I’ve been making a few claims regarding the fact that we really don’t understand what to expect from the proposed changes to HECS. I had a couple of people in my office today, chalk-in-hand, trying to explain some of the distortions that we may expect. Here is a simple example.
Consider a university or private institution offering two courses A and B. Each course is a lottery promising income after graduation:
- Course A gives students an income of $80k for sure. It’s a safe course.
- Course B gives students a 50/50 chance of getting an income of 40k or 120k. The risky course.
The university sets a price for each course, PA and PB, respectively. For simplicity we assume that the university is willing to provide these courses to anyone who agrees to pay the price that they set. So here we are thinking that supply is perfectly inelastic (in the region relevant to us). What prices does the university set?
- If students pay upfront fees, then taking into account risk aversion by students it will certainly be the case that PA> PB. So the safe course will be priced higher than the risky course, which is what we expect in the usual asset pricing models.
- Suppose instead that HECS is available to students. So students get the government to invest in their human capital, by paying the price of the course, and repay this as a percentage of ex post income. However, if they make less than 50k, they pay nothing back to the government. Because courses A and B lead to the same expected income, students under HECS value the risky course more than the safe course. Universities will then charge a higher price for the risky course than the safe course and PB > PA. Essentially, the government foots the insurance bill for course B.
This simple example illustrates the complexity of HECS in the presence of uncertainty. It is a complex financial derivative/insurance scheme that in an uncapped setting is likely distortionary and is not well understood. If the proposed changes introduced in the budget go through, then I expect that private universities will likely want to setup a bunch of risky courses, say a Design degree or Contemporary Film Making, taking advantage of the income insurance afforded to students by the government. Universities will likely undervalue safe courses like Physics teaching degrees and may find it profitable to shift to risky courses.
The “skin in the game” proposal made by Rohan Pitchford and myself (in an earlier post here) , I think, has the potential to mitigate these kinds of distortions.