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Graduate tax: remedy, reform or rebrand?

Haroon Chowdry, Lorraine Dearden and Gill Wyness

Last week the Secretary of State for Business, Innovation and Skills, Vince Cable, suggested a graduate tax as a 'fairer' replacement for tuition fees in higher education. All the Labour leadership candidates - with the exception of David Miliband - have expressed support for this idea, as has the National Union of Students; the leading universities, meanwhile, have opposed it. This Observation examines whether the rationale for such a policy and the practical implications of it have been fully considered.

As Dr Cable acknowledges, the current system of income-contingent loan repayments already constitutes an implicit graduate tax. Students face a notional stock of debt upon graduation, reflecting the total fee and maintenance loans taken out over their degree. However, this debt merely determines the amount of time that a graduate will spend making repayments. The actual repayments depend only on income, being equal to 9% of earnings above £15,000 for a maximum of 25 years following graduation. After this point, any remaining debt is written off.

The system is already progressive, insofar as lower-earning graduates: (i) make smaller monthly repayments (both in cash terms and as a proportion of their income); (ii) benefit more from a subsidised interest rate; and (iii) are more likely to have some of their debt written off.

A graduate tax in its purest form is simply a variant of this with an infinite loan and without a debt write-off point. Whereas a current graduate's repayments stop at some point, their payments under a pure graduate tax would not, creating the possibility for high-earning graduates to pay substantially more over their working life than what it cost to educate them. We understand that a time limit is has been considered as a central feature of the policy, which would mitigate this issue - and, in so doing, come closer to the present repayment schedule -but it would still be possible for the highest-earning graduates to pay back significantly more than the cost of their degree.

At the other end of the spectrum, it may be possible for lower-earning graduates to pay less over their career than they do now, making the spread of contributions more progressive than under the current system. However, the greater progressivity comes with the risk of inducing unintended behaviour, such studying abroad - and thereby avoiding liability for the tax - if the fees abroad are less than the net present value of a student's expected future graduate tax bill. An incentive could also be created for students to work abroad after university, in order to avoid paying the tax.

Part of the Business Secretary's aim in mooting the idea of a graduate tax is to increase the contribution to higher education provided by graduates while reducing the contribution from general taxation. But if cuts are made, it is unlikely that the revenue from a graduate tax would fill the hole quickly. If high-earning graduates respond to the above incentives, the loss of tax revenue would have negative implications for the public finances - particularly as these individuals would be relied upon to effectively subsidise lower-earning graduates. Also, behavioural responses notwithstanding, any revenue from the tax would arrive in Treasury coffers at a slow rate, and a question then arises over how universities are to be funded in the interim.

Introducing an alternative system of funding may be politically expedient, but it raises additional issues. Tuition fees provide a transparent source of income which follows the individual, giving universities an incentive to attract and retain students. Under a graduate tax, it is not clear how allocations to individual institutions would be determined, and whether this incentive would remain. There would also be no obvious, transparent way of allowing contributions to vary according to the university attended or course studied. Furthermore, fees enable students to make judgements about the effectiveness or value for money that universities offer; under a graduate tax, this not possible.

Finally, the tax would replace fee loans only - maintenance loans would continue to be repaid under the current arrangements. While this seems more sensible than using a graduate tax as the only method of repayment, operating two separate repayment systems in parallel would increase the complexity of a funding regime that is already poorly understood.

A graduate tax is the latest in a series of options under consideration by the Browne Review as it explores ways to reform university funding. Alternative possible measures include increasing tuition fees, introducing a real interest rate on student loans or tweaking some other aspects of the current funding system. An IFS Commentary, Future arrangements for funding higher education, published earlier this year, has considered such options in detail, examining their likely effects on graduates and the public finances.

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IFS researchers highlight some of the trade-offs that would be involved in reforming the current system of fees and loans applying to full-time undergraduate study