TaxVox Why Student Debt Forgiveness Won’t Include Higher Tax Bills
John Buhl John Buhl
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President Biden announced plans to forgive $10,000 in student debt for all borrowers with below $125,000 in annual income ($250,000 for couples), while Pell Grant recipients will be eligible for $20,000 in forgiveness. For many, the change will be even more generous because last year’s American Rescue Plan Act (ARPA) makes the loan forgiveness tax free. But that feature could add more than $30 billion to the government’s cost.

Typically, loan forgiveness is treated as taxable income. Imagine hypothetical taxpayers with $50,000 per year in taxable income who had $10,000 in loans forgiven. When they file their taxes, they would instead claim $60,000 in taxable income. This makes sense from a tax policy perspective, since loan forgiveness is an improvement in wellbeing. But for someone making monthly payments on five-figures worth of debt, that lump sum, year-end tax bill could be quite painful and replace what feels like unaffordable loan payments with a large tax obligation.

While much of the public’s attention last year was focused on ARPA’s economic impact payments and the expanded child tax credit, the law also made student loan forgiveness tax free between Dec. 31, 2020, and Jan. 1, 2026. At the time the bill passed, the congressional Joint Committee on Taxation estimated that the provision would cost $44 million over a decade, largely because a relatively small number of borrowers were projected to have student loans forgiven.

But overall the federal government holds $1.6 trillion in student debt for about 43 million borrowers, according to the Education Data Initiative. About two-thirds of borrowers owe more than $10,000. Based on these and other data, the Committee for a Responsible Federal Budget estimates the government will spend about $360 billion forgiving their loans.

Doing some crude math using the average total federal tax rate for all households (roughly 9 percent), that’s about $34 billion in foregone income tax revenue.

There are also state taxes to consider. Several states do not automatically conform to changes in the federal definition of tax income, so unless they have explicit rules in place or take further legislative action, some beneficiaries could end up owing state tax on the forgiven portion of their loans.

Is this the best use of $360 billion? Probably not. Many people never go to college, and those with just a high school education earn far less than those who earn college degrees, making this a regressive policy. On the other hand, Black borrowers hold much more debt, on average, than other groups and are more likely to default on their loans. As a result, forgiveness is seen by proponents as a way to help address racial wealth inequities. To this point, increased forgiveness for Pell grant recipients will help, since those beneficiaries are from lower income families who are disproportionately Black.

Whichever side of the debate you land on, the root cause of the problem is the fast-rising higher education costs that saddled so many with debt in the first place. Biden does include structural changes to student loan administration and a watchlist to monitor school programs producing a high amount of debt. Policymakers may also want to clamp down on for-profit colleges and identify more affordable, alternative career path options, such as apprenticeship programs. But even if you favor some sort of large-scale student debt forgiveness, we’ll have this debate again if the factors pushing the price of college up go unaddressed.

Tags student debt student loans
Primary topic Individual Taxes
Research Area Education