An investigation of education finance reform; graduate taxes and income contingent loans in the Netherlands

In this paper we analyse the consequences of replacing government subsidies with a graduate tax (GT) or income contingent loan (ICL) system for the financing of higher education. Both these systems are directed towards solving capital and insurance market failures.

We constructed an empirically based simulation model to analyse loans, GT's and ICL systems of education finance. We considered various financing regimes that differ in: i) the extent to which non-repayment or default risks are pooled or shifted towards society; and ii) the level of education subsidies.

We show that the switch to a GT or ICL system can significantly reduce the income risks that graduates would experience under an artificially constructed loan system. A reduction in government outlays of about 2.5 billion euro would result if education subsidies are dropped to zero. The tax rate in a GT would then have to be about 6% on average. In an ICL system with full risk pooling the repayment rate would be higher, ranging from 10% - 6%, depending on the size of the default/solidarity premium on the interest rate.

If default risks are shifted to society the repayment rate may be lower, but this goes at a cost of a smaller reduction in government outlays. Under a risk-shifting regime, the government encounters diminishing savings on outlays because reducing ex ante subsidies on education subsidies, increases the costs of default (ex post subsidies). Replacing ex ante subsidies with ex post subsidies makes the resulting distribution of incomes more equal because only those with low life-time incomes benefit from ex post subsidies. We discuss behavioural responses and policy implications.