Opinion: Clarion Call

Human Capital Contracts: An Attractive New Way to Pay for College

Clarion Call No. 210
A report from the Cato Institute suggests an alternative method for paying for higher education. As the need for new methods of finance is growing with the rapidly rising costs of higher education, and as student loans are beset with defaulting and graduates dealing with the uncertainty over being able to make fixed loan payments, the report argues, human capital contracts should be an attractive alternative.

The report, “Human Capital Contracts: ‘Equity-Like’ Instruments for Financing Higher Education,” written by Miguel Palacios of the University of Virginia’s Batten Institute, explains the advantages of human capital contracts over student loans, using the idea of education financing as investment in human capital. Higher education offers investment returns, but they vary widely, owing to the student’s diligence in completing his studies, his skills, and his field.

As Palacios writes, “The difficulty in valuing the investment and the illiquid nature of the asset makes student loans very risky for lenders. Therefore, private-sector loan institutions have stayed away from financing education in the past.”

Rapidly rising costs of, and demand for, higher education have, however, created a need for new methods of finance beyond subsidized federal loans, as now there are capable students who lack the resources to finance their education. Building on ideas of Milton Friedman, Palacios argues for the creation of “an instrument that allows investors to share in the success of students, as well as their failures.” His solution, human capital contracts, would be an “equity-like investment” through “a contract by which an individual obtains resources to finance his or her education by committing a percentage of his or her income for a predefined period of time after graduation.”

What this means is that the amount the investor will receive during the predetermined “repayment” period will be uncertain. It could be less than their investment, but just as easily it could be more. The graduate’s interests are aligned with the investors’ — if he does well, they do, too.

“Human capital contracts are convenient for students and investors for at least four reasons,” Palacios writes. “(1) they relieve the student from any uncertainty about being able to make fixed loan payments, (2) they virtually eliminate default due to financial distress, (3) they are means and needs blind, and (4) they give a subsidy to those who most need it during the repayment period.”

Palacios lays out several issues of human capital contracts for investors, among them being the freedom to construct different types for different fields of study and also concerns over the legal framework protecting the investors. He also notes that the idea is already beginning to take hold. “MyRichUncle currently funds students using human capital contracts,” he writes, “Others plan to follow.”

Palacios writes that this method of financing education “should develop fully during the next few years,” but he warns that since “human capital contracts would increase competition, they will presumably find resistance from those institutions that find shelter in the current less-than-perfect market conditions.” (Elements of that resistance could include certain “higher education administrators,” as the contracts would likely “expose the true costs and economic benefits of particular schools.”) Because of that threat, and because human capital contracts will overcome the “illiquid nature” of the present system to the benefit of students as well as the higher education market itself, Palacios writes, “[e]very effort should be made to ensure that this dream becomes a reality.”
The report is available online at cato.org/pubs/pas/pa-462es.html