Higher education

Funded by the Nuffield Foundation

Under the current higher education (HE) funding system in England, the government pays around £21 billion to fund the education of each cohort of around 480,000 English-domiciled full-time undergraduate students studying anywhere in the UK. This covers spending on students at higher education institutions or at alternative providers that are eligible to charge full tuition fees. It includes payments to universities (largely tuition fee payments funded by government student loans, but also teaching grants) and to students towards their living costs while at university. In the long run, the government gets back part of this initial outlay as graduates make repayments on their student loans. Under current rules and economic projections, the long-run cost will be mostly borne by graduates, but how much exactly is hugely uncertain. (Students from other parts of the UK are eligible for greater government support, so for them a larger share of the long-run cost is borne by the taxpayer.)

The HE system in England is funded primarily through tuition fees. Due to binding caps on the level of tuition fees that institutions can charge, nearly all courses cost between £9,000 and £9,250 per year. Direct teaching grants for universities only amount to around £1,100 per student and year on average, with only some ‘high-cost’ subjects attracting a substantially higher level of direct government funding. This means that for most courses, total teaching resources per student amount to around £10,000 per year.

For most English-domiciled students, all of this funding is initially provided by the taxpayer. This is because English-domiciled students studying for their first undergraduate degree can take out government-subsidised loans to cover the full cost of tuition fees. In addition, they are eligible for so-called maintenance loans to cover part of their living costs. These loans normally accrue interest at a rate between the rate of RPI inflation and RPI inflation plus 3%, depending on a graduate’s income (the interest rate is capped at the “prevailing market rate”, which is based on market interest rates for unsecured consumer credit). They are repaid on an income-contingent basis: graduates repay 9% of their income over a threshold (currently £27,295) and any outstanding loan is written off at the end of the repayment period (currently 30 years) with no adverse consequences for graduates.

As announced in February, there will be substantial changes to this system from the 2023 university entry cohort onwards. For these cohorts, the repayment threshold will be lower (around £24,000 in 2023 prices) and the repayment period will be longer (40 years instead of 30 years). However, the maximum student loan interest rate will be lower, too: from the 2023 entry cohort onwards, all students will be charged interest at the rate of RPI inflation. These changes are discussed in more detail under ‘Past and future changes to the system’ below.

Consequences of the funding model

The current system ensures that students attending university for the first time do not need to pay any up-front fees to attend university and have access to living costs support in the form of maintenance loans. However, the amount of maintenance loan a student is eligible for depends on their parents’ income, and even the maximum rates are low compared with living costs in many parts of the UK. As a consequence, most students spend more than the maximum maintenance loan, and many students who do not receive parental transfers rely on part-time work to fund their studies.

For graduates, this system means that those with low earnings later in life contribute very little towards the cost of their degrees, whereas the highest-earning graduates pay back more than they borrowed because of interest accrued on their loans. The strong link between repayments and lifetime earnings under the current system is illustrated in Figure 1. For the 2022 university entry cohort, we expect graduates in the lowest 10% of lifetime earnings to pay back around £6,000 on average  towards their student loans, because they will rarely earn above the repayment threshold. At the other end of the scale, average student loan repayments of the highest-earning 20% of graduates are likely to be more than £65,000.

This picture looks somewhat different when repayments are considered as a percentage of average lifetime earnings. The lowest-earning 10% of graduates repay around 1% of their lifetime earnings, while the highest-earning 10% of graduates repay around 1.3% of their lifetime earnings. Those in the middle of the graduate earnings distribution repay the most at nearly 2.5% of their lifetime earnings.

Under the current system, we expect nearly 60% of graduates not to clear their loans by the end of the repayment period. The system therefore functions like a graduate tax for most graduates: moderate changes to the repayment rate, repayment threshold or repayment period essentially constitute tax rises or cuts. In contrast, moderate changes in the loan interest rate have no effect on most graduates’ lifetime repayments.

This is not the case for high-earning graduates, for whom the system functions more like a standard loan contract. For these graduates, the key parameter of the system is the interest rate: the higher the interest rate, the more they repay, provided they do not make voluntary repayments. In contrast, moderate changes to the repayment rate, repayment threshold or repayment period will mostly affect how quickly these graduates pay off their loans rather than how much they repay in total.

