Income Contingent Loans


Income contingent loans (ICL) are generally collected through the income taxation system and are repaid only when future incomes exceed a specified level. ICL were first introduced in Australia in 1989 to help college students finance their tuition costs; since then many countries have followed this policy approach. This background chapter analyses the conceptual and empirical basis of ICL, and explains that compared to ‘normal’ bank loans – which are paid on the basis of time – ICL provide the insurance benefits of consumption smoothing and default protection, and are associated with significant collection transactional efficiencies. We examine the prospect of the application of the basic principles of ICL into many other potential areas of social and economic policy, and highlight the significant ICL design difficulties related to both moral hazard and adverse selection.

1.1 Introduction and motivation

In 1988 an options paper was produced for the Australian government motivated to provide the basis for the reintroduction of university tuition fees (Chapman, 1988). The paper recommended an income contingent loan (ICL) for the payment of Australian university fees, to be operated through the income tax system and collected in periods in which the debtors’ income exceeds the average income of employed Australians. The proposal was legislated in 1989, remains in operation and is known as the Higher Education Contribution Scheme (HECS).

argent, billets de banque, bourse

As background, an ICL is a debt in which repayments depend on the income of the borrower. Because the collection institution needs to be able to assess with some accuracy the income of the debtor, the most obvious agency is the internal revenue service (IRS) (or tax office); it has both the legal jurisdiction to know citizen’s incomes, and the administrative apparatus to collect efficiently.

Since the Australian policy change ICLs for higher education financing have been adopted in several other countries2 , and there is active policy debate concerning their possible implementation in many additional countries in reforms of student loan schemes.3 Currently (in 2014) a bipartisan bill is under consideration in the US House of Representatives with the aim of replacing the US College loan system with an ICL.4 Over the last several years there has been burgeoning interest in the potential for policy reform for the adoption of ICL beyond higher education financing. Research on this possibility has traversed areas as diverse as the collection of criminal fines, drought relief policy, paid parental leave and R & D investments. Perhaps as many as 30 to 40 papers have been published on these types of ICL applications5 and several examples of the types of policy possibilities are examined briefly below.

This chapter has two distinct goals: to examine the conceptual basis and policy experience of ICL in higher education to lay the groundwork for a broader analysis of this type of instrument; and to clarify the circumstances in which ICL applied to social and economic policy reform beyond student loans would be welfare improving. Both are examined in turn. Section 1.2 explains the case for government intervention in higher education financing and compares and contrasts the two main approaches used internationally to address the market failure involved in human capital investment funding: government-guaranteed bank loans and ICL. The key characteristic of ICL, and their contrast with normal ‘mortgage-type’ bank loans, is that the collection of the debt is based on capacity to pay. The critical implication of this is that when and if debtors experience adverse economic circumstances they have no repayment obligations in that period. In contradistinction, typical loan schemes debt obligations are constant over time and are thus insensitive to a debtor’s financial circumstances. These distinctions mean that ICL provide:


(i) Consumption smoothing, since debtors pay nothing when incomes are low, and proportionately more when incomes are relatively high.

(ii) Insurance against default which would otherwise result from low income.

The chapter examines these issues and reports in summary some of the empirical evidence associated with the actual and potential effects of different types of student loan schemes in a range of countries.

Section 1.3 broadens the discussion of ICL to consider the conceptual basis of the instrument with respect to social and economic policy domains beyond higher education financing. In an important sense a major motivation is to begin the search for the answer to the question ‘while ICL seems to work in practice, would it work in theory?’ A simple way to begin the journey is to explore the conceptual and policy basis behind a small subset of ICL research applications, the original goal motivating the International Economics Association workshop that is the foundation for this book.

1.2 Student loans in international higher education financing

1.2.1 Introduction

It would be reasonable to describe the spread of ICL, essentially as a substitute for mortgage-type loans, as representative of a quiet international revolution in higher education financing over the last 25 years. What now follows explains the conceptual basis for an understanding of why this has been happening. Empirical evidence is summarised with respect to the major issue associated with non-ICL loan systems, the proportion of a debtor’s income required to repay the loan, with respect to around six countries. Australia’s experience with HECS is also documented.

1.2.2 Theoretical issues

A significant financing issue for higher education is that there is generally seen to be a case for both a contribution from students and a taxpayer subsidy (Barr, 2001; Chapman, 2006). An important question is: is there a role for government beyond the provision of the subsidy? An understanding of the issue is facilitated through consideration of what would happen if there were no higher education financing assistance involving the public sector. That is, a government, convinced that there should be a subsidy, could simply provide the appropriate level of taxpayer support to higher education institutions, and then leave market mechanisms to take their course. Presumably this would result in institutions charging students upfront on enrolment.

