Latest / The Fiscal Policy Podcast with Fexingo: Government Budgets, Stimulus, and Public Spending / How the Government's Student Loan Cuts Higher Ed
Transcript
- Lucas: So there's a number that's been stuck in my head all week: forty-six percent. That's the share of all money spent on higher education in the US that now comes from federal student loans. Not tuition, not state funding, not endowments — loans. The government has effectively become the largest financier of college in America. Luna: And that's not new, but it feels like we're at a pivot point with the August rule changes. What exactly did they cut? Lucas: Right. The Department of Education announced a reduction in the interest rate subsidy on new subsidized Stafford loans for undergraduate students — from 4.99 percent down to 2.75 percent. That sounds like a win for borrowers, but the catch is they're also cutting the origination fee waiver and tightening eligibility for income-driven repayment. So the net effect is the government is pulling back its implicit subsidy. Luna: So it's not a single cut — it's a bundle of changes that together shift more cost onto students and their families. Lucas: Exactly. And the interesting part is the stated rationale. The Office of Management and Budget says the program's lifetime cost to taxpayers has ballooned to nearly two hundred billion dollars. That's because of defaults and income-driven forgiveness. So they're trying to shrink that exposure. But here's the twist: by cutting the subsidy, they might actually increase defaults, because borrowers now face higher monthly payments. Luna: That seems like a classic unintended consequence. Do we have evidence that's already happening? Lucas: Well, we have a natural experiment from the 2011 switch to direct lending. When the government took over from private banks, they initially kept the same subsidy levels. But then in 2013, they tied interest rates to the ten-year Treasury plus a markup. That made rates more volatile — and you saw a spike in default rates among for-profit college students, who tend to borrow the most and have the weakest earnings outcomes. Luna: And those for-profits are a big part of the story. They enroll about ten percent of students but account for nearly forty percent of defaults. So this cut might hit them hardest. Lucas: Yeah, and that's why some economists are predicting a shakeout in that sector. If the subsidy shrinks, for-profit colleges have less margin to absorb the cost, and they may have to raise tuition or cut programs. We've seen this movie before — the 2016 closure of Corinthian Colleges was partly driven by tighter federal oversight and reduced loan access. Luna: But let's step back — why does the government even subsidize student loans in the first place? What's the economic justification? Lucas: The classic argument is that college is a merit good — society benefits from an educated workforce and citizenry, so we should make it more affordable. There's also a capital market failure: private lenders historically wouldn't lend to students because they had no collateral and uncertain future income. So the government stepped in to fill that gap. That's been the logic since the Higher Education Act of 1965. Luna: So the subsidy is meant to correct a market failure. But how do you measure whether it's actually working? The government does a cost-benefit analysis on these programs, right? Lucas: They do, and it's called the 'subsidy rate' — the net present value of what the government expects to lose or gain on each dollar lent. For subsidized Stafford loans, that rate is negative, meaning the government expects to lose money. For unsubsidized loans, it's actually positive — they make a small profit. The issue is that the estimates are based on a discount rate set by OMB, and some critics say that rate is too low, which artificially inflates the cost. Luna: Right, so the cost-benefit math is pretty squishy. But the bigger question might be: does the subsidy actually achieve the goal of making college more affordable? Or does it just inflate tuition prices? Lucas: That's the Bennett Hypothesis — named after former Education Secretary William Bennett, who argued in 1987 that federal aid just gives colleges an excuse to raise prices. There's been a lot of empirical work on this, and the evidence is mixed. Some studies find a pass-through effect — for every extra dollar of aid, tuition rises by fifty to seventy cents. Others find no effect, especially at public institutions with state funding constraints. Luna: So if the subsidy is partly just feeding tuition inflation, then cutting it might actually put downward pressure on prices? Is that part of the administration's thinking? Lucas: Publicly, they've mentioned 'reducing the federal footprint' and 'encouraging cost discipline.' But the real driver is budget math. Under the current baseline, the student loan program is projected to add over one trillion dollars to the national debt over the next decade. They need to show deficit reduction, and this is one of the few spending areas they can touch without a fight in Congress. Luna: Because it's mandatory spending, right? So it doesn't go through the annual appropriations process. That makes it a tempting target for reconciliation. Lucas: Exactly. But here's the rub: cutting the subsidy might save money today, but it could cost more tomorrow in the form of higher defaults and lower college completion. A bachelor's degree still confers a significant earnings premium — on average, about eight hundred thousand dollars over a lifetime compared to a high school diploma. If fewer people get that degree because loans are more expensive, the long-term fiscal impact could be negative. Luna: So it's a short-term gain versus a long-term pain kind of trade-off. But what about community colleges? They're usually the most affordable option, but they're also the most underfunded. How does this affect them? Lucas: Community colleges are the real losers here, because they rely heavily on Pell Grants and state funding more than on student loans. The cut in subsidized loans doesn't directly affect their revenue, but