CRS ANALYZES CLINTON'S TUITION TAX CREDIT AND DEDUCTION.

                  TUITION TAX CREDIT AND DEDUCTION:

[2] The proposed credit would be allowed for each STUDENT for whom the taxpayer paid tuition and fees. It would be limited to the first 2 years of education beyond high school; students would have to earn a B-average the first year and not be convicted of a felony drug offense in order to remain qualified for the second. The credit would be based on net tuition and fees paid by the taxpayer, limited to $1,500, LESS any Pell Grant received; thus one could get up to $1,500 from either the credit or a Pell Grant (or a combination of the two) but not more. The credit would be refundable: taxpayers would receive the full amount to which they were entitled even if it exceeded their tax liability.

[3] The $10,000 limit on the proposed deduction would apply to each TAXPAYER, not each student. The deduction would be allowed for undergraduate, graduate, or postgraduate education and training expenses without regard to the number of years it had been claimed previously. Apparently, the grade-average and drug conviction restrictions would not apply.

[4] Both the credit and the deduction would be phased out for single taxpayers with modified adjusted gross incomes over $50,000 (or $80,000 for married taxpayers filing joint returns).

[5] The President's proposals raise a number of issues including the following:

     o whether the credit and deduction would improve the measurement

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[7] Details of the tax credit proposal have not been resolved, so some aspects are unclear. Nonetheless, the proposed credit and deduction would be a major change in federal policies on financing college and graduate school education. The proposals raise many issues, among them:

     o whether they would improve the measurement of taxable income;

[9] The education of most students in college, graduate, or trade schools cannot qualify as a business expense: the course students take often are not related to their current work (if they are employed at all) and their study programs generally enable them to work in new fields. Even if their education qualifies, further restrictions apply if costs are paid by individuals rather than employers: a deduction is permitted only if the taxpayer itemizes deductions and only to the extent that the qualifying expenditure plus other miscellaneous deductions exceed 2% of the taxpayer's adjusted gross income. ³

[10] Current law provides some tax relief for student aid and intra-family transfers for education. Scholarships and fellowships (including educational grants) provide income to students; yet they are not taxable if they are used for tuition and required course expenses and the student is a candidate for a degree. Tuition reductions for employees of educational institutions are likewise not taxed. (However, these forms of assistance are taxable to the extent they represent payment for services provided by the taxpayer, such as shelving library books or being a lab assistant). While loans are not taxable (they are not income, since they must be repaid), an exemption is also given to interest subsidies, which are considered a form of scholarship. The Internal Revenue Code also allows parents to claim dependency exemptions for full-time students over 18 (but under 24) years of age even if the latter's income exceeds the exemption amount ($2,550 in 1996). In addition, tuition payments are excluded from the federal gift tax. ⁴

THE PRESIDENT'S PROPOSALS

[11] On Dec. 15, 1994, President Clinton proposed a federal income tax deduction of up $10,000 a year for amounts paid by taxpayers for postsecondary education tuition and fees for themselves, their spouse, or their dependents. ⁵ The deduction would be allowed in determining adjusted gross income (a deduction for AGI), not as a subtraction from it (an itemized deduction); thus it would be available to more taxpayers. (See the text box on page 3 for a simplified outline of the tax formula.) As currently envisioned, the maximum deduction for each TAXPAYER would be $5,000 in tax years 1996, 1997, and 1998; thereafter, it would be $10,000. The maximum deduction would be phased out ratably for married taxpayers filing a joint return with modified AGI (before the proposed deduction) between $80,000 and $100,000; for those filing a head-of-household or single return, it would be phased out for modified AGI (before the proposed deduction) between $50,000 and $70,000. ⁶

                    INCOME TAX FORMULA (simplified)

[13] Like the deduction, the credit could be claimed for payments taxpayers made for themselves, their spouse, or their dependents, provided the taxpayer's income is below the thresholds described above. ⁷ However, while the deduction would be based on net tuition and fees (i.e., tuition and fees minus scholarships and other tax-advantaged assistance), ⁸ the credit would be based on net tuition and fees, limited to $1,500, LESS any Pell Grant received. ⁹ Thus one could get up to $1,500 from either the tax credit or a Pell Grant (or a combination of the two), but not more. Consider this hypothetical example:

      Tuition and fees                             5,000

[15] The proposed tax credit would be refundable: taxpayers would receive the full amount to which they were entitled even if it exceeded their tax liability. Thus if their tax liability based on taxable income were $1,000 and their credit were $1,500, they would receive a $500 refund.

