Office of Tax Analysis

Working Paper 113

November 2016

Tax Expenditures for Education

Nicholas Turner

The OTA Working Papers Series presents original research by the staff of the Office of Tax

Analysis. These papers are intended to generate discussion and critical comment while

informing and improving the quality of the analysis conducted by the Office. The papers are

works in progress and subject to revision. Views and opinions expressed are those of the authors

and do not necessarily represent official Treasury positions or policy. Comments are welcome,

as are suggestions for improvements, and should be directed to the authors. OTA Working

Papers may be quoted without additional permission. 
2

TAX EXPENDITURES FOR EDUCATION

November 2016

Nicholas Turner1

The federal government devotes substantial resources to primary, secondary and postsecondary 

education through direct spending programs and tax incentives. This support helps individuals acquire 

the knowledge and skills required to realize good jobs and achieve secure economic outcomes. This 

paper analyzes tax expenditures for education by describing current tax provisions, evaluating current 

tax programs and by reviewing tax reform options. The reforms outlined here simplify the tax code for 

millions of families, while retaining important incentives for investments in education. In addition, the 

reforms will improve coordination between direct spending programs and the tax system, further 

reducing burdens on students and families who are working towards their education goals.

Keywords: tax-based student aid, tax expenditures for education

JEL Codes: H24, I28

 

1 Nicholas Turner: Office of Tax Analysis, U.S. Department of the Treasury, Nicholas.Turner@treasury.gov. 
3

I. INTRODUCTION

The federal government devotes substantial resources to primary, secondary and postsecondary 

education through direct spending programs and tax incentives. This support helps individuals acquire 

the knowledge and skills required to realize good jobs and achieve secure economic outcomes. This 

support also helps the overall success of the U.S. economy. A skilled and educated workforce allows

the U.S. to remain competitive and to prosper in an increasingly competitive global economy. 

From an economic perspective, government support for education is justified if there are failures 

in the education market that prevent students from choosing the socially optimal level of education. The 

socially optimal level of education is an amount of schooling at which one more dollar spent on 

education yields one dollar of benefits. The benefits include private benefits that accrue to the student 

and their family as well as the social benefits that accrue to others. Individuals receive large private 

benefits from education in the form of higher wages, greater job satisfaction, greater likelihood of 

employment and even better health.

2 Despite these benefits, individuals are likely to choose a level of 

education that is less than the socially optimal level. 

One reason for choosing too little education relative to the socially optimal level is that 

individuals are unlikely to account for the social benefits from education. These social benefits are 

positive spillover effects that accrue to people other than the students or the students’ families, and so 

are unlikely to offer the student a strong motive for acquiring more education. Positive spillovers from 

education include increased economic growth that benefits less educated workers, lower crime rates, 

greater civic participation, better political decisions as a result of a literate electorate, and higher rates of 

volunteerism.

3

The positive spillovers from education are likely to be largest for primary and secondary 

education, with smaller spillovers from postsecondary education. 

A second reason that individuals may select a level of education that is lower than the socially 

optimal level is inadequate access to affordable credit. Credit constraints may prevent low-income 

individuals from achieving their desired level of education, even if their lifetime benefits from education 

 

2 Card, David. 1999. “The Causal Effect of Education on Earnings,” Handbook of Labor Economics, Vol. 3, p. 1801-1863. 

College Board. 2011. “Education Pays: Trends in Higher Education.” (http://trends.collegeboard.org/education-pays). 

Currie, Janet and Enrico Moretti, 2003. “Mother’s Education and the Intergenerational Transmission of Human Capital: 

Evidence from College Openings,” The Quarterly Journal of Economics, Vol. 118, p.1495-1532. 

3 Katz, Lawrence and Claudia Goldin. 2010. The Race between Education and Technology. Moretti, Enrico. 2004. 

“Workers’ Education, Spillovers, and Productivity: Evidence from Plant-Level Production Functions,” The American 

Economic Review, Vol. 94, p.656-690. Lochner, Lance. 2004. “Education, Work, and Crime: A Human Capital Approach,” 

International Economic Review, Vol. 45, p. 811-843. Milligan, Kevin, Moretti, Enrico and Phillip Oreopoulos. 2004. “Does 

Education Improve Citizenship? Evidence from the United States and the United Kingdom,” Journal of Public Economics, 

Vol. 88, p. 1667-1695. College Board, 2011. “Education Pays: Trends in Higher Education.” 
4

exceed their costs of schooling.4 An inability to borrow on affordable terms is likely to have the largest 

effect for postsecondary education because states and localities provide free primary and secondary 

education. Direct federal spending programs, such as Pell grants, subsidized student loans and higher 

education tax credits, alleviate credit constraints by lowering the cost of attending college. 

