A little-noticed provision in both the House and Senate tax bills could fleece honest taxpayers and reward those who don't repay their federal student loans, analysts warn.

An option available to any student borrower under the Federal Direct Student Loan Program allows him or her to make very minimum payments, and if the loan isn't repaid within 25 years, any remaining balance is forgiven.

Under current law, the amount forgiven is taxable as income, but President Clinton wants to make the forgiven amount tax free, and apparently Congress is about to oblige him.

• Borrowers now have the option of repaying their student loans at a rate that is tied to their income after graduation.

• If the new provision becomes law, the more students borrow and the less they report in adjusted gross income, the greater their tax-free windfall -- which could cost taxpayers plenty.

• Analysts predict that the provision will create a powerful incentive for students to borrow up to the legal limit.

• The Congressional Research Service has estimated that the forgiveness provision creates an effective default rate 25 percent higher than under a standard repayment plan.

For example, suppose a student chooses a job paying only $20,000 a year -- knowing that a certain portion of the loan will be forgiven after 25 years. He expects pay increases which only match inflation. He originally intended to borrow only $35,000, but computes that an extra $10,000 of debt increases his borrowing costs by only 22.3 cents per extra dollar -- yielding a government subsidy of 77.7 cents per dollar. So why not take the money?

Tax specialists say the problem is exacerbated by the fact that the Department of Education made an error when it indexed the repayment schedule for inflation. For someone whose income just keeps up with inflation, under certain circumstances the nominal monthly payment is held constant through indexing and repayment actually declines as a percentage of income. Thus the potential subsidy is substantially increased.

Critics say there are already enough quirks in the student loan program. Fix those, they say, before meddling around with tax-free defaults.

Source: Rudolph G. Penner (former director, Congressional Budget Office), "... Not Student Deadbeats," Wall Street Journal, July 18, 1997.