PAYE, PSLF, and the future of American higher education

Greg Crespi, a law professor and economist at Southern Methodist University Law School, recently published a very interesting paper on the economics of the latest iterations of federal income-based repayment educational loan repayment programs, i.e., Pay As You Earn and Public Service Loan Forgiveness.

These programs are only a few years old, and as of yet relatively few college graduates in general, and law school graduates in particular, are taking advantage of them (or perhaps are even aware of the option to do so). But with massive educational debt becoming more and more common, this seems certain to change.

Crespi’s direct analysis is limited to the economics of law school attendance, but it’s obviously relevant by extension to graduate and professional schools more generally, and indeed to American higher ed as a whole. As for law schools, he concludes that, if not for the generous loan repayment terms now available via PAYE and (especially) PSLF, law school would be a bad investment for the vast majority of graduates of non-elite law schools, almost all of which nevertheless now feature “Harvard-style” — aka extremely expensive — operating structures. If graduates take advantage of these programs, however, the picture changes:

My conclusion is that the IBR loan repayment and debt forgiveness provisions are sufficiently attractive so that Harvard-style legal education is now again a financially viable proposition for many law students, not only for those students attending the most elite law schools but also for many students attending non-elite law schools, specifically those students who will graduate in the upper half of their class or better at the 40 or so upper- or mid-tier non-elite law schools, and also for those students who will graduate in the upper quarter of their class or better from one of the more than 150 lower-tier law schools. For most other law students, however, who in the current employment market have only a slim chance of obtaining a full-time entry-level legal position paying even $60,000/year, and who have very slim chances of obtaining a qualifying public service legal position under the PSLF program, attending law school is no longer economically justified even with the IBR and PSLF loan repayment options.

Crespi notes that even his optimistic take on the economic effects of PAYE and PSLF on law graduates, the current cost of law school still makes it, on the basis of his model, a bad investment for a majority of graduates of non-elite schools. But, according to his analysis, these programs make — or will make, assuming that they become standard pathways for large numbers of graduates in the coming years — law school a reasonable investment for a much larger number of graduates than it would be otherwise.

The paper is long and fairly technical, but should be read by anyone interested in the economics of American legal education, or for that matter those of American higher ed more generally. As Crespi’s analysis of the law school situation makes clear, PAYE and PSLF may end up having significant and quite perverse effects on the spiraling cost of law school, and again these sorts of effects are likely to be seen in many other higher ed contexts as well.

PAYE works like this: If a graduate qualifies for a “partial financial hardship,” the graduate doesn’t have to pay the full amortized monthly payment on the graduate’s federal loans, even under the extended 25-year repayment plan. The standards for a partial financial hardship are rather liberal, to the point where even many law graduates who secure “market rate” entry level jobs with big law firms (such jobs pay $160,000 salaries, at least in the biggest cities) qualify for PAYE.

Few law graduates get six-figure jobs — the median salary of 2013 grads with reported salaries was $62,000, and only about 40% of graduates had reported salaries, which means the real median was undoubtedly much lower — and since the average federal educational loan debt of new law graduates is approaching and may have already exceeded $150,000, the large majority of current law grads qualify for PAYE. Those who sign up for the program are required to pay 10% of that portion of their adjusted gross income that exceeds 150% of the federal poverty line for their tax status.

This system will often produce outcomes in which graduates will never pay any of the principal on their loans, and only a relatively small part of the interest. For example, assume a graduate obtains a job with a starting salary of $50,000 (this is probably higher than the median salary for current law grads), and has $150,000 in federal educational loans (a typical amount among current law grads). This person will under PAYE owe $277 per month at the start of repayment, and, assuming the graduate remains single with no dependents, and receives average annual raises of 4%, will pay $411 per month after ten years, and $633 per month at the end of the 20-year repayment period (If the grad has or acquires any dependents all these payment numbers will be correspondingly lower. Here is a calculator that allows debtors to determine what they would owe under various scenarios).

After 20 years, the grad will have made just over $100,000 in total payments, which in turn represents just about exactly half of the interest due under the loans. The balance on the loans will have grown to $253,000 (the unpaid interest on the loans accrues but doesn’t capitalize). At this point, Lord willing and the creek don’t rise, the entire balance is scheduled to be forgiven.

Crespi emphasizes that there’s a significant catch, which is that forgiven loans count as ordinary income, which means that the grad in this example would, in theory, owe federal income taxes on that $253,000. (This is what savvy law students and recent grads refer to as the “tax bomb,” waiting at the end of PAYE).

But Crespi’s otherwise accurate breakdown of the PAYE program omits an important detail, which is that the forgiven debt is taxable only to the extent that the forgiveness renders the taxpayer solvent. (The relevant sections of the IRC are 108(a)(1), 108(a)(3) and 108(d)(3)). Here’s an example. Suppose in the above hypo the taxpayer has a net worth, excluding the $253,000 in unpaid debt, of $100,000. That means that, prior to forgiveness, the taxpayer’s net worth is negative $153,000. This means the debt forgiveness puts the taxpayer $100,000 in the black, and he or she will owe federal income tax on $100,000, not $253,000.

The really great news is that the combination of the collapse of much of the traditional market for legal services and the general ravages of the Gilded Age II will undoubtedly leave many law graduates with no positive net worth even without regard to their student debt, which means they will owe nothing when that debt is discharged, no matter how large it may have grown.

The even better news is that the PSFL program has much more favorable terms than PAYE, as it requires only ten years of payments, and the forgiven amount will not be treated as income, which means no tax hit even if the graduate has significant net worth at the end of the repayment period. A very wide range of jobs qualify for PSLF: all government employment, all 501(c)(3) non-profit employment, and even many private non-profit jobs with non-501(c)(3) employees. (It will be interesting to see if government and other non-profit salaries begin to impute implicitly the benefits of PSFL into their compensation structures relative to for-profit employment).

As Crespi argues, all this adds up to a potentially powerful financial lifeline, not only to graduates drowning in debt, but to institutions that would otherwise be forced to alter their cost structures to take into account that their graduates were taking on debts that were completely out of proportion to the employment they were (or weren’t) subsequently securing.

Now it may be that law school, with its crushing cost relative to the employment outcomes for the graduates of all but a handful of elite institutions, may be something of a special case when considering the broader systemic effects of PAYE and PSLF. But, as is so often the case in regard to the financial structure of American higher education, I suspect that legal academia is just the canary in an increasingly toxic coal mine.