The Obama Budget’s Big Student Debt Fix

President Barack Obama’s 2015 budget, introduced Tuesday, contains several interesting policy ideas. The president would extend eligibility to the federal Earned Income Tax Credit (EITC) to adult workers with no dependent children. He would give $750 million to states for preschool development grants. He would also create competitive grants to promote development of a more energy efficient power infrastructure.

And he would also give people with particularly large student loan debt a great big present after they make payments for many years. According to an article at Inside Higher Ed:

The Obama budget will also seek to exempt from taxation the student loan forgiveness the federal government provides to borrowers after they have made payments for at least a decade through income-based repayment programs. The federal government forgives the debt of borrowers working in the public or nonprofit sectors after as few as 10 years. Other income-based repayment programs forgive outstanding debt after 20 or 25 years of repayment.

Under existing rules, instituted in 2007, Americans can enjoy generous student loan relief, but it’s a complicated system.

Income-based repayment allows people with education debt to pay back loans as a percentage of income. No more than 10 percent of someone’s income has to go to service student debt, no matter how big that bill is. And then after 20 years (or a decade, depending upon one’s career) the federal government is supposed to forgive the remaining balance.

TimeBomb

This sounds great, except that the forgiveness is troublesome, because in 20 years that forgiveness of the remaining balance will be taxed as income. That could be pretty big bill, made all the more difficult because the sort of people who will still have large balances remaining after 20 years will be those with relatively low incomes, making it pretty hard to pay the damage.

As Megan McArdle pointed out last year, someone who goes in for income-based repayment after an expensive graduate education (in, say medicine or law) could owe the IRS something in the neighborhood of $200,000 when his loans are forgiven after a couple decades.

The Obama plan would fix that. The federal government would just zero the loan out after years of repayment, and the college graduates would owe nothing.

Now, this is probably not going to happen, because of the notably obstructionist Congress, but it’s a potentially huge change. Even if there’s no movement this year, Obama is at least bringing up one very important flaw in the current income-based repayment: for many graduates it’s something of a financial time bomb.

Daniel Luzer

Daniel Luzer is the news editor at Governing Magazine and former web editor of the Washington Monthly. Find him on Twitter: @Daniel_Luzer