The Student Loan Forgiveness Policy Blunder

The most recent price tag for Biden’s student loan forgiveness plan is estimated to be a half trillion dollars and possibly more. However, I believe there will be another cost: higher inflation.

U.S. inflation is already rising at just below the fastest annual pace in 40 years, prompting the Federal Reserve to aggressively hike interest rates to reduce it. Biden’s plan will make the central bank’s job tougher, raising the risk of a potential recession.

The upward pressure on inflation will result from increased spending by those who see their student debts reduced, as well as from the continuing moratorium on federal loan repayments. This higher demand for consumer goods and services —relative to a world without debt relief or an extended repayment pause through December 30, 2022—will driving up prices for current goods and services if production does not also increase.

About 43 million students owe more than $1.6 trillion on federal student loans. Since the beginning of the pandemic payments on federal student loans have been paused, but that pause was scheduled to end August 31, 2022.

On August 24, President Biden announced plans to forgive at least $10,000 in student loans for borrowers earning less than $125,000 (and couples earning less than $250,000) and to extend the payment pause until December 31, 2022. The plan would forgive up to $20,000 for borrowers that qualified for federal Pell Grants and earn less than $125,000. Loan forgiveness would apply to student loan debt to finance undergraduate and graduate degrees.

The policy also makes changes to the rules governing income-driven repayment plans. These changes include raising the amount of income that is excluded from calculations, reducing the required payment to 5 percent (from 10 percent) of discretionary income, forgiving interest expenses above the 5 percent payment amount, and allowing for complete forgiveness after 10 years (instead of 20 years) if the amount borrowed is less than $12,000.

The argument for the policy is that helps lower income Americans that are struggling to pay for debt incurred to earn a college degree. However, several factors raise questions about the impact of this policy on various income groups. Consider that the plan will wipe out all student loan debt for roughly 15 million borrowers—that is, borrowers who owe less than $10,000 (or $20,000 for Pell Grant recipients). Are these borrowers really in need of debt forgiveness? Before answering, note that the annual payments are only $1,359 for a $10,000 loan paid over 10 years at 6% interest. Clearly, the answer is “no.”

Proponents of the policy claim that loan forgiveness will help those at the bottom of the income distribution relative to those at the top. However, research on this topic clearly shows this is not the case. Instead, it shows that borrowers in the bottom half of the income distribution receive about 25% of the benefits of loan forgiveness, while borrowers in the top 30% of the income distribution receive about 40% of the benefits. This is true for a couple of reasons. First, income-driven repayment plans already reduce annual payments and offer loan forgiveness to many low-income borrowers. In addition, many of the largest debtors are holders of advance degrees and are likely to earn relatively high incomes across their lifetimes.      

Another side effect could be that Biden’s debt relief offers incentives to students entering or currently in college to take on additional debt in anticipation of future rounds of forgiveness. Economists call this moral hazard. Other research found that increases in student borrowing can result in bigger tuition increases.

Some research has pointed to positive economic outcomes for those who receive debt relief, such as less future indebtedness, greater job mobility, and higher salaries. But these effects are based on a full discharge of student debt and not an incremental reduction like the one Biden announced. In addition, it is unclear whether the behavioral changes estimated for this specific population of borrowers would hold for the general population of student loan borrowers.

Ultimately, loan forgiveness—whatever its merits—will likely lead to larger federal deficits and higher inflation. While it benefits those with student loan debt, it is clear that many of the beneficiaries are not really in need of government assistance. Policymakers should focus on more targeted policies, such as reforming income-driven repayment plans, aimed at benefiting a much smaller group of low-income borrowers. In addition, policymakers should weigh the benefits of such policies against the costs it imposes on others and the economy. 

©2022 by Rice University’s Baker Institute for Public Policy