Human Capital Contracts

Cross-posted on my blog here. Par­tially in­spired by some slat­estar­codex dis­cus­sion here.

Sum­mary: Hu­man Cap­i­tal Con­tracts would al­low peo­ple sell a cer­tain % of their fu­ture in­come in re­turn for up­front cash, as op­posed to tak­ing out a loan. This would be less risky for them, would give them valuable in­for­ma­tion about differ­ent col­lege ma­jors, and would help give peo­ple de facto ‘men­tors’, among other ad­van­tages. Ad­verse se­lec­tion could re­duce the benefits, and re­duc­ing in­ter-state com­pe­ti­tion poses a ma­jor pos­si­ble dis­ad­van­tage. We also dis­cuss two niche ap­pli­ca­tions: par­ents and di­vorce.

Read­ers with an eco­nomics back­ground might like to jump to the sec­tions on ‘Ed­u­ca­tion’ and ‘Men­tors—In­cen­tive Align­ment’

Debt vs equity financing

There are two meth­ods of fi­nanc­ing for com­pa­nies; debt and equity.

Debt is fun­da­men­tally very sim­ple. I give the com­pany $100 now; it promises to give me $105 in a year’s time. They owe me a fixed amount in re­turn. Hope­fully in the mean­time the com­pany has in­vested that $100 in a pro­ject or piece of equip­ment that pro­duces more than $105; if so they made a profit on the trans­ac­tion as a whole. Here the risk is borne by the com­pany; they have no choice but to pay me back, even if they didn’t make a profit this year. This form of fi­nanc­ing is fa­mil­iar to most peo­ple, as they per­son­ally use sav­ings ac­counts, credit cards, mort­gages, auto loans and so on.

Equity, un­like debt, does not rep­re­sent a fixed level of obli­ga­tion. In­stead the com­pany owes you a cer­tain frac­tion of fu­ture prof­its. If you give a com­pany $100 in re­turn for a 10% share, and they made a $50 profit, your share of the profit is $5. Hope­fully they will make grow­ing prof­its for many years, in which case your por­tion will grow to $6, to $7, and so on. Here the risk is borne by you; if they don’t make a profit, you get noth­ing. This form of fi­nanc­ing is much less fa­mil­iar to most peo­ple; about the only ex­pe­rience they are likely to have would be in­vest­ing in the stock mar­ket, but that is now highly ab­stract so the un­der­ly­ing me­chan­ics are ob­scured.

Equity: Less Risky than Debt

One of the biggest ad­van­tages of this sys­tem is it moves the risk from the in­di­vi­d­ual bor­rower to the in­vestor. When you bor­row money, you put your­self at sub­stan­tial risk. What if you strug­gle to find a good job af­ter col­lege? You’re still obliged to make re­pay­ments, which could be very difficult if you only have to ac­cept a very low-pay­ing job. Or if you bor­row money af­ter col­lege, what if you lose your job? Or have a fam­ily emer­gency? Your cir­cum­stances have de­te­ri­o­rated, but you’re still obliged to make the same level of pay­ments – mean­ing your post-debt in­come falls by even more than your pre-debt in­come.

With equity, on the other hand, you don’t have the risk. If you don’t find a job af­ter col­lege, your in­come will be zero, so your re­pay­ments will be X% of 0 – namely 0. If you find a low-pay­ing job, your re­pay­ments will be low. The in­vestors will be made whole by the peo­ple who in­stead find high-pay­ing jobs – who can also af­ford to re­pay more. So equity in­vest­ments bet­ter match up your re­pay­ment obli­ga­tions with your abil­ity to re­pay.

Here is an chart show­ing the differ­ence, in terms of the % of in­come you’d be spend­ing on re­pay­ment, from an ex­am­ple worked out later in the ar­ti­cle:

Debt burden under adversity

The risk is trans­ferred to the in­vestor, who now loses out if you don’t have much in­come. But they are in a much bet­ter po­si­tion to deal with the risk – they can di­ver­sify, in­vest­ing in many differ­ent peo­ple, and also in other as­set classes. Some hu­man cap­i­tal con­tracts could be a good di­ver­sify­ing ad­di­tion to a con­ven­tional port­fo­lio of stocks and bonds.

