Using The Tax Code To Enhance College Affordability

A new report out today from the Center for American Progress examines how the U.S. tax code could better promote college affordability throughout the college process—while parents are saving for college, during the time that students are in college, and while borrowers are paying back student loans. The current tax code provides smaller rewards for middle-class families’ college saving than higher-income earners, leading to low usage of tax-free savings vehicles toward college costs. The tax code also provides a complicated set of multiple incentives for parents and students while in college and does not always benefit student-loan borrowers in repayment. As a result, the report recommends a number of changes to the tax code that would help middle-class families better afford higher education.

As the report outlines, the U.S. tax code is full of provisions designed to encourage or reward specific behaviors, such as owning a home or saving for retirement. The more than $30 billion in annual tax benefits for higher education—tax benefits that effectively double the federal government’s support for higher education—are no exception: Contributions to some college savings accounts grow tax-free, college tuition is often tax deductible, and some student-loan borrowers are able to deduct the interest paid on their student loans just as they would the interest paid on their mortgage. These higher education tax provisions have implications for access, affordability, and equity.

“Many provisions of the tax code are upside-down. They benefit high-income families much more than the middle class—and billions of dollars toward higher education are no exception,” said Joe Valenti, Director of Asset Building at the Center for American Progress. ”The policy changes we have identified would make the tax code more progressive and benefit parents and students struggling with college costs.”

The report presents a menu of potential ideas for making each stage—before enrollment in college, during enrollment, and post-enrollment—more effective and equitable in terms of directing tax incentives to those who would benefit most from them.

Among others, the recommendations in the report include: 

• College savings incentives should be more progressive and accessible to middle-class families. The Treasury Department should establish a national standard for gift contributions to 529s. A technological solution could make it possible for family members, friends, and community organizations to make contributions to a child’s college savings and would facilitate savings contributions from multiple sources, including nonprofits that could provide families with financial support for future college costs. Congress should establish an annual contribution limit to 529s and cap tax-free buildup within them, as virtually no other tax benefit for individuals’ savings is currently limitless. Congress should also consider a matching component for higher education savings by lower-income families and ensure that college savings do not punish working families in asset tests and for financial aid purposes.

• Duplicative tax credits while in school should be eliminated by building off the successful American Opportunity Tax Credit, or AOTC, and adopting the most generous provisions of each. The structure of the tax credits for currently enrolled students is overly complex. As a result, families are required to make choices among options that are difficult to assess—and frequently choose the option that does not provide the maximum benefit. The American Opportunity Tax Credit is often the best choice, but the Lifetime Learning Credit is also important for adults continuing their education. As part of streamlining the tax code, the ban on the AOTC for students with felony drug convictions should also be lifted; this provision is unusually invasive and punitive, identifying one particular type of offender who is ineligible for higher education tax benefits while all other criminal offenses are exempt.

• The student-loan interest deduction should be converted into a credit, and borrowers in income-based repayment plans should not face a tax bill for debts forgiven at the end of the repayment period. As a 15 percent credit, higher-income borrowers would not receive a larger tax benefit than lower-income borrowers with lower marginal tax rates, making the treatment of student-loan interest more progressive. Under current law, many borrowers who are currently participating in income-based repayment plans face a large tax bill after making payments for 20 or 25 years because their forgiven debt is treated as income. Borrowers participating in these plans should not be subject to this future tax penalty, which can be substantial and surprising.

Read the report: Harnessing the Tax Code to Promote College Affordability by Joe Valenti, David A. Bergeron, and Elizabeth Baylor