Low-risk lending

21 Nov 2006

The principles of the HECS scheme can be used in other government programs, argues Bruce Chapman

AUSTRALIA led the world by introducing income contingent loans, or ICLs, to higher education in 1989. But governments have been slower to realise that there are many other areas of public policy where ICLs would be very useful. In a new book Government Managing Risk: Income Contingent Loans for Social and Economic Progress, I explain the basis, role and application of ICLs. Together with colleagues I show how ICLs would work in areas as different as drought relief and criminal justice.

Through ICLs, citizens in need of financial assistance get help from the government. The resources they receive take the form of a loan, but it is a loan with a very unusual characteristic. The loan has to be repaid when and only if those with the debt are in a position to repay in the future. Repayments of an ICL depend on those assisted having the capacity to do so, and this makes them very different from normal bank loans.

The best known example of an ICL is the Higher Education Contribution Scheme, or HECS, in which the government essentially pays a university charge for the student on enrolment, with the student undertaking to repay the debt when and only if their incomes reach a certain level (currently around $38,000 per annum). HECS was designed to remove the financial barrier for students of having to find money to pay fees on enrolment. It is a policy motivated by the notion that students not be denied access to higher education if their financial circumstances are poor at the time of enrolment.

The basic idea behind HECS is very simple, and in the book I argue that its essence can be applied to a very large number of disparate policy areas. Take two very different issues: government drought relief, and the payment of fines for low level criminal activity.

Over the last few weeks the government has announced further - and very large - financial assistance to farms in drought. The assistance takes the form of grants paid to farm businesses to be used to help pay the interest on the farm’s commercial loans. The approach has been controversial for a long time, and perhaps it is time for a different and fairer way involving the use of an income contingent loan.

Farming is an uncertain business. For many farmers the best forms of assistance are those which smooth incomes across the business cycle. This allows farmers to borrow from future good years in order to meet the needs of the present bad years - with the loan only to be when the farm recovered from drought. The most important feature of this type of loan for farmers is that there is default protection - the farm is not at risk of repossession due to an inability to meet repayment obligations.

ICL for drought relief are a good solution for taxpayers and farmers, for the following reasons. First, grants for drought relief are paid for from the taxes of all citizens. Yet a great many of these citizens will be far worse off over their lifetimes than will be those farmers currently receiving assistance. Drought relief in the form of taxpayer financed grants can be seen to be regressive and unfair.

Second, if some or all of the drought relief is to be repaid, the money will go further. If, as reported, the government has decided to spend $750 billion on drought relief it can actually provide more than that to farmers as the government is getting some or all of it back. It can help more farmers during drought.

Finally, as with any form of government expenditure, every dollar spent on drought relief is unavailable for other purposes, such as schools, hospitals, infrastructure, child care places, university enrolments or lower taxes. Many farmers experiencing short term difficulties are asset-rich. It seems reasonable that they are assisted when they are in need but return some of these funds to the community - who on average do not have the same level of wealth - when they are in a position to do so.

In the book Linda Botterill and I model this proposal and show that ICLs provide a realistic alternative to interest rate subsidies for the delivery of drought relief to farm businesses.

A second and very different application of an ICL involves the criminal justice system. Fines for low level criminal offences, such as for drunken driving, assault, and break, enter and steal, are very expensive to administer. Here are the facts.

Around 50 per cent of fines are not paid when first due. In response the courts require the offender to reappear when the fine is increased. If it remains unpaid the offender might be required to undertake community service, but a large proportion do not turn up. Finally, some offenders will be sent to gaol in lieu of fine payment.

These are extremely expensive mechanisms Gaol, for example, costs taxpayers around $70,000 a year and imposes very high potential costs on offenders, since a period in gaol makes it difficult for offenders to get mainstream employment upon release.

My colleague John Quiggin came up with a brilliant idea: use the income tax system to collect the offender’s fine. With criminologists Arie Freiberg and David Tait we explain the advantages of introducing ICLs.

A fine would be recorded as an obligation to be repaid, depending on the offender’s future income. If income did not reach the first threshold of repayment there would be no payment, and when income exceeded this threshold a percentage of income would be collected and the level of debt reduced accordingly until it is repaid in full.

The beauty of an ICL for criminal activity is that the administrative and other costs involved are kept to a minimum. There is no need to bring the offender back to court if the fine is not paid, there is no need for community service, there is no need for imprisonment. If the repayment parameters are set sensibly, there is no default of an ICL. And since HECS is already in place, there is an administratively efficient mechanism available to collect the fine.

The book explains and canvasses a large number of other possible applications of ICLs. They can be used to finance, for example, child care, paid maternity leave, community investment projects, housing credits for low income people, elite athlete training and aged care. They can be applied to influence where immigrants settle or they can be used to collect fines for white collar crimes such as insider trading and collusion.

Bruce Chapman is Professor of Economics in the Research School of Social Sciences, Australian National University. This article first appeared in the Australian.

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