Big news this past week. A large scale student loan relief program. Let’s not dwell too much on the numbers, with estimates that start around $300 billion and gets closer to around $500 billion in relief, but instead think through the impact on the behavior of individual households. That is, what will I do and what will others do in response to this policy?
A Little Economic Model
Sometimes it really helps to take a complex issue and simplify it to get to a core idea. Then we cab go back to reality, using the core idea as a starting point. To do so, suppose there is an economy in which everyone is the same (a bit boring) and everyone lives forever (good news).
In this economy, individuals have some debt outstanding to the government, from some loans taken out in the past. We will come to the reason for borrowing later. So individuals make two types of payments to the government: (i) paying interest and principal on their debt and (ii) tax payments on income earned.
There is a government that collects taxes as well as the repayments on these loans and spends, say on bridges and dams to make matters concrete. The government also pays interest on its outstanding debt.
Notice that the government does not exist independently of the individuals in this economy. It is just a “tool” to engage in fiscal exercises of taxes and spending and borrowing on behalf of us all.If spending exceeds taxes and loan repayments, then the government runs a deficit and issues more degt to finance it. This government also is powerful enough at any point to change taxes and to provide relief on the payment of student loans. For now, let’s not touch those bridges and dams!
Consequences of Debt Relief
So what are the consequences for the government and for citizens of this economy if a large chunk of the debt outstanding is forgiven?
In the best of all worlds, the answer is simple: nothing! In particular, the debt relief does not create an incentive for people to spend more.Think of it this way. In each period, after the debt relief each individual has a lower loan repayment to make. So far, that is the good news we hear! But, there is a cost to this. If the government is not going to reduce its expenditures, then the lost revenue must be recovered. That will happen either by raising taxes now or in the future. Remember we agreed not to touch the bridges and dams.
If the government raises the revenue by increasing taxes now, then it should be clear why the answer above is “nothing”. For every dollar of loan reduction, there is an increase in one dollar of tax obligation. This is true for all of us since we are all the same. So instead of making a loan repayment, you make a tax payment. In terms of the flow of funds between you and the government, this is just a wash. If you look at income less interest payments on loans and less taxes, the individual has the same amount of resources available. This makes a lot of sense once you recognize that debt relief just passes the obligation from those who owe the debt to those who pay the taxes. In our simple world, those are the same people! In effect, you borrowed for yourself and from yourself when you took out the loan.
What if the government does not raise taxes at the same time it provides debt relief, but instead issues new government debt to finance the increased deficit? Issuing more debt is just a way to put off the taxation: eventually the increased debt will be paid off by taxes. If individuals anticipate this future tax bill, then they will save the entire amount obtained from the debt relief to meet this future obligation. So even without raising taxes today, the debt relief does not lead anyone to spend more, it is all saved. Again, nothing happens.
Sounds a bit too good (or too bad depending on the outcome you are looking for) to be true. So yeah, as usual, there are some caveats.
Think about the taxes. In an ideal world, the taxes we impose are lump-sum. This means that no matter what choices the individual makes, they pay the same amount of taxes. In this way, if the government changes the amount of taxes it collects, this has no effect on people’s decisions to work, to save, to start a business, to go to college, etc.
But every April 15 we are reminded that this is not the case. There is an income tax that household’s pay where the tax is not lump-sum but is a proportion (increasing in income) of what you earn from working and other sources of income. Changes in taxes are distortionary: if the government raises the (marginal) tax rate on some activity, households will do less of that activity. In this case, eliminating some debt and replacing it with a tax will impact all those decisions, not just how much someone works. So the “nothing” becomes a “something”. The size of the economic pie is impacted by this policy. What the effects are will depend on what taxes are changed etc.
A second caveat goes back to this ideal world in which everyone is the same and we live forever. Of course, there are vast differences among us, partly due to our different ages (and thus position in the life cycle) and partly due to differences in our DNA.
Why does this matter? Well go back to the student debt relief. Here are some important differences. First, not everyone in the economy went to college or is going to college. This depends in part of where you are in the life-cycle. Second, of those who did go to college, not everyone borrowed. Third, of those who borrowed, some repaid their debt already, not knowing that debt relief was just around the corner.
So, in the end, unlike the ideal world described earlier, those who benefit from the student debt relief are a select group. But the taxpayers whose taxes are raised (either now or later) to pay for the lost revenue are a very different and much larger group.
What this means is that a big part of the effects of the student debt relief has to do with redistribution. Resources flow from those who pay the taxes to those with the outstanding student debt.
If the taxes that must be raised were not distortionary, then this would just be an exercise in pure redistribution. But with distortionary taxes, there is a resource cost to the added tax burden.
It is interesting, even for economists, to see if people understand the link between student debt relief and taxes. Because I lived in his district in Pa., I got an email survey from Congressman Glenn Thompson asking:
“Do you agree with the decision to have the American taxpayers bear the cost of student loan debt for qualifying individuals?”
I am interested to see the responses.
Education Choices
One final, but I think important, point relates to the effects of all of this on education choices. It relates to the point above about distortionary taxes.
Economics like to use the terms ex ante and ex post, meaning “before the event” and “after the event” respectively. That distinction is super important here.
After someone’s decision to go to college and to borrow or not, they are in a situation of repaying any outstanding debt.
If there is debt relief, this has no effect on their college decision since the debt relief is ex post. So, unlike the labor tax, there is no distortionary effect of the debt relief on the education decision. Clearly debt relief does not matter for the education decisions of those who are done with higher education.But matters are very different ex ante. If you are now thinking about going to college and figuring out how to finance that expense, what do you think about the costs of borrowing? In particular, does the fact that there was student debt relief this year change your view of whether there will be further student debt relief when it is your turn to repay your debt? If so, then the cost of going to college is perceived to be lower and we would expect college rates to increase. Or, perhaps you will think that the student debt relief today will continue for a few years and then end. This may still impact your college choice since you could anticipate a higher tax bill once you finish college and have a job. This reduces the return to going to college as long as tax rates rise with income.
This is just another example of the importance of beliefs surrounding government interventions. The government takes an action today in the form of student debt relief. That is tangible. But what action is it taking with respect to future student debt relief? That is left unclear. Individuals are left to make decisions using their beliefs about future government actions.
Did they think of all of this?
Here “they” are the folks who decided to undertake the debt relief. Probably not. From what I have read, it sure sounds like debt relief helps out “some folks” without impacting others.
But clearly this is not consistent with the constraints faced by governments. Let’s see what the outcome is of Congressman Thompson’s survey to better understand if the people understand these connections.It may seem a bit odd for us to owe the government based on our borrowing and at the same time for us to lend to the government. Seems like it should all cancel. Actually, that is part of the point!
The low estimate of the relief of $300 billion is 18.75% of the total student debt outstanding according to the Federal Reserve Bank of New York. As far as I can tell, this is a fraction of public debt. There is also private debt outstanding which is a much smaller amount.
Here I just talk about college but a large amount of the student debt is associated with advanced professional schools, such as law and medical.
A tweet by an Ohio state representative says it well “Student debt cancelation isn’t paid for by the taxpayers, the federal government is the lender.”