Education

Fund­ing higher ed­u­ca­tion is per­haps the best ap­pli­ca­tion for Hu­man Cap­i­tal Con­tracts.

Firstly, this is an ex­tremely risky in­vest­ment. There are countless sto­ries of peo­ple who took out huge stu­dent loans to fund an arts de­gree and then have their lives dom­i­nated by the strug­gle to re­pay. Alter­na­tively, if peo­ple could discharge ed­u­ca­tion debts through bankruptcy, the risk to the lender would be too great, as the bor­row­ers typ­i­cally lack col­lat­eral, so loans would be available only at pro­hibitively high in­ter­est rates, if at all. Sel­ling equity shares would avoid this prob­lem; peo­ple who did badly af­ter school would only have to re­pay a min­i­mal amount, but lenders could af­ford to offer rel­a­tively gen­er­ous terms be­cause the av­er­age would be pul­led up by the oc­ca­sional very suc­cess­ful stu­dent.

The other ap­peal is the in­for­ma­tion such a mar­ket would provide stu­dents. It is fair to say that many stu­dents don’t re­ally un­der­stand the long-term con­se­quences of their choices. The in­for­ma­tion available on the fu­ture paths opened up by differ­ent ma­jors is poor qual­ity – at best, it tells you how well peo­ple who stud­ied that ma­jor years ago have done, but the la­bor mar­ket has prob­a­bly changed sub­stan­tially over time. What stu­dents re­ally want is fore­casts of fu­ture re­turns to differ­ent col­leges and ma­jors, but this is very difficult! And many peo­ple are not even aware of the back­wards-look­ing data. The situ­a­tion isn’t im­proved by pro­fes­sors, who gen­er­ally lack ex­pe­rience out­side academia, and some­times sim­ply lie! I re­mem­ber be­ing told by a philos­o­phy pro­fes­sor that philoso­phers were highly in de­mand due to the “trans­fer­able think­ing skills” – de­spite the to­tal lack of ev­i­dence for such an effect. Hu­man Cap­i­tal Con­tracts would largely solve this prob­lem.

TIPs mar­kets provide a fore­cast of fu­ture in­fla­tion. Pop­u­la­tion-linked bonds would provide similar fore­casts of fu­ture pop­u­la­tion growth. Similarly, Hu­man Cap­i­tal Con­tracts could provide fore­casts of the fu­ture re­turns to fu­ture de­grees. Len­ders would ex­pect higher re­turns to some col­leges and ma­jors (Stan­ford Com­puter Science vs No-Name Com­mu­ni­ca­tions Stud­ies), and so would be will­ing to ac­cept lower in­come shares for peo­ple who chose those ma­jors. As such, be­ing offered fi­nanc­ing for a small per­centage would in­di­cate that the mar­ket ex­pected this to be a prof­itable de­gree. Be­ing offered fi­nanc­ing only for a large per­centage would be a sign that the de­gree would not be very prof­itable. Some peo­ple would still want to do it for love rather than money, but many would not – sav­ing them from spend­ing four years and a lot of money on a de­ci­sion they’d sub­se­quently re­gret.

What could make clearer the differ­ence in ex­pected out­comes than be­ing offered the choice be­tween Eng­ineer­ing for 1% or Fine Art for 3%?

Cer­tainly I think I would have benefited from hav­ing this in­for­ma­tion available. Most peo­ple prob­a­bly know that Com­puter Science pays bet­ter than English Liter­a­ture, but that’s prob­a­bly not a pair many peo­ple are choos­ing from. I was con­sid­er­ing be­tween Physics, Math, Eco­nomics or His­tory for my ma­jor. I knew that His­tory would prob­a­bly pay less, but didn’t have a strong view on the rel­a­tive earn­ings of the oth­ers. I prob­a­bly would have guessed that math beat physics, for ex­am­ple, but in ret­ro­spect I think physics prob­a­bly ac­tu­ally beats math.

