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Invest in People with Income Contingent Loans
Three entrepreneurs are offering a share of their life’s income in exchange for cash upfront and have banded together to form the Thrust Fund, an online marketplace for such personal investments.
Kjerstin Erickson, a 26-year-old Stanford graduate who founded a non-profit called FORGE that rebuilds community services in Sub-Saharan African refugee camps, is offering 6 percent of her life’s income for $600,000.
(quoted here). A closer look reveals that this is more of clever marketing play to interest donors in supporting a philanthropy. What, for example, does Kjerstin want do with the money? She writes:
Some people may think that it's crazy to give up a percentage of your income for the sake of scaling a nonprofit venture. But to me, it makes perfect sense.
Well it does make perfect sense for Kjerstin but not so much for a profit-seeking investor (moreover any income would be taxed twice, a problem with equity financing in general but especially so here without corporate tax breaks.) Investing in just one entrepreneur is also risky - why not subdivide the investment and invest in many?
Jeff at Cheap Talk raises a larger but closely related issue, "Why don’t we replace student loans with student shares?" In fact, Milton Friedman advocated income contingent loans in 1955.
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. There seems no legal obstacle to private contracts of this kind, even though they are economically equivalent to the purchase of a share in an individual's earning capacity and thus to partial slavery
...One way to do this is to have government engage in equity investment in human beings of the kind described above. ...The individual would agree in return to pay to the government in each future year x per cent of his earnings in excess of y dollars for each $1,000 that he gets in this way. This payment could easily be combined with payment of income tax and so involve a minimum of additional administrative expense. The base sum, $y, should be set equal to estimated average--or perhaps modal--earnings without the specialized training; the fraction of earnings paid, x, should be calculated so as to make the whole project self-financing.
Another Nobelist of a more liberal stripe, James Tobin, helped to implement an income-contingent tuition program at Yale in the 1970s. Alas, the program was terminated largely due to rent-seeking when many Yale graduates become so successful that the repayment amounts became substantial and the nouveau riche chose to default (also here).
Bill Clinton later tried to take the idea national but it didn't get very far in the United States. (Not coincidentally Clinton had been a beneficiary of the Yale program.)
Australia, however, implemented an income contingent loan program in 1989. Australian students don't pay anything for university when they attend but once their income reaches a certain threshold they are charged through the income tax system. Many other countries are experimenting with income contingent loans.
Hat tip to Alexander Ooms.
Posted by Alex Tabarrok on March 9, 2010 at 07:30 AM in Economics, Education | Permalink
Comments
Putting a $10 million present valuation on the future earnings of a nonprofit employee? I think I (and everyone else who prefers to make money rather than lose it) will pass.
One thing I fear will doom this sort of market is the endowment effect - that sellers will fail to discount and there will be a fundamental disconnect between what sellers expect (which probably is based on a non-discounted sky-high optimistic valuation) and what buyers would expect (something comparable in pricing to a variable annuity).
Of course, one of the worst things about this is that the marginal tax rates start becoming ridiculously high once you sell any appreciable portion of yourself. With total marginal rates well over 50% in many areas, an additional 6-10% of your income, whether after-tax or otherwise, likely makes the appeal of being a stay at home parent (or other generator of non-taxed imputed income) overwhelming.
Presumably the answer to the last concern, at least, is to structure this as a contingent debt instrument that could somehow allow the individual to deduct the payments, which would be difficult to structure, though probably the appropriate treatment.
Posted by: anon at Mar 9, 2010 8:04:57 AM
Cato has written in the past about this idea, calling it Human Capital Contracts.
Link to PDF on Cato site:
http://www.cato.org/pubs/pas/pa462.pdf
Posted by: Ano at Mar 9, 2010 8:12:57 AM
William Yu and Don Salyards wrote about this here:
http://www3.interscience.wiley.com/journal/121406658/abstract?CRETRY=1&SRETRY=0
Can't find an ungated version.
Posted by: mike at Mar 9, 2010 8:38:46 AM
Seems like the big potential problem with this approach is adverse selection. So students who are pursuing degrees in lucrative careers will find other means of financing their education, while those planning on lower-paying careers (or no-paying careers -- think mommy track) will sign up for a percentage deal. And confident, motivated students who are sure they'll succeed in school and their careers will avoid the percentage deals whereas students who aren't really sure what they want or if college is really for them--those students will sign up.
Posted by: Slocum at Mar 9, 2010 8:47:45 AM
How about taking shares of soon to be foreclosed houses, loaning to the soon to be foreclosed person, and sharing any gain from the sale if the owner stays on the property for five or more years.
