Gaming the Lambda School system and avoiding the tax

The New York Times reported last week:

Now, Silicon Valley is backing a novel idea that proposes to rewrite the economics of getting an education.

The concept is deceptively simple: Instead of charging students tuition — which often requires them to take out thousands of dollars in loans — students go to school for free and are required to pay back a percentage of their income after graduation, but only if they get a job with a good salary.

The idea, known as an Income Share Agreement, or I.S.A., has been experimented with and talked about for years. But what’s happening at Lambda School, an online learning start-up founded in 2017 with the backing of Y Combinator, has captivated venture capitalists...

At Lambda, students pay nothing upfront. But they are required to pay 17 percent of their salary to Lambda for two years if they get a job that pays more than $50,000. (Lambda says 83 percent of its students get a job with a median salary of $70,000 within six months of graduating.) If they don’t get a job, or their salary is lower, they pay nothing. Payments are capped at $30,000, so a highly paid student isn’t penalized for success, and if a student loses a job, the payments pause.

It is a model that so far has been aimed at vocational education but has the potential to end the crushing cycle of student debt and change the way schools think about students.

“It aligns the incentives fully,” said Mr. Lewis, the venture capitalist.

I'm not sure whose incentives are aligned here, but I doubt they are aligned fully in the way Mr Lewis thinks they are. Sure, the Lambda School has a strong incentive to make their graduates employable, and employable at a high salary, in order to maximise their return in the two years that the graduate is paying the 17 percent Lambda tax.

However, the student's incentives are not necessarily aligned with those of Lambda. They'd rather avoid paying that Lambda tax, and the more income they earn, they more they have to pay to Lambda. On the surface, the student still maximises their income by finding the highest paying job after graduation.

However, I'd say this system also creates some strong incentives for students in the opposite direction to what Lambda wants. There is an incentive for the student to engage in moral hazard. Moral hazard the tendency for someone who is imperfectly monitored to take advantage of the terms of a contract (a problem of post-contractual opportunism). In this case, the student takes advantage of their free tuition, but then tries to avoid paying the 17 percent Lambda tax.

There are several ways students could game the Lambda system, by their actions after completing their education. For instance, the student could choose to take the first two years off after graduating, thereby paying Lambda back nothing. Of course, the student also gives up two years of earnings, so that isn't very attractive. And in any case, surely Lambda has thought of that already and there is a contract clause preventing it (say, the students have to pay 17 percent of their first two years' working after graduation).

So, maybe the student could work as a volunteer, or in the Peace Corps? Or go on a Mormon mission? The student is still giving up their salary for two years, but they are adding to their CV and might earn more once they start working, and they don't have to pay anything to Lambda. Of course, Lambda could no doubt contract around those situations as well (e.g. 17 percent of the student's first two years of paid work after graduation).

So, what if the student joins a start-up and is paid a nominal salary in cash, which is less than the $50,000 threshold, and receives the rest of their salary as stock options? Again, Lambda could contract for that eventuality. So, the smart student play here might be to find an employer who would agree to some form of deferred salary payment, payable after more than two years and thereby not subject to the 17 percent Lambda tax. Or they go into self-employment and pay themselves the $50,000 salary, but the remainder in dividends. Or... you can probably see by now there are lots of alternatives to get around the Lambda tax.

Of course, not all students would engage in this opportunistic behaviour. But it's clear to me that Lamba's system is too easily exploited. One solution for Lambda (if they don't want to move to a formal student loan system) would be to have some minimum required payment, which would be paid back regardless of how many years it takes, and 17 percent for two years otherwise. That makes it less attractive for students to engage in moral hazard to avoid the Lambda tax.

[HT: Marginal Revolution]