As­tute read­ers might ob­ject here that I am con­flat­ing the benefits of the type of fi­nanc­ing (debt vs equity) with the mechanism for pric­ing the fi­nanc­ing (free mar­ket or price fixed). If there was a free mar­ket in debt fi­nanc­ing, lenders could charge differ­ent in­ter­est rates, and these would provide in­for­ma­tion to the stu­dents. This is true, ex­cept that 1) the in­ter­est rate would only tell you about the risk you’d end up su­per-poor, rather than pro­vid­ing in­for­ma­tion about the full dis­tri­bu­tion of out­comes, and 2) as stu­dent loans can­not be discharged through bankruptcy, there’s not re­ally much rea­son for lenders to differ­en­ti­ate be­tween can­di­dates. If stu­dent loans could be discharged through bankruptcy, the in­ter­est rates charged would be in­for­ma­tive but also prob­a­bly very high. Per­haps this would be a good thing!

Ed­u­ca­tion Fund­ing – some illus­tra­tive ex­am­ples.

Be­cause it can be hard to think about these things in the ab­stract, I’ve tried to pro­duce some worked-out ex­am­ples. Sup­pose some­one bor­rows $100,000, and then starts out earn­ing $50,000 when they grad­u­ate. Their in­come grows over time, as they gain ex­pe­rience (ma­tu­rity) and the econ­omy grows (NGDP/​cap­ita). If we as­sume a 6% re­turn for in­vestors and a 20 year du­ra­tion, they would have to give up just over 5% of their in­come of this time pe­riod. The re­pay­ments would be much more man­age­able – in year one, it would rep­re­sent just 5% of their in­come, as op­posed to 17% if they used debt.

Debt Equity Repayment Structures, equal r

(click for larger image)

Now, in­vestors might de­mand a higher rate of re­turn for equity in­vest­ments, as they’re riskier than debt ( but then again maybe not . Here’s the same calcu­la­tions, but as­sum­ing equity in­vestors re­quire a 10% re­turn vs 6% on debt:

Debt Equity Repayment Structures, unequal r

What hap­pens if the stu­dent runs into fi­nan­cial difficulty later in life? Here’s what hap­pens if their in­come falls by 50% and never re­ally re­cov­ers:

Debt Equity Repayment Structures, equal r, unexpected poverty

with equity, the hit is af­ford­able, but with debt they have to pay 20% of their in­come in debt re­pay­ments – per­haps at the same time as hav­ing med­i­cal prob­lems.

And what about the in­for­ma­tion value? Well, the in­vestors would be will­ing to offer them $100,000 for just a 5.6% share, in­stead of 7.85%, if they took a ma­jor that would offer a $70,000 start­ing salary in­stead.

Debt Equity Repayment Structures, unequal r, higher initial

Men­tors – In­cen­tive Alignment

The mod­ern world is very com­pli­cated, and we can’t ex­pect peo­ple to un­der­stand all of it. Which is fine, ex­cept when it comes to un­der­stand­ing con­tracts, or credit cards, or multi-level-mar­ket­ing schemes. At times the com­plex­ity of the mod­ern world al­lows peo­ple to be taken ad­van­tage of, even in trans­ac­tions which would be perfectly le­gi­t­i­mate had the par­ti­ci­pants been bet­ter in­formed.

Equity in­vest­ments have the po­ten­tial to help a lot here. All of a sud­den I have a third party who is gen­uinely con­cerned with max­i­miz­ing my in­come. I could ask them for ad­vise about look­ing for a job. Per­haps they could ne­go­ti­ate a raise for me. In­deed, they might even line up new jobs for me! Ob­vi­ously their in­cen­tives are not to­tally al­igned with me. Ex­cept in­so­much-as happy work­ers are more pro­duc­tive, they might not put much weight on how pleas­ant the job is. But true in­cen­tive al­ign­ment is rare in gen­eral; even your par­ents or your spouse’s in­cen­tives aren’t perfectly al­igned, and the gov­ern­ment’s cer­tainly aren’t. Even bet­ter, it’s very clear ex­actly how and to what de­gree my in­ven­tor’s in­cen­tives are al­igned with mine: I don’t need to try and work out their an­gle. I can trust them on mon­e­tary af­fairs, and ig­nore their ad­vice (if they offered any) with re­gards hob­bies or friend­ships or what­ever else.

