Ed Money Watch

This week, The College Board released its annual Trends in College Pricing and Trends in Student Aid reports for the 2012-13 school year. This year, the headline of the reports has been that 2012-13 in-state tuition at public four-year colleges rose from last year’s tuition levels at a slower rate than it did in the previous two years. (Even that comparison fails to note the real news, though, that tuition rose by more than three times inflation this year. See this post from our sister blog, Higher Ed Watch, for more.)

Given that lawmakers are sure to plunge into a deficit-cutting frenzy after the November elections to avoid the across-the-board spending cuts set to take effect in January, the Student Aid report buries a key development in student aid trends. In 2010 (the most recent year for which data are available), the federal government spent some $3.5 billion more on education tax credits than the year before – a rapid rate of growth.

These so-called tax expenditures are a rarely noted, but highly significant, part of federal education spending, particularly for higher education. They go largely unnoticed in education funding debates because they don’t look like spending to the untrained eye. But in every way that matters, they are just like spending on Pell Grants or student loans. Yes, education tax benefits provide savings to families, but in the form of foregone tax revenue for the federal government. Therefore, they factor into the federal balance sheet as a cost, even though they’re less visible to policymakers and the public than appropriations.

So what’s behind the big increase in this form of federal education funding? For one, the American Opportunity Tax Credit (AOTC). This new benefit was created in the 2009 stimulus bill to provide additional tax relief to middle-income and lower-income families and policymakers extended it beyond its original expiration date to the end of the 2012 calendar year. Meanwhile, the Hope credit, a smaller credit that includes more income restrictions, was suspended until the AOTC expires.  According to the report, the total amount of tax credits and deductions before the AOTC took effect was $7 billion (adjusted for inflation). After, it jumped to $15.4 billion. By 2010 it had climbed to $18.8 billion.

The Trends in Student aid report also shows that, when those who claim the AOTC are mapped by their adjusted gross income (AGI refers to total income minus pre-tax benefits like health insurance premiums or 401k contributions), a substantial portion of the dollar total – 23 percent – went to families with incomes over $100,000. Meanwhile, only 24 percent went to low-income families with an AGI below $25,000.  Even worse, only 3 percent of the 1.2 families who claimed the tuition and fees deduction in 2010 (down from 3.0 million in 2008) were those low-income families.

When the dust settles from the elections next month, Congress will return for a quick session to finish out the year before the newly-elected members of Congress take their seats.  At the top of the agenda are two urgent items: extending the tax expenditures already in place before the expire at the end of the calendar year, and resolving the 8.2 percent across-the-board discretionary spending cuts before they take effect on January 2, 2013.  Millions of families reap substantial savings from the credits and deductions available to them, and changes to the expenditures might be unpopular. But the College Board report shows what many in Congress already recognize: The tax expenditures for education and other fields are big-ticket items on par with regular appropriations, and are benefiting families that could hardly be described as needy. That makes them ripe for the kind of large-scale deficit reduction Congress needs to reach a compromise.

Last week, the New America Foundation released the policy paper Safety Net or Windfall?: Examining Changes to Income-Based Repayment for Federal Student Loans, which demonstrates that the Obama Administration’s pending changes to the Income-Based Repayment plan for federal student loans, called Pay As You Earn (PAYE), will provide windfall benefits to high-debt, high-income borrowers and could allow graduate and professional schools to raise tuition with impunity. The report also recommends that the Obama Administration make a few tweaks to its proposed changes to IBR before the regulations become final in the coming weeks.

If the Administration allows the pending regulations to take effect without addressing the benefits that the plan will provide for high-debt borrowers, it could jeopardize the integrity of the IBR plan. Even though the IBR plan provides important benefits to struggling, lower-income borrowers, the media and the public may come to view the entire IBR as just another way that government programs are rigged to help the most well-off rather than the most needy.  

Below are the common-sense recommendations from the recently-released New America Foundation paper. The Obama Administration should adopt these recommendations as an easy way to fix the windfall benefits and perverse incentives in the pending IBR regulations.  

Recommendation #1: Maintain the lower payment calculation (10 percent of AGI) in New IBR, but only for borrowers with AGIs at or below 300 percent of the federal poverty guidelines ($33,510 for a household size of one). Borrowers with AGIs above 300 percent will pay according to the Old IBR formula (15 percent of AGI).

