How Do Student Loans Work?
How Do Student Loans Work?
What is “Student Loan Repayment”, how does the system work? Of course, everyone has at least an estimate of these questions. But the people who dealt with any student loan would need some clearer and more accurate information. In the following article, we tried to briefly explain How Do Student Loans Work?
Government Support for Higher Education
In most developed economies, the government provides some form of public support for higher education, either through grants or loans. Rationales for government support for higher education generally relate to positive externalities beyond the direct benefits to the individual student.
These externalities may be economic in nature or may relate to more subjective values espoused by a given polity. Values-based rationales in the United States often cite the role of public investment in education in reducing inequality or providing socioeconomic mobility.
Higher Education as an Investment in Human Capital
Economic benefits of higher education are well known: education increases wages and reduces the risk of unemployment, presumably by increasing labor productivity.
In addition to benefiting the student by facilitating higher future income, education may also lead to positive financial externalities such as increased tax revenues, reduced burdens on public services, and more rapid technological innovation and economic growth.
This perspective—known as “Human Capital Theory” —is the leading economic explanation for the higher wages of educated workers. An alternate view that developed during the 1970s, “Signaling Theory,” claims that education leads to a more efficient allocation of talent by sorting workers according to innate ability.
Risk-based pricing of student loans is compatible with either a Human Capital or Signaling view, although the case for subsidized education is stronger under Human Capital Theory.
Empirical evidence in favor of Human Capital Theory has mounted over the last thirty-five years, including many studies of wage differences of identical twins who differed with respect to the number of years of education.
In addition to the twin studies, there have been many careful econometric studies that controlled for various measures of innate ability.
These studies suggest that a college degree on average increases wages by 40%.
Early Human Capital Theory focused on the number of years of schooling or the completion of a degree, while more recent studies have focused on differences between fields of study. These studies generally conclude that the choice of field of study affects wages and employment, even after controlling for ability sorting.
Human Capital Theory helps explain wage and employment differentials between theoretical and applied majors. For example, although math majors on average have higher standardized test scores than engineering or computer science majors, math majors are less likely to be offered employment at graduation and receive lower starting salary offers than students who majored in computer science or engineering. Similarly, business majors, who have relatively low average standardized test scores, have better labor market outcomes than higher-scoring social science or humanities majors.
Although these observations could be interpreted in various ways, the differences appear to reflect the value of field-specific skill development rather than differences in ability levels. Even within engineering, there are large starting wage differences by specialty.
Human Capital Theory also helps explain higher average per-capita productivity and wages in states and nations with higher levels of educational attainment. If education only sorted workers according to ability, it would presumably only increase the variance of wages (i.e., income inequality), while leaving the mean unaltered.
Further, Human Capital Theory helps explain the willingness of many employers to pay for professional degree programs for successful employees.
Employers’ willingness to educate workers whom employers already know to be of high quality suggests that employers believe that professional education has skill-development value rather than mere sorting value.
Just as corporations depend on the productivity of their employees, workers’ productivity and wages are an extremely important source of revenue for central governments. Labor is less mobile than capital, and therefore easier to tax.
In a country such as the United States, which taxes wages at much higher rates than capital, public expenditures that increase wages are more likely to benefit public finances through higher future tax revenues than public expenditures that increase the return on private capital.
Whereas the capital gains tax rate is typically fifteen percent, the average effective tax rate on human capital—that is, the tax on the increase in wages attributable to education—will often be around thirty to fifty percent because the wage premium will fall into high federal, state, and local income tax brackets and will often also be subject to payroll taxes.
In addition, education is not treated as favorably under the Tax Code as other forms of investment with respect to the ability to recover investment costs, deduct interest on loans, or smooth income across tax years.
In sum, a large proportion of the benefits of human capital redound to public finances rather than to the educated worker. Education is generally a profitable public investment, not a mere expenditure.
In fact, the public benefits from higher education in the United States are the highest in the developed world, while public costs are among the lowest, suggesting that public investment in higher education in the United States could be profitably increased.
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