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CRS Reviews Three Higher Education Tax Benefits

SEP. 25, 2001

RL31129

DATED SEP. 25, 2001
DOCUMENT ATTRIBUTES
Citations: RL31129

                       CRS REPORT FOR CONGRESS

 

 

             HIGHER EDUCATION TAX CREDITS AND DEDUCTION:

 

                AN OVERVIEW OF THE BENEFITS AND THEIR

 

               RELATIONSHIP TO TRADITIONAL STUDENT AID

 

 

                         September 25, 2001

 

 

                             Adam Stoll

 

                    Analyst in Social Legislation

 

                   Domestic Social Policy Division

 

 

                          James B. Stedman

 

                  Specialist in Social Legislation

 

                   Domestic Social Policy Division

 

 

SUMMARY

[1] The Taxpayer Relief Act of 1997 established two federal income tax credits for qualified postsecondary education expenses -- the Hope Scholarship tax credit and the Lifetime Learning tax credit. The Economic Growth and Tax Relief Reconciliation Act of 2001 established a new tax deduction for higher education expenses beginning in 2002.

[2] The Hope credit was introduced to help ensure that students have access to the first two years of undergraduate postsecondary education. The Lifetime Learning credit and new tax deduction provide support for students in any year of study in undergraduate and graduate programs. Additionally, the Lifetime Learning credit and new tax deduction occupy a unique niche as widely available assistance for individuals taking occasional courses. Middle and upper-middle income individuals are the targeted beneficiaries of each of these higher education tax benefits.

[3] Key features of the credits and the new deduction largely dictate who these provisions benefit and the amount of aid they will receive. Among these are limits on maximum benefits, the nonrefundable nature of the credits, income thresholds for phasing out the benefits, and the type of school enrollment covered by the benefits.

[4] The Hope credit, a nonrefundable credit for the tuition and fees required for enrollment that are not offset by grant aid, has a maximum value of $1,500. The Lifetime Learning credit, also a nonrefundable tax credit, has a maximum value of $1,000, The new deduction permits deduction of qualified expenses of up to $3,000 for 2002 and 2003, and up to $4,000 for 2004 and 2005. The value of the tax deduction will depend, in part, on taxpayers' marginal tax rates. At specified thresholds of modified adjusted gross income, the tax benefits phase out. These thresholds are identical for the tax credits, and higher for the tax deduction.

[5] With the introduction of these tax benefits, individuals can now receive substantial amounts of federal financial assistance for postsecondary education from two parallel systems -- the federal income tax system and the traditional student aid delivery system, which provides aid such as grants, loans, or work opportunities. The traditional system helps students meet current expenses; the tax system requires families to make higher education outlays that are reimbursed through tax reductions determined near the end of or after an academic year. Tax benefits may offer streamlined delivery of aid, while most other aid is delivered through relatively cumbersome and labor-intensive processes. Some criticize the complexity of the tax process, which adds another system that students and families must navigate. Institutional reporting requirements associated with the tax benefits are viewed by many in the higher education community as burdensome and expensive.

CONTENTS

 

 

     Introduction

 

 

     Form -- An Overview of the Benefits

 

          Hope Scholarship Credit

 

          Lifetime Learning Credit

 

          Higher Education Deduction

 

          Major Features of the Tax Benefits

 

     Function -- Intended Beneficiaries and Benefit Size

 

          Overview

 

          Intended Role for Each Benefit

 

          Relative Worth of Each Benefit to Beneficiaries

 

          Factors That Determine Benefit Size and Eligibility

 

          Income and Tax Liability

 

          Qualified Tuition and Related Expenses

 

     Relationship to the Traditional Student Aid Delivery System

 

          Timing of Awards

 

          Disbursement of Aid

 

          Overall Complexity of College Financing

 

          Direct Effect of Tax Benefits on Traditional Student Aid

 

 

LIST OF TABLES

 

 

Table 1. Major Features of the Hope Scholarship Credit,

 

     Lifetime Learning Credit, and Higher Education Tax Deduction

 

 

Table 2. Education Tax Credits, 1999 (Preliminary Data)

 

 

                  Higher Education Tax Credits and

 

             Deduction: An Overview of the Benefits and

 

            Their Relationship to Traditional Student Aid

 

 

INTRODUCTION

[6] The Taxpayer Relief Act of 1997 (TRA, P.L. 105-34) established two federal income tax credits for qualified postsecondary education expenses -- the Hope Scholarship tax credit and the Lifetime Learning tax credit. In 2001, the Economic Growth and Tax Relief Reconciliation Act of 2001 (P.L. 107-16) established a new tax deduction for higher education expenses beginning in 2002. 1 The value of these benefits in foregone federal revenue places them among the largest sources of federal support to meet the costs of postsecondary education. Preliminary data from the Internal Revenue Service (IRS) for 1999 show that in that tax year 6.5 million returns claimed $4.8 billion in education tax credits. 2

[7] At present there are two parallel systems through which the federal government provides assistance for postsecondary education attendance -- the traditional student aid delivery system and the federal income tax system. With the anticipated expiration of the funding authority for Higher Education Act (HEA) programs during the 108th Congress, the Congress will be considering the amendment and extension of major federal aid programs under HEA Title IV that use the traditional delivery system; among these programs are the Pell Grant program (an estimated $9.2 billion in grant aid for FY200 1) and the Federal Family Education Loan and Direct Loan programs (an estimated $34.8 billion in new loan volume for FY2001). 3

