A fair trade for the student loan interest deduction

A fair trade for the student loan interest deduction
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Rube Goldberg described his famous drawings of nonsensically complicated machines as a “symbol of man’s capacity for exerting maximum effort to achieve minimal results.” His drawings also remind us how we are inclined to assume erroneously that complexity must add value.

Policymakers seemed to have fallen victim to that faulty assumption during decades of tinkering with the federal student loan program. The program is now so complicated that many of its terms and benefits overlap and can even cancel one another out. But the tax reform bill pending in Congress might be just the opportunity lawmakers need to fix part of this unwieldy program.   

Last week, Republicans in the House of Representatives proposed to cut taxes for families in all income groups while eliminating targeted tax breaks, including the deduction for student loan interest. Journalists and advocates are caterwauling about how the loss of the deduction will make things worse for families already struggling to pay off record levels of student debt.

While that point will be debated in the coming weeks, observers risk missing the chance it provides to go further and fix another part of the loan program.   

Like all loans, student loans issued by the federal government accrue interest, but the rate a borrower actually pays is not the rate she sees. For loans that undergraduates take out this school year, the advertised interest rate is a fixed 4.45 percent. However, the government also levies a fee when the loan is originated, which is immediately added to the loan balance. This origination fee makes the effective interest rate slightly higher, more like 4.68 percent. But then there is the tax deduction.

When the borrower files her income taxes, she can deduct up to $2,500 of the interest she paid that year, bringing the effective interest rate down to something more like 3.8 percent, below the stated rate. Except she may not able to claim the deduction for the entire time she repays, since borrowers can only claim the full deduction during years in which their incomes are below $65,000. Suppose she can claim the deduction for only part of her repayment term. That would make the effective interest rate over the life of her loan about 4.45 percent, the rate advertised on the loan in the first place.

That’s the Rube Goldberg machine at work. The government charges borrowers an origination fee that appears as part of their balance, which is confusing, but then effectively charges them less interest than it advertises, which is also confusing. The interest rate is higher than stated and their taxes are lower than stated.

A deduction for interest would make more sense if the government weren’t the one making the loans and collecting the taxes. But because it does both in this case, the government is effectively charging a fee and then waving it. The budget reveals that is indeed what is happening. The deduction will reduce payments to the government by about $1.97 billion in 2017 while the origination fees will increase them by at least $1.83 billion. (The deduction figure includes interest deducted on private student loans, so the relevant figure for this case is lower.)

There is, of course, a long and complicated history that explains how policymakers ended up enacting such self-defeating policies. It is hardly worth repeating here since it does nothing to justify the current state of affairs. No policymaker today would implement this set of policies if he were designing the student loan program from scratch.

Those who oppose lawmakers’ efforts to eliminate the student loan interest deduction might help students more if they supported ending the interest deduction in exchange for lawmakers ending origination fees. That set of reforms would leave the benefits in the loan program largely unchanged on average and provide students with a more transparent and less complicated program.

Jason Delisle is a resident fellow at the American Enterprise Institute.