[16] The deduction and credit would be allowed for payments made to postsecondary education institutions eligible to participate in federal student aid programs under Title IV of the Higher Education Act. Nearly all public and private colleges and universities would be included, as would many vocational and proprietary schools (for-profit trade and technical schools). Only tuition and required fees could be taken into account, not books, meals, lodging, or transportation. Education involving sports, games, or hobbies would not qualify unless it were part of a degree program or related to the student's current employment. Programs must lead to a recognized credential, and students must be enrolled at least half- time or in courses enabling them to improve current job skills or acquire new job skills.

[17] According to the White House, the proposed tax credit is estimated to cost $25.1 billion over 6 years (fiscal years 1997- 2002), while the proposed deduction would cost $17.8 billion. ¹⁰ The 6-year total would be $42.9 billion.

MEASURING INCOME

[18] The federal income tax is levied on net income, that is, gross income minus expenses incurred to produce it. Thus one test for a proposed deduction or credit is whether it would improve or impede the proper measurement of net income. Provisions that impede proper measurement still might be justified as tax expenditures, if they bring about desirable outcomes (such as increased enrollment as discussed on page 5). But absent good reasons for having such special or preferential exceptions, provisions that distort the measurement of income generally are difficult to defend.

[19] It has long been argued that what taxpayers spend for postsecondary education may not get proper treatment under the tax code. ¹¹ If taxpayers invest in physical capital (a machine used in manufacturing, for example), the code permits deductions for the recovery of investment costs over the asset's useful life, if not faster. These deductions (or depreciation) reduce the income taken into account for taxation to a net amount that more closely approximates the accounting return on the investment. But if taxpayers instead invest in human capital by attending college, no deduction is permitted for their investment spending (tuition, books, etc.) other than in the limited circumstances described above. The additional income they earn as a result of college is not reduced to a net amount.

[20] The President's proposals would change this discrepant treatment of tuition costs, and it is tempting to justify them on these grounds. After all, postsecondary education is widely viewed as an investment. But two other perspectives ought to be considered before reaching this conclusion. First, the absence of a deduction or credit in current law might be justified as a way of offsetting the failure to tax the institutional subsidies that all college students receive. (These subsidies occur because tuition charges cover only about 20% of education and general expenditures at public institutions and 50% at private institutions.) ¹² Similarly, there is no taxation of the income implicit in the increase in human capital that college students receive by attending school instead of working. (This implicit income is usually considered to be equal to students' foregone earnings.) Second, instead of the proposed deduction or credit, which generally would allow a complete recovery of tuition costs when they were incurred, it might be preferable to amortize costs (deduct them pro rata) during subsequent years when the income attributable to the schooling is being earned. While needing further development to be feasible, this approach would more accurately reflect net accounting income. It would also be parallel to the depreciation deduction allowed for physical capital.

TUITION INCREASES

[21] If the President's proposals were enacted, schools might raise their tuition charges to absorb the tax benefits. For example, if families with a 28% marginal tax rate are currently willing to pay $7,000 a year for tuition, the proposed deduction would enable them to pay $9,722 a year with no loss in their after-tax financial position ($9,722 minus 28% of $9,722 = $7,000). To the extent shifting like this occurs, the tax deduction would not help families, though it would provide schools with additional revenue.

[22] In 1987, William Bennett, then the Secretary of Education, charged that recent increases in student aid had enabled colleges and universities "blithely to raise their tuitions" since government subsidies would cushion the increase. ¹³ Subsequent research showed that the Secretary's assertion could not generally be substantiated: for example, one study of the 1978-1985 period found no relationship between aid and tuition increases for 4-year private colleges and 2- year public colleges, though it did find a relationship for 4-year public colleges. ¹⁴ One reason that federal student aid at that time did not have more pronounced effects on tuition levels is that less than half of all students received any. Another is that federal aid was capped in such a way that increases in tuition typically generated only minor increases in assistance.

[23] Neither of these constraints would be significant for the proposed deduction or credit. Most families with students would be able to claim one or the other, and many could receive substantial tax savings. ¹⁵ Thus schools would likely find it economically feasible to raise tuition, while families' resistance might be tempered. Since students' families have different marginal tax rates (ranging from 0% for those with no tax liability to 28% or 31% for those with the highest eligible incomes), the deduction would result in different tax savings for a given tuition charge; it is possible that a tuition increase would leave some families better off (if their total tax savings exceeded the increase) but others worse off (if their total tax savings were less than the increase). The credit, which would generally yield the same tax savings for a given tuition charge, would make it more likely that most families would be better off even with a tuition increase.

