Income share agreements: the student debt crisis and the developing world

What if you could pay your tertiary education fees by selling stocks in yourself? It sounds strange but an idea known as an income share agreement (ISA) is becoming increasingly popular around the world. Unlike a student loan where a student is obligated to repay interest in addition to the principal borrowed, an ISA is an alternative which requires the student to repay a percentage of their income to the lender upon the completion of their degree. Take this example:

A student requires financial aid to pay three years of tuition totalling $75,000. The lender (usually their university) agrees to cover their tuition but requires a 15% share of their annual income for the next 10 years. If their starting salary is, $60,000 straight out of university, they are required to repay their university or lender $9,000 that year. As their income increases, they repay a greater amount and vice-versa—the 15% is fixed and agreed upon at the start of the contract.

In practice, ISAs are a bit more complicated. Adjustments to the repayment percentage are based on your major/s and hence your projected starting salary, the agreement ‘pauses’ if you are not actively seeking work, and the repayment is often capped at 2.5 times the principal borrowed.

ISAs offer an alternative to student loans (not schemes such as Australia’s superior HECS-HELP programme) which have led to the US$1.6 trillion student-debt crisis.[1]  According to the 2017 New America Report, “the average student loan interest-rate is 5.8% among all households with student debt” and can be even higher for individuals from low-income families.[2] Therefore, ISAs could be helpful to those students worrying about their prospects of sourcing a high-paying job as they are not obligated to repay the full amount borrowed (compared with a student loan). Although, these cases were the student does not repay the entire amount, are rare as lender’s typically offset this risk by requiring a higher percentage—discussed below.

ISAs were initially floated back in 1955 by one of the most famous economists of all time, Milton Friedman. Friedman, born in 1912, was a firm believer in free-market capitalism, including privatisation and fervently opposed government intervention. He proposed in his essay, The Role of Government in Education, that private investors should help finance a student’s education and, in return, receive a portion of their income. Since Friedman’s idea, universities such as Yale and Purdue as well as organisations such as Lumni have implemented slightly modified versions (the ISAs in today’s world) but they are still uncommon.

A key reason for the unpopularity in the past has been due to lenders’ reluctance because of the risks involved. This reluctance is underpinned by the common economic problem of adverse selection—created when there is information asymmetry between the buyer and the seller, leading to unfavourable outcomes (market failure). For example, a student knows more about their work-ethic, motivations and ideal career path than their lender. Consequently, only poor-performing, unmotivated students will take up the offer since high-achieving, motivated students will reject the terms and choose a loan instead, as they will likely earn a higher salary. Thus, to offset their risk, the lender will require a higher percentage annual payment. This adverse selection is somewhat counteracted by setting different repayment percentages for different majors, but information asymmetry still exists within students in those fields. As such, critics have been quick to suggest lenders will only offer ISAs to those students at the best universities around the world.

Furthermore, for students, the apprehension towards ISAs exists largely because of the unknowns. It is difficult for individuals to ascertain their future income however, for the vast majority, it will rise over time. As such, they are reluctant to agree to giving a fixed proportion of their income for an extended period. Therefore, students are only likely to accept an ISA with favourable terms which conflicts with lender reluctance as expressed earlier. However, could ISAs be used to finance higher education for those most in need?

The answer is unclear at this stage but I hope to take you through a scenario where ISAs could provide education to those who are often without access. According to Nicholas Barr from the London School of Economics, countries typically have three considerations when implementing higher education; large quantity with high accessibility, high quality, and how it is financed. A trilemma emerges as only two can be pursued at the expense of the third:[3]

1. Large and tax financed, but with worries about quality (France, Germany, Italy)
2. High quality and tax financed, but small (the United Kingdom until 1989)
3. Large and good quality, but fiscally expensive (Scandinavia)

In developing countries, higher education would need to be almost completely subsidised to allow individuals to attend, similar to the programs Scandinavia (option 3). However, developing countries are unlikely to have the budget to accommodate the needs of their population on a large scale. Perhaps there exists a possibility for the United Nations, venture capitalists or even wealthy individuals (as Friedman proposed) to create an ISA contract with a student from a developing country therefore, reducing the strain on public spending. Further, with the returns the lender would receive, that money could be reinvested back into further ISAs or developing communities to help individuals and communities alike break out of the vicious cycle and into the virtuous cycle.

Evidently, this idea will likely not occur for many years given the structural changes that must first occur, however, Nobel-prize winning research by Esther Duflo and Abhijit Banerjee last year has spurred life into the field of development economics and the fight to eradicate poverty. Ultimately, ISAs offer an alternative to financing substantial (and rapidly increasing) fees that students face to obtain the benefits of higher education. Therefore, whether it helps to alleviate the stress of students wishing to avoid lifelong debt or assists those in the developing world in the future, income share agreements could be a valuable tool to promote greater access of education.

[1] https://edition.cnn.com/2020/01/19/us/student-loan-slow-repayment-moodys-trnd/index.html

[2] https://www.nerdwallet.com/blog/loans/student-loans/student-loan-interest-rates/

[3] https://press-files.anu.edu.au/downloads/press/p148581/pdf/book.pdf