An Economic Perspective of Income Share Agreements

An Economic Perspective of Income Share Agreements

July 15, 2019
An Economic Perspective of Income Share Agreements
Income Share Agreements (ISAs) have received attention
of uncertainty, ISAs provide protection against the risk of a
as an alternative to student loans for financing higher
low-paying job and unemployment since the amount a
education expenses. Purdue University’s “Back a Boiler”
student repays depends on the income they earn and not on
program has perhaps received the most attention recently,
the amount of initial funding they received. In contrast,
although the University of Utah and a number of smaller
conventional debt financing generally requires full
schools—Colorado Mountain College, Messiah College,
repayment with interest regardless of income, which places
and Clarkson University—as well as several independent
a borrower at risk of becoming overly debt-burdened if
private companies offer such programs.
their income is too low. Income contingent loans, which are
discussed below, address this feature of conventional debt.
This In Focus provides an overview of ISAs along with a
comparison to student loans. Because no federal ISA
Alternatively, students who are confident about their future
program currently exists and the majority of student loan
prospects may determine that repaying a fraction of their
debt is associated with the federal student loan program, the
income is too costly of a commitment. In this case, student
overview and comparison primarily focuses on private ISAs
loans may be a more attractive option because the amount
and federal student loans but generalizes some parts of the
the student would have to repay is limited to what they
discussion to highlight particular features of each financing
borrowed plus interest and fees. The student would be,
approach. To conclude, potential policy issues and
however, at risk of becoming overly debt-burdened should
questions Congress may consider are presented.
their income be lower than they expected.
Overview of ISAs
The ISA model relies on risk-based underwriting to set
An ISA is a contract between a student and an investor in
specific terms for each student or type of student. This
which the student receives college funding in exchange for
means that students who are perceived to be lower risk and
pledging a fraction of the student’s future income to the
have higher earning potential are offered more favorable
investor for a specified period of time. As an example, a
terms. Investors may consider a range of student
student may receive $20,000 for college in exchange for
characteristics during the underwriting process, such as a
repaying 5% of the student’s income for 10 years upon
student’s major, degree track, year in school, academic
graduation. Under these terms, the student could end up
record, and alternative sources of financing, among others.
paying more or less than the student received depending on
Investors may also consider the quality and type of school
his or her future earnings. If the student were to earn
the student plans to attend—for example, traditional four-
$50,000 each year for the next 10 years, the student would
year college, two-year technical college, or online college.
repay a total of $25,000. Alternatively, if the student were
to earn $35,000 per year after graduating, the student would
The individualized financing terms may influence students’
repay a total of $17,500. In either case, the student’s
educational and career decisions. For example, a student
repayment burden is proportional to his or her income.
with a passion for art history may decide the financing
terms are better if she minors in the subject and majors in
From an economic perspective, ISAs are an equity-like
engineering, which has higher income prospects on
source of financing because students are effectively
average. As another example, the financing terms may sway
“selling” a claim to their future earnings in exchange for
a student to pursue a two-year technical degree over a
funding. The comparison that is occasionally made is that
traditional four-year degree given their desired career path.
of a company selling stock to finance business investment.
Equity can be well-suited to finance risky ventures such as
This feature of ISAs is popular among its advocates,
startups or higher education because no collateral is
because in their view students are being provided
required, repayment is dependent on the outcome of the
transparent market signals about the cost and return to
investment, and the equity investors bear the majority of the
students’ education and career decisions. On the other hand,
downside risk for the right to share in a potentially
it can be argued that such signals could reduce the number
significant return. College can be considered a risky
of students who may enter careers that generate social
endeavor even though the average return to graduating is
benefits beyond the private returns, or that some students
high because for any individual student there is the
may not be granted financing to pursue a particular college
potential of not completing school, earning a lower-than-
path.
expected income, or being unemployed at some point.
Comparison to Student Loans
Whether ISAs are perceived by students as an attractive
Student loans are debt, while ISAs are a form of equity
source of financing depends on the uncertainty they face
financing; the distinction can be critical. The structure of a
about their future income. For those who face a great deal
typical loan limits a lender’s return to the loan amount and
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An Economic Perspective of Income Share Agreements
interest. However, there is a chance that the lender will not
education or if there are social returns beyond those
recoup its initial investment since some borrowers will
realized by students who pursue certain careers.
default. As a result, private student loan lenders would
generally demand a high interest rate to compensate for the
