Extra credit: education tax credits may prove detrimental to students and colleges

National Review, Sept 15, 1997 by Alan Reynolds

When President Clinton dealt himself a new hand in the middle of the tax-cut game, he claimed that he did so partly because he was unhappy with the House and Senate tax breaks for college. "They do an inadequate job," he said, "of opening the doors to college." Unfortunately, this issue was framed as a debate over which plan can lose the most money, rather than which is most effective.

For the first two years of college, the President proposed a 100 per cent tax credit for the first $1,000 of tuition, and 50 per cent of the next $1,000. The Senate offered a 75 per cent credit for the first $2,000 spent at a community college, or 50 per cent of $3,000. All these plans would cut $1,500 off a taxpayer's bill, so the differences were trivial. In the end, Congress went along with a modest variation of the President's plan: A 100 per cent tax credit for the first $1,000 of tuition, 50 per cent for the next $1,000, and 20 per cent for the balance up to $5,000, and 20% for the next $5000.

Unfortunately, a 100 per cent tax credit for the first $1,000 of college tuition makes no more sense than a 100 per cent tax credit for the first $1,000 invested in a computer. A 100 per cent tax credit means those receiving the benefits of a $1,000 education will bear none of the cost. The burden will fall on other taxpayers, most of whom do not have a college degree. Nevertheless, this gift will undoubtedly increase the quantity of applications for enrollment in community colleges -- mainly by attracting more students with marginal motivation and commitment. This would create more problems than solutions.

First of all, the intended surge in applications to community colleges would force those institutions to ration entry by raising fees and admission standards. Higher standards would keep out more inner-city youths disadvantaged by notoriously inferior public-school preparation. Higher tuitions would be most damaging to the poorest of the poor. They can make no use of the tax credit because 1) they owe no income tax, or 2) they are eligible for a Pell grant, which makes them ineligible for the tax credit.

Second, community colleges would appear free, until tuitions went up, but parents or students would bear the burden of upgrading to a state or private university. This would tend to channel greater numbers of the most able low-income students toward the cheapest colleges, which may not be in their best interest.

Third, the President's plan is heavily skewed toward the first two years of college, with the credit dropping from 100 per cent to 20 per cent in the third and fourth years. Yet only a fourth of first-year college students stay in school long enough to earn a bachelor's degree. Many drop out after one year. Why use tax bribes to encourage more people to start college when so few actually finish?

Fourth, tax credits have to be used when the tuition is paid, or they are lost forever. Instant tax relief is dandy if parents are footing the bill, and if they owe enough taxes to benefit. But an immediate tax credit is useless for students putting themselves through college with student loans and part-time jobs. Such struggling students rarely owe $1,500 in taxes. In order to make tax breaks available to students who are paying their own way, tuition tax deductions (not credits) would have to be carried forward until the students begin to earn higher incomes. Tuition costs could be depreciated over the student's remaining years of work, for example. Or the cost could be "expensed" by the parent or student, with any unusable deductions carried forward at least ten years.

The Senate and Clinton plans do include one provision that could help self-financing students: They allow some interest on student loans to be deducted each year for five years. But that covers only limited interest expense, not tuition expense, and five years is not long enough to repay many student loans.

Fifth, the attempts to encourage saving in some of these plans will be thwarted by other tax and spending policies which have the opposite effect. The House proposed a $10,000 deduction for prepaid tuition, and the President suggests a small tax-deferred savings account for college. If parents put aside savings for their child's education, however, that will make their child ineligible for Pell grants or subsidized Stafford loans. Income testing on grants and loans likewise discourages both parents from working as their children reach college age. Yet the current budget deal does not repair or replace such flawed programs. It merely adds some inefficient, inequitable, and costly tax breaks to the inefficient, inequitable, and costly spending programs.

Sixth, a tax break for the first $1,500 or so of college tuition is ineffective at the margin, where decisions are made. Everyone who would have gone to college anyway would get this tax break. But those who may be contemplating investing more of their own money in a better education are given no incentive to do so. To have a significant impact, an educational tax incentive would be on the last $1,500 spent, not the first $1,500.