[8] This report is intended to provide background information for the HEA reauthorization process about the direct assistance for education expenses provided through the federal income tax system, thereby placing the congressional consideration of the HEA student aid programs in a broader context. Although data on the actual use and impact of the tax credits are scarce, key aspects of the form and function of these credits and the new deduction dictate, to a large degree, who these tax provisions benefit and by how much. These key features of the benefits are explored in this report. Further, it explores the relationship of the traditional student aid delivery system with the tax system as a conduit for postsecondary education assistance, identifying specific issues that may be important for congressional consideration during HEA reauthorization. This is a background report and will be updated only to reflect major changes to the benefits or newly available data on their distribution and size.

[9] An important distinction underlies this report -- the tax system as a mechanism for providing benefits for post secondary education expenses differs in significant ways from the traditional student aid delivery system. Tax benefits flow through a system that is dependent upon individuals' tax status and the level of qualified higher education expenses incurred. The tax benefit calculations are independent of any direct measurement of the ability to pay for postsecondary education. Further, these benefits are not subject to annual appropriations. In contrast, federal assistance provided through the traditional delivery system consists of grant, loan, and work aid. Much of this aid is awarded directly to students while some is controlled and disbursed by financial aid officers at postsecondary institutions. A significant portion of this assistance is awarded on the basis of students' financial need. 4 Finally, a significant portion of this assistance is subject to annual appropriations.

FORM -- AN OVERVIEW OF THE BENEFITS 5

[10] HOPE SCHOLARSHIP CREDIT. The Hope Scholarship credit is a nonrefundable credit against federal income tax liability for qualified tuition and related higher education expenses. 6 At present, the credit for each eligible student is 100% of the first $1,000 of qualified tuition and related expenses and 50% of the second $1,000 of such expenses, for a maximum of $1,500. After tax year 2001, the maximum Hope credit will be indexed for inflation.

[11] Taxpayers can claim the credit for qualified higher education expenses paid for eligible students -- including the taxpayers themselves, their spouse, and dependents for whom they claim tax exemptions. 7 A taxpayer can claim a credit with respect to each eligible student. Eligible students must have been enrolled on at least a half-time basis for at least one academic period during the tax year in a higher education program leading to a degree, certificate, or credential. They cannot have finished the first two years of undergraduate education and the credit can only be claimed for their first two years. Individuals with a federal or state felony conviction for drug possession or distribution are not eligible for the credit.

[12] Qualified tuition and related expenses are tuition and fees required for enrollment at institutions eligible to participate in U.S. Department of Education (ED) student aid programs, including accredited public, private, and proprietary postsecondary institutions. Eligible expenses include those fees required as a condition for enrollment. 8 Room and board expenses are not included. Qualified higher education expenses are reduced by the amount of non-taxable educational assistance (exclusive of loans and gifts) received by a qualified student. This includes education assistance that is excluded from taxpayers' gross income, including Pell Grants, scholarships, veterans' educational benefits, and employer-provided tuition reimbursements.

[13] The Hope tax credit begins to be phased out for individuals as modified adjusted gross income 9 increases beyond $40,000 and is completely phased out at $50,000 (for those filing joint returns, the income thresholds are $80,000 and $100,000). 10 These various income thresholds will be indexed to inflation beginning after tax year 2001.

[14] The Hope credit cannot be claimed for a student if the Lifetime Learning credit is claimed for the same tax year for that same student. Individuals for whom a Hope credit is claimed cannot concurrently benefit from the deduction for qualified higher education expenses.

[15] LIFETIME LEARNING CREDIT. The Lifetime Learning credit is also a nonrefundable tax credit for qualified tuition and related higher education expenses. Currently, the credit per tax return is 20% of the first $5,000 of qualified higher education expenses, for a maximum of $1,000. For qualified expenses paid after December 31, 2002, the credit will be a maximum of $2,000, calculated as 20% of the first $10,000 in qualified expenses.

[16] As with the Hope credit, taxpayers can claim the Lifetime Learning credit the qualified higher education expenses paid for eligible students -- including the taxpayers themselves, their spouse, and dependents for whom they claim tax exemptions. Eligible students are those enrolled in one or more courses of undergraduate or graduate instruction to acquire or improve job skills. There is no limit on the number of years for which the credit may be claimed.

[17] Qualified tuition and related expenses are calculated and treated in the same fashion as they are under the Hope credits, including the reduction for nontaxable educational assistance received.

[18] As with the Hope tax credit, the Liftime Learning credit begins to be phased out as modified adjusted gross income increased beyond $40,000 and is completely phased out at $50,000 (for individuals filing joint returns, the income thresholds are $80,000 and $100,000). 11 These various income thresholds will be indexed to inflation beginning after tax year 2001.

[19] The Lifetime Learning credit cannot be claimed for a student if the Hope credit is claimed for the same tax year for that same student. Individuals for whom a Lifetime Learning credit is claimed cannot concurrently benefit from the tax deduction for qualified higher education expenses.

[20] HIGHER EDUCATION DEDUCTION. The Economic Growth and Tax Relief Reconciliation Act of 2001 (P.L. 107-16) establishes a new above-the-line deduction for taxpayers who pay qualified higher education expenses. 12 It is terminated for tax years beginning after December 31, 2005.