On the university side, a key consequence of this system is that the bulk of teaching funding is not centrally controlled and therefore not subject to short-term government budget pressures: spending on student loans automatically rises in proportion to the number of loan-eligible students admitted. This is advantageous for universities but makes it more difficult for the government to control spending. A more subtle effect, highlighted in our previous work and emphasised in the 2019 Augar Review, is that funding varies less across subjects than the cost of provision: in many cases, lab-based subjects are likely to be cross-subsidised by social science and humanities subjects that are cheaper to teach. This gives universities an incentive to shift provision towards subjects that are less expensive to teach, which may not align with government priorities.

Accounting for the cost of student loans

Accounting for the cost of student loans under this system is a challenging task. First, it requires a prediction of student loan repayments for decades into the future, which is unavoidably highly uncertain. Second, one needs to take a stance on how future receipts should be valued relative to current expenditure.

The UK government’s approach is to model student loan repayments using a prediction model of individual borrowers’ loan sizes, earnings and repayments. This model primarily relies on historical data on borrowers’ earnings from the Student Loans Company and macroeconomic forecasts from the Office for Budget Responsibility (OBR). It is used to generate two different statistics:

1. the Department for Education’s ‘RAB charge’, which is a measure of the long-term cost of student loans;

2. the Office for National Statistics’ ‘write-off share’, which measures the share of student loans that is not expected to be repaid and is used in the UK National Accounts.

These two measures differ in how future receipts are valued relative to current expenditures; they represent two different approaches to splitting student loans into a graduate share and a taxpayer share. Neither of these indicators is ‘better’ than the other; rather, they are answers to different questions.

The RAB charge measures the expected long-run government cost of providing student loans, considering the government’s cost of funding the loans (rather than other government projects). In contrast to the write-off share, the RAB charge crucially depends on an assumed discount rate meant to capture the opportunity cost of government funds. The Treasury has recently lowered the relevant ‘financial instruments discount rate’ to RPI inflation minus 1.3% (previously RPI inflation plus 0.7%). This negative real discount rate means that, somewhat counterintuitively, the same repayment in real terms now counts for more in the RAB charge calculation the farther in the future it is made. (A negative real discount rate can be justified with reference to the negative real interest rates at which the government can currently borrow; however, it is somewhat puzzling that the government now favours a negative real discount rate for student loans but still uses a substantially positive discount rate of 3.5% for general policy appraisal.)

The write-off share used in the National Accounts is the share of student loans not expected to be repaid. It is the result of partitioning student loans issued into a grant element (oddly counted as capital spending and a loan that is expected to be repaid in full, which is treated like other government loans in the National Accounts. This is equivalent to discounting future repayments at the actual interest rates charged on student loans. The write-off share is higher than the RAB charge, because the interest rate on student loans (between RPI inflation and RPI inflation + 3%, depending on the borrower’s earnings) is higher than the discount rate used to construct the RAB charge (RPI inflation – 1.3%).

As the government’s student loan model is not publicly available, we have developed our own model of individual graduates’ loan amounts, earnings and repayments using a different methodology that does not rely on confidential student loans data. We use that model to estimate various measures of the cost of student loans, including the Department for Education (DfE) and Office for National Statistics (ONS) approaches. For the 2022 university entry cohort, our estimate of the RAB charge calculated using the government’s preferred discount rate stands at minus 12%, which translates into a long-run taxpayer gain of £1.0 billion, and our estimate of the write-off share stands at 30%, which translates into an initial grant element of £6.1 billion. Without any real discounting, we estimate that taxpayers will have to contribute around £0.1 billion, to the cost of loans for the 2022 entry cohort, with an RAB charge of 0%. It should be noted that there is enormous uncertainty in these estimates: among other things, they depend on policy remaining constant for many decades into the future and on economic forecasts being accurate over the same time horizon.

Partly due to methodological differences in the student loan model, these estimates differ from official government estimates. The difference is especially large for our estimate of the RAB charge: for the RAB charge on student loans issued to full-time students in the 2022–23 fiscal year, the DfE estimate is 28%, which is roughly comparable to our 0% for the 2022 entry cohort. The main reason for this discrepancy appears to be that the RAB charge is now very sensitive to assumptions about graduates’ mid-career earnings, and our model is substantially more optimistic about these earnings than the DfE model. One likely reason is that our model relies on earnings differences by age within a year to predict earnings growth, whereas the DfE model relies on observed earnings growth between years for the same individual.

