# Presentation: 261436

## Tax Incentives for EducationProfessor Susan DynarskiKennedy School of GovernmentTestimony before the President’s Advisory Panel on Federal Tax ReformMarch 16, 2005

## Overview

- Background on college costs
- Tax expenditures for education
- Education savings accounts
- Complexity
- Distribution of benefits
- Tuition tax credits and deductions and exemptions
- Complexity
- Distribution of benefits
- Concluding Thoughts

## College Costs Trends:Very High for the Few at Private Schools, Moderate for the Many at Public Schools

- Source: *Trends in College Pricing 2003*, College Board (2004). Enrollment-weighted averages of tuition and required fees are in 2003 dollars.

## Tax Expenditures for Education(with estimates from the Joint Committee on Taxation in billions of dollars)

- Tax Expenditures Aimed at Reducing:
- Future Education Costs
- Coverdell & 529 savings accounts ($0.5 in 2005; $1.1 in 2009)
- Current Education Costs
- Hope & Lifetime Learning credits ($5.7 in 2005; $5.7 in 2009)
- Personal exemption for student dependents age 18-23 ($2.6 in 2005; $1.4 in 2009)
- Tuition deduction ($1.7 in 2005; sunsets after 2005)
- Exemption from taxation of employer benefits for education ($0.6 in 2005; $0.7 in 2009)
- Completed Education Costs
- Student loan interest deduction ($0.8 in 2005; $0.8 in 2009)

## Future Education Costs:Coverdell & 529

- Think of these savings accounts as Roth IRAs for education
- 529 for college
- EGTRRA 2001 eliminated federal taxes on 529 withdrawals
- This provision sunsets in 2010
- Tax liabilities of 529 backloaded - realized when funds drawn down when child goes to college
- Very rapid recent growth in 529s
- Coverdell for K-college

## College Saving Complexity: Multiple Tax-Advantaged Options

- Education Savings Accounts (ESAs)
- 529
- Coverdell
- Retirement Vehicles
- Roth IRA
- Traditional IRA
- 401k
- Other
- Uniform Transfer to Minors Act (account in child’s name)
- Savings Bonds
- Home Equity

## Complexity in College Savings:More than One Hundred 529 Plans to Choose From

- Arizona and Nevada each sponsors *six *529s
- Every plan has its own...
- Application
- Contribution limits
- Investment options
- Costs
- Asset-based administrative fees, loads, expense ratios, annual fees
- SEC disclosure rules *do not *apply  no way to easily compare costs across plans
- Penalties for non-educational use

## Variation in After-Tax Returns Creates Complex Choices

- After-tax return to saving for college depends upon whether you save in
- Standard mutual fund
- Traditional IRA
- UTMA
- 529
- Coverdell

## Assumptions in Calculating After-Tax Returns

- Married couple, two kids, one earner
- Pretax deposit of $1,000 made when child is born
- After-tax earnings reinvested
- Funds drawn down over four years of college

## Portfolio Assumptions

- Stock returns 9%
- 2% dividends
- 7% long term capital gains, unrealized until withdrawal
- Bond returns 4%
- Aggressiveness of portfolio decreases as child ages

##  After-Tax Returns Vary Considerably Across College Savings OptionsExample: Household Income=$50,000

## Value of Savings IncentivesDepends on Your Tax Bracket, Rising Sharply with Income

*Return shown is relative to non-advantaged account*

## Penalties Make Coverdell Risky for Low-Income Families

## Slide 14

## Tax Benefits for Current Education Costs

- Hope Tuition Tax Credit
- Lifetime Learning Credit (LLC)
- Tuition Tax Deduction
- Sunsets in 2005

## Household Choice of Tuition Tax Benefits: Depends on ...

- Income Phase-out Range
- Credits: $42 - 52K (single)/ $85 -105K (married)
- Deduction: $65 - 80K (single) /$130 -160K (married)
- AMT
- Credits do not survive AMT
- But deduction does
- Marginal Tax Rate (MTR)
- Does not affect value of credits
- Affects value of deduction (value increases with MTR)

## Household Choice of Tuition Tax Benefits: Depends on ...

- Enrollment Status
- Hope covers first two years of college, LLC covers all levels
- Must be at least half-time in school for Hope, not for LLC
- Number of Students in Household
- One LLC allowed per *household*
- One Hope credit allowed per *student *in the household
- Deduction cap is for *household*
- Schooling Costs
- Hope covers 100% of first $1,000, 50% of second $1,000
- LLC covers 20% of first $10,000
- Deduction is for up to $4,000

## Value of Tuition Tax Benefits: 2003

**Notes:**
Note that the value of the LLC does not max out until tuition and fees are $10,000.

## Take-up of Education Credits Concentrated Among Middle & Upper Tax Brackets

- $15K

- $30K

- $50K

- $100K

- Under

- to

- to

- to

- to

- $15K

- $30K

- $50K

- $100K

- $200K

- Income group's total credits
-  (in billions)

- $0.21

- $1.36

- $1.78

- $2.55

- $0.00

- Income group as % of credit
- claimants

- 9%

- 26%

- 28%

- 36%

- 0%

- Income group as % of all
- returns

- 29%

- 23%

- 19%

- 21%

- 7%

- Income group share of total
-  credit $

- 4%

- 23%

- 30%

- 43%

- 0%

## Where are Tax Credits Spent?

- Most of Credits Spent at Expensive Private Colleges
- Full benefit of LLC does not kick in until tuition and fees are $10,000 a year
- Typical student attends a public university, where
- Tuition and fees average $4,700
- Just 4% of students pay over $8,000.
- At community colleges, average costs are less than $2,000
- (Amounts are for 2003-2004 and expressed in 2003 dollars
- Source: *Trends in College Pricing 2003*, College Board, 2004)

## Who Benefits from the Tax Incentives for Education?

- Savings Plans
- Value highest for higher-income families
- Risky for lower-income families due to penalties
- Early takeup concentrated among higher-income households
- Tax Credits
- Greatest benefit to those at most expensive private schools
- Takeup highest in middle and upper brackets

## Effect of Incentives on Behavior

- Tax credits do not increase college-going (Long, 2004)
- Too complicated
- Not available to lower brackets, where there is more room for response
- Savings plans
- No strong evidence they increase savings
- Too early to tell if they increase college-going

## Concluding Thoughts: Costs of tax complexity 

- Some taxpayers spend time researching complicated rules (or pay others to advise them) then alter their behavior to maximize credits/deductions and asset returns
- 		 waste of social resources
- Other taxpayers do not understand the complicated rules & pay higher taxes than those who do
- 		  horizontal inequities
- Simplifying the code can have a positive impact on both efficiency and equity