[24] Two groups would not benefit from either the proposed deduction or credit and might be adversely affected by any subsequent tuition increase. One is families with incomes higher than the eligibility thresholds; the other is families of students who receive Pell Grants of $1,500 or more. Schools that increase tuition could use some of the additional revenue they receive to aid these families. Tuition discounts could be given higher income students (particularly those the schools most want to attract) and additional need-based aid given Pell Grant recipients. However, not all affected families might apply for this aid or qualify for it. Determining appropriate changes in tuition and student aid policies may be especially difficult for institutions with heterogeneous student bodies, such as large public universities. Tuition and student aid changes are also likely to be influenced by schools' recruitment policies, the extent to which cost affects total enrollment, and, for public institutions, State education policies.

ENROLLMENT INCENTIVE

[25] The economic justification for public subsidy of higher education is that students cannot obtain private financing simply on the promise of their future earnings. Investors can borrow to pay the cost of physical capital by pledging acquired assets as collateral, but liens cannot be placed on human capital, at least not since indentured servitude and slavery were outlawed. Even with high rates of return, people will underinvest in education (that is, fail to enroll) if they must find financing themselves. This market failure can be overcome only with public support of some sort.

[26] Studies show that both tuition levels and financial aid can significantly affect enrollment in higher education. The effects are strongest among students who attend low-cost schools or who come from lower income families. ¹⁶ Since the proposed tax deduction and credit may reduce net costs (depending on the extent to which schools raise tuition), they could become an additional incentive to enroll. However, it would be risky to assume that enrollments would change very much. The deduction and credit would reduce tax liability, not tuition, and might not be perceived as yielding comparable savings. Most research shows that tuition changes have greater enrollment effects than changes in financial aid; apparently, the "sticker price" is more noticeable than net cost. Moreover, the tax proposals may do little to help families with the lowest incomes, the very ones whose enrollment decisions are most sensitive to cost. As long as the credit is offset by the Pell Grant, these families could be even worse off if schools raise their tuition. Finally, enrollment in higher education has increased substantially over the last two decades -- the proportion of high school graduates who immediately enroll in college has risen from 46.6% in 1973 to 61.5% in 1993 -- and factors other than cost may be more important in determining further enrollment growth.

[27] The proposed deduction and credit might encourage more enrollment by older adults who seek advanced training or preparation for new careers. While students over 24 years of age already represent more than 40% of total enrollment in higher education, the proportion of older adults who attend school in any one year is under 5%. About two-thirds of the population ages 25 through 49 has not attained an associate's (2-year) degree and so is likely to be eligible for the proposed credit.

EQUITY

[28] The President's original proposal for a tuition tax deduction raised a serious equity issue. Deductions result in different savings to taxpayers depending on their marginal tax rate. For tuition payments of $7,000, a family with a 28% marginal rate would save $1,960 from the proposed deduction, a family with a 15% rate would save $1,050, and a family with no tax liability would save nothing. Viewed alone, these differences would strike most people as inequitable, particularly since families with higher marginal rates have higher incomes. It is unlikely that a new program of student grants with these benefits would be proposed.

[29] The proposed credit would remedy some disparities caused by the deduction. With the credit, lower income taxpayers not eligible for Pell Grants could get up to $1,500 a year for tuition payments (for each student); with the deduction, their tax savings for a $1,500 payment would at most have been $225 (if their marginal tax rate were 15%). However, some disparities would remain: the credit would be restricted to the first 2 years of study, and it would be offset by any Pell Grant the student received. As the hypothetical example on page 3 indicates, some lower income taxpayers with net tuition payments might be not be able to claim the credit.

[30] The requirement that students have B-averages to obtain the credit a second year may create other equity problems. ¹⁷ Apparently the requirement would not apply to the deduction; thus different standards would apply depending on which tax allowance taxpayers could claim. Having a B-average is not necessary to receive a Pell Grant, which the proposal treats as a substitute for the credit. ¹⁸ The B-average standard would penalize students who attend schools with higher academic standards or who take more difficult courses, neither of which should make any difference to one's tax liability.

CONCLUDING COMMENTS

[31] The President's proposals raise important issues about the proper tax treatment of education expenses, whether schools would increase tuition, whether enrollments would increase, and equity. In considering these questions, one might ask whether a new broad-based public subsidy is needed at all. For most students, existing subsidies arguably provide adequate financing: they already are enrolled, after all, and evidence that they need a different form of assistance, let alone more assistance, is not persuasive. For students and nonstudents still thwarted by financial barriers, arguably expanding existing aid programs would be more helpful. If the government has $42.9 billion more to spend on postsecondary education over the next 6 years, consideration should be given to improving those programs before concluding that the tax measures should be adopted.