Potential Policy Issues and Questions
risk of not being fully repaid, and this rate would likely be
Widespread use of ISAs would represent a significant
such that some students no longer find it financially
change to how students finance college. The change would
beneficial to attend college. This failure of private credit
raise a number of policy issues and questions Congress may
markets to fund investments in college with an otherwise
choose to address.
positive return is one of the principal rationales for
government intervention; by bearing some of the risk, the
Federal Student Loan Program. ISAs and federal student
federal government can offer loans with below-market
loans need not be mutually exclusive financing options.
interest rates, albeit at a cost, and fund educational
What changes, if any, would there be to the federal student
investment with a net positive social return.
loan program to respond to postsecondary education
financing through ISAs?
ISAs and federal student loans differ in how funding
amounts are determined. ISAs use risk-based underwriting
Federal ISA Program. ISAs are often heralded as a
to determine financing amounts, while the federal student
market-based solution to higher education financing. Would
loan program does not. Although the borrowing limits in
the federal government initiate its own ISA program? How
the federal student loan program vary depending on student
would the government determine the financing terms of the
dependency status, and whether the student is seeking an
ISAs it offers? Would federally sponsored ISAs compete
undergraduate or graduate degree, within those categories
with privately offered ones, or would they be geared toward
all students are eligible to borrow the same amount.
serving students with limited access to the ISA market?
Therefore, unlike with ISAs, the loan amount a student
qualifies for does not depend on the potential risk and
Regulation of ISA Industry. What aspects of the ISA
return of each student’s investment. There are at least two
industry would be regulated and by whom? What
potential consequences of this.
regulations would be needed to protect students from unfair
ISA practices? Would regulations prohibit the use of certain
First, in some cases students may be borrowing amounts
student characteristics in the underwriting process? How
that cannot be financially justified by the students’ future
would this affect the financing terms for participants? What
earning potential. Second, there is no market mechanism
limits would be placed on the securitization process, which
influencing the education and career decisions of students; a
can promote liquidity and risk sharing, but that can also
student who majors in a field with low projected earnings is
reduce the incentives to scrutinize ISA applicants?
eligible for the same financing terms as a student who
majors in a field with high projected earnings. This can lead
Indentured Servitude. It has been argued by some that
to a misallocation of scarce resources (labor and capital)
ISAs result in indentured servitude. Others argue that as
throughout the economy, currently and in the future.
long as investors are not permitted to influence or pressure
a student in any way once funds are provided, then students
Federal student loans and ISAs are also different under the
are free to make choices in their own interest just as with
routinely assigned standard repayment plan in the federal
student loans. How would policymakers ensure students are
student loan program. Under the standard plan, students are
free from investor influence?
required to repay their full loan amount in fixed payments
with interest over 10 years, similar to a fixed-rate mortgage.
Psychological Barriers. There may be psychological
Although a student borrower is never at risk of repaying
barriers to adoption of ISAs. Milton Friedman framed this
more than the principal and interest that accrues, they are at
issue as there being a potential reluctance to think of human
risk of becoming overly debt-burdened if their income is
capital investment as akin to physical capital investment.
too low. In comparison, students may repay more or less
College, however, is currently primarily financed with debt,
than the amount of funding they received under an ISA, but
which is also a major source of financing for investment in
their repayment burden is always a constant percentage of
physical capital by business and the government.
their income.
Legal Issues. What recourse would investors have to
The federal student loan program, however, offers several
enforce ISAs? What if a student changes major or careers?
repayment plans that depend on a student’s income after
How would ISAs be treated in bankruptcy proceedings?
graduation, and that forgive the remaining unpaid loan
Would ISAs be subject to securities laws in the same ways
balance after a predetermined number of payments have
that stocks, bonds, and other financial instruments are?
been made. These plans offer students protection against
low income similar to ISAs. Unlike ISAs, however,
Tax Treatment. The income generated by an ISA would be
income-based loan repayment plans never result in a
taxable to investors. As currently written, the tax code
borrower paying back more than the principal and interest.
would not provide a deduction for ISA payments similar to
Thus, the government bears the cost when the full loan
the interest deduction for some student loan payments. It
amount is not repaid under income-based repayment plans,
also appears that canceled ISAs would not be taxable as is
whereas it is private investors who bear this cost with ISAs.
the case with some canceled student loan debt. Congress
This cost to the government may be economically justified
could address the tax treatment of ISAs.
if there are market failures in the funding of higher
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An Economic Perspective of Income Share Agreements

IF11269
Mark P. Keightley, Specialist in Economics

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