In­deed, you could imag­ine schools that funded them­selves en­tirely through equity in­vest­ments in their stu­dents, and ad­ver­tised this as a strength: their in­cen­tives are well al­igned with their stu­dents. They would teach only the most use­ful skills, as effi­ciently as pos­si­ble, and ac­tively sup­port your fu­ture ca­reer pro­gres­sion. This is ba­si­cally the model App Academy uses:

App Academy is as low-risk as we can make it.

App Academy does not charge any tu­ition. In­stead, you pay us a place­ment fee only if you find a job as a de­vel­oper af­ter the pro­gram. In that case, the fee is 18% of your first year salary, payable over the first 6 months af­ter you start work­ing.

source

Com­pare this to cur­rent uni­ver­si­ties, which ac­tively push minor­ity stu­dents out of STEM ma­jors to main­tain grad­u­a­tion rates.

Progressive

A clear im­pli­ca­tion of equity fi­nanc­ing is that peo­ple who go on to earn more for ex ante un­pre­dictable rea­sons will pay more than those who are ex post un­lucky. As such, this sys­tem is mildly re­dis­tribu­tive in a man­ner many peo­ple find at­trac­tive – like a sort of ideal­ized so­cial in­surance that Luck Egal­i­tar­i­ans like talk­ing about. The lucky rich pay more and the un­lucky poor pay less. Even bet­ter, it man­ages to do so in a vol­un­tary way.

Taxation

The idea of hu­man cap­i­tal con­tracts may sound very strange. But we ac­tu­ally already have some­thing similar in tax­a­tion. Govern­ments in­vest in the ed­u­ca­tion, health etc. of their cit­i­zens, and then levy taxes upon them. Th­ese taxes tend to be pro­por­tional to one’s abil­ity to pay; they are some frac­tion of in­come, or ex­pen­di­tures (sales taxes). So Hu­man Cap­i­tal Con­tracts should feel fa­mil­iar to so­cial­ists and the like.

There are of course a few differ­ences be­tween Hu­man Cap­i­tal Con­tracts and tax­a­tion. For ex­am­ple,

  • Hu­man Cap­i­tal Con­tracts are op­tional, whereas tax­a­tion is manda­tory.

  • Hu­man Cap­i­tal Con­tracts give you more choice about what you spend the money on, whereas gov­ern­ments typ­i­cally give you lit­tle choice.

  • Fi­nally, Hu­man Cap­i­tal Con­tracts are cus­tomiz­able; you could ne­go­ti­ate differ­ent terms with the lender (like the % share you’re sel­l­ing, or the in­come level at which you start re­pay­ing, or the timing of re­pay­ments), whereas in­di­vi­d­u­als rarely get much choice about the taxes they will be made to pay.

In­deed, the ad­van­tages of hu­man cap­i­tal con­tracts sug­gest a new way of do­ing tax­a­tion: the state could sim­ply claim a cer­tain % own­er­ship of its cit­i­zens. Per­haps it might de­mand a higher % for those who use pub­lic ed­u­ca­tion or pub­lic health­care.

The idea of the state liter­ally own­ing (a stake in) its cit­i­zens, with­out their con­sent, might sound evil. But this is ba­si­cally what the gov­ern­ment already does with tax­a­tion – it claims a cer­tain frac­tion of your in­come, leav­ing you no re­course. Even re­nounc­ing your cit­i­zen­ship will not per­suade the IRS to let its prop­erty go. Hu­man Cap­i­tal Con­tracts just make it more ex­plicit that the gov­ern­ments of most coun­tries effec­tively own some­where be­tween 30% – 60% of their pop­u­la­tions. Worse, if they want to they can in­crease their own­er­ship stake with­out the con­sent of those af­fected. Com­pared to this, it is hard to make vol­un­tary Hu­man Cap­i­tal Con­tracts sound prob­le­matic.

