Make student loans what they effectively are: a tax

You borrow a large amount of money to buy a product. You expect your investment in that product to produce enough cash to repay the loan (plus a pleasing sum to spare) over a 30-year period. It does not. Something has clearly gone wrong.

Is it with the product? Is it the way you have managed your ownership of the product? Or is it the structure of the product itself?

If you are about to go to university, or have a child who is, you should note that 77% of students who take out loans to cover their tuition fees and maintenance costs will never pay them back in full, according to estimates from the Institute of Fiscal Studies published this week.

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Instead, over the long term, the taxpayer is set to pick up a bill of about £5.9bn a year in unpaid loans (student debt is written off after 30 years). Given the state of the UK's government finances, that is definitely not a good thing.

So let's start with the product. Is the average university education just too rubbish to generate a return sufficient to cover its cost? There is something in this, but the answer has to depend on how much you pay for your degree.

The UK's universities have begun to operate in a similar manner to our fund management industry. Regardless of the income-earning potential, quality or underlying cost of their offerings they all charge pretty much the same. That makes no sense.

Go to Oxford, Cambridge or the London School of Economics, study business administration, law or computer sciences and you should be earning well over £50,000 within five years of graduation. Given that you have to pay 9% of any salary over £21,000 towards the debt, assuming your salary rises with your experience, you should repay every penny of your loan.

Go to a less prestigious university, study something creative or vocational, and you almost certainly will not. These degrees should therefore be priced very differently their income potential should be a major factor in their price. They aren't and it isn't.

Next up, the users of the product. In a rational world, anyone with a debt of more than £30,000 hanging over their head would do everything they could to maximise their income to pay it back. Not all graduates do.

Some have children and work part-time, or take a career break. Some just take time out. Some prioritise job satisfaction over high income. They buy an expensive product, but they don't all maximise the financial returns that should be available from it something they are effectively incentivised to do by the way the repayments work and the automatic 30-year write-off period. There's definitely a problem here for the taxpayers picking up the bill at least. (Please don't write in and tell me non-financial returns are important too. Of course they are. But we are talking here about why money borrowed is not being repaid).

On to the product itself. Student loans used to come with relatively low interest rates. That changed in 2012. Anyone who started university since then is charged RPI plus 3% from the second they start borrowing (inexplicably, as RPI has not been the government's preferred measure of inflation for years).

RPI hit 3.1% in March. That means the rate on student loans from September will be 6.1%. Borrow the maximum (tuition fees and maintenance) every year for three years and you'll owe £5,000 in interest before you've rolled home from your last graduation party. Borrow £45,000. Start life with a debt of £50,800. Shocking and for most people juggling the rest of life, too much money to pay back.

But the key thing to note here is that student loans are not really "loans". If they were, we would think about credit risk and the taxpayer would lend less and at higher rates to those studying creative writing at Bournemouth than those studying law at Cambridge. We would also lend less to women on the basis that there is a higher risk they will be non-earners for part of the 30 years in question.

Nor would we allow people to pay nothing until they earn over £21,000, or charge significantly higher interest rates to higher earners than lower earners. We wouldn't write off the debt after 30 years, but we would of course wipe it off as we do all other debts in the event of bankruptcy.

These "loans" are treated so unlike all other loans that it should be clear to everyone that the student loan system is actually a progressive tax system one that firmly favours low earners over high earners. You could, as moneysavingexpert's Martin Lewis does, see this as a good thing in that it means students don't really need to worry about how much debt they have: pretty much everyone will pay 9% of some of their salary for the first 30 years and that will be that regardless of anyone's headline debt number.

But once you start thinking of student loan repayment as a hypothecated tax you start to see the problems. It is too progressive. The fact that you pay very little on low earnings (make £22,000 and your annual bill is £90) means that there isn't much pressure on bad universities to make bad courses better (everyone knows the courses are effectively "free"). But it is also too high.

Coupled with national insurance, this extra 9%"graduate tax" takes the marginal rate for basic-rate taxpayers up to 4%. For higher-rate taxpayers, it becomes 5%.

Earn £60,000 and you will pay £3,510 a year in graduate tax. That's potentially a large part of a mortgage, about 30% more than would be paid into your pension via auto enrolment, and (at a guess) one of the key reasons why you are extremely angry with the generation above you.

So what to do? The answer is not to make university free. Do that and England will end up like Scotland with places rationed and the disadvantaged locked out. Nor is it to keep things as they are.

It might be to admit that this is a tax, and then to make it both lower and more widely applied 5% on all graduates regardless of income, perhaps. That would raise a reasonable amount of money but also put more pressure on both students (and hence universities) to think about value.

In the meantime, should you pay your child's fees upfront to save her from them? Although my own children are years away from university, my guess is not immediately. Wait and see how she goes. If she leaves university and looks as if she will fly, pay them off for her then. Yes, you will have paid a few thousand in interest for the first few years. But that is nothing to the loss you will be carrying if you paid upfront, only to see her enter a low-earning career that could have made her university education free.