CRS Examines Effects of Higher Education Tax Benefits

Since 1997, education tax benefits have become an increasingly important component of federal higher education policy. Fourteen tax benefits are currently available for college students and their parents to help pay for higher education. The available tax benefits are a mixture of credits, deductions, exclusions, and other incentives. The benefits can be placed into one of three general categories: incentives for current-year expenses, preferential tax treatment of student loans, and incentives for saving for college. The Joint Committee on Taxation (JCT) estimates the cost to the federal government of education tax benefits -- the revenue foregone from offering these benefits -- to be $95.3 billion between 2010 and 2014.¹

Tax Benefits Versus Traditional Student Aid

The federal government provides financial assistance for higher education expenses in two ways: tax benefits and traditional student aid (loans, grants, and work-study assistance). To qualify for traditional financial aid, students first submit a free application for federal student aid (FAFSA) to the Department of Education. Financial aid officers at the student's college or university use the asset and income information provided by the Department of Education to determine the student's federal financial aid award.² This financial aid is then used to pay for higher education expenses at the time they are due.

A summary of available traditional financial aid is beyond the scope of this report. For more information, please see CRS Report RL31618, Campus-Based Student Financial Aid Programs Under the Higher Education Act, by David P. Smole; CRS Report R40122, Federal Student Loans Made Under the Federal Family Education Loan Program and the William D. Ford Federal Direct Loan Program: Terms and Conditions for Borrowers, by David P. Smole; and CRS Report R41437, Federal Pell Grant Program of the Higher Education Act: Background, Recent Changes, and Current Legislative Issues, by Shannon M. Mahan.

In contrast, most tax-based higher education assistance becomes available after higher education expenses have been incurred -- sometimes several months afterward. Aside from tax-preferred college savings accounts, taxpayers must wait until they file their federal income tax returns to claim any federal higher education tax benefits. Another difference between the two forms of educational assistance is that traditional financial aid is often directed toward students with financial need, while tax benefits are generally available to eligible taxpayers regardless of need.

Brief Historical Perspective of Tax Benefits

Tax benefits for higher education were first introduced nearly 60 years ago. While most of these benefits were originally structured as deductions and exclusions, which reduce taxable income, they now include tax credits, which directly reduce tax liability.

Between 1954 and 1996, eight tax benefits for education were enacted:

The Taxpayer Relief Act of 1997 (P.L. 105-34) enacted five new education tax benefits:

Summary and Cost of Current Benefits

Table 1 summarizes the higher education tax benefits currently available. The benefits can be divided into three groups: incentives for current-year higher education expenses, incentives that provide preferential tax treatment of student loan expenses, and incentives for saving for college. Generally, a taxpayer cannot claim more than one tax benefit for the same education expense.

The benefits available are either a tax credit, deduction, exemption, or exclusion. While these terms are sometimes used interchangeably, they are different. It is important to understand the distinction between the types of incentives.

• Tax credits reduce the amount an individual owes in taxes directly, on a dollar for dollar basis. Credits are available to all qualified taxpayers, whether they itemize deductions or not. Credits can be nonrefundable or refundable. Nonrefundable credits cannot exceed taxes owed, and therefore can only reduce an individual's tax liability to zero. Refundable credits can exceed taxes owed, meaning a taxpayer with no tax liability receives the credit amount as a refund check. A tax credit is partially refundable if, in cases where the credit is larger than the taxpayer's tax liability, the IRS only refunds part of the difference. Education tax credits include the Hope Credit and Lifetime Learning Credit, both nonrefundable and the American Opportunity Tax Credit which is partially refundable.

• Tax deductions reduce the amount of a taxpayer's income which is subject to taxation ("taxable income") by the amount of the deduction. As a result, deductions reduce a taxpayer's tax liability, but only by a percentage of the amount deducted depending on the taxpayer's highest marginal tax bracket.⁵ Hence, deductions are generally less valuable than a given dollar amount in tax credits. Generally, the amount that may be deducted is equal to a portion of some expense incurred. Deductions can either be "above the line" or "itemized." Above the line deductions are typically more advantageous than itemized deductions and may be claimed by most taxpayers. Itemized deductions may only be claimed by those taxpayers who itemize all their deductions on their tax returns. The alternative to itemizing is claiming the standard deduction. Education tax deductions include the business deduction for work-related expenses (an itemized deduction), the deduction for tuition and fees, and the student loan interest deduction (both "above-the-line" deductions).

• Tax exemptions reduce the amount of a taxpayer's income which is subject to taxation by a fixed dollar amount per exemption claimed. Generally, every taxpayer is allowed to claim one exemption for themselves, one exemption for a spouse, and one for each dependent. Exemptions function similarly to deductions in that they reduce the income that is subject to taxation, but they are based on a fixed amount per person instead of actual expenses. An exemption's value to a taxpayer is also similar to the value of a deduction in terms of being proportional to a taxpayer's highest marginal tax bracket. Parents of students between the ages of 19 and 23 are eligible for a personal tax exemption for their children.

• Tax exclusions are amounts of income that are not included as income for tax purposes because the tax code explicitly excludes -- or exempts -- them from taxation. Education tax exclusions include the exclusion of certain scholarships, grants, and tuition reductions, the exclusion of employer-provided educational assistance, the exclusion of qualifying cancelled student loans, and the exclusion of direct transfers to educational institutions.

A number of higher education tax benefits also have income limitations. When an income limitation does exist, it is in the form of an income phase-out range. Taxpayers with incomes below the start of the phase-out range are eligible to claim the maximum tax benefit amount. The amount of the credit that can be claimed is then reduced for individuals with incomes within the phase-out range, and is zero for those with incomes above the phase-out range.

Table 2 presents the JCT cost estimates for each available tax benefit. The JCT advises that these estimates cannot be simply summed to estimate the aggregate revenue loss from multiple tax provisions. This is because of interaction effects. When the revenue loss associated with a specific tax provision is estimated, the estimate is made assuming that there are no changes in other provisions or in taxpayer behavior. When individual tax expenditures are summed, the interaction effects may lead to different revenue loss estimates. Consequently, aggregate tax expenditure estimates, derived from summing the estimated revenue effects of individual tax expenditure provisions, are unlikely to reflect the actual change in federal receipts associated with removing various tax provisions.

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^b Students must generally pay taxes on any part of a scholarship, fellowship, or tuition reduction that can be attributed to teaching, research, or other services that have been performed, are being performed, or will be performed. A temporary exception to this general rule was allowed for the National Health Service Corps Scholarship Program and the F. Edward Hebert Armed Forces Health Professions Scholarship and Financial Assistance Program by EGTRRA (P.L. 107-16).

^c The tax free earnings in Coverdells can also be applied towards select K-12 education expenses. and the income phaseouts for Coverdells apply to any individual who contributes the Coverdell (including the beneficiary).

² This information can also used to calculate any aid provided by the college or university to the student.

³ Above-the-line deductions, unlike itemized deductions, are available to all tax filers. Taxpayers who claim the standard deduction cannot benefit from itemized deductions.

⁴ This provision was originally scheduled to expire in 2006 under EGTRRA. It was subsequently extended by P.L. 109-432 (2006-2007), P.L. 110-343 (2008-2009), and P.L. 111-312 (2010 and 2011).

⁵ For example, a $4,000 deduction for someone whose highest marginal tax bracket is the 10% bracket will result in a $400 reduction in that taxpayer's tax bill. If the taxpayer's highest marginal tax bracket is the 35% bracket, their tax bill will fall by $1,400.