Posted by: Bill at Mar 9, 2010 8:50:13 AM
A similar concept drove the plot in an excellent recent sci fi novel, The Unincorporated Man:
http://www.amazon.com/Unincorporated-Man-Sci-Essential-Books/dp/B0030EG1BA/ref=sr_1_1?ie=UTF8&s=books&qid=1268142906&sr=8-1
Posted by: Prosecutorial Indiscretion at Mar 9, 2010 8:57:12 AM
Slocum: That's exactly what happened at Yale. It wasn't so much rent-seeking as Alex pointed out, but there was pooling which adverse selection killed. All the students in the arts took the TPO (as it was then known) while the future investment bankers and lawyers failed to sign up. A given year's TPO was pooled, and the amount owed grew every year as the revenues failed to match the interest owed and negative amortization kicked in. By the late '90s, my wife, having faithfully made her contributions every year, still owed about six times what she originally borrowed, and we finally paid it off in a lump sum as the real death spiral began.
Posted by: Jonathan Falk at Mar 9, 2010 9:13:39 AM
Bill,
That is what John Hussman has been proposing for over a year now.
"The Economy Needs Coordination, Not Money, From the Government"
http://www.hussmanfunds.com/wmc/wmc090223.htm
Personally, I don't even think the economy needs coordination from the government. The economy just needs the gov't to get it's head out of the banks assets and stop subsidizing the banks hostile takeover of the homes they tricked people into buying.
Posted by: Andrew at Mar 9, 2010 9:25:17 AM
Adverse selection could be a problem in equilibrium but for the Yale program the problem was not that the investment bankers didn't sign up but that they signed up and then defaulted when they had to pay big bucks.
"Each borrower had to continue paying until the debt of their entire graduating class was repaid. The program unraveled when high-earning graduates realized they would have to repay far more than they had borrowed, subsidizing not only students in low-paying professions, but the 15 percent of graduates who were deadbeats. Few students realized how many classmates would renege on the loans."
http://www.bc.edu/bc_org/avp/soe/cihe/newsletter/News27/text002.htm
See also here
http://www.slate.com/id/1000326/
Posted by: Alex Tabarrok at Mar 9, 2010 9:39:14 AM
"Seems like the big potential problem with this approach is adverse selection."
How is this any different from corporate finance? Business leaders who see substantial upside in their firms will prefer to raise debt capital. Those with less optimistic outlooks will be more willing to offer additional equity.
While many outcomes may have been sub-optimal, the financial market have managed to effectively deal with this issue in a way that has created value for both businesses and investors.
Posted by: Russ R. at Mar 9, 2010 9:40:26 AM
Right off, as noted, rewarding people as a percentage versus a set amount is going to encourage people to earn lower absolute numbers and thus is going to shift university seats toward lower ROI majors, which if investors/lenders assume a historical rate of return they will either be disappointed or cause a default. That's the math problem. The qualitative problem is that we already have too much college for no productivity careers. It is really funny to me that we make gradeschool kids do stuff they hate while school is free, then we encourage college kids to "follow their passion" when school (not to mention the opportunity cost) is something that they will have to pay back out of earnings.
Posted by: Andrew at Mar 9, 2010 9:40:54 AM
While a student at Harvard Business School, I donated $6,000 to charity in exchange for 1% of a classmate's total income for the year 2015 (we agreed on an arbitrary year > 10 years in the future). He continues to work PE/investment banking, so I am hoping to make out quite well!
Posted by: Jon P at Mar 9, 2010 9:53:04 AM
Wait a second. Why rely on private investment for this? Why not just ...
Have the government pay for higher education and have a higher marginal tax?
Seems to me like the proposed scheme is just a taxation mechanism run by private sources instead of the government (perpetual repayment and all).
The government is certainly more efficient in doing this (fewer deadbeats and fewer reneging on loan obligations).
Posted by: Allan at Mar 9, 2010 10:01:40 AM
I believe that Dean Martin, when he was first starting out, sold shares in his lifetime income totalling considerably in excess of 100%---and spent much of the rest of his life embroiled in the resulting lawsuits.
Posted by: Steven Landsburg at Mar 9, 2010 10:05:04 AM
"How is this any different from corporate finance? Business leaders who see substantial upside in their firms will prefer to raise debt capital. Those with less optimistic outlooks will be more willing to offer additional equity."
