New Bill Doesn’t Address the Fundamental Issue with Higher Education Tax Credits

The House Committee on Ways and Means amended the Student and Family Tax Simplification Act last Thursday and has issued a comprehensive report on the bill. The bill, or H.R. 3393, was developed by Representatives Diane Black (R-TN) and Danny Davis (D-IL) in an attempt to further mitigate post-secondary education costs and simplify the education tax benefit structure. While these intentions may be noble, policymakers should approach education subsidies in a more holistic manner.

The legislation consolidates the four existing tax benefits into one permanent, partially-refundable annual credit of up to $2,500 per student which is indexed to inflation and phases out with income. Additionally, the legislation increases the maximum refund, tightens educational institution compliance measures, and improves the tax treatment of Pell Grants.

On the surface, H.R. 3393 appears to promote good tax policy. Consolidating existing tax benefits into one credit simplifies individual returns, thereby reducing compliance cost, with the added benefit of improving the credit’s effectiveness in achieving its goal of helping low-income taxpayers. Establishing a permanent credit affords individuals the certainty that the benefit will be there in the future. Making educational institutions report tuition received, instead of charged, allows for the computation of a tax liability that is more representative of the taxpayer’s situation.

Touting these benefits alone, however, indicates too narrow of an approach to the issue of education tax credits. Stepping back, the first question anyone should ask is why should the income tax system be an education policy and social welfare tool rather than a means for raising revenue? Tax credits, for education or otherwise, impose an administrative burden on the IRS—an undue burden considering that the Department of Education is an existing agency dedicated to “establishing policies on federal financial aid for education, and distributing as well as monitoring those funds.”

But beyond this elementary question are economic and equity considerations of education tax credits. A primary goal of H.R. 3393 is to mitigate the growing costs of post-secondary education. However, there is substantial doubt that subsidies like tax credits actually lower costs. This is because suppliers of education are near-perfect price discriminators—that is, colleges have personal financial information on all of their customers who file a FAFSA and they use this information to tailor their financial aid programs so that they receive most, if not all, of the benefits of tax credits. As credits decrease the marginal cost of education experienced by the student by a dollar, colleges increase tuition by a dollar.

Tax credits also disproportionately benefit upper-middle income taxpayers and future high earners. In 2010, 38% of credits went to taxpayers earning above $75,000. While H.R. 3393 may reduce this regressivity, credits will still accrue only to the taxpayers who actually choose to pursue a degree. William J. Bennett, former U.S. Secretary of Education, points out that as tuition increases, “poor kids look at the tuition—$40,000, $50,000 a year—and say, ‘Forget it.’” The students interested in an education but unable to afford it, even with credits, are left earning half the salary of students who receive credits and graduate college.

These economic concerns alone should be enough to convince policymakers to stop and think about the $17 billion, and growing, system of education tax credits and entertain other solutions. The Pell Grant is a much more effective instrument in targeting students from lower-income households, and its expansion would probably help this demographic more so than an expansion of tax credits. A universal tax-deferred savings account would mitigate costs for all income levels and allow households instead of colleges to retain the benefits. Although the passage of H.R. 3393 might make the education tax credit system simpler and better targeted, the very continuance of the system is economically and equitably unsound compared to other policy solutions.