[21] In 2002 and 2003, the maximum deduction permitted per return is $3,000. This deduction can be taken by individuals with modified adjusted gross income of up to $65,000. For filers of joint returns, the deduction is available for those with modified adjusted gross income of up to $130,000. For 2004 and 2005, the maximum deduction rises to $4,000 with the same income limits. A smaller deduction of $2,000 is provided for 2004 and 2005 for taxpayers whose modified adjusted gross income is more than $65,000 but not more than $80,000 (for those filing joint returns, more than $130,000 but not more than $160,000).

[22] How much the deduction will be worth to a taxpayer depends upon a variety of factors, including the taxpayer's marginal tax rate. 13 The higher education deduction reduces a taxpayer's adjusted gross income dollar for dollar. Depending upon the taxpayer's marginal tax rate that reduction is worth different amounts. For example, for a taxpayer in the 15% tax bracket with $3,000 in qualified expenses in 2002 or 2003, the tax benefit would be $450 in reduced tax liability. 14 For an individual in the 27% tax bracket with $3,000 in qualified expenses, the $3,000 tax deduction would be worth $810. 15

[23] Taxpayers can take the deduction if they pay the qualified higher education expenses for themselves, spouses, or dependents for whom tax exemptions are claimed. 16 There are no limitations on the level of postsecondary education enrollment (undergraduate and graduate enrollment is covered) or the intensity of enrollment (eligible expenses related to just a single course of study are covered).

[24] The qualified higher education expenses for the deduction are defined as they are for the Hope and Lifetime Learning credits. Qualified higher education expenses appear to be reduced in the same fashion as they are for the credits.

[25] The deduction cannot be taken for the qualified higher education expenses for any individual for whom the Hope or Lifetime Learning credits are claimed.

[26] MAJOR FEATURES OF THE TAX BENEFITS. TABLE 1, below, provides an overview of the major features of each of these three tax benefits.

        Table 1. Major Features of the Hope Scholarship Credit,

 

     Lifetime Learning Credit, and Higher Education Tax Deduction

 

 

                         Hope Scholarship        Lifetime Learning

 

       Feature           Credit                  Credit

 

 ______________________________________________________________________

 

 Type of benefit         Nonrefundable tax        Nonrefundable tax

 

                         credit (cannot exceed    credit (cannot

 

                         tax liability)           exceed tax liability)

 

 

 Maximum benefit         $1,500 (100% of first    $1000 (20% of first

 

                         $1,000 in qualified      $5,000 in qualified

 

                         expenses, 50% of         expenses) per return

 

                         second $1,000) per       through tax year

 

                         student through tax      2002; after which the

 

                         year 2001; after         credit will be a

 

                         which the maximum        maximum of $2,000

 

                         Hope credit will be      (20% of first $10,000

 

                         indexed for inflation    in qualified

 

                                                  expenses)

 

 

 Income limit            Credit begins to         Credit begins to

 

                         phase out at $40,000     phase out at $40,000

 

                         modified adjusted        modified adjusted

 

                         gross income and is      gross income and is

 

                         fully phased out at      fully phased out at

 

                         $50,000 ($80,000         $50,000 ($80,000

 

                         and $100,000             and $100,000

 

                         thresholds for joint     thresholds for joint

 

                         returns)                 returns)

 

 

                         Income levels            Income levels

 

                         indexed to inflation     indexed to inflation

 

                         effective tax year       effective tax year

 

                         2002                     2002

 

 

 Postsecondary           Tuition and fees         Tuition and fees

 

 education expenses      required for             required for

 

 qualifying for benefit  enrollment               enrollment

 

 

 Type of                 First 2 years of         For any year of

 

 postsecondary           undergraduate            undergraduate or

 

 education               education when           graduate enrollment

 

                         enrolled on at least a   with no limit on the

 

                         half-time basis in a     intensity of

 

                         program leading to a     enrollment or the

 

                         degree, credential, or   type of program

 

                         certificate

 

 

 Effective dates         Permanent program        Permanent program

 

 

                           [Table Continued]

 

 

                               Higher education

 

       Feature                 tax deduction

 

 ____________________________________________________________

 

 Type of benefit               Above the line tax

 

                               deduction (filers do

 

                               not need to itemize)

 

 

 Maximum benefit               $3,000 deduction for

 

                               2002 and 2003 per

 

                               return; $4,000

 

                               deduction for 2004

 

                               and 2005 per return

 

                               ($2,000 maximum

 

                               deduction for 2004

 

                               and 2005 available

 

                               for higher income

 

                               taxpayers). Note:

 

                               value of the

 

                               maximum deduction

 

                               depends upon

 

                               taxpayer's marginal

 

                               tax rate

 

 

 Income limit                  For 2002 through

 

                               2005, deduction

 

                               available to

 

                               taxpayers with up to

 

                               $65,000 in modified

 

                               adjusted gross

 

                               income ($130,000

 

                               for joint returns); for

 

                               2004 or 2005,

 

                               taxpayers with

 

                               modified adjusted

 

                               gross income of

 

                               more than $65,000

 

                               but less than $80,000

 

                               can claim a smaller

 

                               maximum deduction

 

                               ($130,000 and

 

                               $160,000 thresholds

 

                               for joint returns)

 

 

 Postsecondary                 Tuition and fees

 

 education expenses            required for

 

 qualifying for benefit        enrollment

 

 

 Type of                       For any year of

 

 postsecondary                 undergraduate or

 

 education                     graduate enrollment

 

                               with no limit on the

 

                               intensity of

 

                               enrollment or the

 

                               type of program

 

 

 Effective dates               Expires on January

 

                               1, 2006

 

 

FUNCTION -- INTENDED BENEFICIARIES AND BENEFIT SIZE

[27] OVERVIEW. Higher education tax benefits like other forms of federal financial aid are human capital investments expected to yield benefits for society and individual recipients. The tax benefits are not available to everyone seeking to meet postsecondary education expenses; rather they are primarily focused on specific groups of individuals and provide them with different amounts of assistance.