It's very different. Bad corporate risks are charged high rates or denied loans entirely. Or, alternately, they have to sell a larger fraction of the company to raise a given amount of capital. But in this case, there's no opportunity to charge higher rates for poor risks. What percent of future income would you demand to in exchange for providing, say, $200K+ for 4 years at an Ivy League institution for...an early childhood education major? You'd want a very high percentage (actually, if you were sensible, you'd probably be unwilling to make the deal at all) -- but a basic feature of these plans is a fixed percentage of income regardless of the characteristics of the student or the intended major, so there's no opportunity to price risk.
Posted by: Slocum at Mar 9, 2010 10:06:32 AM
Adverse selection is a problem, as some other commentators here have mentioned, but as Russ R. points out this problem is common to equity financing in general (firms with worse prospects disproportionately seek out equity financing; firms with better prospects seek out debt financing to keep profits in-house). In short, this is not a problem particular to income contingent loans.
But moral hazard is an issue, too, in a way that isn't as important in equity financing. Giving up 6% of your income has the same effect as a 6 percentage point higher marginal tax rate. If the doomsday predictions about the effect of failing to extend the EGTRRA/JGTRRA tax cuts are to be believed (which would increase the top rate by 4.6 percentage points), then surely a 6 p.p. increase would be much more devastating to incentives.
It's been awhile since I read Friedman's Capitalism and Freedom, but I seem to recall him proposing a government income contingent loan program that would help address this problem somehow. I'd appreciate it if someone recalls his proposal or has a copy of Capitalism and Freedom handy and is willing to look it up.
Posted by: libert at Mar 9, 2010 10:12:24 AM
Income contingent loans seem totally stupid to me, as presented here. We have the opposite problem to some degree, people getting heavily subsidized university education and choosing to study unprofitable subjects, say Medieval Literature, with our money. Perhaps a better scheme would be to only pay for studies in subjects that are deemed to be under-subscribed, and only pay the subsidy in the event of a successful graduation. I can definitely see how my company could do this, by identifying and sponsoring prospective students and then paying for their education in return for a few years of labor after they graduate with useful skills.
Posted by: mattmc at Mar 9, 2010 10:30:44 AM
This would also have the extra advantage of providing a market price-signal for various majors. An English major with an SAT of 1100 would have a much higher interest rate than a Comp Engineering major of SAT 1300. Well if the regulators allow that of course
Posted by: Contemplationist at Mar 9, 2010 10:31:02 AM
The easiest way to avoid adverse selection would be to make the loans contingent on certain decisions (you'd have to keep taking those financial engineering classes, for example) that correlate with being on money-track careers. This way investors would only invest in those with the most "useful" careers.
Interestingly the market signal would also provide objective evidence of what characteristics correlate with high future earnings.
Posted by: PeterW at Mar 9, 2010 10:33:58 AM
Guess what, schools already capture the growth in income potential of their students.
That's why elite schools have selective admission policies that not only select on the basis of future success, but on the current success of the parents.
Think: Alumni contributions.
If you are a college which graduates potential high income earners, or graduating children who have interited wealth, would you be interested in creating loyalty to the old alma mater? You betcha.
Colleges are already in the game. Why not let some entrepreneur underwrite someone's education and get the money that would go to the alumni association.
Posted by: Bill at Mar 9, 2010 10:36:18 AM
Harvard Business School rejected Warren Buffett.
I just re-learned this today and thought it was at least tangentially interesting.
Think about that, the allegedly best admissions entity missed the greatest business prodigy of all time, probably due to over-thinking what they thought they were good at.
And people think the rest of the education system is probably fine, or at least too good to make major changes.
Posted by: Andrew at Mar 9, 2010 10:43:07 AM
How is it not just another ploy to transfer wealth from productive young people to unproductive old people?
Posted by: Tomasz Wegrzanowski at Mar 9, 2010 10:50:42 AM
"economically equivalent to the purchase of a share in an individual's earning capacity and thus to partial slavery"
Economists are funny if they think that is slavery. Slavery involves whips. In a non-sexy way.
Posted by: Andrew at Mar 9, 2010 10:53:55 AM
Income contingent loans by universities would provide direct market incentives for those universities to provide better education. Say a university is entitled to 5% of a graduate's income. That university must maximize expenses which result in additional income for the student (presumably, worthwhile educational expenditures / career services) while minimizing expenses which do not create additional income (a fifth or sixth year of undergraduate education, unnecessary electives, new buildings, athletics). The university would have incentive to offer majors / programs leading to high income for graduates. With this balance, the increased tuition dollars would go to what students need, rather than what administrators want.
