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January 26, 2015

Optimism about President Obama's higher education tax reform proposals

January 26, 2015

This post originally appeared on the Urban-Brookings Tax Policy Center's blog, TaxVox.

President Obama will feature higher education prominently in next week’s budget—a choice that makes sense, given that educational attainment is the most straightforward pathway for economic advancement. Many of his ideas, which he highlighted in his State of the Union address, are controversial. And some don’t go far enough. But they’d do a better job helping households who most need education assistance than the current complex array of programs.

Obama would restructure both spending and tax subsidies for higher education. Sandy Baum and Judith Scott-Clayton have commented on Obama’s plan for free community college education. But many of his ideas are aimed at tax subsidies. While replacing those tax programs with direct support would be more effective, the president’s proposals would go a long way towards simplifying the existing system. The tax code’s 14 tax preferences for higher education complicate filing and discourage people from choosing the most effective form of government assistance.

It’s important consider what these programs should be doing. Should they be aimed at reducing costs for students who’d be going to college anyway? Or at expanding access to those who would otherwise not enroll? If the primary aim is the latter—and it should be—the system need to be easier to navigate and better targeted to low- and middle-income households.

The best way to do that through the tax code is to replace deductions with credits—preferably refundable credits-- so that the size of subsidy does not increase with income. By that standard, the President would improve the current system.

Existing tax preferences provide assistance before, during, and after attending school. The President’s plan addresses them all. Let’s take them in order.

Before: Obama’s proposal to reduce tax preferences for Sec. 529-type college savings plans is getting a lot of attention. While supporters argue that tax-free savings encourages college attendance, the plans are regressive and poorly designed. While we know little about the students who benefit from the accounts, there is no question that the savings plans primarily benefit high-income parents or other family members.

Because low-income households pay little or no federal income tax, the tax exemption doesn’t help them at all. Higher-income families are saving anyway, and their children are already the most likely to go to college. According to estimates based on the 2013 Survey of Current Finance data, only about 3 percent of families participate in 529-type plans and over 70 percent of accounts comprising 87 percent of the balances are held by taxpayers earning over $100,000; almost 70 percent of balances are held by the 6.4 percent of households earning over $200,000.

During: The President would simplify, consolidate and better target tax benefits received during college. He’d eliminate the Lifetime Learning Credit and the tuition and fees deduction, while expanding the American Opportunity Tax Credit that now provides a partially refundable credit for the first four years of postsecondary education. Currently limited to degree-seeking students enrolled at least half time, the credit is the most generous preference for most families in terms of both size and the range of expenses it covers. Obama would not only consolidate these subsidies into a single simple credit, he’d expand eligibility to five years and allow a refundable credit for less than half-time attendance— changes that make the credit more in keeping with the typical time frame of low-income students.

The President would also make tax-free the portion of Pell Grants used for living expenses. As a result, recipients could use tuition expenses to qualify for the AOTC and use their Pell Grants to cover living expenses that don’t qualify for the credit.

After: While the return on the investment in college is generally high, some graduates struggle with large student debt. While Obama would eliminate the current deduction for student loan interest, he’d shift the subsidy to a tax exemption for any forgiven debt under the already adopted income-based loan repayment plan. This too would better target assistance to those who need it most.

The President’s proposals move in the right direction. They do a better job of targeting subsidies to students of limited means and save money by curbing tax benefits now available to high-income households, whose children would likely go to college without government assistance.

The best education policy would subsidize education through direct spending on programs such as Pell Grants and loan relief rather than with tax breaks. Direct aid is easier to target, easier to deliver in a timely manner, and easier to understand. But if we are going to continue to rely on the tax system to subsidize college education, the president’s reforms would improve the targeting and effectiveness of educational aid.

Photo: (AP Photo/Jessica Hill, File)

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