[28] The tax benefits were enacted to help preserve and enhance access to postsecondary education for students from middle and upper middle income families. This group of families is not centrally targeted by most other federal aid programs, which place primary emphasis on assisting students with the greatest amount of financial need. Yet, middle income families make up a large proportion of the college population and face the challenge of meeting costs of higher education that have been increasing at a rate that has consistently outpaced inflation in recent decades.

[29] Available data on tax benefit recipients indicate that the tax credits are, as intended, primarily serving middle and upper- middle income individuals. Preliminary data on the tax credits for tax year 1999 (see Table 2, below) reveal that over 39% of the 1999 tax returns claiming the education credits were from tax filers with adjusted gross income of $50,000 or more. These tax filers claimed nearly 46% of the total amount claimed in these credits for that year. In contrast, only about 11% of the returns claiming the credits were from tax filers with adjusted gross income of less than $15,000; these returns claimed less than 7% of total amount claimed. 17

        Table 2. Education Tax Credits, 1999 (Preliminary Data)

 

 ______________________________________________________________________

 

                                         Adjusted gross income

 

 ______________________________________________________________________

 

                                          $15,000   $30,000   $50,000

 

                                 Under    under     under     under

 

                    All returns  $15,000  $30,000   $50,000   $100,000

 

 ______________________________________________________________________

 

 Number of returns

 

 claiming credits   6,483,703  719,442  1,522,542 1,693,912  2,547,807

 

 

 Percent of all

 

 returns

 

 claiming credits        100%      11%        23%       26%        39%

 

 

 Amount of credits

 

 claimed ($ in     $4,819,032 $314,531 $1,088,536 $1,205,026 $2,210,937

 

 thousands)

 

 

 Percent of total        100%        7%        23%       25%       46%

 

 claimed

 

 ______________________________________________________________________

 

 

SOURCE: IRS. Individual Income Tax Returns, Table 1. Sum of percentages may not equal 100% due to rounding. These data do not distinguish between the Hope and Lifetime Learning credits.

[30] INTENDED ROLE FOR EACH BENEFIT. The Hope and Lifetime credits were introduced together in 1997, as complementary benefits. The higher education tax deduction, introduced in 2001, extends their reach. In simplest terms the role envisioned for each benefit can be characterized in the following manner:

     o The Hope credit was introduced to help ensure middle income

 

       students have universal access to the first 2 years of

 

       postsecondary education.

 

 

     o The Lifetime Learning credit was designed to offer continued

 

       support to such traditional undergraduate students, not

 

       limited to the first 2 years of study. It also offers support

 

       to graduate students and "lifetime learners" (i.e., those not

 

       necessarily pursuing degrees).

 

 

     o The higher education tax deduction will support the same set

 

       of higher educational pursuits as the Lifetime Learning

 

       credit, extending tax benefits to higher income individuals

 

       than either credit.

 

 

A more detailed discussion of these roles follows.

[31] The Hope credit is targeted to a narrower group of postsecondary students -- those in the first two years of postsecondary study, and enrolled half time or more in pursuit of a degree, certificate, or credential -- than either the Lifetime Learning credit or the higher education deduction. For those individuals eligible for the Hope credit, it is likely to offer a more substantial benefit than either the Lifetime Learning credit or the new tax deduction. Beyond their first two years of postsecondary education, individuals enrolled on a half time or more basis will benefit from either the Lifetime Learning credit or the new tax deduction.

[32] Significantly, the Lifetime Learning credit, which can be claimed for an unlimited number of years, supports traditional and nontraditional students regardless of their enrollment or degree status. Part-time and full time students can qualify for this credit as can graduate, undergraduate and non-degree students. These same eligibility criteria apply to the tax deduction. As a consequence, the Lifetime credit and the tax deduction occupy a unique niche in the student aid landscape. The Lifetime Learning credit currently, and the tax deduction prospectively, are widely available benefits that can support students who are taking occasional courses but are not necessarily enrolled in an educational credential or degree program. These may be a major source of direct financial aid available to many individuals who may want to take courses periodically over the course of their careers to upgrade their skills. 18

[33] Even though the Lifetime credit has been designed to provide aid to a wide array of students, it is likely that the credit will provide a good deal more benefit to traditional undergraduate and graduate students on a PER YEAR basis than to sporadic course- takers (e.g., those who may want to take courses periodically over the course of their careers to upgrade their skills). This is due to the fact that the credit covers 20% of higher education costs and traditional students are likely to incur more costs. However, sporadic course-takers can receive support for an unlimited number of years, and may ultimately gain more value from the credit OVER A SERIES OF YEARS than do more traditional students. In much the same way, the tax deduction covers a broader array of courses of study and types of students but will deliver it greatest tax savings when the maximum qualified expenses are incurred, unlikely for taxpayers taking individual courses periodically.

