By Matt Miner

Democrats are the self-styled proponents of “the little guy”.  As part of this push, they are looking to reduce student loan interest rates by having the government pick up a portion of the cost of borrowing.

Before we launch into what is admittedly a “financial” article, a few definitions are in order.  A key principle (no pun intended) in finance is that a dollar today is worth more than a dollar tomorrow.  If one wishes to compare dollars, one “discounts” them into the present using a “risk-adjusted rate of return.”  This process of discounting into the present gives something called “present value”.  This present value is the value of a dollar today, adjusted for the level of risk associated with it ever being paid (any dollar which will be paid in the future may not actually be paid, as the debtor may be unable or unwilling to pay it.  Therefore, the dollar has to be considered more “risky” than the one in your wallet; another factor in this risk is inflation). 

All dollars in my comparison have been “discounted” into present-value terms.  This is done to attempt to give an apples-to-apples comparison, because if you just multiplied the lifetime earnings of various people, you would not get a sense of when they collected their dollars.

Finally, a note on assumptions: My discount rate is 7%, chosen to mimic a mortgage rate, as this is the rate at which most people can borrow money.  Further, I assume that students don’t work at all.  Finally, I do not consider the tax-advantaged character of student loan interest.  These last two assumptions have the effect of making attending college look less financially attractive than it probably is.

	PV of Sal incl lost earnings to attend school	PV of 20 year loan payment with 8% rate	Value compared to HS degree with Mkt rate of 8%	20 year loan payment with 4% rate	Value compared to HS degree with subsidized rate of 4%
Doctoral Degree	$    800,839	$    (29,101)	$    409,525	$    (21,023)	$    417,602
Professional Degree	$ 1,099,544	$    (72,752)	$    664,578	$    (52,558)	$    684,772
Master's Degree	$    538,102	$    (43,651)	$    132,238	$    (31,535)	$    144,354
Bachelor's Degree	$    477,547	$    (29,101)	$     86,233	$    (21,023)	$     94,310
Associate's Degree	$    377,472	$    (14,550)	$          708	$    (10,512)	$       4,747
Some College	$    358,159	$    (14,550)	$    (18,605)	$    (10,512)	$    (14,567)
High School Grad	$    362,214	$            -	$            -	$            -	$            -
High School Dropout	$    270,995	$            -	$    (91,219)	$            -	$    (91,219)

 

The column on the left “PV of Sal incl lost earning to attend school” shows a 30 year salary minus the lost salary spent in college.  It is based on 2002 data from the US. Census Bureau, discounted into the present.  Likewise, the next column shows the cost of a student loan in present value dollars at a student loan rate of 8%.  The third column shows the value of the degree compared to a High School diploma.  The fourth column shows the present value cost of the same student loan with a government subsidized interest rate of 4%.  The final column shows the relative value of the degree with the subsidized rate.  My full analysis is available in Excel format if you want to see my calculations.  Also, Excel pastes badly into this blogging software - I apologize that my chart does not appear more attractive.

My main finding is that the discount on the interest rate helps especially those who will attend professional school (like me).  It saves them, on average, $20,000 in present-value dollars.  From there, it dwindles down to saving those who earn an associates degree about $4,000 over their lifetime.  It can be argued that the most efficient system would be achieved via no government meddling in markets (the Chicago School), if one accepts government meddling in markets, it is usually on the basis of helping those who cannot help themselves.  This case turns even that logic on its head and most helps those who, over their lifetime, will earn nearly three times what a high school graduate will earn!

(Of course, it should be pointed out that those with professional degrees will pay something like ten-to-fifty times more per year in taxes than their High School Graduate counterparts, so the government does get them in the end.  Still, the friend of the little guy argument falls apart rather badly on this point.)

There’s more: By making student loans cheaper than they would otherwise be, some may attend college who otherwise should not.  Because the cost is made artificially low, they will try it out.  In so doing, society loses their productivity in other areas, and they are unlikely to find college to be what they had hoped for.

One funny anecdotal finding is that getting “some college” makes one poorer than having just a high school diploma, assuming the student spends as much as his/her friends who complete their degrees.

It is worth pointing out that these are averages.  Going to school is an individual decision, and individuals do well or poorly for different reasons.  Further, we can assume a strong selection bias for intelligent individuals pursuing more education; these same individuals might have done very well without their diplomas, but earned them anyway.

Perhaps most importantly, the ability of those without education to make a living is rapidly being eroded in our knowledge society.  The relative earnings of High School Graduates and High School dropouts will continue to fall during our lifetime.  The future of earning power is about knowledge capital, and not about wielding a shovel, or even manning a place on an assembly line.  This means that people who have invested in appropriate education will be better positioned to survive these changes.

It comes as no shock that those with more education earn more.  But there is a better way to provide access to the appropriate education than by subsidizing school interest rates.  These dollars could be spent more profitably to offer continuing education to those who find themselves displaced by the effect of knowledge on what had hitherto been a good way to make a living.  This type of spending would be more likely to help society as a whole by producing the workforce that is needed.  It would also significantly help the particular individuals who are hurt by the declining relative value of the work they do compared to more knowledgeable workers.  Finally, it would reduce the resistance and waste associated with fighting the trend depicted in the table above.

Nevertheless, this measure seems destined for success – the people who vote would love to see the cost of education fall and get a little of the high taxes they pay back.  Of course, if passed, it will have unintended consequences including the one mentioned above.  Additionally, the schools themselves will likely capture much of the goodness through tuition increases since demand for higher education far outstrips the supply of education (suggesting that the good is very under-priced - Harvard, for example, could probably charge $70,000 per year for tuition and still attract more qualified students than it could place).  This is just one piece of the knowledge revolution that is playing out and will play out in our lifetime.  It will be interesting to watch the show and observe the effect of accumulated decisions on society.