Tax rate for graduates could be cut by 10% if the government cut real interest rates to zero and slashed repayment rates to 5% on plan 2 student loans.
The market value of the English student loan book is approximately £33 billion (~21%) lower than recorded in Government accounts, suggesting Public Sector Net Financial Liabilities are higher than currently thought;
Graduates with both undergraduate and postgraduate loans can face effective marginal tax rates as high as 77%, leaving them with less than a quarter of their marginal income.
The Adam Smith Institute (ASI) is calling for a "Combined Package" of reforms: cutting real interest rates to zero and slashing repayment rates to 5%;
To ensure fiscal sustainability, the write-off period should be extended to 40 years and the repayment threshold cut by one-third.
Reforming Plan 2 student loans could see marginal tax rates for graduates cut by 10% while making the system more sustainable for taxpayers, new research from the Adam Smith Institute reveals.
The English student loan system is widely considered to be structurally flawed, imposing excessive fiscal costs and creating perverse disincentives for work.
The Chancellor recently chose to freeze income thresholds for Plan 2 loans, reinvigorating the debate over fairness and efficiency. The ASI calls the government accounting into question; the new research shows the loan book is overvalued by £33 billion because the official discount rates do not reflect market reality.
ASI analysis shows that some graduates, particularly those in the "£100,000 trap" with both undergraduate and postgraduate loans, face an effective marginal tax rate of 77%. This means less than 25p of every extra pound earned actually hits their pocket, dampening the incentive to seek promotions or work more hours.
To address these tax traps, the ASI proposes lowering the repayment rate from 9% to 5%. This would be paired with a reduction of the real interest rate to RPI (0% real) to eliminate the psychic impact of ballooning imaginary debt balances that currently afflict 70% of Plan 2 borrowers.
To offset the cost, the report recommends extending the write-off period to 40 years, matching the graduate's full working life, and lowering the repayment threshold by one-third. This combined package would be strongly fiscally positive, increasing the net present value of loans for low, middle, and high earners alike.
Naturally, tweaking the parameters of existing loans is only the first step. Our current system allocates too much risk to the taxpayer rather than those best able to minimize it.
To fix the system for the long term, we must introduce institutional underwriting. This means requiring universities to take on a portion of the loan risk, encouraging them to prioritize degree programs with strong employment outcomes rather than channeling students into low-value courses. We should also enable employers to offer bonded study funding agreements, allowing them to finance the degrees of future employees in exchange for guaranteed service.
Mitchell Palmer, economist of the Adam Smith Institute said:
“Britain’s student loan system has quietly become one of the most punitive tax traps in the country.
“A simpler, fairer system is possible. Cutting repayment rates and removing punitive real interest would reduce these extreme tax rates while making the system more transparent and sustainable for taxpayers.
“In the longer term, ministers must reform the system so that universities share more of the risk. If institutions had skin in the game, they would be far more focused on offering degrees that deliver real value to students and the economy.
Suella Braverman, Reform member of parliament for Fareham and Waterlooville, said:
“For too long, education has been seen as a social experiment for Whitehall’s planners, rather than its original role as a foundation stone for national success.
“It cannot be right that the taxpayer is funding graduates being channelled into low-value courses that saddle them with debt and leave them unprepared for today's world. Nor can it be right that high-earning graduates are disproportionately penalised through the repayment scheme.
“The proposed package of lowering interest rates, adjusting thresholds, and extending the write-off period is one possible route to easing the burden on graduates while improving fiscal sustainability.”
ENDS
For further comments or to arrange an interview, contact joanna@adamsmith.org| 0798 5540467.
Read the full research here.
Methodology:
The model tracks a single Plan 2 borrower from graduation to either full repayment or write-off. Income grows each year based on an age-dependent real earnings profile and economy-wide wage growth. In the status quo case, repayments are calculated as 9% of income above the repayment threshold, with interest charged on a sliding scale between RPI and RPI+3% depending on earnings. Any remaining balance is written off after the statutory term. The resulting cash flows are then discounted under three conventions — government, market, and ONS — to produce net present value estimates and a RAB charge representing the implicit taxpayer subsidy. The loan parameters — interest rate, repayment rate, repayment threshold, and write-off period — are then adjusted, and the model re-runs the simulation under the changed settings alongside the status quo. By comparing the two sets of outputs for representative borrowers at different income levels, it shows how a given reform would affect repayment burdens, loan duration, and the fiscal cost to the taxpayer.