College Education and Income Contingent Loans in Equilibrium: Theory and Quantitative Evaluation

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This paper investigates the welfare and efficiency implications of income-contingent loans (ICLs) used for financing risky college education. Using a simple two period human capital model, we show that the laissez-faire allocation is constrained inefficient due to incomplete markets and pecuniary externalities working through the skill premium. Furthermore, we show that although ICLs can restore the second best efficiency of the economy, the social planner may achieve the same outcomes using progressive income tax systems. Building on these insights, we construct an overlapping generations life-cycle economy with heterogenous agents and calibrate it to the US tax system, education and labor markets. We find that although the current design of ICLs induces some redistribution across wealth-ability groups, it does not increase overall utilitarian welfare. Decomposing the results, we show that the positive effects of ICLs are significantly attenuated by the existing progressive income tax system and general equilibrium effects.