Tuition Tax Deductions and Credits:
Is this a "middle class tax cut"?
1 Dec 2006 in Regulatory Economics, Regulatory Policy
The incoming Democratic Congress is promising to make college tuition "deductible from taxes, permanently." Elsewhere this is described as a "tax credit," which of course is very different. Tax deductibility is valued at the taxpayer's marginal tax bracket, but tax credits are worth 100% of their cash amount. In either case, the proposal is described as a "middle class tax cut."
The economics of both tax deductibility and tax credits are actually very different. The benefits of either policy are likely to be enjoyed mostly among those with the highest income. And, these benefits will be much smaller than expected because they will cause college tuition to rise.
The language being used to describe these proposals is vague and somewhat inconsistent, the interchangeable use of tax deductions and tax credits being perhaps the most obvious example. The analysis below takes at face value the words used in the proposals, which may be different from the words intended and quite likely differ from the actual legislative text.
With that caveat in mind, let's first distinguish tax deductions from tax credits. Making college expenses tax deductible means allowing families to pay using pre-tax dollars. For a family in the 33% tax bracket, a $3,000 in deductible college expenses costs $2,000 in after-tax dollars. A tax credit is much more valuable. The same $3,000 in college expenses would cost $0 after taxes.
The lower a family's tax bracket, the greater is the benefit of a tax credit over a tax deduction. A family in the 15% tax bracket would save just $450 on $3,000 of tax deductible college costs, whereas a family in a 50% tax bracket would save $1,500.
The proposal contained in the House Democrats campaign document contains the following text:
Our New Direction plan for college affordability will also dramatically increase the tax deductibility of college tuition by simplifying the maze of tuition laws to allow a 100% tax credit for tuition up to $3,000 – the equivalent of a $12,000 deduction for most middle-class families (p. 17).
Note that the terms tax deductibility and tax credit are used interchangeably. The $3,000 figure appears to be an annual cap and limited to four years (hence the reference to $12,000). But it has very different meaning if it is a tax deduction or a tax credit. Following our previous example assuming a 33% tax bracket, a $3,000 annual ($12,000 lifetime) tax credit is equivalent to a $9,000 ($36,000 lifetime) tax deduction.
If the proposal is implemented as a tax credit, it will have greater benefits for lower-income families than higher-income families. If it's implemented as a tax deduction, it will have greater benefits for households in the highest tax brackets. As is the case with all tax deductions, this one would be more valuable the greater your income. The "rich" have more income than the "middle class."
Whether implemented as a tax credit or a tax deduction, there will be pressure to increase the cap beyond $3,000 per year and $12,000 per lifetime. In 2004, the Department of Education reported that 47% do not complete bachelor's degrees within five years. Many of these students dropped out, but 14 percent of males and 10% of females were still enrolled at a 4-year institution. In addition, a 4-year cap would exclude graduate school education from the benefit and there will be pressure to permit deductibility of those costs, too.
If the tax credit or tax deduction is increased, the share of program benefits received by wealthier families will increase. The wealthy are more likely to send their children to elite private and out-of-state public schools, and they are much more likely to foot the entire bill because they are ineligible for financial aid.
Finally, the benefits of either tax credits or tax deductions are almost certain to be smaller than expected. That's because colleges and universities will respond to the policy by increasing college tuition. What starts out as, say, a 33% reduction in the after-tax cost of college could turn into a 33% increase in its nominal price, thus wiping out all household gains. To the extent that tax policy enables tuition to rise, these benefits will be transferred from families sending kids to college to the college they send their kids.
