Redesigning Education Finance: How Student Loans Outgrew the debt Paradigm

ARTICLES

Redesigning Education Finance: How Student

Loans Outgrew the “Debt” Paradigm

JOHN R. BROOKS* & ADAM J. LEVITIN**

This Article argues that the student loan crisis is due not to the scale of stu-

dent loan debt, but to the federal education f‌inance system’s failure to utilize

its existing mechanisms for progressive, income-based payments and debt

cancellation. These mechanisms can make investment in higher education

affordable to both individuals and the government, but they have not been

fully utilized because of the mismatch between the current system’s economic

reality and its legal, f‌inancial, and institutional apparatus.

The current economic structure of federal student loans does not resemble a

true credit product, but a government grant program coupled with a progres-

sive, income-based tax on recipients. For example, federal direct loans do not

require the full repayment of all principal and accrued interest. Instead, bor-

rowers have the contractual right to satisfy their obligations by paying only a

percentage of their income for a f‌ixed period of time. Debt forgiveness is con-

tractually baked into the federal student loan product.

The education f‌inance system, however, still relies on a legal, f‌inancial,

and institutional apparatus based on “debt,” developed under the pre-

2010 system, which was based on private loans backed by federal govern-

ment guarantees, rather than the post-2010 system of direct federal lend-

ing with income-driven repayment. The frictions between the legacy legal,

f‌inancial, and institutional “debt” apparatus and the economic reality of

subsidized f‌inance; progressive, income-driven repayment; and debt for-

giveness are the source of nearly all of the problems in education f‌inance,

including high levels of default, abusive servicing, and even the very idea

of a student debt crisis.

It’s time to call federal student loans what they really are—a tuition

grant plus an income surtax on students. To this end, this Article pro-

poses a set of targeted reforms: automatic income-based payments using

a graduated rate schedule; collection through the tax withholding and

return f‌iling; and replacement of interest accrual with an inf‌lation adjust-

ment. Moving toward a grant-and-tax framework would facilitate

* Professor of Law, Georgetown University Law Center. © 2020, John R. Brooks & Adam J. Levitin.

** Agnes N. Williams Research Professor and Professor of Law, Georgetown University Law

Center. This Article has benef‌itted from presentations at the 2019 American Law & Economics

Association Annual Meeting, the 2018 National Tax Association Annual Meeting, Georgetown

University Law Center, and Loyola Law School, and from comments from Jonathan Glater, Jennifer

Mishory, and Robert Shireman. Thank you to Mitchell Mengden for his research assistance.

5

substantial reforms to the f‌inancing of higher education and help ensure

that instead of being a debt trap, federal f‌inancing facilitates affordable

higher education.

TABLE OF CONTENTS

INTRODUCTION . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8

I. A BRIEF HISTORY OF STUDENT LOANS . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16

A. EARLY YEARS OF FEDERAL HIGHER EDUCATION FINANCE . . . . . . . . . 17

B. THE FIRST FEDERAL LOANS: THE NATIONAL DEFENSE EDUCATION

ACT OF 1958............................................. 19

C. GUARANTEED LOANS: THE HIGHER EDUCATION ACT OF 1965 . . . . . . . 22

D. SOLIDIFYING THE FEDERAL ROLE: 1970S–1980S.................. 25

E. WATERSHED CHANGES: 1992 AND 1993 . . . . . . . . . . . . . . . . . . . . . . . . 27

F. THE OLD SYSTEM BREAKS DOWN: 1990S AND 2000S............... 28

G. A NEW ERA: 2009 TO PRESENT . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31

II. STUDENT LOAN DEBT IS NOT LIKE OTHER DEBT . . . . . . . . . . . . . . . . . . . 33

A. LACK OF UNDERWRITING . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35

B. INCOME-CONTINGENT PAYMENTS . . . . . . . . . . . . . . . . . . . . . . . . . . . . 36

C. FORGIVENESS OF UNPAID BALANCES . . . . . . . . . . . . . . . . . . . . . . . . . 37

D. INTEREST ACCRUAL . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 38

1. Income-Contingent Repayment . . . . . . . . . . . . . . . . . . . 39

2. Income-Based Repayment . . . . . . . . . . . . . . . . . . . . . . . 40

3. Pay As You Earn . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40

4. Revised Pay As You Earn. . . . . . . . . . . . . . . . . . . . . . . . 40

E. LACK OF PENALTY FOR LATE PAYMENTS . . . . . . . . . . . . . . . . . . . . . . 41

F. TAX TREATMENT OF DEBT FORGIVENESS . . . . . . . . . . . . . . . . . . . . . . 41

G. NONDISCHARGEABILITY IN BANKRUPTCY. . . . . . . . . . . . . . . . . . . . . . 43

H. FEWER CONSUMER PROTECTIONS . . . . . . . . . . . . . . . . . . . . . . . . . . . . 44

I. MINIMAL REGULATORY OVERSIGHT . . . . . . . . . . . . . . . . . . . . . . . . . . 45

J. EXTREME CONSEQUENCES OF DEFAULT . . . . . . . . . . . . . . . . . . . . . . . 47

6 THE GEORGETOWN LAW JOURNAL [Vol. 109:5

III. STUDENT LOAN PROBLEMS STEMMING FROM THE DEBT PARADIGM . . . . . 48

A. UNNECESSARILY HIGH LEVEL OF LOAN DEFAULTS. . . . . . . . . . . . . . . 48

B. ABUSIVE LOAN SERVICING . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50

1. Student Loan Servicing . . . . . . . . . . . . . . . . . . . . . . . . . 50

2. Misaligned Servicer Compensation. . . . . . . . . . . . . . . . . 52

3. Misdesigned Allocation of Servicing Rights . . . . . . . . . . 55

4. Lack of Oversight of Servicers . . . . . . . . . . . . . . . . . . . . 57

C. OUTDATED REHABILITATION APPROACH. . . . . . . . . . . . . . . . . . . . . . . 60

D. PUNITIVE TAX TREATMENT . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 61

E. OVERWEIGHTING THE IMPORTANCE OF PAYMENT HIERARCHY . . . . . 62

F. MISFRAMED PUBLIC DISCOURSE ON STUDENT LOAN DEBT . . . . . . . . . 64

IV. CONSIDERING THE TAX ALTERNATIVE . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 66

A. GRANT-AND-TAX COMPARED TO TRADITIONAL TAXES. . . . . . . . . . . . 67

B. PROBLEMS WITH THE TAX PARADIGM. . . . . . . . . . . . . . . . . . . . . . . . . 68

1. Budget Politics . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 68

2. Public Policy Discourse and Framing . . . . . . . . . . . . . . . 69

3. Tax Enforcement . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 71

4. Transition. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 71

C. REJECTING OTHER MODELS: THE INCOME SHARE AGREEMENT

ALTERNATIVE........................................... 72

V. A HYBRID PARADIGM FOR EDUCATION FINANCE . . . . . . . . . . . . . . . . . . . . 73

A. AUTOMATIC INCOME-BASED REPAYMENTS . . . . . . . . . . . . . . . . . . . . . 74

B. COLLECTION THROUGH TAX WITHHOLDING . . . . . . . . . . . . . . . . . . . . 75

C. ELIMINATION OF INTEREST AND FORGIVENESS. . . . . . . . . . . . . . . . . . 76

D. PROGRESSIVE, GRADUATED REPAYMENT RATES . . . . . . . . . . . . . . . . . 78

CONCLUSION . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 79

2020] REDESIGNING EDUCATION FINANCE 7