Justification: This change targets the benefits of lower monthly payments under New IBR to lower-income borrowers only. Borrowers earning more, while still eligible for IBR, must make payments based on the Old IBR formula. While the savings that New IBR provides to lower-income borrowers are less than they are for higher-income borrowers, this recommendation would still allow borrowers who are the most likely to struggle to make payments with the added relief offered by New IBR. Additionally, by requiring borrowers with incomes above 300 percent of the federal poverty guidelines to make monthly payments based on 15 percent of their AGIs, it is much less likely that high-income borrowers will receive loan forgiveness. It also allows borrowers with lower incomes to benefit from the 10 percent rate that New IBR offers, but ensures that they will repay those benefits by paying at a higher rate if their incomes increase later.

Lastly, those borrowers with AGIs above 300 percent of the poverty guidelines will likely have total incomes that are markedly higher than their AGIs because they are able to make pre-tax benefit payments, contribute to retirement savings, and take larger above-the-line deductions. Imposing a higher payment calculation (15 percent of AGI) on these borrowers compensates for their significantly lower AGIs relative to their total salaries.

Recommendation #2: Maintain the loan forgiveness threshold from New IBR (20 years), but only for borrowers whose loan balances when they entered repayment do not exceed $40,000. Borrowers with higher initial balances would qualify for loan forgiveness after 25 years of repayment, the same as under Old IBR.

Justification: Like the first recommendation, this proposal would maintain the more generous benefits of New IBR, but not for all borrowers. A two-tiered loan forgiveness system based on initial debt levels would keep the 20-year loan forgiveness targeted toward borrowers who have debt from undergraduate studies or moderate amounts of debt from graduate studies and who struggle to repay. By creating a longer loan forgiveness threshold for borrowers with debt levels above $40,000, this recommendation also reduces the tendency that New IBR has to provide loan forgiveness to high-income, high-debt borrowers when they are most able to make higher payments on their loans for a total of 25 years. This two-tiered approach would discourage graduate and professional schools that charge high tuitions and their students who borrow federal loans from using IBR as an indemnification tool.

Recommendation #3: Eliminate the maximum payment cap. Borrowers must always pay based on the IBR income formulas, no matter how high their incomes are. Additionally, borrowers may not opt to enroll in another repayment plan once enrolled in IBR.*

Justification: The maximum payment cap targets IBR benefits to higher-income borrowers either by reducing their monthly payments, increasing the amount of loan forgiveness they receive, or both. It can also increase the chances that a borrower earning a very high income (over $200,000) would qualify for loan forgiveness. Lastly, requiring that borrowers stay in IBR for the duration of their repayment term once they enroll will ensure that borrowers who used IBR when their incomes were low will pay commensurately higher payments should their incomes increase—this helps offset some of the initial costs the government incurred when the borrowers benefitted from low payments while their incomes were lower.

Recommendation #4: The U.S. Department of Education and policymakers should be forthcoming about the negative consequences borrowers may face when repaying through IBR. The Department should promote the consolidation repayment option as another alternative that borrowers have to reduce their monthly payments and extend their repayment terms, particularly given how similar IBR is to the consolidation repayment plans for many types of borrowers. The Department should provide borrowers with illustrative examples of how paying off their loans more slowly could increase what they pay and provide clear warnings. Private companies servicing federal student loans should clearly indicate to borrowers how much interest accrues on their loans when they repay through IBR and how that is likely to increase the repayment term and total interest costs they will pay. Policymakers should also make consolidation less onerous for borrowers; currently, it requires significant paperwork and effort to enroll.

Justification: Some policymakers and student aid advocates have promoted IBR with hardly a mention of the financial risks it poses for borrowers (those risks exist for Old IBR, the only plan in which borrowers have enrolled to date, though New IBR entails far less financial risk for borrowers with debt levels that exceed $20,000). Borrowers may save little per month under IBR and end up paying more and for longer due to the added interest costs. Borrowers do make a trade-off in choosing IBR over other repayment options, and loan servicers and the U.S. Department of Education should ensure that borrowers are informed of those trade-offs. 

Recommendation #5: IBR payments for a borrower who is married but files a separate income tax return should be based on the household’s combined AGI. The program currently allows borrowers to file separate income tax returns and use only the borrower’s income to calculate payments under IBR. This policy should include an exception for cases where both spouses are making payments on federal student loans under IBR. In that case, each borrower’s loan payments should be based on one-half of household income.