[34] RELATIVE WORTH OF EACH BENEFIT TO BENEFICIARIES. The tax benefits were not designed to have seamless boundaries. In many instances their target populations overlap. Since many students are eligible for more than one of the benefits, taxpayers have to choose the appropriate benefit to realize the maximum value of assistance available to them. In general, when examining the relative worth of the benefits the following rules of thumb apply.

     o As income increases, the thresholds at which the tax credits

 

       and tax deduction are eliminated become increasingly important

 

       in determining who can receive which benefit. The tax

 

       deduction's thresholds are higher than those for the Hope and

 

       Lifetime Learning credits.

 

 

     o For those middle income taxpayers eligible to receive the Hope

 

       credit and whose incomes are under the phase out thresholds,

 

       the Hope credit is generally designed to be more valuable than

 

       either the Lifetime Learning credit or the tax deduction.

 

 

     o For those middle income taxpayers eligible to receive the

 

       Lifetime but not the Hope credit and whose incomes are below

 

       the phase out thresholds, the Lifetime Learning credit or the

 

       higher education deduction could be more valuable depending on

 

       their marginal tax rate and qualified expenses.

 

 

[35] A simple example illustrates that the Hope credit provides its beneficiaries with a potentially more substantial tax benefit than either of the other provisions. For an individual with $3,000 in qualified expenses in 2001 and whose modified adjusted gross income is below the beginning of the phase out thresholds, the Hope credit is worth a maximum of $1,500 (this is the overall maximum Hope credit reached when qualified expenses meet or exceed $2,000). 19 For that same individual with $3,000 in qualified expenses in 2001, the Lifetime Learning credit is worth a maximum of $600. 20 The Lifetime Learning credit's peak value for 2001 is $1,000, available when qualified expenses reach $5,000. The new tax deduction would be worth less to this individual than the Hope credit regardless of his or her marginal tax rate.

[36] A more complex relationship exists between the tax deduction and Lifetime Learning credit. Basically, the relative worth of these benefits will likely hinge upon an individual's marginal tax rate. Depending upon the marginal tax rate, the deduction may be worth more or less than the Lifetime Learning credit. For example, a taxpayer with $3,000 in qualified higher education expenses would be better off taking the tax deduction than the Lifetime Learning credit if his or her marginal tax rate were 27% (deduction would be worth a maximum of $810 in reduced tax liability; Lifetime Learning credit would be worth a maximum of $600); but with a marginal tax rate of 15%, the Lifetime Learning credit would be worth more than the deduction (Lifetime Learning credit of $600 and a deduction reducing tax liability by $450).

[37] FACTORS THAT DETERMINE BENEFIT SIZE AND ELIGIBILITY. The very structure of the Hope and Lifetime Learning credits and the higher education deduction dictates their focus on enhancing postsecondary access for students from middle and upper middle income families. What follows is a discussion of the mechanisms designed to "enforce" targeting and determine benefit value.

[38] Eligibility and benefit size are a function of several key aspects of the tax credits and deduction. For example, as delineated above, intensity and level of enrollment can determine whether one is eligible for a Hope credit (available only to individuals enrolled at least half-time in their first 2 years of undergraduate education). The subsections below explore two additional sets of factors that play central roles in determining who is eligible for one of these benefits and how much the benefit will be:

     o income and tax liability,

 

 

     o and qualified tuition and related expenses.

 

 

[39] INCOME AND TAX LIABILITY. As has already been shown, the Hope and Lifetime credits benefit middle income families. The income- related eligibility boundaries are established by income ceilings, and tax liability levels essentially function as a floor for the benefit.

[40] The credits are fully phased out for taxpayers with modified adjusted gross income of over $50,000 ($100,000 in the case of a Joint return). Filers earning more than those levels are ineligible for the credits. 21 The deduction extends federal tax benefits for postsecondary education expenses to higher income taxpayers. 22 For 2002 or 2003, the income threshold is $65,000 ($130,000 for joint returns). In 2004 or 2005, that threshold is raised still further so that filers with modified adjusted gross income of between $65,000 and $80,000 ($130,000 and $160,000 for joint filers) are eligible for the smaller deduction.

[41] The credits only provide assistance to those with sufficient tax liability to claim nonrefundable credits. If there is no liability because a filer's income is completely offset by standard deductions and personal or dependent exemptions, neither credit may be claimed. 23 If the tax liability is below the maximum value of the credit, only the lesser amount may be claimed.

[42] Another factor that can affect the value of tax credits is the number of "competing credits" claimed by a tax filer. If a tax filer with limited tax liability claims competing tax credits such as dependent care tax credits, the full value of a Hope or Lifetime credit may not be realized because the other credits reduce the filer's liability below the amount of the education credits. For instance, if a tax filer has $1,000 in tax liability and qualifies for a $480 dependent care tax credit, $1,500 Hope credit for one student, and a $1,000 Lifetime credit for another student, the filer can only receive a total tax benefit of $1,000 (i.e., tax liability is less than the aggregate of credits for which the taxpayer may be eligible).

