otherwise unable to earn high incomes. There have been problems with the implementation of IDR plans in the U.S., but these are fixable, including through recent legislation. Many countries such as the United Kingdom and Australia successfully operate IDR programs that are administered through their respective tax authorities.

Beyond providing relief to borrowers, which is important, we could do more to fix technical problems and incentives. We could give servicers more tools to contact borrowers and inform them of repayment options such as IDR, and we could also incentivize servicers to sign more people up for an IDR plan. But while we may be able to make some technical fixes, servicers are not the root of the problem in the student-loan market: a small number of schools and programs account for a large portion of adverse outcomes.

To fix this, policy makers can also directly align the incentives for schools and borrowers. For example, Brazil, which has had similar problems with its student-loan program, recently gave schools skin in the game by requiring them to pay a fee based on dropout and default rates. This helped align the incentives of the schools and the student borrowers. Making revenues go directly to schools from IDR plans, or implementing income-share agreements in which individuals pay an uncapped portion of their income, could also help align the incentives of schools, students, and taxpayers.

Federal student loans are an important part of college financing and intergenerational mobility. The root of our student-loan crisis is a misalignment of incentives. Since the problem has been so slow moving and continuous, I like the analogy of a frog slowly boiling in a pot of water over a flame. Policies such as student-debt cancellation are not extinguishing the flame—they aren’t fixing the incentive problem. All they do is move the frog into a slightly cooler pot of water. And if we don’t fix the core of the problem, even if we forgive $50,000 of debt for current borrowers, balances will continue to grow, and we will be facing a similar crisis in 10 or 20 years.