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

Abstract

We investigate the welfare implications of income-contingent loans (ICLs) used for financing college education in presence of the dropout risk that depends on unobservable effort. Using a simple model, we show that the laissez-faire enrollment is inefficiently low due to missing insurance against dropping out. However, providing this insurance generates a moral hazard cost of lowering effort. We show that ICLs can implement the second best allocation. Then, we construct a heterogeneous agent OLG life-cycle model, calibrate it to the US and show that ICLs significantly increase welfare and that their non-linear structure is essential to delivering high welfare gains.