Know When to Withhold 'Em, Know When to Fold 'Em

If you earn a paycheck, you know that you’ll never see “all” of that money. Your employer withholds some of it for taxes.  Not even the most vehement advocate of personal responsibility argues this is paternalistic, or that employees should instead write a check each month to the federal government for their tax payments. So why not use the same approach for repaying federal student loans?

It's complicated. 

This idea has gained traction lately with politicians and policymakers, even Nobel Prize-winner Joseph Stiglitz. Unfortunately, the suggestion is about as far as most proponents ever get. To advance the idea beyond mere suggestion, policymakers need to know specifics. And they need to understand the proposal comes with considerable tradeoffs.

The current student loan system has a problem that this proposal is trying to address. Of the 38.7 million borrowers and $895 billion that are in active repayment (not counting borrowers in school or deployed overseas), at least 40 percent (15.5 million) are currently not repaying, either through financial hardship deferments, forbearances, delinquency, or default. Many were given loans to attend schools with terrible employment and earnings outcomes, but borrowers saw the fact that these institutions were receiving federal aid as a sign that the schools were implicitly backed by the federal government.

Despite the fact that non-repayment has been increasingly identified as a problem, we’re still not totally sure why people aren’t paying back their student loans. While some borrowers find the payments unaffordable, others may be choosing not to pay back the loan either out of procrastination, low prioritization, or resentment. What makes withholding so attractive to so many is that whatever the reason borrowers aren’t repaying now, withholding should reduce non-repayment.

For those who currently find their payments unaffordable, withholding puts them on a plan through which they pay an affordable percentage of their income each month (for lower-income people, somewhere between zero and six percent). And for those who are choosing not to repay for a reason other than affordability, withholding would, by default, start withholding a percentage of a borrower’s wages (assuming the borrower has wages). Instead of just not repaying by not doing something (sending in a monthly check), the borrower would have to actively do something to get out of repaying.

But with promise comes compromise. Federal student loans differ from income taxes in three very important ways, and all have big implications for this idea.

First, unlike payroll taxes, which any working person pays, not everyone has a student loan. That means that some process must be put in place to accurately identify who has a loan to be withheld. This could be initiated by the student, the employer, or the government, but each option comes with tradeoffs. What if employees feel uncomfortable with the government identifying them as student loan borrowers to their employer, or if a borrower incorrectly identifies himself as a borrower when he is not?

Second, unlike taxes, which one keeps paying as long as one works, loans have balances and interest rates. That means that the government would need to keep track of how much a borrower has paid, borrowers would need the ability to prepay and check their balances, and someone would need to tell employers to stop withholding once the loan is fully repaid.

Third, with taxes, married couples who are both working both have payroll taxes withheld and those filing jointly (most married couples) pay a single percentage rate on combined income. But what would happen if both work but only one has a loan, or if only one has a loan but only the other partner works? These aren’t insurmountable questions, but that doesn’t mean there are any easy answers. The government has a range of options, but the basic tradeoff is that it can be simple (with the government potentially failing to account for total household income) or more complicated (with the borrower paying more back).

Income earned through something other than wages (say, contract income) would require a separate process from wage withholding, which would likely be similar to the quarterly taxes that contractors must file with the federal government. It would also mean lump-sum student loan payments at the end of the year for households that earn significant levels of income through things like capital gains. Also, because of the way monthly payments are calculated, borrowers with two employers could drastically over- or under-withhold (depending how the system were designed).

Any attempt to include other types of income besides wages increases the potential complexity of the reconciliation process at the end of the year, when either the borrower or the government would inevitably be responsible for reconciling the difference between wages withheld and the total amount due as a percentage of total income. If the borrower falls short, she would need to pay a lump-sum payment immediately to the government at the end of the year (or possibly have her term until forgiveness extended—another tradeoff policymakers must wrestle with).

Of course, any legislation that involves withholding results in additional costs and burdens on employers, so lawmakers would need to work hard to avoid ire from the business community by writing the law to make the withholding simple and mitigate employers' liability for something going wrong.

Finally, due to privacy concerns and potential backlash from people just disliking the new system, the government would likely need to allow borrowers to "opt out" of the withholding process, meaning borrowers could choose to repay on a traditional plan. And at a recent meeting of stakeholders and experts convened to discuss withholding, many agreed that borrowers should be given the right to defer their payments in the event of financial hardship, and even the right to default. This means that no matter how automatic or universal we make withholding, the government would still operate a parallel system that looks similar to the one we have today—the very system we sought to get rid of in the first place.

All of these are surmountable challenges to implementation. Too often, however, big ideas like withholding for federal student loans are applauded, and the dirty details are ignored. For withholding to work well and fulfill its potential to ease burdensome monthly payments and reduce non-repayment, Washington must confront these challenges. Bills introduced in both houses by Congressmen Polis and Hanna and Senators Warner and Rubio have addressed the issues in different ways. They serve as models of legislation with detailed instructions for the executive branch. While withholding holds great promise, policymakers must consider that any game-changing idea comes with plenty of tradeoffs. And there’s no option to opt out on the details.