Informational barriers and complexity may also prevent students from selecting the socially 

optimal level of education. These factors are likely to impact the level of postsecondary education 

because of incomplete information on student aid and complexity in the student aid application process. 

These frictions may cause some students to forgo federal student aid and thus select a level of education 

less than the socially optimal level. Research suggests that providing youths information on the costs of 

college and reducing transactions costs for financial aid application increases college enrollment.5 

II. DESCRIPTION OF CURRENT TAX PROGRAMS

Tax benefits for postsecondary education take the form of credits, deductions and income 

exclusions. As these benefits lower tax revenue compared to a comprehensive income tax system that 

taxes all income and activities in the same way, they are considered tax expenditures.

6

 The term tax 

expenditure is used to describe these tax benefits because they, or their effects, are similar to direct

spending programs. 

Tax expenditures are an imperfect way to provide subsidies. They tend to hide the subsidy from 

public view and complicate the operation of the tax system. These problems do not arise when 

providing a comparable subsidy through a direct spending program. Tax expenditures effectively 

require the IRS to monitor and administer economic and social programs, which may make it difficult 

for the IRS to fulfill its core mission of collecting tax revenue. This is especially true during periods, 

like the present, when the IRS budget is limited. 

Yet, tax expenditures are often politically popular because they can be a substitute for direct 

spending programs with the additional benefit of providing a tax cut. In addition, using the tax system 

can offer some advantages compared to direct spending programs. Nearly all families file tax returns, so 

 

4 Economic research is mixed on the extent to which credit constraints currently prevent low-resource individuals from 

attending postsecondary institutions. However, even studies that suggest credit constraints are currently non-binding note 

that credit constraints would likely prevent postsecondary attendance in the absence of existing federal student aid programs.

5

See Bettinger, Eric, Terry Long, Bridget T, Oreopoulos, Phillip and Lisa Sanbonmatsu. 2012. “The Role of Application 

Assistance and Information in College Decisions: Results from the H&R Block FAFSA Experiment,” The Quarterly Journal 

of Economics, Vol. 127, p. 1205-1242.

6 Deductions or exclusions for expenses related to the earning of income are not tax expenditures. For example, the itemized 

deduction for work-related education expenses in excess of two percent of adjusted gross income is directly related to earning 

income, and is not included in this discussion of tax expenditures. However, most education tax provisions are not directly 

related to earning income. 
5

that the burden of claiming a tax benefit may be reduced compared to a direct spending program that has 

an additional application.7 Another benefit of using the tax system for subsidies is that income 

information is readily available so that it may be easier to restrict program access to the income-eligible 

population. In part because tax based programs allow for anonymity, there may be less stigma attached 

to taking tax benefits compared to taking direct spending benefits, resulting in higher take up. 

Whatever the relative merits, many major government programs are run through the tax system, 

including a variety of subsidies for education. This is true even though the federal government already 

devotes substantial resources to education through direct spending programs. Total direct federal 

spending for all levels of education was over $298 billion in 2015.

8

 

Tax expenditures for education can be divided into the following categories.

1. Tax benefits for current postsecondary education expenses (see Table 2A for further details).

a. Credits and Tuition Deduction.

Tax incentives for higher education include two credits and a tuition deduction. Taxpayers may 

claim at most one education credit or the tuition deduction per student per year. The credits and 

deduction are subject to income limits that are intended to target the tax reductions to lower and middle 

income families. Only education spending net of other tax-free education assistance, such as grants, 

scholarships or distributions from education savings accounts, qualifies for these tax benefits.

For many families, the American Opportunity Tax Credit (AOTC) offers the largest tax benefit

among these programs. The AOTC is available for up to four tax years for students enrolled at least 

half-time who pursue a degree or credential. The AOTC has a maximum value of $2,500 per student per 

year (up to $10,000 in tax relief over four years).

9

 Up to 40 percent of the otherwise allowable credit is 

refundable, meaning that taxpayers who do not have any income tax liability, including many lowincome students, may still benefit from the credit. The AOTC replaced the similar, but less generous, 

Hope Tax Credit (HTC).10 

 

7

For example, many families fail to apply for federal student aid administered through the Department of Education. 

According to data from the Department of Education (National Postsecondary Student Aid Study, 2012) about 70 percent of 

enrolled undergraduate students applied for federal student aid for the 2011-12 school year. 

8 National Center for Education Statistics, Digest of Education Statistics, 2015. Table 401.10. This total includes on-budget 

support, off-budget support and nonfederal funds generated by federal legislation.