Justification: Married borrowers with low individual, but high household incomes can still qualify for IBR (including loan forgiveness) by filing a separate income tax return. If these borrowers also have children, they can significantly increase the benefits they earn under IBR by claiming the children as dependents on their own federal income tax returns since it increases their household size and the poverty exemption they receive under IBR.** This provision is another way in which higher-income borrowers (based on household income) can qualify for generous benefits under IBR. Ending this provision will ensure that the program’s benefits are targeted to borrowers who need the most assistance. The exception for couples in which each spouse is repaying a federal student loan will ensure that borrowers in a two-borrower household do not each have to make payments on their loans on their combined incomes—which would essentially be double-counting their incomes.

Recommendation #6: Make loan forgiveness tax-free using budgetary savings that arise from the other recommendations outlined above.

Justification: Federal tax law treats loan forgiveness under IBR (except when provided for public service employees) as taxable income. Borrowers who receive loan forgiveness (under an IBR that reflects the recommendations outlined here) will likely have experienced some degree of financial hardship. Therefore, they are also likely to struggle with what could be a relatively large tax bill in the year they receive loan forgiveness. If IBR is meant to aid this type of borrower, then it should not impose its own type of financial burden on them.

Recommendation #7: Allow all borrowers to enroll in an IBR that reflects these recommendations. Do not limit it to new borrowers. Use the savings that would arise if policymakers implemented all of the recommendations listed above to offset the incremental costs of this recommendation.

Justification: Old IBR is available to all borrowers, but Congress and the Obama administration have limited access to New IBR to more recent borrowers to reduce the cost of the program. The recommendations outlined above would preserve some of the benefits of New IBR, but target them to those borrowers with more financial need, thereby reducing the cost. The recommendations would further reduce costs by limiting benefits to higher-income borrowers compared to even Old IBR. Therefore, policymakers c­­ould open the program to all borrowers at little or no incremental cost to taxpayers, and a greater number of borrowers would gain access to lower repayments and earlier loan forgiveness.

Yesterday, the New America Foundation’s Federal Education Budget Project released Safety Net or Windfall?: Examining Changes to Income-Based Repayment for Federal Student Loans, a report detailing how pending changes to the Income-Based Repayment (IBR) plan for federal student loans will affect different types of borrowers. The New York Times highlighted the report and noted that other policy experts agree with the report’s findings – namely that high-debt borrowers will receive the biggest increase in benefits even if they earn a high income. But one of those experts, FinAid.org founder Mark Kantrowitz, also called into question the way some of the numbers in the paper were calculated.

We would like to set the record straight with regard to Kantrowitz’s criticism. We have confirmed with student loan servicers, correspondence between student loan servicers and the U.S. Department of Education, and a careful review of the federal statute, that our analysis and calculations are, in fact, accurate.

The disagreement referenced in the Times arose over how borrowers’ payments are credited to outstanding loan balances under IBR.  According to the legal statute, a borrower’s payments must first go to any unpaid interest, before payments go to pay down the original loan (the principal). FinAid.org hosts an IBR calculator that in some cases erroneously credits a borrower’s payments not to owed interest, but to principal. The New America Foundation calculator follows the IBR statute and always credits payments to any interest owed before it applies it to the principal.

That distinction makes a significant difference in how much a borrower owes over the life of his loan and how much loan forgiveness he receives. To understand how this happens, let’s quickly review how borrowers repay their loans through IBR.

Because a borrower makes payments based on his income under IBR, it is possible that his payments are too low to pay off the full amount of interest that accrues on his loans each month. For example, a borrower with $145,000 in loans and a starting salary of $75,000 who enrolls in the new IBR program (set to take effect around the end of 2012) will pay $485 a month, not enough to cover the interest that accrues. So by the end of the first year, he has $4,144 in unpaid accrued interest.  While that unpaid interest is not added to his loan balance as long as he qualifies for IBR—he isn’t charged interest on the interest—he still must pay it before he can pay off the principal balance on this loan. 

Assume then that the same borrower’s income jumps to $150,000 in his eighth year of repayment. He still qualifies to repay through IBR at that income level, but his monthly payment is greater than the interest that accrues each month. What happens to the excess payment, the portion of the payment that more than covers one month’s interest? Is it credited to the accumulated unpaid interest from prior years, or is it instead credited to the original $145,000 loan, the principal?

According to the statute mentioned above, the excess payment must first go to the unpaid interest. Correspondence between student loan servicers and the U.S. Department of Education, as well as a careful interpretation of the law, confirm that this is how the servicing companies have been instructed to administer the IBR program. All unpaid interest must be paid off before the borrower’s payment can begin to reduce the $145,000 principal balance on his loan. To read the statute yourself, check out §493C(b)(2) of the Higher Education Act, or 34 CFR 685.221(c).