However, there are major problems with this arrangement, traceable in most instances to the potent presence of risk and uncertainty. The essential point is that educational investments are risky, because

(i) Enrolling students do not know fully their capacities for (and perhaps even true interest in) the higher education discipline of their choice. This means in an extreme they cannot be sure that they will graduate with, in Australia for example, around 25 per cent of students ending up without a qualification.

(ii) Even given that university completion is expected, students will not be aware of their likely relative success in the area of study. This will depend not just on their own abilities, but also on the skills of others competing for jobs in the area.

(iii) There is uncertainty concerning the future value of the investment. For example, the labor market – including the labor market for graduates in specific skill areas – is undergoing constant change. What looked like a good investment at the time it began might turn out to be a poor choice when the process is finished. (iv) Many prospective students, particularly those from disadvantaged backgrounds, may not have much information concerning graduate incomes, due in part to a lack of contact with graduates.


These uncertainties are associated with important risks for both borrowers and lenders. The important point is that if the future incomes of students turn out to be lower than expected, the individual is unable to sell part of the investment to re-finance a different educational path. For a prospective lender, a bank, the risk is compounded by the reality that in the event of a student borrower defaulting on the loan obligation, there is no available collateral to be sold, a fact traceable in part to the illegality of slavery. And even if it was possible for a third party to own and sell human capital, its future value might turn out to be quite low taking into account the above-noted uncertainties associated with higher education investments.

It follows that, left to itself – and even with subsidies from the government to cover the presumed value of externalities – the market will not deliver propitious higher education outcomes. Prospective students judged to be relatively risky, and/or those without loan repayment guarantors, will not be able to access the financial resources required for both the payment of tuition and to cover income support.

These capital market failures were first recognised by Friedman (1955) who suggested as a possible solution the use of a graduate tax or, more generally, the adoption of approaches to the financing of higher education involving graduates using their human capital as equity. The notion of human capital contracts developed from there and is best explained and analysed in Palacios (2004). A critical point for policy is that without some form of intervention higher education financing will not deliver the most propitious outcomes in aggregate, nor can such markets left alone deliver equality of educational opportunity because those without collateral (the poor) will be unable to participate.

Consequently, in almost all countries, governments intervene in the financing of higher education. As noted, there are currently two major forms that this intervention takes: government-guaranteed loans provided by banks, and ICL. What now follows examines some critical empirical findings with respect to both forms of assistance.

1.2.3 Country studies: repayment burdens with mortgage-type loans

The first type of higher education financing system involves governmentbacked loans provided by banks and is known as a mortgage-type arrangement in which loan repayments are made on the basis of predetermined amounts over a given time period. Currently this collection basis is used to help finance higher education in many countries, including the US, Canada, the Philippines and Thailand.

Since our main focus in a comparison of mortgage-type loan and ICL relates to the issues of insurance what now follows reports analyses of socalled repayment burdens (RB), the proportions of graduate incomes per period that need to be allocated to repay mortgage-type student loans. Education economists and others have examined the concept and implications of student loan repayment burdens for more than a quarter of a century.7 Defined simply in a comparative static context, an RB is, formally:

The attention given to RBs with respect to mortgage-type loans is apposite because the essential difference between bank loans and ICL is that the latter have RBs set at a maximum by law8 ; by contrast, RBs for mortgage-type loans are unique for each individual borrower and can in theory and practice be close to zero for high income debtors and even well over 100 per cent for very low income debtors.

RBs are very important to an understanding of the effects of mortgage-type student loan systems because the higher is the proportion of a graduate’s income that needs to be allocated to the repayment of a loan the lower will be disposable income. And lower student debtor disposable incomes have two adverse and related consequences: consumption hardship and higher default probabilities for student loans. There is arguably no more important aspect of the feasibility of a student loans system than the associated RBs


There is by now considerable empirical analysis of RBs associated with mortgage-type student loans in many different countries, 9 including with respect to Vietnam, Thailand, Indonesia, Germany and the US. An important and innovative aspect of this empirical work is that in all cases the calculation or simulation of RBs for graduates is done at different parts of the graduate earnings distribution using an unconditional quantile regression approach; this allows the impact of student loan repayment obligations to be revealed for all aspects of the gradate income distribution by age and sex, a major improvement over previous analyses which generally focussed on RBs at the means of graduate income distributions.