Idea to consider: Human capital contracts

Dec. 31, 2002 at 4:46 PM
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WASHINGTON, Dec. 31 (UPI) -- Human capital contracts -- a novel but untested type of instrument for financing higher education -- could help attract more private money to the college financing sector and fill in existing gaps there, according to a recent paper from the libertarian Cato Institute.

"I see this as a potential revolution in the way you finance higher education," Miguel Palacios, a fellow at the Darden Graduate School of Business Administration at the University of Virginia and author of the report, told United Press International. "I think it is a much better way to finance education than other traditional methods."

In his paper, "Human Capital Contracts: 'Equity-like' Instruments for Financing Higher Education," Palacios says these contracts are a good way to address the clear need for new financing options in the face of the rising cost of higher education.

A human capital contract combines aspects of financial aid with aspects of an investment instrument: students enter into a contract with the financing source and agree to repay a fixed percentage of their income after graduation for a set time period in return for the money loaned.

Under such a system, the terms of the contract are individually tailored to each student based upon a host of factors including the school attended and earning potential in the student's field of study. For example, a person who takes a degree in art history might repay a smaller amount of money than a student who takes a business degree but borrows the same amount.

Palacios and other proponents of human capital contracts say that a major incentive is that students could save money over the cost of a government-backed fixed rate loan, but they acknowledge that there is a risk involved for the student as well as the investor, because the student's future income is an unknown variable.

Nevertheless, Palacios said he believes that the benefit of human capital contracts -- for students as well as investors -- is that they reduce students' uncertainty about their ability to meet fixed loan payments after graduation, and they virtually eliminate default.

He also noted that these instruments are more effective than student loans for attracting private capital to higher education financing, because investors can better spread their risk over a cross-section of students, with the potentially to gain a higher rate of return than they can in the student loan market.

The human capital concept was first proposed by economist Milton Friedman in 1955, and although there have been attempts to implement it in the United States since then, none has been terribly successful.

The most commonly cited example is Yale University's failed program that attempted to make a hybrid of income-contingent and more traditional loans to students.

In Australia, however, a government-backed system has been in place for a number of years, under which students repay the cost of college by returning a fixed percentage of their income to the government until the entire debt is repaid.

In contrast, human capital contracts are a private sector vehicle, and there is currently only one company in the United States offering such contracts, a firm called My Rich Uncle.

The firm has reportedly succeeded over the last couple of year in attracting limited investment capital but has completed only a small number of contracts compared to the enormous student loan market in the United States.

Another firm, Human Capital Resources Inc., has been pursuing the establishment of a mutual fund business based upon such contracts, but has been unsuccessful in gaining the changes in the tax code that they feel are needed to support the business. Palacios and other advocates say that the payments under such contracts should be made tax deductible in the same way the student loan payments are.

In addition, he says that other changes in the tax laws are needed to ensure that human capital contracts are fully recognized as securities, and get some of the same legal protections afforded to student loans.

Eric Hanushek, a senior fellow at the Hoover Institution, said that although the basic concept is a good one, there are a number of critical considerations that can determine whether such a system will be successful. For instance, the system would need to be able to collect and analyze an enormous amount of data addressing complex, many-faceted questions in order for such program to be successful, including information about school, student majors and other issues.

But the greatest problem with such contracts is the issue of adverse selection, Hanushek said. Students with potentially high earnings are less likely to be attracted to such contracts, because they could end up paying out more than they would under the relatively low interest rates provided with for government-backed loans.

It is also important to note that, statistically speaking, the lower wage earners would likely outnumber high wage earners because there are simply more people on the lower end of the wage scale in the United States.

"You would tend to get more people signing up for (human capital contracts) who are going to be low earners, and what they do is push up the repayment rate, essentially," said Hanushek. "I think there are attractive aspects of this plan, but its success rests on the willingness of some successful people to subsidize those who are not economically successful."

Palacios, however, said that the adverse selection problem can be adequately addressed through actuarial data, much in the way it is done by insurance firms.

"The way to face the challenge of adverse selection is to price every contract according to the different abilities of every student," he said, noting that a key to success is developing a repayment amount for each contract that best takes advantage of potential high earners without pricing them out of the market. For example, the low-earning graduate with a degree in art history might repay a smaller amount of his loan, which represents a significant portion of his smaller salary, while a high-earning business major might repay more of his loan, which would represent a smaller percentage of his greater salary.

Krista Kafer, a senior policy analyst at the conservative Heritage Foundation and a proponent of market-oriented answers to education policy problems, said that such private sector-centered ideas are needed in the realm of education funding, but that she is unsure about the likelihood for success with this model.

One aspect that could limit the success of human capital contracts is that only a third of students who go to college end up completing a degree of some form, she said. This limits the earning potential for a large portion of the market.

"I think (human capital contracts) are a good thing in that they can help more people get a higher education," she said. "But I wonder if investors will go for it."

Despite his enthusiasm for these instruments as an investment vehicle and a means to fund education, Palacios said he expects the difficulties in implementing the contracts will limit their potential impact.

He noted that human capital contracts are likely to remain a niche funding vehicle used by people to fill holes in the higher education financing, possibly even being used as a way to match gaps left between tuition costs and the amounts of student loans.

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