Should 'Private Equity' Pay for Junior's College?

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"The counterpart for education would be to 'buy' a share in an individual's earning prospects: to advance him the funds needed to finance his training on condition that he agree to pay the lender a specified fraction of his future earnings. In this way, a lender would get back more than his initial investment from relatively successful individuals, which would compensate for the failure to recoup his original investment from the unsuccessful."

Think of it as making a student's four-year degree—and postgraduate pursuits—a kind of private equity deal with the government.

A Hedge Against the Luck of the Draw

Forget family income and wealth. Eliminate the need for taxing parental savings and the tortuous process of figuring out expected family contributions. Get rid of forbearance and deferment. Have the baseline method for paying for college come out of future earnings. The repayments would come through the progressive income tax system eliminating the need for much of the existing bureaucracy. Grants could be targeted at low-income students.

A system like this would allow graduates greater freedom to explore the job market. They would have some financial protection against the luck of the draw, such as graduating during the Great Recession. They would no longer have to worry about paying back their student loans if they had an accident or lost their job.

The proposal is far from radical: Such arrangements are already on the books. For instance, the Education Dept. ran a small income contingent loan program starting in 1995. It still exists, but a better product was offered beginning last year: an Income-Based Repayment program. The payments are capped at 15% of discretionary income, and any remaining debt is forgiven after 25 years. The House is considering a change to the IBR program for student loans after 2014 that would cap payments at 10% of discretionary income and a 20-year expiration date.

But a high-powered group of educators advocate going even further. The report from the Rethinking Student Aid study group published by College Board proposes a much broader expansion of the IBR, especially for low-income students.

Better yet, Australia already does a progressive tax-based repayment system. There's nothing wrong with stealing good ideas.

Mom & Dad Savings & Loan

Of course, there are many risks and pitfalls in a dramatic shift like this. Students with a clear desire for more lucrative careers may choose other ways to pay for their degree up front (tapping the bank of Mom & Dad, perhaps) so they don't end up facing high marginal tax rates later on. The cost of the program could balloon if it ends up attracting only students with low-income aspirations.

Students could end up feeling they traded their financial freedom as middle-aged adults for financial freedom when they were younger and naïve. The overall cost of a college education will balloon for those who pay small amounts year after year.

Nevertheless, the supply-side effects should more than compensate for the risks. The Obama Administration has ambitious goals to increase dramatically the number of young Americans with some form of college degree, from community colleges to private universities. It's classic supply-side economics. No one knows what the most in-demand jobs of the future will be. But having a ready supply of well-educated workers and entrepreneurs means having the kind of folks who can create new ideas, new markets, and new products.

Indeed, America's embrace of mass supply-side economics when it comes to education helps explains much of the nation's economic growth, including the Morrill Land Grant College Act of 1862, the high school movement in the late 19th and early 20th centuries, the 1948 GI Bill, and the 1958 National Defense Education Act.

The lesson of history is that more education is better than less. The lesson of the Great Recession is that America took on way too much debt. Let's turn away from borrowing and embrace equity financing in the nation's best and brightest. The investment will provide solid returns for the economy—and society.

Farrell is contributing economics editor for BusinessWeek. You can also hear him on American Public Media's nationally syndicated finance program, Marketplace Money, as well as on public radio's business program Marketplace. His Sound Money column appears on BusinessWeek.com.

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