Student loans and the budget deficit

In the absence of any policy changes, student loans affect the government budget deficit (public sector net borrowing) in a given year in two ways. First, the portion of new loans that is not expected to be repaid is recorded as (capital) spending. Second, like interest on other government loans, the ‘modified’ interest accrued on the remaining portion of all existing student loans is counted as a (current) receipt. The total deficit impact of student loans is then the difference between these two values. In the 2021–22 fiscal year, spending on new loans was £12.7 billion and modified interest receipts were expected to be £2.3 billion, resulting in a total deficit impact of £10.4 billion.

Forecast and policy changes can affect both the partitioning of student loans into grant and loan elements and later receipts in the form of interest accrued. This complicates the National Accounts treatment of existing loans. Under the ONS’s methodology, changes to the partitioning of student loans as a result of forecast changes will never affect the budget deficit but will be recorded in the National Accounts as ‘other economic flows’. Policy changes affecting past cohorts only affect the budget deficit if they ‘significantly [alter the] loan stock value by changing amounts the government is expected to receive’. Notably, this is true of the reform announced in February 2022; revaluation effects from this reform meant that the total deficit impact of student loans in the 2022–23 fiscal year was in fact negative.

Quirks in student loan accounting

One important point to note about the ONS accounting methodology for student loans is that reductions in the student loan interest rate have a counterintuitive effect on the write-off share: if the interest rate on student loans is lowered, future loan repayments will fall, but the write-off share will also fall. The reason is that lower interest rates mean that loans become more ‘affordable’ for graduates, so a larger share of each student loan will be paid off with interest and a lower share of each loan will be written off under the ONS’s ‘partitioned loan’ accounting methodology. The paradoxical implication for the public finances is that lowering interest rates and thus making loans more attractive for students also lowers the initial cost of loans for the Treasury.

The same effect arises as a result of the government’s proposed reform of the Retail Prices Index. Under the plans, RPI will be calculated in the same way as the Consumer Prices Index including owner-occupiers’ housing costs (CPIH) from 2030. CPIH inflation is typically around 0.9% lower than RPI inflation calculated using the traditional methodology. This will lead to a ‘real’ reduction in the interest rate charged on student loans, as that interest rate is currently linked to RPI. But the effect that will dominate as far as the budget deficit is concerned is the ‘accounting’ change in how much repayments are valued: the write-off share will fall, because a higher value will be attached to future student loan repayments. (A similar effect could be expected to arise for the RAB charge, as the discount rate used also depends on RPI; however, the government has now said that the real discount rate relative to RPI should be changed to RPI – 0.2% following RPI reform, leaving the nominal discount rate unchanged in expectation.)

RPI reform also has another ‘real’ effect on student loans. As the repayment threshold on student loans will be indexed to RPI, the repayment threshold can be expected to rise more slowly following RPI reform. This reduces the cost of student loans, as graduates will have to repay more from 2030 onwards.

Past and future changes to the system

Since the current system of university funding in England was introduced in 2012, it has been subject to constant tinkering by successive governments. According to stated government policy, the fee cap is meant to increase with (RPIX, RPI excluding mortgage interest payments) inflation every year, but it has in fact only been increased once (in 2017) and is now set to remain frozen until 2025. This amounts to a policy change practically every year, which has complicated universities’ financial planning and distorted any modelling of the future cost of student loans.

On the repayment side, the repayment threshold was supposedly linked to average earnings, but was frozen in nominal terms before it could increase for the first time in 2016 (supposedly until 2021). In a surprising change of policy, it was then raised to £25,000 in 2018 and rose with average earnings until 2021. Since then, it has been frozen again, and is set to remain frozen until 2025. From 2025 onwards, the threshold will now supposedly be indexed to RPI inflation instead of average earnings. These policy changes constitute large retrospective changes to student loan conditions and have been criticised by consumer rights advocates.

An even bigger set of changes is set to come in for university entry cohorts from 2023 onwards. For these cohorts, the repayment threshold will be lowered to £25,000 (compared with £27,295 for entry cohorts up to 2022) and frozen in nominal terms until 2027. The repayment period will be longer at 40 years, up from 30 years now. And the interest rate on student loans will be the rate of RPI inflation, instead of a maximum of RPI inflation plus 3%. If RPI reform goes ahead, this means that from 2030, the interest rate on student loans for these cohorts will be the rate of consumer price inflation.