There’s very little holding a university accountable for how tuition dollars are spent under the current system of college financing. I’d like to see how Yale’s expenditures compared under the income percentage program of the 1970s as to today.
Posted by: Cody L. Custis at Mar 9, 2010 10:56:15 AM
1. Isn't our whole income tax system already like this? I can't justify my very high tax rate on the services I receive now. I can only think of it as my 'angel' invested in me by allowing me to grow up here, so he gets 30% of everything I make up to a certain level, then 50% of everything above that.
2. How would you get an enforceable mortgage on future income to stop the "Dean Martin" (or I would say "Producers") problem that Steven Landsburg mentions above? We have lien registries for real estate, cars & other personal property, etc..., but not for personal income. We'd need a new US Treasury lien registry!
3. Would these be dischargeable in bankruptcy? Normal school loans often aren't. But these would almost have to be, since they could be such an anchor on people trying to get a fresh start.
4. These interests would also need to be on all credit reports since they have the effect of reducing income above a certain amount.
5. This is fun to talk about but insane in our world, where we nearly destroyed the relatively simple business of home loans because of decades of making them tools of public policy. Imagine the mayhem Congress would create in trying to 'fix' these investments.
Posted by: tom at Mar 9, 2010 10:58:17 AM
'33 Act?
Posted by: Adam at Mar 9, 2010 11:17:43 AM
As far as concerns of a portion of future income being a bad investment, lifetime income is Nassim Taleb classic black swan territory with an exponential distribution. It’s very difficult to tell which incoming freshmen will have massive income, dwarfing their peers. One of the most successful individuals associated with the University of Montana is Jeff Ament, a drop out who went on to play bass guitar for the band Pearl Jam.
There is also an information problem. College freshmen who start in ‘high income’ majors such as engineering might switch to less stressful majors, or drop out entirely. The professions which are associated with very high median income, such as lawyers, doctors, and economists, require graduate degrees. The point that I am making is that one can make a much better prediction of an individual’s lifetime income after four years of college, rather than the beginning of college. One still cannot predict mean income because of extreme successes, but one at least has an idea where to find the median.
Posted by: Cody L. Custis at Mar 9, 2010 11:19:05 AM
Alex: With all due respect to the two articles you linked to, I'm quite certain that defaults were a smaller problem than adverse selection in the pool to begin with. I know that Yale put in some pretty strong efforts to enforce these contracts: the money just wasn't there. For a somewhat more balanced view, see http://www.yaledailynews.com/news/university-news/2001/03/27/70s-debt-program-finally-ending/ and
Posted by: Jonathan Falk at Mar 9, 2010 11:29:36 AM
Sorry I meant also see Willem Buiter, http://eprints.lse.ac.uk/847/1/tobin.pdf at pages 11-12
Posted by: Jonathan Falk at Mar 9, 2010 11:39:40 AM
Seems to me a good predatory percentage-of-income financier (say, one who's own family wealth derived from the old "company store" industries) would be better served approaching aspiring community-college students rather than Yale students. Sure, the prospective rate of return per individual would be lower but by dangling additional perqs ("for just one extra percentage of your lifetime income we'll throw in a private dorm room too, for another percent we'll finance a Spring Break trip all four years") or introducing between-student competition ("well... we've already got people offering to give us 7% of their lifetime income so offering only 6.5% isn't going to cut it anymore...") you could get back to complete serfdom in just a couple of generations.
I'm surprised the payday loan industry isn't already advocating something like this. It would be a logical extension of their business model.
figleaf
Posted by: figleaf at Mar 9, 2010 11:45:53 AM
The incentive-dampening effect may be an feature, not a bug. See my comment here.
http://cheeptalk.wordpress.com/2010/03/08/shes-selling-equity/#comment-3450
Posted by: jeff ely at Mar 9, 2010 12:45:51 PM
Even if this doesn't amount to slavery, it might constitute a "badge of servitude"...