A calculator that credits the borrower’s payments to the principal balance before it credits the payments to the unpaid interest from prior months will severely under-estimate the total amount a borrower will owe over the life of the loan. It shows that a borrower’s principal will decrease at a faster rate than it actually would as that borrower repays through IBR. At the same time, it shows that the borrower will owe less interest over time, as well, because that interest accrues on a smaller amount of principal.

Thus, the FinAid calculator understates the total interest that the borrower will owe or have forgiven in certain circumstances. In the scenario outlined above, the FinAid calculator shows that the borrower has $56,947 forgiven. But the correct figure is actually $94,634, as shown by the New America Foundation calculator. (A spreadsheet is available here showing the full calculation using the New America Foundation IBR calculator.)

The confusion makes one thing obvious: Income-Based Repayment is so labyrinthine in its many nuances and rules that even researchers struggle to understand every component. That said, the New America Foundation calculator –and the findings in our report – accurately reflect how the IBR program works.

As I wrote last week on Ed Money Watch, states are so concerned over Common Core implementation that many have not established the necessary policy structures to ensure the effort will deliver on its college- and career-ready promise. Most states have adopted curriculum standards that incorporate the knowledge and skills students need to meet postsecondary expectations, and two state consortia, PARCC and SmarterBalanced, are developing assessments that accurately measure student mastery of these competencies. But the majority has only begun to fight the battle for performance standards that inform high school graduation policies, school and educator accountability systems, and higher education admissions and placement decisions.

Adopting college- and career-ready performance standards for high school graduation will be particularly challenging because it requires intense coordination between K-12 and higher education when the Common Core is largely perceived as a K-12 initiative. Given the substantial resources invested by states, the federal government, and corporate and private philanthropy, Common Core supporters should be alarmed by postsecondary institutions’ ambivalence toward Common Core, especially because the initiative faces stiff competition.

Despite the PARCC and SmarterBalanced hysteria, the SAT and ACT – along with their remedial placement cousins, ACCUPLACER and COMPASS – are likely to continue to serve as the de facto performance standard for college entry. These assessments are already accepted within higher education, for better or worse, while the Common Core will be greeted with scrutiny and suspicion at many institutions.

Further, some states, like Kentucky and Alabama, have not been waiting for the new tests to arrive. Instead, they are using ACT’s assessment system to measure students’ postsecondary readiness in high school now. This is a logical, smart response to the demand for college-ready students, since it will be three years before the Common Core tests are fully ready. But, it could be even more challenging to transition to Common Core benchmarks now that these states have institutionalized the ACT benchmarks.

More significant, ACT and College Board are positioning themselves to directly compete with the Common Core – and win. Rather than collaborate with PARCC, ACT announced its own next-generation assessment system, which is aligned to Common Core and includes formative and summative assessments offered from elementary to postsecondary. Similarly, the College Board’s incoming president and Common Core architect, David Coleman, has big plans for the SAT, “transforming it from an aptitude test intended to control for varying levels of school quality, to a knowledge test aligned with the Common Core.” And don’t forget about College Board’s increasingly-popular Advanced Placement exams, offering students an edge in the admissions process and accepted for credit at many institutions.

But what about the COMPASS and ACCUPLACER? Since the majority of students attend non-selective colleges, these remedial placement exams are often the real barrier to entry in higher education. Students identified for remediation are much less likely to complete their degree. Although neither ACT nor College Board has formally announced changes to these assessments, if their plans for the ACT and SAT are any indication, both organizations will act to align their remedial tests to the Common Core, building the case further for higher education to stick with what they know.

If this is the case, in five years it’s likely that students in many states will need to pass PARCC or SmarterBalanced tests to graduate high school, and schools and teachers will be evaluated on how well their students perform on these tests. But students will also need to ace the SAT and their AP exams to get into a selective college and pass the ACCUPLACER to avoid remediation in their local community college – just as they do today.

Would this mean the Common Core ‘failed?’ Hardly. Establishing common curriculum standards in forty-six states and two comparable, high-quality assessments of these standards is no small feat. The Common Core is a vast improvement over most state standards and tests currently in use. And its development required a tremendous amount of work and dedication from state policy leaders, educators, and advocates. But it could be so much more.

Unfortunately, there isn’t a readymade solution to offer, although uniform remedial placement policies based on K-12 performance standards are a good starting point for states. Still, Common Core supporters must begin to look beyond the implementation challenges within K-12 education and focus more of their attention where college readiness is ultimately determined: the postsecondary admissions and placement process dominated by the SAT and ACT exams. If they don’t, odds are on the existing players – the College Board and ACT – to carry the day.