[43] In contrast to the credits which reduce an individual's tax liability on a dollar for dollar basis, the deduction reduces a taxpayer's adjusted gross income. As was delineated in the example presented above, the potential impact of that reduction on tax liability is realized through the taxpayer's marginal tax rate. Further, some taxpayers may have such limited tax liability BEFORE the application of the deduction that its actual benefit will be small.

[44] Also, taxpayers seeking to claim the tax credits may be affected by the alternative minimum tax provisions that limit the aggregate nonrefundable personal credits a taxpayer can claim. As a result, some of these taxpayers may find the deduction to be a preferable option.

[45] QUALIFIED TUITION AND RELATED EXPENSES. Students attending postsecondary education institutions where the qualified higher education expenses are less than the maximum allowable tax benefits will not be able to claim their full benefits. At many public institutions, low tuition and fee levels are likely to limit the ability to realize the full tax benefits. For the Hope tax credit, qualified higher education expenses must be at least $2,000 for the maximum credit to be realized. In academic year 1999-2000, average tuition and fees at public 2-year institutions were below that level ($1,705). 24 Realizing the full value of the Lifetime credit may be difficult for many students at public institutions in general -- qualified expenses have to be at least $5,000 to actualize a $1,000 Lifetime Learning credit, markedly higher than the average tuition and fees at public 2-year or 4-year ($3,510) institutions. For the deduction, a taxpayer can claim the maximum deduction only if qualified expenses are $3,000 in 2002 and 2003, or $4,000 in 2004 and 2005. At $3,000, the average public 2-year tuition and fees are less; at $4,000, the average tuition and fees are less at both public 2-year and 4-year institutions.

[46] In contrast, average tuition and fees at private institutions far exceeded any of the tax benefit maximums ($7,458 at 2-year private institutions, $16,332 at 4-year private institutions). Tuition and fees are probably sufficiently high at many of these institutions to pose no barrier on their own to realization of the full value of these credits and deduction.

[47] The ability to capture the full value of these tax benefits is further limited by the fact that the Hope and Lifetime credits and the higher education tax deduction can be claimed to reimburse students and their families only for the NET cost of qualified expenses, that is, the qualified expenses remaining after any non-taxable educational assistance received (exclusive of loans and gifts) is subtracted. This reduces if not eliminates the tax benefits for many students receiving relatively large amounts of grant or scholarship aid. This is particularly the case for students receiving relatively large federal Pell Grant awards. Pell Grants are need-based grants that currently (2001-2002 award year) provide a maximum of $3,750 to the neediest students (i.e., students whose families are expected to contribute no resources toward postsecondary education costs). Students attending institutions with low tuition and fee charges and receiving large Pell Grants may have little or no net qualified expenses remaining for which to claim a credit or deduction. At the same time, these low-income students and their families may not have much if any tax liability, also restricting their ability to benefit from the credits or deduction.

[48] As a result, students attending higher cost institutions, and those receiving relatively little grant or scholarship aid, are well positioned to capture a good deal of the potential value of their Hope and Lifetime credits and higher education deduction, assuming their families have sufficient tax liability to realize the maximum benefit from the credits or deduction.

RELATIONSHIP TO THE TRADITIONAL STUDENT AID DELIVERY SYSTEM

[49] The introduction of the higher education tax benefits represented a departure from the federal government's more common practice of primarily making aid available through the traditional student aid delivery system. Given that the federal government is the primary provider of direct aid to students, and tax benefits have quickly grown to become a major component of the federal aid effort, considerable discussion has emerged related to the merits of providing aid through the tax system.

[50] Providing student financial support toward meeting the costs of college through the federal income tax system has a number of advantages and disadvantages relative to the traditional process of providing grants, loans, and work support. Relevant issues are explored below.

[51] TIMING OF AWARDS. One issue that distinguishes the traditional student aid system and the tax system is the timing of the awards. The traditional system provides aid such as grants and loans just in advance of the arrival of tuition bills. Tax credits and deductions, in contrast, require families to make an initial capital outlay which is reimbursed in the form of tax refunds arriving near the end of or after an academic year. This difference may limit the attractiveness of the tax system, particularly for lower income students who may not be able to meet current expenses that will be partly or fully reimbursed by a later tax benefit. Nevertheless, it is possible for taxpayers to adjust their tax withholding throughout the year in order to realize the tax benefits earlier. This would require some sophistication on the part of taxpayers. Further, for students enrolling in consecutive years, the tax benefit for a previous year may be provided in time to help meet the upcoming year's educational expenses. Finally, to the extent that the current tax benefits are available primarily to middle and upper middle income individuals, the timing issue may be less important.

[52] DISBURSEMENT OF AID. Tax credits and deductions may offer the advantage of streamlined delivery of funds to aid recipients who directly claim their financial assistance as part of their annual tax-filing process. Most other aid is delivered through relatively cumbersome and labor intensive processes that require considerable effort on the part of financial aid officers, ED personnel, and loan services, in the case of loans, who must collectively certify student eligibility for aid, monitor enrollment status, disburse funds, and deal with refunds and account reconciliation.