Posted by: EJR at Mar 9, 2010 1:04:10 PM
The Thrust Fund was catalyzed by Rafe Furst's post on Investing in Superstars. http://emergentfool.com/2009/10/30/investing-in-superstars/
Posted by: Daniel Horowitz at Mar 9, 2010 4:32:47 PM
Here is a paper extending the idea of income contingent loan: "A securitised market for human capital," publised in Economic Affairs 2008.
http://course1.winona.edu/wyu/research/p07.pdf
Posted by: William Yu at Mar 9, 2010 4:51:45 PM
That is also a idea developed in a French novel (can't find an English translation): Les Actifs corporels de Bernard Mourad. What happens when, at last, everybody could be IPOed... Highly recommended.
http://www.amazon.fr/actifs-corporels-Bernard-Mourad/dp/2709627809/ref=sr_1_1?ie=UTF8&s=books&qid=1268174050&sr=8-1
Posted by: monsieur Jean at Mar 9, 2010 5:46:20 PM
I think this might work as long as unwitting taxpayers are not involved. Investors that wish to risk their own money will make smarter investments. But when decisions are made with other people's money, judgement goes out the door.
Posted by: Al Brown at Mar 9, 2010 5:54:54 PM
Actually, the income is probably effectively alienated or alternatively derived on trust (ie not derived at all) and thus not subject to income tax.
Posted by: Patrick at Mar 9, 2010 6:35:16 PM
Patrick - what do you mean by that comment? I've never heard that kind of argument.
Posted by: anon at Mar 9, 2010 7:10:29 PM
Why wouldn't the rate just be based on major/SAT score/GPA/etc, presumably at the end of your graduation. If you don't graduate then you have to repay the money.
This would get rid of some of the adverse selection. a 4.0 CS major would have to pay a much smaller percent of income than a 2.0 English major.
Posted by: Andy at Mar 9, 2010 8:43:10 PM
Professional golfers have done this, with some success. The golfer gets a group of investors to front him travel expenses for a season, in return for a cut of his winnings.
Posted by: Doug at Mar 9, 2010 9:31:13 PM
Regular student loans already have income contingent repayment with any remaining balance forgiven after 25 years: http://www.finaid.org/loans/icr.phtml
Posted by: Jacqueline at Mar 10, 2010 12:34:01 AM
...choosing to study unprofitable subjects, say Medieval Literature, with our money.
English/Literature majors:
Danielle Steel
J. K. Rowling
Stephen King
Dean Koontz
J. R. R. Tolkien
Of course, Hollywood would have been far less profitable if there were no Medieval Literature, nor those with the knowledge of the subject to create lots of screen plays that became popular movies.
I bet you dismiss study of graphic novels and scifi as unprofitable as well.
Posted by: mulp at Mar 10, 2010 3:06:33 AM
Jacqueline's link above on the US government program is real. I didn't realize how well established the 'minus' side of income contingent loans was here.
I couldn't find numbers showing how many loans are covered by this today. It looks like it started within the past 3-5 years. But it seems very broad and it seems to allow large reductions in payments and eventual forgiveness based on AGI.
It seems strange that the only testing is based on income, which can be a pretty weak measure of ability to pay. I would have guessed they would require more complete means-testing. It is a welfare program.
Posted by: tom at Mar 10, 2010 11:51:29 AM
Nobody making the analogy between "student shares" and corporate finance seems to have caught the obvious disanalogies between buying shares in a company and buying shares in a person. First, when you buy equity in a company, you don't get a share of their gross revenues, nor even a share of their net earnings. You get a share of the dividends paid out to shareholders, which is a lot less, even for successful companies (look at how long it took Microsoft to pay any dividend at all). If you wanted "student shares" to work like real equity financing you would have to allow the graduate to deduct housing costs, taxes, and other "necessary" expenses (good luck policing that), and you would have to have some procedure for deciding when to declare a dividend and how much to make it.
Another difference is that in a company you hire management (possibly the founders, possibly someone else) to run the company. You pay them a salary, and you give them performance-based bonuses that completely swamp the disincentive to earn due to having to pay out part of the profits to other shareholders. (Whether those bonuses create other perverse incentives is an argument for another time.)
Finally, if a company's management is not performing, you can fire them and replace them with someone else. You can't fire an individual from his own life, nor can you reclaim the human capital he acquired with your investment, the way you could with traditional business assets.
When you take all of that into account, the differences between "student shares" and company shares are much greater than the similarities. That's not to say that there is no possible way to make student shares work, but to imagine that they would not be "any different from corporate finance," as one poster put it, is just preposterous.
Posted by: rpl at Mar 10, 2010 12:44:35 PM
The Boston Fed just published a working paper on this topic:
http://www.bos.frb.org/economic/wp/wp2010/wp1001.htm
Posted by: NoBill at Mar 10, 2010 2:19:38 PM
I believe the now defunct myrichuncle.com offered the same tuition financing, at least when they first started.
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