How­ever, this sug­gests a dan­ger with equity in­vest­ments in peo­ple. At the mo­ment you can es­cape most gov­ern­ments by flee­ing abroad. The cou­ple of ex­cep­tions are largely viewed as im­moral aber­ra­tions, not the right­ful state of af­fairs. This exit-right pro­vides a vi­tal check on their power, and forces them to com­pete to some de­gree. Without it they can de­scend to the most abu­sive tyranny. If equity in­vest­ments be­came widely rec­og­nized, how­ever, gov­ern­ments might start to rec­og­nize each other’s own­er­ship of its pop­u­la­tion to a greater de­gree than now, which would make them harder to es­cape. Of course, vir­tu­ally any in­no­va­tion can be op­posed by point­ing out they make it eas­ier for gov­ern­ments to op­press ‘their’ pop­u­lace, from coinage to maps to cell phones. Per­haps a more pow­er­ful gov­ern­ment would be a more be­nign one, as many differ­ent peo­ple have ar­gued – though per­haps not.

Mechanics

Oper­a­tionally this would be slightly more com­pli­cated than tak­ing out a stan­dard loan, be­cause the amount owed to the lender would be vari­able. As such, they need to ver­ify my in­come so they can check I’m re­pay­ing the cor­rect amount. There are many ways this could be done, but an ob­vi­ous one would be through the tax sys­tem; I would sub­mit to the lender a copy of my tax re­turn to show my an­nual in­come. Per­haps this could be au­to­mated through Tur­boTax. An even eas­ier op­tion would be if the pay­ments were de­ducted from my pay­checks – this is how English stu­dent loans work.

Pos­si­ble Regulations

One op­tion for reg­u­lat­ing the sys­tem would be to im­pose a max­i­mum amount of equity an in­di­vi­d­ual could sell. This would pre­vent peo­ple from sel­l­ing 100% of them­selves, which might be a bad idea! Though for-profit in­vestors would prob­a­bly be un­in­ter­ested in buy­ing up to 100%, as the in­di­vi­d­ual would lack any rea­son to ac­tu­ally work. Prob­a­bly the only peo­ple in­ter­ested in buy­ing 100% own­er­ship would be cults, com­mu­nist co-ops and ter­ror­ist move­ments.

Another would be to reg­u­late the con­tin­gen­cies that could be at­tached to such con­tracts.

A third would be to pro­hibit the in­vestor from em­ploy­ing the in­vestee, or vice versa.

Ad­verse Selection

One of the biggest im­ped­i­ments to such a sys­tem might be ad­verse se­lec­tion. Stu­dents have ‘in­sider in­for­ma­tion’ about their fu­ture prospects – they know about their ca­reer plans. The less you ex­pect to earn, the more at­trac­tive sel­l­ing equity is over the fixed pay­ments of debt. Con­versely, the more you ex­pect to earn, the less at­trac­tive equity is vs debt. As such, the stu­dents who opted for equity fi­nanc­ing might be dis­pro­por­tionately the stu­dents with the low­est ex­pected out­comes. This would in­crease the % in­vestors would de­mand in re­turn for fund­ing, fur­ther de­ter­ring the higher-ex­pec­ta­tion stu­dents, un­til even­tu­ally only the very low­est-ex­pec­ta­tion stu­dents would re­main in the pool.

We could imag­ine this be­ing a big is­sue in some sub­jects, like physics, where there is a large var­i­ance in in­come for the differ­ent exit routes – grad school vs in­dus­try vs quant fi­nance. For oth­ers it’s less of an is­sue; if you go to law school you’re prob­a­bly aiming to be­come a lawyer, though even there you might choose be­tween crim­i­nal or cor­po­rate law.

How­ever, there are sev­eral fac­tors which would miti­gate against such an out­come. Firstly, the risk aver­sion we dis­cussed ear­lier means stu­dents would prob­a­bly be will­ing to pay a sub­stan­tial amount to avoid the risk as­so­ci­ated with debt. Ad­verse se­lec­tion would mean it would be even more at­trac­tive to stu­dents pes­simistic about their long-term earn­ings, but so long as it is at­trac­tive enough for the op­ti­mistic ones, it would still work.

In­deed, this is ba­si­cally how it works for health in­surance. In the­ory ad­verse se­lec­tion is a prob­lem for pri­vate health in­surance; but in prac­tice there is not much ev­i­dence this is ac­tu­ally a prob­lem; healthy peo­ple still buy health in­surance.

