The National Commission on Education's alternative student loan scheme is the best option, argues Christopher Johnson.

The Government has succeeded beyond expectations in increasing the demand for higher education places, but has had to freeze the supply at just over 30 per cent of the 18 to 21 age group because of the enormous financial strains.

The official student loan scheme, and the rest of the present ramshackle financial apparatus, is unable to cope even with the present numbers, let alone the inevitable increase in the next few years.

The scheme gets the worst of both worlds. It is a huge drain on public finance, and yet students have had to resort to high-interest overdrafts from the banks to make ends meet.

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The essential feature of the National Commission on Education's alternative contribution scheme is that the main funding would come from private sector sources, pension and life insurance funds even more than banks. It would thus give a big upfront saving of public money, and allow the Treasury's limited resources to go much further in terms of increases in the student population and in the inadequate level of provision per head.

The commission scheme is totally different from the proposal turned down by the banks some years ago, in which they would have had all the chores of administering loans funded by the Government with little benefit to themselves.

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The commission scheme has been worked out so as to provide attractive long-term assets for the private financial sector, but with enough Government support to make the loan servicing costs tolerable from the students' point of view. It has some points in common with other new proposals, but others are original, and could tip the balance in its favour. The Treasury would have to review some of its present rules, but the saving in public expenditure is such that they might actually be persuaded to do so. The current cost of student loans and maintenance in the United Kingdom is more than Pounds 2 billion a year, without counting tuition fees.

The important thing now is for private sector institutions to back the scheme, and amend it if they think it could be improved. The progress of the public finance initiative to allow universities to borrow on their capital assets shows that new ideas are making headway.

The tax and national insurance collection system would have to be used to collect loan interest and repayments. This would be far more efficient than the present system, and would lower the risk of default. Although the speed of repayment might depend on a graduate's income, it would not be a graduate tax, because payments would cease as soon as the graduate had finished servicing the loan.

The loans would be guaranteed by the Government, as student loans are in the United States. Thanks to the use of the tax system, the default rate would be far lower than in the US, but some provision would have to be made for the suspension of repayment obligations for graduates not earning the agreed minimum or temporarily leaving the labour market. A provision of 20 per cent of total loans advanced should be sufficient. This would be a charge on public funds, but the other 80 per cent would be saved. The pension funds and other private sector providers of the loan money would receive the market rate of interest on other Government-guaranteed stock, such as gilt edged, which can be estimated at about 6 per cent in the long run. As pension funds, under the new rules, will need bigger holdings of government stock to guarantee that they can meet their obligations, the new bonds would come at the right time for them.

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Students would, however, get a 25 per cent tax credit similar to the existing mortgage interest relief at source. As MIRAS is being reduced, it makes sense to shift this kind of subsidy from bricks and mortar to human capital, with benefits to economic growth and living standards.

The interest rate to graduates would then fall to 4.5 per cent. This is one percentage point higher than the current rate of inflation, which sets the interest rate for the present student loans. But the repayment period would be lengthened to up to 20 years, so the servicing costs would fall in real terms, as the principal of the loan was eroded by even a moderate rate of inflation.

The commission scheme would create a new class of low-risk financial assets, which could be held to maturity, or traded in the secondary market, as gilt-edged government stocks are now. This process, called "securitisation", would make the loans even more attractive to the private sector, because holdings would be liquid and flexible in accordance with the changing needs of each institution.

The loans would be administered by a Student Support Agency, replacing the present Student Loans Company. Students would need to borrow contributions for maintenance and for 20 per cent of tuition fees. However, a discount would be given for contributions paid in advance, which would be particularly appropriate for mature students with savings or with contributions from employers.

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These contributions would replace the existing grants and parental contributions, as well as the Government's student loans. The phasing out of grants is logical, because the ability to repay the contributions depends not on the existing income of parents, but on the future income of students. All students, irrespective of family income, would be asked to invest in their own future. The better earnings and job prospects for most graduates make it a good investment, but there would be a Government safety net, in the shape of the loan guarantee and interest subsidy, for those unable to repay.

"Getting into debt" has got a bad name among students, and may deter some people from entering higher education - although the growth in numbers suggests that such effects are minimal. For this reason, the commission is presenting its scheme as consisting of contributions by students to maintenance and 20 per cent of tuition. In most cases, the contributions would effectively be Government-guaranteed loans from private financial institutions. The servicing of the loans would be regarded as deferred payment of contributions by graduates to their own higher education.

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Christopher Johnson is a member of the National Commission on Education, and former chief economic advisor to Lloyds Bank.