David R. Henderson  

A Perverse Incentive for Graduate School

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Adaptation and Economics... Brown M&Ms and Hotdogs...

On a flight from Rochester, New York to Washington Dulles last Friday, I sat beside a young woman who had recently graduated from Penn State and had just started a new job. We got talking about student debt. She told me that her debt from being an undergrad was about $48,000 and that that was unusually low because she had paid reduced tuition due to her mom's being a Penn State employee. Many of her friends, she told me, had debt in the six figures.

I asked her what they were doing to pay it if they, as she had said earlier, some had not yet found jobs. She said many of them were contemplating going to graduate school even though not all were enthused about doing so.

So let's get this straight: They're in a lot of debt and their solution is to go into more debt by going to graduate school. This didn't make sense to me.

But then she explained. If you go to graduate school, the government will pick up the tab for the interest owed on your undergraduate loans. Think about some plausible numbers. The debt is $100,000. The interest rate is 6%. Annual interest: $6,000. So you save $500 a month (after-tax, mind you) by going to graduate school. That's a strong marginal incentive. And we taxpayers pick up the tab.


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COMMENTS (20 to date)
Gabriel Rossman writes:

I can't find a link but I'm pretty sure that in one of the recent budget fights the administration either changed this policy or made a serious proposal to do so.

Robinson writes:

It's worth noting that some graduate programs, especially PhD programs in the sciences, actually pay their students with modest stipends (along with covering their tuition).

C L writes:

Is this true? I seem to remember, back in the late 90s when I graduated that if you defer paying back student loans due to further education, the missed interest payments are rolled back into your loan balance, not eliminated altogether.

Ken B writes:

I wonder if it's a perverse incentive. It sounds like a deliberate one to me. it's not like it's a deduction clearly designed for one purpose providing an incetive for some other purpose. It sounds like the goal was to make it easier to go to grad school. To get more grad students. There are lots of folks who could want that outcome, not least university profs and their lobby groups.

John Hall writes:

Like Mr. Rossman, I recall a recent change to student loan interest, but I think it was more favorable to current grad students. As a former grad student, it didn't affect me at all.

That being said, you didn't mention that the Stafford interest rate is 6.8% for grad students (direct plus is 7.9%) when 10-year Treasury notes are below 2%. (Stafford loans are 3.4% for undergrads, so they have a relative disincentive there for grad schools). Given how hard it is to shake off student loans (don't believe you can get rid of it in bankruptcy), I would guess that the default rates are low enough that the government makes a decent amount of money on the spread. On the other hand, the government gives an option (besides prepayment) also so that if you're unemployed you don't have to pay up to three years, which would likely put upward pressure on the rate they charge.

Ryan P writes:

I'm currently wrapping up grad school, and I believe this is only the case for some loans; e.g., Subsidized Stafford, yes; Unsubsidized Stafford, no. Though there is a slight advantage for unsubsidized loans, in that while the interest accumulates, it doesn't actually capitalize until you leave (i.e., it's simple interest, not compound).

I agree with Ken B. It's totally intentional, even the "not all that enthused" part. The point of a subsidy is supposed to be that it changes behavior -- someone on the margin changes his or her mind. It's perverse only insofar as the goal is a bad one (and it may be!). For anyone who thinks the subsidy is good policy, the effect you're describing is a feature, not a bug

Alex S writes:

You also have to remember that not all graduate students are taking on more student debt. In the more high demand fields you can get your schooling paid for you by going to graduate school and even get an hourly wage doing research as part of working towards your higher degree.

Glen Smith writes:

If the expected present value of the additional value flows created by going to grad school is greater than what it costs, why would this not make sense?

David R. Henderson writes:

To all who question my use of the word “perverse.”
I can grant that the government may well have intended this incentive effect. That does not mean that it’s not perverse. If you have been following Bryan Caplan’s posts, you know how strong a case he has made that there is already overinvestment in schooling. When the government gives an added incentive for schooling, that’s perverse.

