Grad Tax vs Loans: the national accounting differences

Accounting is governed by conventions. These conventions have rationales behind them, but they can also be abused or bent out of shape so that the rationale gets obscured or lost. Focusing on rule-following without getting the larger picture clear will lead to fundamental misunderstandings about decisions and options.

In the case of English higher education, these mistakes form part of a narrative insisting that “there is no alternative” (TINA). Politicians appealing to accounting rules might be dogmatists, they might be credulous or they might be opportunists looking for a good way to close down debate. It’s hard to tell at times what’s animating their claims, so it’s easiest just to show how to think about accounting and budgeting for loans otherwise and more constructively.

Let’s take a simplified example.

A government wishes to pay for undergraduate tuition and decides it must have some repayments from graduates to mitigate the cost of the policy. Further, they think non-universal provision like higher education shouldn’t be covered from general taxation, since not everyone gets to benefit.

Let’s say they devise two competing schemes: a fee-loan model and a graduate tax model. Both models require £10bn outlay each year and generate £7bn of repayments over the 20 years after the student leaves university. Both schemes are time-limited so that repayments stop at that point and both use the same repayment threshold to generate returns.

I’m asking you to imagine, for the sake of argument, that we have no differences in outlay and cash coming back in the two schemes (whether in timings or amounts received).

In the long-run, both schemes cost government £3bn in cash terms. But this plays out very differently in the national accounts (which run on a cash in, cash out basis). And this means that the government of the day has a big incentive to prefer loans over a graduate tax.

A graduate tax is treated straightforwardly:

• the initial £10bn outlay on tuition is current expenditure;
• cash as and when it comes back in from graduates counts as income;

Expenditure counts against the deficit; income scores as a benefit to it.

You can see the timing implications: in year 1, there is £10bn of expenditure, and much smaller bits of income are scored as a benefit in subsequent years. Providing tuition in this way means a big hit upfront that is gradually mitigated by income.

The policy therefore appears more costly than it is at the initial stage and this impression is compounded by the fact that in year 2 the government has to issue another £10bn to cover the next lot of loans, and so on. It is only two decades and more down the line that total annual income attributed to graduate contributions reaches a level comparable to that £7bn. The deficit measure takes a big hit until then.

Loans are different. Issuing a loan creates a financial asset – formalised by the balance telling the borrower the nominal amount owed to government.

The accounting treatment for “financial transactions” recognises, in a way the graduate tax does not, that there is a future income stream associated with the loan-asset. Accordingly, the £10bn loan outlay is not classified as expenditure.

Neither loan outlay nor loan repayments score in relation to the deficit: loan outlay is not expenditure; loan repayments are not income.

Instead, interest accruing scores as income each year, and the outstanding loan balance written off, when it is written off, scores as capital expenditure.

Loans therefore do score against expenditure, just not today. Cash did go out the door back in year 1, and it had to be covered with borrowing, but that cash outlay was not recorded as expenditure.

In effect, the loss on loans scores as expenditure when it is known, i.e. retrospectively. And that makes some sense. But it also makes loans far more attractive today if you have chosen the deficit as your primary target in the fiscal mandate.

(Note, the sale of students loans adds several layers of complexity and the ONS is still adjudicating how to classify the sale that was conducted before Christmas).

There are a few points of emphasis here:

• There are no cash implications when loans finally score against expenditure: the relevant transactions have all already happened. There is no fiscal “bomb” or “black hole” resulting from the fact that loans are in play.
  When write-offs score, it is just a recognition of the difference between outlay and repayments in cash terms. It is not equivalent to being presented with a bill (finally!) that has to be paid.
  I predict that, when the first significant loan write-offs come through in the 2040s, politicians will switch to a deficit measure based on the current balance (where no capital expenditure appears).
• The main fiscal and budgetary action with loans today happens elsewhere. In national accounts, you have to look at cashflows and how these affect public debt without having been recognised in the deficit. Loans are not “off-balance-sheet” – they are assets owned by government. It is just that the cash used to create them is not recognised as current spending.
  Better still, you can look at what happens in departmental accounts, which is where budgetary control happens through the RAB allocation and charge, where projected long-run costs are recognised today.

In my example, the cashflows and costs of loan ad graduate tax were imagined to be exactly the same. The appeal of a loan over a graduate tax is obvious.  A loan is better able to recognise formally the promissory structure of the deal between student/graduate and government and so makes the headline fiscal statistics look much better in the short term.

The different impacts of loans on the deficit is what made the switch to loans very appealing in the early days of austerity.  The tendency of recent governments has been to target the deficit over the short-run (a particular headline measure is chosen) and to fix an overall expenditure envelope before considering the pros and cons of different policy decisions. This contributes to the idea that public spending is  a zero sum game where switching away from loans automatically entails cuts to spending elsewhere.

But misplaced deficit targetry clouds the policy options available. Nothing from the accounting per se prevents the government from choosing a graduate tax, except its fixed thinking, which equates a lower deficit to better fiscal position, and misplaced ideas about the constraints on public funds.

That loan outlay is not classed as spending or expenditure at the time of issue explains much of their appeal, but it doesn’t settle policy questions in their favour.  In short, their advantage appears to be presentational: the form and timing of cost recognition. Nothing prevents a government from choosing to run a larger deficit today because it believes it will have higher tax revenues later. You can invest for growth and you can do so without solely relying on financial transactions.

There are other reasons to be less keen on a graduate tax, including the difficulties of defining a graduate and the problem of concurrent repayment of maintenance loans. Chiefly though, a graduate tax cannot be levied on graduates who leave the UK, whereas a loan can (in principle) be pursued abroad.

On the flipside, the graduate tax involves no debt and no interest. And that makes them a popular solution with some politicians. But you’d still be taking the equivalent of repayments from graduates, with the same impact on their disposable income.

A supplementary note on Write-offs

It’s also important not to get confused by write-offs in the manner of, for example, Peter Hain and John Denham. Write-offs tell you something about where the share of costs falls (on the borrower or on public finances); they don’t tell you what the money was spent on or whether it was productive or not.

The following comparison (which Hain attributes to Denham) makes no sense:

“[Denham] has estimated that English taxpayers spend £6 on debt cancellation for every £1 on teaching students.”

The loans were used to pay tuition fees and to support with living costs. They were the means of providing funds, not something that absorbed the funds. That there is a write-off (‘debt cancellation’) tells you the government will have picked up that part of the tab (and so spent more on tuition than claimed by Denham and Hain).

If you loaned £6bn to cover tuition, and repayments were £3bn less than outlay, the £6bn spent was split between individual and government. Moreover that £3bn write-off was what the “taxpayer” spent on tuition.

Commentators frequently forget that lowering write-offs might mean you made individuals repay more. But if it results from lending less, then you might end up spending less overall on HE. (And this latter outcome is what universities fear will result from the current review of HE funding).