If fully implemented and kept in place, this reform will transform the student loans system from one where only a small minority of students go on to pay off their loans fully to one where most students will, and can expect repay roughly the same amount as they borrowed in real terms. Under the new system, student loans will become cheaper for high-earning graduates and more expensive for those with lower earnings (see Figure 2). This is because the freeze in the repayment threshold and the extension of the repayment period will increase repayments for all borrowers except the highest earners. The cut in interest rates will counterbalance this effect, but only for the typically high-earning borrowers who pay off their loans in full

For the taxpayer, the student loans system from 2023 onwards will likely be more expensive in the long run than the (reformed) 2022 system. The reason is that the increase in repayments of lower earners due to the lower repayment threshold will likely be more than outweighed by the fall in repayments of high earners due to the lower interest rate. However, this will only be true if – as predicted by the OBR – economic growth over the next few decades is substantially faster than it has been for the last 15 years. It is also worth noting that the initial taxpayer cost of student loans that counts towards the government deficit will be lower from 2023 onwards whatever happens to growth; this is due to the paradoxical effect of the lower student loan interest rate on the budget deficit highlighted above.

Even though the 2023 system will be less progressive and likely costlier for the taxpayer, there is a strong case for reforming the system broadly along the lines proposed. The lower interest rate will reduce distortions and increase fairness between high earners who have taken out loans and those whose parents paid for their education. The change could also increase trust in the student loans system, as the new system will be a good deal for all students, including those who go on to become high earners.

Unresolved issues

Several problems with the system remain unresolved after the reform. The most important issue is inadequate inflation adjustment of the parameters of the maintenance system. At a time when inflation is unexpectedly high, the system as currently set up produces large ‘stealth cuts’ in maintenance support that can cause genuine hardship for students on tight budgets.

These cuts arise from two major flaws in the system. The first is that parental earnings thresholds for maintenance loan eligibility are frozen in nominal terms. The lower income threshold, below which students are entitled for full maintenance loans, has been frozen at £25,000 since 2008, and the higher income threshold, above which students are only eligible for the minimum level of maintenance support, has been frozen since 2016 at around £62,300 for students living away from home and studying outside London (different higher income thresholds apply for those living at home or studying in London). These freezes mean that at a given level of real parental earnings, students are entitled for less and less maintenance support over time, with entitlements falling especially fast in times of high inflation.

The second flaw is that annual increases in maintenance loan levels are determined by inflation forecasts made years before actual inflation is known, with no provision for errors to be corrected. This is problematic at a time when there are large differences between actual inflation and such forecasts. Since inflation has been higher than previously expected, the value of maintenance loans was around 10% lower in the 2022–23 academic year than if it levels had been increased from 2020–21 with actual rather than forecast (RPIX) inflation. This amounted to a large cut in maintenance support of around £90 a month for students from the poorest families. The government has announced that levels will rise by 2.8% in the 2023–24 academic year, which is likely to represent another real-terms cut in support.

Another unresolved issue highlighted above is that because of a mismatch between funding and the cost of provision, it is still financially attractive for universities to shift provision towards courses that are inexpensive to teach. The continuing freeze in the tuition fee cap until 2025 will likely lead to a substantial reduction in real tuition fees, which could be an opportunity for the government to resolve this issue. It could increase the level of direct teaching grants differentially across courses, thus realigning overall funding to better reflect the cost of provision. But it is not certain that the government will take up this opportunity: under current plans, the overall level of teaching grants will barely keep pace with inflation, and it is not clear to what extent nominal increases will be differentiated across courses.

The reform arguably also creates a new problem. At around £40,000, the cost of student loans for tomorrow’s graduates with lower middling earnings is now set to be nearly 3% of their gross lifetime earnings. Partly as a result of the distortions created by the tax system, this high cost may well put off some students from attending university even when it would be good for society as a whole for them to go.

The government could address this issue in various ways. Instead of making changes to the parameters of the student loans system, it could adjust the tax system – for example, by making student loan repayments tax-deductible. Alternatively, the government could bring back more substantial direct grants to students, which are likely to be more salient for prospective students than later-life tax reductions.