it makes it harder for their students to pay for books, transportation, and living expenses. And we've seen that when students have to work more hours to cover costs, their completion rates drop. So this policy could push some community college students out entirely. Luna: And those are often the students who'd benefit most from a degree in terms of earnings mobility. So we're making the people who need the help the most take on more risk. Lucas: That's the core tension. The government is simultaneously the lender, the risk-taker, and the safety net. When it pulls back on the subsidy, it's saying 'we don't want to bear as much risk,' but that risk just gets shifted onto students and families — who are the least equipped to handle it. Luna: And then there's the political economy angle. Who actually benefits from the subsidy? Is it the students, or is it the colleges and the lenders who've historically made a killing off these loans? Lucas: Well, before 2010, private banks like Sallie Mae were guaranteed a rate of return on student loans — they made fat profits with zero risk, because the government covered the losses. That was a huge giveaway. Now that the government lends directly, the 'lenders' are the taxpayers, and the subsidy is meant to lower the cost to borrowers. But the evidence suggests that a good chunk of that subsidy gets absorbed by colleges in the form of higher tuition — especially at for-profits, which have also been accused of aggressive recruitment tactics. Luna: So the subsidy is essentially a transfer from taxpayers to colleges, with students caught in the middle. That's a bleak way to look at it. Lucas: It's not always bleak — there are well-managed institutions that use federal aid to keep tuition flat. But the incentive structure is perverse. If you're a college president and you know the government will lend students up to a certain amount, why not raise tuition to capture some of that? That's the Bennett Hypothesis in action. Luna: And this is a global issue too, right? Other countries have different models — like Australia's income-contingent loans or Germany's free tuition. How does the US compare? Lucas: The US is an outlier. We spend more per student than almost any other developed country, and we rely heavily on loans rather than grants. Australia's system has a repayment rate that's tied to your income — so you only pay when you can afford it, and the government absorbs the risk of low earners. Germany scrapped tuition altogether. We're the only major economy where college costs are as high as a mortgage. Luna: So when the government cuts the subsidy, it's not just a budget decision — it's a statement about who should bear the cost of higher ed. And right now, that's falling on students. Lucas: And that's why this policy feels so short-sighted. We're trying to reduce the deficit by making college less affordable, but we're likely to end up with a less educated workforce, lower earnings, and ultimately less tax revenue. It's a fiscal own goal. Luna: Let's zoom out for a second. There's a lot we've covered here, and I think one of the things that strikes me is how this connects to the broader theme of government as an investor. We often talk about the government using taxpayer money to build roads or fund research — but student loans are a form of human capital investment. And when you cut that investment, you're saying something about your priorities. Lucas: Exactly. And it's not just about the budget line item — it's about the signal. If the government is unwilling to invest in people's education, that sends a message to the private sector too. A lot of businesses are already complaining about skills gaps, but they're not going to fill that gap if workers can't afford the training. Luna: So what would a smarter policy look like? If you had a magic wand, what would you do differently? Lucas: I'd focus on outcomes-based funding — tie federal aid to completion rates and earnings, not just enrollment. And I'd expand income-driven repayment, but cap the total amount borrowed at the undergraduate level, so the subsidy goes to the students who need it most, not to fund a lifestyle for someone who should be at a state school. Luna: That's a big idea. But I guess we're stuck with the current system for now. So what's the one thing you want listeners to take away from today's episode? Lucas: That the student loan program is a multibillion-dollar tool of fiscal policy that shapes who gets a degree and who doesn't. And when the government cuts the subsidy, it's not just a budget number — it's a bet that people will still go to college anyway. I think that's a risky bet. Luna: And if that bet doesn't pay off, we all end up paying for it in one way or another. Thanks for listening — and hey, if you want to help us keep having these conversations without ads, you can support us at buy me a coffee dot com slash fexingo. It really does help. Lucas: Yeah, a few listeners do that each month and it keeps the lights on here. Appreciate it. But back to the economics — there's another wrinkle I think we should mention. Luna: What's that? Lucas: The timing. These rules take effect for the upcoming academic year, which starts in just a few weeks. So current students and families are already making decisions based on the old rules. That creates a lot of confusion and, frankly, a bit of chaos on campuses as financial aid offices scramble to figure out the new numbers. Luna: Yeah, that's a real logistical nightmare. But it also means the full impact won't be felt for a few years. So we're in a waiting period where we'll see if the default rates actually spike. Lucas: And that's the data I'll be watching closely. If defaults rise, we'll know the policy backfired. But if colleges adjust their pricing and students still enroll, maybe the subsidy wasn't doing as much as we thought. Either way, it's a natural experiment in real time. Luna: And it's a reminder that fiscal policy is never just about the numbers — it's about people's lives. Lucas: Very true. Well, that's a good place to leave it. Thanks for joining us on this deep dive into the economics of student loans.