Taxation and the Family: What tax incentives exist to help families pay for college?

Rapidly rising college expenses in the 1990s spurred the 1997 enactment of tax incentives for higher education: the Hope Credit, the Lifetime Learning Credit, and a deduction for tuition and fees. As a consequence, federal higher education in-school tax subsidies rose from zero before enactment to roughly $6 billion in 2005-06. College savings incentives also exist, not discussed here. Critics complain that the tax benefits have not changed enrollment patterns, but instead have provided subsidies to people who are likely to attend college anyway. Many low-income students who might be most influenced by reduced college costs receive little or no benefit from the credits because they are nonrefundable and thus can only offset income taxes owed. At the other end of the income scale, many high-income families are in or beyond the earnings range where eligibility phases out. As a result, the highest average benefits go to families with annual incomes between $30,000 and $100,000.

• For each student, families may claim only one of the three tax benefits but they need not claim the same benefit for all students. Complexity associated with having to choose which benefit to take results in people frequently choosing sub-optimally (GAO 2005).
• The Hope Credit applies to tuition and fees for students enrolled at least half time in their first two years of college. The credit equals 100 percent of the first $1,100 of eligible expenses plus 50 percent of the next $1,100, yielding an annual maximum credit of $1,650 when qualifying expenses are at least $2,200. Each qualifying student in the household can receive a Hope credit.
• The Lifetime Learning Credit equals 20 percent of tuition and fees for any post-secondary education, up to a maximum annual credit of $2,000. That maximum applies to the combined expenses of all students in the household claiming the credit and is reached when total qualifying expenses reach $10,000.
• The maximum benefit for both tax credits phases out between adjusted gross incomes of $45,000 and $55,000 for single taxpayers, or between $90,000 and $110,000 for married couples.

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• The deduction for tuition and fees allows taxpayers (parents or students, whichever pays) to reduce taxable income by up to $4,000. To qualify, a family’s adjusted gross income may not exceed $65,000 for single filers or $130,000 for married filers. Single filers with AGI between $65,000 and $80,000 or married filers with AGI between $130,000 and $160,000 can deduct up to $2,000 of expenses. After that, a family is no longer eligible for the deduction. The tuition and fees deduction is scheduled to expire after 2008.
• Both the Hope Credit and the Lifetime Learning Credit are nonrefundable, so only people who owe income tax can benefit. Similarly, the deduction for tuition and fees is valuable only for people with taxable income.
• These tax programs provide relatively modest benefits: an average of $771 per household. Average benefits are highest for those receiving a Hope Credit ($1,069), followed by the Lifetime Learning Credit ($978), and finally the tuition and fees deduction ($324).
• Using the tax system to subsidize higher education has two primary advantages: Students need not fill out the complicated Free Application for Federal Student Aid form, and every student who qualifies receives a benefit.
• Little evidence exists to show that the programs actually influence behavior. Instead, they are likely subsidies to people who would attend college even without the tax benefits - with the majority of benefits flowing to tax units with income exceeding $50,000. This is in stark contrast to traditional aid programs such as the Pell grant, where benefits flow mostly to low-income families.

Possible options for reform

• Making the credits refundable would provide assistance for poorer families, who cannot benefit from the current credits because their tax bills are too low.
• Broadening the range of covered expenses to include, for example, room and board and books and raising the maximum allowable expenses would provide more assistance.
• Providing benefits directly to schools when students enroll (based on the previous year’s taxes) would help students cover college costs when they actually have to make payments, not months later when their families file tax returns.
• Combining the Hope and LLC into one credit (while allowing the tuition and fees deduction to expire) would avoid confusion over which tax benefit is most beneficial to families who currently qualify for multiple benefits.