[32] In describing the proposed credit, the Administration has said that "14 years of education -- 2 years of college -- should be considered the universal norm, the minimum that people need in order to do well in the new economy." ¹⁹ Whether the credit would be the best means of reaching this goal is debatable: for most students, likely tax savings would cover only a portion of tuition costs, let alone other expenses associated with college, and other forms of assistance might be simpler to administer. No matter how the funding occurs, some might question whether the federal government should provide general, untargeted assistance for education at all. In addition, the contention that 2 years of college should be the norm merits further public discussion before steps are taken to bring it about.

² 26 Code of Federal Regulations 1.162-5.

³ If education costs are paid by employers, individual taxpayers normally may exclude all payments from their gross income if the education qualifies under IRS regulation 1.162-5. Prior to January 1, 1995, Section 127 of the code authorized an exclusion for employer-paid education even if it did not qualify under 1.162-5, as long as it was provided through a formal program meeting other tests. Employers generally may fully deduct education expenses they incur for their employees.

⁴ For more information see: U.S. Library of Congress. Congressional Research Service. Federal Taxation of Student Aid. CRS Report for Congress No. 94-749 EPW, by Bob Lyke. Washington, 1996.

⁵ Legislative language for the President's tuition tax deduction proposal was submitted to Congress on March 19, 1996, along with other FY 1997 budget material. At that time, the proposal had higher income eligibility thresholds than the current proposal. Daily Tax Report, March 21, 1996. p. S-5.

⁶ The income thresholds would be adjusted for inflation after 1999. To claim the proposed deduction, married couples would have to file a joint return. The deduction would not be available to taxpayers (such as children) who may be claimed as dependents on another taxpayer's return.

⁷ The restrictions on married couples and taxpayers who may be claimed as dependents on another's return would apply to the credit as they do to the deduction.

⁸ Tax-advantaged assistance would include veterans educational benefits and interest on EE savings bonds that is excludable under section 135 of the Internal Revenue Code. In addition, no deduction or credit would be allowed with respect to expenses that could be deducted under other Code provisions (such as deductible business expenses) unless the taxpayer waives the latter deduction. However, the deduction or credit would be allowed for payments made with proceeds of loans (including federally-subsidized education loans) and, presumably, work-study assistance.

⁹ Information about how the tax credit would be calculated was provided by Treasury Department officials. It has not yet been determined whether the credit would be offset by other federal grant or scholarship assistance (such as Supplemental Educational Opportunity Grants or Byrd Scholarships).

¹⁰ Daily Tax Report, June 5, 1996. p. G-6. The estimate excludes fiscal year 1996 since the year is almost over. The cost for the deduction is lower than previous estimates since the income eligibility thresholds are lower (thus reducing the number of taxpayers who would qualify) and many taxpayers would find the credit more advantageous.

¹¹ Two recent analyses include: Davenport, David S. Education and Human Capital: Pursuing an Ideal Income Tax and a Sensible Tax Policy. Case Western Reserve Law Review, v. 42, 1992. p. 793-953; and U.S. Department of Labor. Commission on Workforce Quality and Labor Market Efficiency. The Tax Treatment of Training and Educational Expenses. Investing in People. Background Papers, by John M. Quigley and Eugene Smolensky. p. 803-850.

¹² Hauptman, Arthur M., with Jamie Merisotis. The College Tuition Spiral. The American Council on Education and The College Board, 1990. p. 9. It might be noted that students attending proprietary schools typically would not receive such institutional subsidies.

¹³ The New York Times, February 18, 1987. p. 31.

¹⁴ McPherson, Michael S., and Morton O. Schapiro. Keeping College Affordable. Brookings. Washington, 1991. p 72-73, 245.

¹⁵ Tax-savings from the credit or deduction might be partially offset by reductions in need-based student aid: under need analysis formulas, tax savings would increase after-tax income and thus the expected family contribution.

¹⁶ However, evidence is mixed regarding the enrollment effects of means-tested programs such as Pell Grants. (Kane, Thomas J. Rising Public College Tuition and College Entry: How Well Do Public Subsidies Promote Access to College? Unpublished report. April 1995). For a comprehensive analysis of enrollment studies see: Leslie, Larry, and Paul Brinkman. Student Price Response in Higher Education. Journal on Higher Education, v. 58, 1987. p. 181-204.

¹⁷ The requirement is likely to cause administrative problems as well. Presumably schools would have to determine average grades and provide certification to the student or the Internal Revenue Service. Regulations would have to be developed to deal with pass/fail courses, incomplete course work, and early withdrawals.

¹⁸ Pell Grant recipients must make "satisfactory progress," which is a looser (and lower) standard.

¹⁹ Gene Sperling, Deputy Assistant to the President for Economic Policy. Press briefing. June 4, 1996.