Education Tax "Subsidies" - Justified or Not?

May 13, 2008

At a Senate Finance hearing on Capitol Hill today on the issue of the individual side of tax reform, current Heritage Foundation scholar (and former Executive Director of the Tax Foundation) J.D. Foster took issue with the Joint Committee on Taxation's labeling of many of the education provisions of the tax code as "tax subsidies" for education. Foster argued that tax deductions for education are consistent with the taxation of investment income, which allow for a deduction of input costs. Foster argues that education is a cost of an individual's investment in human capital and should thereby be deductible.

In theory, Foster is correct. Individuals should be allowed to deduct from their income the expenses incurred as part of earning that income. However, there is more to the entire issue of education financing than a deduction on one's tax return. First, as William Gale pointed out in the testimony, even if you agree with Foster that education should receive favorable tax treatment, the current system of multiple credits and deductions for education should be improved. Ideally, under Foster's argument there would be one above-the-line deduction for education expenses for all taxpayers. (I ignore the problem of carrying forward those expenses since most students don't earn much income while in school.)

There are two other issues, however, that those in Congress should take note of before fully embarking on more favorable tax treatment for education. First, there is indeed a consumption element to education. Therefore, to the extent that students obtain utility out of attending school, it would ideally be taxed under either a consumption or income tax. Note that while this is almost impossible from an administrative perspective, it is still worth pointing out that under full deductibility, higher education would likely be over-subsidized (ignoring any public good component). Second and more importantly, economic evidence suggests that higher education should actually be subject to a Pigouvian tax given that there is a labor market failure of over-investment in education. As the work of Nobel laureate Michael Spence discovered, much of higher education investment is merely signaling to the employer; and while it may be in an individual's self-interest to obtain a college degree, there is a prisoner's dilemma whereby given the aggregation of those individual preferences, too many people obtain degrees from society's overall perspective. Therefore, it may actually be in society's interest to impose a Pigouvian tax on education as opposed to subsidize it.

Overall, the net effect of these conflicting proper tax policies suggests that actually allowing no deductibility and having little subsidization of higher education may be the proper policy. But saying that higher education receives too much money from government is probably not too popular.

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