[53] Still, some have criticized the complexity of the process for taxpayers seeking to claim the tax benefits. 25 Further, there are institutional reporting requirements associated with the tax provisions that are viewed by some in the higher education community as potentially burdensome and expensive. TRA, as interpreted by the IRS, requires educational institutions to report to the IRS a broad array of data for any individual enrolled for academic credit for whom the institution receives tuition and fee payments. Of particular concern has been the requirement for institutions to report to the IRS for each student: the aggregate amounts of qualified expenses paid, scholarship and grant aid received, aggregate refunds made, and the identity of the taxpayer claiming the student as a tax dependent. The IRS limited the reporting requirements during the first four years of implementation (1998-2001) to less than those stipulated by the TRA. Even these more limited reporting requirements have been criticized as costing institutions substantial resources. 26

[54] OVERALL COMPLEXITY OF COLLEGE FINANCING. Given the extensive system already in place, the addition of the tax benefits, albeit delivered through an arguably more streamlined process, may actually increase the complexity of the overall national effort to help students and their families meet college costs. With the availability of the tax credits and the establishment of a new deduction, students and their families seeking to realize as much federally financed support as possible for college expenses must navigate not only the traditional financial aid system but also the federal income tax system. Potentially, the tax benefits may more likely be claimed successfully by sophisticated filers.

[55] DIRECT EFFECT OF TAX BENEFITS ON TRADITIONAL STUDENT AID. The potential for a direct effect of these tax benefits on traditional student aid differs substantially between federal aid and non-federal aid.

[56] EFFECT ON FEDERAL STUDENT AID. By statute, the receipt of the tax credits is to have no effect on a student's eligibility for, or level of, federal student aid. First, in calculating what a student and his or her family is expected to contribute toward college costs (expected family contribution or EFC) under the Higher Education Act (HEA) student aid programs, HEA Section 480(a)(2) states that the tax credits cannot be considered income or assets for purposes of that calculation. Second, HEA Section 480(j)(3) provides that the determination of need for HEA Title IV aid programs -- student's cost of attendance minus the EFC and non-Title IV assistance -- is not to include the credits as non-Title IV assistance. Any non-Title IV assistance included in this calculation reduces a student's need and, hence, his or her eligibility and level of assistance under need-based Title IV aid. There is no comparable language in the HEA governing the interaction between the new tax deduction and the Title IV assistance.

[57] Tax benefits and Title IV aid may interact, however, in the federal funding process. It is possible that, in congressional deliberations over the budget and spending for federal programs, the forgone tax revenue associated with the tax benefit provisions may have a negative impact on the willingness or ability of the Congress to devote funds to the traditional federal student aid programs.

[58] EFFECT ON PACKAGING OF OTHER AID. The limited evidence available suggests that financial aid officers are far from uniform in whether or how they consider the tax benefits when packaging financial aid for students. Indeed, it is not clear whether the majority actively factors the tax benefits into this process at all.

[59] Financial aid officers who want to factor the tax credits into their aid packaging calculations may find the effort complicated by the absence of information about the actual value of the tax benefits students will receive. As noted earlier, tax benefits are claimed and their value known by April 15 of the year after the payment for qualified expenses are made.

[60] Certain other aspects of the design of the tax benefits may make it difficult to infer their value before they are claimed. The actual value of the tax benefits to recipients is affected by a series of offsets and limitations that are built into the design of the tax system (for example, as explored earlier, a recipient must have sufficient tax liability to claim the credit and even then the value of the credit may be reduced by competing credits that can be claimed). The potential effects of these internal offsets and limitations make it hard for financial aid officers to project the value of the credit when packaging aid.

[61] Those financial aid officers who would take the tax provisions into account in packaging aid, and thereby, reduce other kinds of aid for recipients, must make assumptions about the benefits' value. If gaps exist between the credits' actual and assumed value the recipients may receive more or less aid than intended.

[62] EFFECT ON STATE DECISIONS RELATED TO TUITION LEVELS AND AVAILABLE SOURCES OF AID. The effect of the tax benefits on the setting of tuition levels by states and higher education institutions is largely unknown. State higher education officials face challenges similar to those faced by financial aid officers stemming from the hidden value of tax credits. They must make decisions about tuition levels at state institutions and about the structure and targeting of state aid programs which can be shaped in part by assumptions about the value of aid that they expect will be available to students. Precisely gauging the net financial benefit flowing from the tax benefits is problematic, however some states have considered, at least, raising the tuition and fees in some schools in order to enable their students to "capture" as much of the tax benefits as possible. Some states have also considered targeting their state grant programs in ways that avoid inhibiting students' ability to capture the full value of other credits. 27 Such decisions regarding tuition and aid will affect whether and how the tax benefits will enhance recipients' ability to finance postsecondary education.

 

FOOTNOTES

 

 

1 This report does not address other tax provisions intended to help families meet their postsecondary education expenses through savings, such as the Federal Coverdell education savings accounts. See CRS Report RS20289, Education Savings Accounts for Elementary and Secondary Education, by Bob Lyke and James Stedman.

2 Balkovic, Brian. Internal Revenue Service. Individual Income Tax Returns, Preliminary Data, 1999. Statistics of Income Bulletin. Spring 2001. Downloaded from the IRS web site, [http://www.irs.treas.gov/],August 3l, 2001. (Here after cited as IRS, Individual Income Tax Returns.)

3 Only somewhat less than 40% of the new loan volume consists of federal funds; the remainder is private capital supported by federal loan guarantees and subsidies.

