Making Higher Education Tax Credits Work

 Perspectives M Huelsman Perspectives - Masthead  

By Mark Huelsman, Institute for Higher Education Policy 

Millions of taxpayers qualify for help with education costs each year in the form of deductions on tuition and fees and student loan interest, tax-free growth in college savings plans, and tax credits to help pay for college expenses. The latter—including the American Opportunity Tax Credit (AOTC) and the Lifetime Learning Credit—are a form of financial aid to students delivered at tax time rather than the beginning of the semester. Unfortunately, while tax credits may help some middle-income students, there is little evidence that this form of tax-based financial aid reaches those who need assistance most, namely low-income students. Given the price tag of tax credits—which is more than $34 billion annually—it is imperative that we find ways to make tax incentives work for the disadvantaged students who stand to benefit most. 

Tax Credits Don't Reach Needy Students

To understand why tax credits are failing our neediest students, we first need to consider how these tax credits, particularly the AOTC, function. Congress created the Hope Credit in 1997 for individuals earning below $60,000 and households earning below $120,000. Filers could claim it for two years and receive up to a $1,800 annual benefit, although households without a tax liability were ineligible. As part of the 2009 American Recovery and Reinvestment Act (ARRA), Congress reformed the Hope Credit (renamed AOTC), extending eligibility for up to four years, increasing the maximum benefit to $2,500, expanding  eligibility to individuals earning up to $90,000 ($180,000 for households), and including low-income households—to a point. The ARRA made the credit partially refundable so that low-income families can receive up to 40 percent (or $1,000) of the credit.

However, according to the Tax Policy Center, a quarter of all the assistance provided by the AOTC still goes to households making between $100,000 and $200,000 annually, yielding more than 2.5 times the assistance to these households than to low-income students and families. While rising college costs have certainly impacted middle- and upper-income households, the structure of higher education tax credits means that low-income students receive far less relief than their more advantaged counterparts. Research has found little or mixed evidence that the AOTC and other forms of tax-based aid have an impact on college enrollment for low-income households, and suggest that tax-based aid primarily goes to students who already would have attended college.

Timing and Complexity Also Reduce Impact of Credits

If this were the only flaw, one could simply assume that making tax credits fully refundable and/or instituting a lower income cap for eligibility would solve most of the problem. Unfortunately, the AOTC suffers from more than just issues of targeting. 

By definition, tax filers receive tax credits for behaviors that have already taken place such as paying for college. Given that tuition bills are due primarily in August and January of each year, a subsidy that is received in April or later of the following year—up to 16 months after tuition is paid—is unlikely to give students much in the way of financial help, much less incentivize college attendance. 

Also, the AOTC only applies to tuition, fees, books, and computers and is unavailable to offset essential college costs such as living expenses, transportation, and child care. Further, since grant aid is almost always applied to tuition and fees before other expenses, students who receive grants may be less likely to receive the AOTC, particularly at low-tuition institutions. 

Finally, the sheer complexity of tax-based financial assistance increases the likelihood that families without the ability to hire a tax accountant will miss out on benefits. The U.S. Government Accountability Office found recently that one out of every four filers eligible for an education tax credit received less than the maximum to which he or she was entitled. 

Improving the AOTC: Better Targeting, Better Timing

Although many have called for tax credits to be eliminated and appropriated toward grant aid, which has proven more effective for low-income populations, the AOTC has broad bipartisan support and was renewed for five years in the January 2013 deal to avert the fiscal cliff. Also, the AOTC is funded as a tax expenditure while grant aid is largely funded as appropriations, complicating any possible shift between them. But despite political and other hurdles, two changes may improve the credit without eliminating it.

First, it would be of great help to low-income students if they could acquire the credit in the first place. Extending refundability up to 100% for low-income tax filers would allow them to receive the full benefit of the credit, and applying the credit to non-tuition costs would help students, particularly at low-tuition institutions.

Second, timing and complexity must be addressed. One option is to make the AOTC a formal part of students’ financial aid packages along with Federal Pell Grants, Federal Work Study, institutional aid, and loans. This could be done in a way that “fronts” the credit to institutions, rather than directly to the students, and would require coordination between the IRS and the U.S. Department of Education—already working on ways to integrate FAFSA and tax data—to determine if the combination of a student’s income and expected college expenses would qualify for the credit.

Alternatively, families could have the option of receiving an advanced credit when a student is high-school age or earlier, deposited into an account that could only be used for educational expenses and to which families could also contribute. The money would revert back to the IRS if the student does not enroll. This option may allow students to better understand how higher education can be financed, and even build meaningful balances over time.

Federal tax credits as a form of financial aid remains popular with lawmakers and taxpayers. However, as the nation wrestles with how to increase national education attainment while reducing the federal budget, re-routing tax-based financial assistance so it reaches students who most need it, at the time they most need it, may be a good place to start.

Mark Huelsman is a research analyst for the Institute for Higher Education Policy in Washington, DC.  



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