9 The $2,500 maximum amount is not indexed for inflation.

10 The Protecting Americans from Tax Hikes Act of 2015 made the AOTC permanent.
6

Instead of the AOTC, taxpayers may choose one of two other tax benefits for current education 

expenses. One option is the Lifetime Learning Tax Credit (LLTC), which is available for an unlimited 

number of years of education and is available to students enrolled in a post-secondary degree program or 

for coursework to acquire or improve job skills. The LLTC offers up to a $2,000 non-refundable tax 

credit per tax return. Another option available to taxpayers (through tax year 2016) in place of the tax 

credits is the tuition and fees deduction. Taxpayers need not itemize to claim this deduction of up to 

$4,000 of education spending (because it is an “above the line deduction”). Like the LLTC, the 

deduction is available for an unlimited number of years and applies to coursework towards a postsecondary degree or for coursework to improve job skills. Neither the tuition deduction nor the LLTC is 

refundable, and thus they do not provide benefits to taxpayers who do not have income tax liability.

To claim the AOTC, the LLTC, or the deduction, taxpayers must generally receive a Form 1098-

T from the institution of higher learning that reports the amount of qualifying education expenses paid. 

In addition, taxpayers must report the employer identification number (EIN) of the institution of higher 

learning on the tax form when claiming certain credits (Form 8863 for the AOTC or LLTC). These 

reporting requirements were modified or added by legislation in 2015 to increase program compliance 

and to help reduce taxpayer confusion.

b. Extension of child-related benefits.

The tax code also extends child-related tax benefits to families with students. Full-time students 

ages 19-23 qualify for the dependent exemption. For dependent children who do not attend full time, 

eligibility for the dependent exemption ends at age 18. Low-income working families may also be able 

to claim an eligible full-time student ages 19-23 for the Earned Income Tax Credit. Eligibility for the 

EITC ends at age 18 for children who do not attend school full-time.11 

c. Exclusions from income.

Current law allows taxpayers to exclude scholarships, grants, tuition reductions, and up to $5,250 of 

employer-provided educational assistance from income. Tuition reductions provided to employees of 

 

11 For more information about the benefits for qualifying children, see Ackerman, Cooper, Costello and Tong (2016) “Tax 

Support for Families with Children: Key Tax Benefits, their Impact on Marginal and Average Tax Rates and an Approach to 

Simplification 2017 Law” https://www.treasury.gov/resource-center/tax-policy/tax-analysis/Documents/WP-112.pdf
7

institutions of higher education and their spouses are also excludable from income. In addition, direct 

payments of tuition by a donor on behalf of a student are not subject to gift tax.

2. Tax benefits for education savings (Table 2B provides further details).

The tax code incentivizes education savings in several ways. Earnings in qualified tuition 

savings accounts (so called “529 plans” allowed by Internal Revenue Code section 529 and “education 

IRAs” allowed by section 530) are not taxed when they are used for qualified education expenses. 

Generally, 529 plans can be used for undergraduate and graduate expenses,

12 while 530 education 

accounts may be used for these expenses as well as certain expenses at the K-12 level. For both 529 

plans and 530 accounts, distributions of earnings that are not used for qualifying expenses are generally 

subject to income tax and a 10 percent penalty.13 Most 529 plans are administered by states and 

maximum allowed account balances are high. In recent years, 529 plan maximums ranged from 

$225,000 to $370,000. Contributions to 530 accounts are capped at $2,000 per year per beneficiary 

across plans and can only be made by joint filing households with less than $220,000 of AGI (or 

$110,000 for persons from non-joint-filing families).14. 

Besides education savings accounts, the tax code provides additional incentives for education 

savings. Taxpayers may take early distributions from IRA accounts without penalty if the distributions 

are used for education expenses.15 Interest on savings bonds that are used for education expenses is not 

taxable. 

3. Tax benefits for prior education expenses (see Table 2C for details).

Beyond providing tax relief for current and future education expenses, the tax code also provides 

tax benefits for prior education expenses. Taxpayers who meet income limits may deduct up to $2,500 

of qualified student loan interest paid. In addition, the discharge of certain forms of student debt is 

excluded from income subject to tax. 

 

12 There are two types of 529 plans: pre-paid tuition plans and college savings plans. Pre-paid tuition plans allow college 

savers to purchase units or credits at participating colleges and universities for future tuition and, in some cases, room and 

board. College savings plans permit a college saver (the “account holder”) to establish an account for a student (the 

“beneficiary”) for the purpose of paying the beneficiary’s eligible college expenses.