4 While still dominant, the portion of student aid that is being awarded dependent on need may be declining. As reported by the Advisory Committee on Student Financial Assistance, "At the state level, new grant aid has shifted steadily in favor of merit-based aid and against need-based aid." (Access Denied: Restoring the Nation's Commitment to Equal Educational Opportunity, February 2001, p. 8.) The Committee reports that 18.6% of state grant aid funds are now merit-based.

5 See also CRS Report 97-915, Tax Benefits for Education in the Taxpayer Relief Act of 1997: New Legislative Developments, by Bob Lyke.

6 Only individuals with income tax liability can benefit from a nonrefundable tax credit. Unlike a deduction, which reduces the amount of income subject to tax, a credit directly reduces the tax itself. A nonrefundable credit cannot be worth more than the amount of the tax. For a taxpayer with a refundable tax credit that exceeds tax liability, a payment is made by the federal government to the taxpayer in the amount of the difference.

7 Expenses paid by a dependent or someone other than the filer, spouse, or dependent are treated as if paid by the taxpayer.

8 Fees for course-related books, supplies, and equipment and activity fees are included only if they are paid to the institution as a condition of enrollment.

9 In general, taxpayers' modified adjusted gross income will equal their adjusted gross income. For taxpayers who exclude income earned abroad or from certain U.S. territories or possessions, modified adjusted gross income is their adjusted gross income increased by those excluded amounts.

10 A formula adjusts the credit values for income of less than the ceiling but more than the threshold for receiving the full benefit: the modified adjusted gross income is subtracted from the income ceiling, the remainder is divided by $10,000 ($20,000 for joint returns) and then multiplied by the originally calculated credit value to produce an adjusted credit value. For example, for a taxpayer filing a joint return with modified adjusted gross income of $90,000 and a tentative Hope credit of $1,500, the Hope credit would be reduced by half to $750 ($100,000 - $90,000 = $10,000; $10,000/$20,000 = .50; $1,500 x.50 = $750).

11 Lifetime Learning credits are phased out by same formula applied to Hope credits when income is higher than the threshold for the full credit but less than the threshold for complete elimination of the credit.

12 An above-the-line deduction is taken against a taxpayer's gross income, directly affecting the calculation of adjusted gross income. This deduction can be taken regardless of whether the taxpayer itemizes deductions.

13 The marginal tax rate is the tax rate applied to the last additional dollar of income.

14 The calculation is as follows: 15% of $3,000 = $450 maximum in tax savings.

15 The calculation is as follows: 27% of $3,000 = $810 maximum in tax savings. The statutory rates of 15% and 27% used in this example are the marginal rates that will usually apply to the majority of middle income parents in tax years 2001-2003.

16 Based on the statutory provisions in P.L. 107-16, the broader provisions of the Hope and Lifetime Learning credits concerning payments made by dependents or someone other than the filer do not appear to apply to the deduction.

17 The higher education deduction is not in effect yet, and thus no data can be provided on its claimants. It is similar to the Hope and Lifetime credits in that it targets middle income recipients. However, it phases out at higher income levels than the credits.

18 Among other more narrowly targeted benefits for individuals seeking to upgrade skills is employer education assistance.

19 The calculation is as follows: 100% of first $1,000 in qualified expenses = 1,000; 50% of the second $1,000 = $500.

20 The calculation is as follows: 20% of $3,000 = $600.

21 A high income family with a student for whom the dependent exemption could be claimed might decide NOT to make such a claim. This would allow the student to claim a credit assuming he or she has income below the phase out thresholds and has tax liability against which a credit could be taken.

22 Although the income thresholds for the Hope and Lifetime Learning credits will be indexed for inflation after the 2001 tax year, the thresholds for the higher education tax deduction will still be significantly higher.

23 The point at which a taxpayer will begin to have tax liability depends upon such factors as the taxpayer's income, number of dependents, and tax deductions. For example, a family of a husband and wife with a child in college, taking the standard deduction, would have no 2000 tax liability at an adjusted gross income level at or below $15,750, assuming this family takes three exemptions of $2,800 apiece for a total of $8,400 and takes the standard deduction of $7,350.

24 The College Board. Trends in College Pricing 2000. 2000.

25 See, for example, Wolanin, Thomas R. Rhetoric and Reality: Effects and Consequences of the HOPE Scholarship. The Institute for Higher Education Policy, April 2001. (Hereafter cited as Wolanin, Rhetoric and Reality.)

26 Proposed IRS regulations issued June 16, 2000 (according to Internal Revenue Service Notice 2000-62, these regulations are to be finalized in 2001) would implement most, but not all, of the reporting requirements in TRA, applicable to returns required to be provided after December 31, 2001. It would require reporting on the aggregate amounts paid, reimbursed or refunded, and received as grants or scholarships. Still, it would not require institutions to report the name, address, and taxpayer identification number of taxpayers claiming students as dependents for federal income tax purposes.

27 One recent analysis that has explored available information on this issue concludes that the Hope Scholarship provides resources that "are an incentive for private and public institutions of higher education to increase tuition or to reduce aid to students. Indeed, the HOPE Scholarship benefits institutions of higher education ONLY IF they raise tuition or decrease student aid. Several states have considered or undertaken strategies to capture the HOPE Scholarship through either tuition increases or aid reduction." (Wolanin, Rhetoric and Reality, p. 29)

 

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