Student loans have become an increasingly important part of our fiscal forecasts, with gross outlays reaching £18.1 billion (0.8 per cent of GDP) in 2018-19 and forecast to reach £22.6 billion (0.9 per cent) in 2023-24. Flows of this size would make student loans an important source of medium-term risk at any time, but prospective changes to their treatment in the National Accounts and potential future policy changes provide additional sources of risk.
Accounting treatment developments since our previous report
In our 2017 Fiscal risks report we discussed the fiscal illusions resulting from recording interest income on student loans that would never be received as revenue. Subsequently, both the Treasury Select Committee and the House of Lords Economic Affairs Committee have produced reports calling for changes to the accounting treatment of student loans in the public finances.a
In July 2018 we issued a working paper discussing the various fiscal illusions associated with student loans.b The ONS published an article alongside our report setting out potential improvements.c The illusions to be addressed included those arising from significant write-offs of unpaid loans expected at the end of their 30-year term and from the sale of loans at deep discounts to their recorded value in the National Accounts without hitting borrowing.
In December 2018, after consulting international statistical authorities, the ONS published a follow-up article laying out its plans.d Eurostat also published advice on the recording of income-contingent loans.e The ONS proposed a new approach under which outlays on student loans would be split (‘partitioned’) into a portion that was expected to be repaid and would therefore be treated as a loan accruing interest, and a portion that was not expected to be repaid and would therefore be written-off at the point of outlay and so recorded as expenditure.
We updated our fiscal forecasts to take account of the ONS’s plans in Annex B of our March 2019 EFO. In June 2019 the ONS then released an article detailing the methods it would use to calculate the loan-partitioning and how it would approach revisions.f Provisional ONS estimates of the impact of the new treatment suggest that our March estimates were reasonably accurate: these ranged from an increase to PSNB in 2018-19 of £10.5 billion (ONS estimate £10.6 billion) rising to £13.6 billion in 2023-24. The ONS intends to introduce a new student loans time series into the public finances in September this year.
Fiscal risks under the new accounting treatment
By removing fiscal illusions, the new approach constitutes a material improvement. When the terms on the loans or the economic assumptions underpinning projected cash flows change, the accounting treatment will henceforth correctly reflect the changes in the underlying cash flows. (That is not the case with changes in interest rates charged, which will only affect cash flows for the minority of borrowers that repay in full, but will affect upfront write-offs for the majority that are not expected to do so.) This much closer alignment of the accounting treatment with economic reality reduces perverse incentives and promotes fiscal sustainability, so reducing risks.
However, the new treatment increases uncertainty in the medium term by introducing multi-decade projections into the calculation of outturn data, and thus introduces a new source of risk to our forecast. The economic assumptions embodied in our student loans forecasts and long-term projections will be revised routinely at each forecast. Government has also periodically changed the terms and conditions on the loans. Both affect the expected stream of interest charged and repayments, which under the new treatment will change the estimated partition of gross loan outlays into expenditure and loan portions.
We will show the impact of such changes on future loan outlays in our forecasts, regardless of the underlying source of the change. But all changes to economic assumptions (such as projections for earnings growth or RPI inflation) and many policy changes will also affect estimates of how the existing stock of loans should be partitioned. The ONS will not revise historical estimates of PSNB in the light of these changes, but could change the loan balance and so PSNB in the year that policy changes come into effect. It has provided guidance about how these changes to the loan balance should be treated and considered three general cases:
- Where changes derive from revisions to underlying economic assumptions, these will generally be recorded as a revaluation on the balance sheet, with no associated flow transaction recorded in PSNB.
- Policy changes “that significantly change the loan stock value through expectations of future repayments” – i.e. policy changes that affect cash flows significantly – will be recorded as a flow transaction affecting PSNB and the balance sheet in equal measure. The ‘significant’ test is designed to avoid making large changes to PSNB due to changes in terms and conditions that do not genuinely affect economic reality. But by creating a dividing line in the accounting treatment, it might also generate opportunities for policymakers to try to avoid their policy decisions affecting the deficit.
- Policy changes “that affect the stock value predominantly through a change in the discounting factor” – i.e. policy changes that affect the interest rate charged, but not the amounts repaid – will be recorded as a revaluation, with no associated PSNB transaction. (Since lowering the interest rate charged reduces future write-offs, if a PSNB transaction were recorded it would generate a large fiscal benefit in year one offset by decades of lower interest receipts.) The ONS argues that this would “adversely affect the interpretation of the fiscal aggregates”, hence the different treatment to other policy changes. It also removes a potential fiscal illusion that policymakers might feel a strong incentive to exploit.
The ONS article provides an illustrative scenario with the impact on a single cohort of plan 2 English loans issued in 2018-19 of a decision to link interest rates to CPI, rather than RPI, inflation from 2024-25 onwards. This is the equivalent of reducing the interest rate charged by around 1 percentage point. Under the new treatment, this change increases the estimate of the loan balance for this cohort from £9.6 billion to £10.3 billion (out of total outlays of £16.3 billion).
We can use this example to give an idea of the scale of future revisions. If all future loans paid 1 percentage point less in interest – a little larger than the effect an RPI methodology change might have (see Box 7.1) – it would reduce spending by a little less than £1 billion a year in our forecast. If it applied to existing loans (and passed the ONS’s test as a policy change that significantly affected future repayments) the impact might be around £5 billion in 2019-20.
The Augar Review
In May 2019, an independent review chaired by Dr Philip Augar reported its findings.g The review made recommendations across both further and higher education, but it is those relating to higher education financing that would be most fiscally significant were they to be adopted.
The review recommended:
- a reduction (compared to current plans) on spending on higher education by freezing the fee cap for a number of years and reducing eligibility for financing of ‘foundation years’;
- some giveaways to students, including replacement of part of the loan with a grant, the reintroduction of means-tested maintenance grants, lower in-study interest rates and a cap on total repayments; and
- some takeaways from students, including lower repayment and interest rate thresholds and a longer payment duration so that outstanding amounts would be written off later.
The review suggested that, (under the proposed new accounting treatment), the further and higher education recommendations would together raise borrowing by £1.2 billion to £1.5 billion in 2024-25. This reflected a mixture of proposals that would increase and reduce spending. The departing Prime Minister welcomed the recommendations but also noted that funding decisions needed to be “taken in the round”.h This highlights the most important consequence of the ONS accounting treatment change: in the future, higher education financing will have to compete with other tax and spending policies, rather than appearing to be a ‘free lunch’ as at present.