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Real interest rates – submission to Treasury Committee report

March 29, 2018

I recommend reading the Treasury Committee’s report into Student Loans. It was published last month and is based on a series of hearings held from October to December.

I prepared a couple of private submissions before my appearance as a witness. Unfortunately I neglected to “OK” them for publication afterwards. One was on the background to interest rates on student loans; the other a briefing on accounting.

I have covered the accounting on here in detail but the interest rate piece summarises some thoughts that came together at the time. The pdf below gives some background to the following extract from the Treasury report:

The Committee also took evidence from Dr Andrew McGettigan who, when asked about the interest rate as a mechanism to introduce a degree of progressivity into the student finance system, argued that this was not the Government’s original intention.
(page 17)

The exchange referenced above can be seen in the following extract from the transcript.

Rushanara Ali: Do you agree with the IFS that the high interest rates will act as a redistributive tool from higher earners to lower earners? That is what the evidence seems to be pointing to as well. Do you have any further comments to add to that?
Dr McGettigan: I do not think that is what it was meant to do. There is some careful distinction to be made between whether we think higher earners are repaying more than the equivalent of what they borrowed in the first place, so you make a little surplus on them and that cross-subsidises the scheme and brings up the average. The original  design was very careful to minimise the number of people who were going to be repaying more than they borrowed and the extra surplus they would be repaying.
Rushanara Ali: The Government has been accidentally progressive. That is interesting.
Dr McGettigan: This is what I mean about a series of piecemeal decisions. On the original loan scheme, the discount rate was RPI plus 2.2%, which is in the ballpark of an interest rate taper from RPI to RPI plus 3%. When you change the discount rate down to RPI plus 0.7%, all of a sudden you are making a spread and the additional interest that is being repaid is much larger. You have not changed your projection of cashflows, but you have changed how you value those cashflows.
People will not feel it in their pocket, but you are saying, “I value those repayments higher now, so I am making less of a loss”. When you look at it in terms of “Am I getting more back from them than I lent to them?” it will look like that, because you have pushed up the value of all those repayments.
One thing about the design of the interest rate taper was it was tied to this idea that the cost of borrowing was RPI plus 2.2%. You can see that in the extract from the Browne Report I put in my written submission. They were suggesting an interest rate at RPI plus 2.2% in the Browne Report, and we have got one of nought to three. The discount rate change in 2015 has altered this profoundly, and not because it was a planned decision to try to introduce a redistributive element to the payments.

Rushanara Ali: Whether it happened deliberately or accidentally, we are where we are. What is your assessment of this tool, as a more redistributive mechanism for financing, given that 40% of the lower earners would be better off than the pre-2012 system? If you disagree with it, what is the alternative? What might be the alternative to this model?
Dr McGettigan: At the moment, I do not understand what it is trying to achieve anymore, because it has been divorced from the discount rate. That is my first point. Is it there because it is an incentive for higher earners to make additional voluntary repayments? The Treasury has a preference for cash today, as we know from the sale. If you have a real interest rate, is it signalling to borrowers that they should consider making additional repayments over and beyond what is demanded of them each month? That may be part of the design.
The other point is, if you lower the interest rate, the people who will benefit are the highest earners. That is clear. It is a regressive move in that technical sense.
Presentationally and optically, it [the current interest rate] is awful. You are having people making decisions: “Should I look at alternative finance options? Should I remortgage for the sake of my children, because I can get a lower interest rate?” In my opinion, those questions should not even be on the table. No one should be asked to make that kind of decision. The loan scheme should be clearly the best deal out there. No one should be taxing themselves to work out between the options.

Dr McGettigan: I have one very quick point: the interest rate on pre-2012 loans is recognised to be an impediment to their sale to the private sector, because it is below RPI. Another thing you have to factor in here is whether the overall real interest rate design is also because it is much closer to a private sector preference for potential purchase of post-2012 loans if they are ever offered to market.

PDF: Real Interest Rates on Student Loans REVISED

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