Glen S. McGhee writes:

It's called in-school deferment.

This should make sense, if you realize that you are exempt if you are in grad school. You do not have to pay back your loans while in school. Nuff said.

Glen S. McGhee writes:

It's called in-school deferment.

This should make sense, if you realize that you are exempt if you are in grad school. You do not have to pay back your loans while in school. Nuff said.

http://en.wikipedia.org/wiki/Grad_PLUS

PrometheeFeu writes:

Are you kidding David? Right now is the most rational time for them to go back to school and get a new degree. What are they giving up by doing so? A part-time job busing dishes for minimum wage if not worst? Or, they could go to graduate school where they will be intellectually stimulated and hopefully by the time they get out, the recession will be over and they will have a new better degree that will significantly boost their earning potential and allow them access to a more interesting job. Even if the recession is not over, having an advanced degree significantly improves your chances of getting a good job.

Think of it this way. Let's say you're running a retail shop and you want to send your employees to a training program to help with their sales skills. Do you do that right in the middle of the Christmas shopping season or during the down days?

Andreas Moser writes:

I rather study in Europe.
Much cheaper and no lesser quality.

Glen Smith writes:

PrometheeFeu,

Not to mention that telling people that you are a graduate student is significantly more valuable as opposed to telling people you are a college graduate that can't find a job.

PrometheeFeu writes:

@Glen Smith:

I had not even thought about that. And it's not just a nice social thing. It will probably also be very helpful when you go back on the job market. A year of unemployment requires explanation during an interview. 2 years in a Masters program do not.

David R. Henderson writes:

@PrometheeFeu,
All very good reasoning. And none of it contradicts what I said about a perverse incentive.

Ken B writes:

Perverse in its core, theological, sense means 'persistent in error'; that is off the one true path. In its less technical usages it means contrary, against what is expected. All its connatations involve something askew, a divergerence for the intended or expected course.

When a policy creates an incentive the relevant course from which divergence is meant is the intended one. Since the intent of the regulation is to incent graduate school enrolment this is not a perverse incentive.

This regulation could ceate a perverse incentive in some ways. Imagine that schools were ranked and funded by the percent of their graduates who repaid their loans without government subsidy. Then this regulation would create an incentive for a school to discriminate against its own graduates when selecting grad students. That would be a perverse incentive.

David needs a more suitable term of disapprobation. English supplies a panoply of these; a casual perusal of Paul Krugman's column will turn up some of the more vituperative of them, but here I think 'wasteful' will do nicely.

Bryan Willman writes:

What's more, what if the student has changed focus from, say, the study of porcelain birds, to, say, robotics and automation.

While her undgraduate degree may never get her a good wage, her graduate degree likely will. So the "incentive" (perverse or not) helps to fix an error.

Charlie writes:

Can anyone find this? I have not found it yet. I have found the Lifetime Learning Credit, but nothing about paying undergrad loans.

PrometheeFeu writes:

@David R. Henderson:

I think I may have been reacting to something else without realizing it: You can defer subsidized loans for economic hardship under the same conditions as you can defer for going to graduate school. (I'm not 100% sure, but that's my recollection from personal experience when I was unemployed, my wife was making minimum wage and we got a deferment on her student loans with no interest charge)

So there is a perverse incentive, but it's not the one you're thinking of, it may actually be worst: If the only job you have available is washing dishes/flipping burgers, you're deferring and not paying interest anyways. Going to graduate school is still a smart move for the reasons I mentioned above, but deferments shouldn't affect the way you think about it. (apart from individual wealth effects) On the other hand, if you get offered a good job with a good paycheck, then, you can't defer anymore (can't claim economic hardship). So the people who are encouraged to go to graduate school instead of looking for a job are not the friends of that young woman. It is that young woman herself.

I didn't have time to look at what the cut-off is for claiming economic hardship, but I'll have a look and write a blog post. Me thinks there might be some discontinuities...

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