The effect would also be sub­stan­tially re­duced by stu­dents own lack of knowl­edge about their fu­tures. Many stu­dents change their mind over the course of their stud­ies about what they want to go on to do. So some low-ex­pec­ta­tion stu­dents might take out equity fi­nanc­ing, think­ing they were be­ing cun­ning… and then change to a high pay­ing ca­reer track! This seems to be the more com­mon di­rec­tion of travel in gen­eral; stu­dents go to col­lege plan­ning on be­com­ing hu­man rights lawyers, or en­g­ineers, or artists, but in­stead end up as cor­po­rate lawyers, in­vest­ment bankers and ad­ver­tisers.

So this is a prob­lem I’d ex­pect the bond/​equity/​in­surance mar­ket to be more than ca­pa­ble of deal­ing with.

Ad­den­dum: Spec­u­la­tive Extensions

Here are some more ideas where equity in­vest­ments in peo­ple could be use­ful. The idea could still be valuable even with­out these though; ed­u­ca­tion is prob­a­bly the best use-case.

Parents

Once upon a time the land was rich and fruit­ful, and the peo­ple were fe­cund with beau­tiful offspring.

… maybe that never hap­pened, but fer­til­ity rates definitely have fallen over time, prob­a­bly to our detri­ment. Fu­ture peo­ple mat­ter, a lot! And even if they didn’t, we still need some­one to fund so­cial se­cu­rity.

One guess as to why fer­til­ity has dropped is once upon a time your chil­dren could be re­lied upon to live near you, fol­low­ing your cus­toms, and sup­port­ing you in your old age, though its un­clear if this ever made strictly eco­nomic sense. Now, how­ever, chil­dren feel much less moved by filial piety, and fre­quently move far away. As such, par­ents seem much less value in hav­ing chil­dren, and only do so out of char­ity – rais­ing a child takes a lot of effort, and the mod­ern world is full of su­per-stim­uli to dis­tract you from pro­duc­tive pro­cre­ation. Giv­ing par­ents a small equity stake in their chil­dren would go some way to­wards rec­og­niz­ing the in­vest­ment par­ents put into their chil­dren, and hope­fully boost fer­til­ity rates.

It would also en­courage par­ents to sup­port their chil­dren and their ca­reers; now the high-fly­ing child is not merely a source of pride but also a source of re­tire­ment. A friend I dis­cussed this with sug­gested that first-gen­er­a­tion im­mi­grants tended to give their chil­dren very prac­ti­cal ad­vice about school, ca­reers and re­la­tion­ships, whereas whites tend to be more wishy-washy; per­haps this would pro­mote a re­turn to re­al­ity-based par­ent­ing.

Divorce settlement

Another niche case where these could be use­ful would be di­vorce set­tle­ments. The clas­sic fem­i­nist ar­gu­ment about di­vorce set­tle­ments was that the woman had in­vested in do­mes­tic and fam­ily la­bor, which was dis­rupted by the di­vorce, while the man had in­vested in his ca­reer, which he kept. Partly as a re­sult of ar­gu­ments like this, we now see di­vorce set­tle­ments where one party gets a claim to some of the re­sources of the other.

How­ever, a fixed sum is not a very nat­u­ral way of deal­ing with this. The woman, in en­ter­ing mar­riage, as­sumed she would be benefit­ing from a cer­tain share of the man’s out­put. If he were suc­cess­ful, this would be more; if he came upon poor for­tune, this would be less – rather than tak­ing a costly and messy court case to ad­just the pay­ments. Hu­man Cap­i­tal Con­tracts would al­low a di­vorce set­tle­ment to rec­og­nize this: in a di­vorce were the man were at fault, the woman might be granted a 1% equity share for each year of mar­riage.

Ob­vi­ously if you thought per­mit­ting di­vorce was a mis­take – “til death do us part” – then you’d have lit­tle in­ter­est in this ap­pli­ca­tion.

Fur­ther Reading

Fur­ther Read­ing: Risk-Based Stu­dent Loans


Cross-posted on my blog here. Par­tially in­spired by some slat­estar­codex dis­cus­sion here.