Income Based Repayment Is One Sick Puppy

“There’s not enough work for veterinarians,” NPR’s All Things Considered told us this week. The New York Times was onto the same story six months ago with the headline “High Debt and Falling Demand Trap Vets.” In other words, there’s a mismatch in the supply and demand for veterinarians, vet school is expensive, and students leave with lots of debt. NPR says that puts vet schools “in a bind – tuition money on one side, market realities on the other.” Or does it?

Thanks to the federal Income-Based Repayment program for student loans (what the Obama administration calls Pay As You Earn) it’s much easier for graduate and professional schools to charge tuitions that far outstrip what even a successful graduate could expect to repay based on his earnings. The new Income-Based Repayment (IBR) caps a borrower’s payments based on a share of his income and he never pays beyond 20 years. Because of that design, his payments have a maximum limit regardless of how much he borrows. (Graduate students can take out federal loans to pay for the entire cost of their education as determined by the school they attend.)

It turns out that for veterinary schools tuition is already so high that most graduates have borrowed well beyond the point at which borrowing more actually increases what they will have to repay on those loans – with one very important caveat. More on that later.

Consider a vet who earns a salary over the next 20 years that is greater than 75 percent of vets in his age group. Once he accumulates $105,000 in debt while in school, any additional amount he borrows is forgiven under the New Income Based Repayment program after 20 years of payments. He could borrow $150,000, $190,000 or more, but he makes the same monthly and total payments over the next 20 years had he borrowed only $105,000. See table.

Here is the kicker. According to the American Veterinary Medical Association, 70 percent of graduates leave school with more than $105,000 in debt today. And remember, the point at which a vet student stops incurring a cost for borrowing more in federal loans – $105,000 – was calculated for high earning vets, those making more than 75 percent of their peers, not the average.

Now for the important caveat. The federal government taxes any debt that it forgives at the 20-year mark. Even though a borrower makes no additional payments on his loan once he accumulates a balance of $105,000 while in school, his tax payment in year 20 increases as he borrows more. (See table) Therefore, the taxability of loan forgiveness is the only check on what is otherwise an open-ended system of tuition increases, borrowing and loan forgiveness. But some lawmakers want to remove even that minimal safeguard.

Earlier this year, President Obama asked lawmakers to pass a bill that makes loan forgiveness tax-free. The top Democrat on the tax law committee in the House supports the proposal.

To be sure, taxing loan forgiveness does run counter to the intended purpose of Income-Based Repayment. The program cannot be a safety net for struggling borrowers if their debts are simply transferred from the Department of Education to the IRS – which, by the way, is probably the only federal agency with more punitive and powerful collection tools than the Department of Education.

That’s the dilemma for policymakers. They cannot make loan forgiveness tax free to ensure IBR works like a safety net without removing the only check on excessive tuition pricing and over-borrowing. Worse yet, low and high income borrowers alike would benefit, with high earners getting the biggest relief thanks to progressive income tax rates.

Lest you think high earners won’t get loan forgiveness, consider that in the veterinarian example above, a vet earning at the 75 percentile over his entire repayment term would earn about $120,000 in today’s dollars the year his debt is forgiven. How much would he have forgiven? A little over $204,000 assuming he leaves school with the average debt load of his peers.

President Obama said for the first time last week that he wants to “work with Congress to ensure that the benefits [of Income Based Repayment] are targeted to the neediest borrowers.” That sounds like progress, but he hasn’t offered any specifics. Meanwhile, his specific proposal to make loan forgiveness tax-free would disproportionately target more benefits to the least needy borrowers: graduate students and high earners.

Congress should make loan forgiveness tax-free, but only after the Obama administration agrees to a package of changes that put tighter limits on the benefits Income-Based Repayment provides to graduate and professional students – and the schools who enroll them.

The next time you hear a story about how vet school tuition is totally out of line with vet salaries, you can rest assured that there’s a federal program for that. And as long as there’s a federal program for that, you can rest assured that there will be stories about how vet school tuition is totally out of line with vet salaries.