13 If the student receives a scholarship then generally 10% penalty does not apply.

14 The income restriction is based on modified adjusted gross income, which for most families is equal to AGI. See IRS 

Publication 970 for details on modified adjusted gross income.

15 In general, early distributions from IRA accounts are subject to a 10% penalty.
8

4. Benefits for education institutions (Table 2D provides further details).

The tax code provides important benefits for public and non-profit education institutions. 

Charitable contributions by individuals may be deducted from income (by taxpayers who itemize their 

deductions) and contributions received by these institutions are not taxable. Public and non-profit 

education institutions may benefit from tax-preferred financing. Bonds that qualify for tax-free interest 

include private activity bonds, student loan bonds and school construction bonds. The tax code also 

provides tax credits for investors who hold zone academy bonds. These bonds are typically used to 

finance operation of primary and secondary schools in low-income areas. 

Teachers at the K-12 level may deduct $250 (or $500 for a joint return with two teachers) for 

unreimbursed expenses for professional development expenses, for books, supplies, computer 

equipment, or other material used in the classroom.16 While teachers claim the deduction, schools (and 

students) may benefit from the subsidy for classroom materials.

III. EVALUATION OF CURRENT TAX PROGRAMS

A. Criteria for Effective Education Tax Benefits 

Policymakers should consider several criteria when evaluating education tax benefits. First, does 

the benefit work towards a clearly defined and justified policy goal? Second, is the benefit best delivered 

through the tax system? Third, is the tax benefit easy for taxpayers to use? Fourth, how does the benefit 

impact the progressivity of the tax code?

B. Evaluation of Current Education Tax Programs 

1. Tax benefits for current postsecondary education expenses.

In tax year 2014 over 14 million families benefited from education tax credits and/or the tuition 

deduction. Research suggests that the introduction of education tax credits and the tuition deduction 

increased college enrollment, meeting an important policy goal.

17 Targeting of the tax benefits towards 

lower-income and middle-income families is one reason that education tax credits may increase college 

attendance, though the tax benefits also lower the cost of attendance for many families who would have 

 

16 Beginning in 2016 the $250 maximum amount is indexed to inflation.

17 See Turner, Nicholas. 2011.“The Effect of Tax-Based Aid on College Enrollment,” National Tax Journal, Vol. 64, p. 839-

861.). 
9

sent their children to college absent the tax benefits. 18 Making these tax benefits more generous and 

expanding eligibility to higher income families may not have the same impact on enrollment.19

Although tax subsidies for education are widely used, they are complex. Complexity in program 

rules and complex interactions across programs may limit the effectiveness of these tax benefits.

20 As a 

result, many taxpayers do not select the single tax benefit that offers them the largest reduction in taxes 

when they are eligible for multiple programs and many taxpayers fail to claim a tax benefit when they 

are eligible.21 Interactions with direct spending programs, including Pell grants, add additional 

complexity for many students and their families and results in some families failing to claim the full 

value of their total education benefit.

22

For many families, the ability to claim a personal exemption for full-time students ages 19-23 is 

unlikely to impact education decisions because this benefit is relatively small for lower-income families 

which are more likely to have children on the margin of college attendance. In contrast, the ability to 

claim a dependent student for the Earned Income Tax Credit offers a relatively larger benefit for lowerincome families and may increase college enrollment and persistence for lower-income youths.

23

Allowing families with dependent college students to qualify for the Earned Income Tax Credit also 

makes the tax code more progressive, which may be a desirable policy outcome. 

By excluding employer provided education assistance, the tax code treats education expenses

differently across students. An employee who realizes this benefit may receive up to $5,250 per year of 

tax-free education. In contrast, an employee who does not receive this benefit may have to cover 

 

18 The effectiveness of the tax credits and the tuition deduction may be offset by the strategic response of institutions of 

higher learning. There is evidence that some colleges and universities act to capture the financial benefits of the tax credits 

and the tuition deduction by reducing their own financial aid for students who receive education tax benefits (Turner, 

Nicholas. 2012. “Who Benefits from Student Aid? The Economic Incidence of Tax-based Federal Student Aid,” Economics 

of Education Review, Vol. 31, p. 463-481.). 

19 See Bulman, George and Hoxby, Caroline. 2015. “The Returns to the Federal Tax Credits for Higher Education,” in Tax 

Policy and the Economy, Volume 29. Ed. (Brown) and Bulman, George and Hoxby, Caroline. 2015. “The Effects of the Tax 

Deduction for Postsecondary Tuition: Implications for Structuring Tax-Based Aid,” National Bureau of Economic Research 

Working Paper No. 21554) 

20 Individuals are more responsive to clear incentives than to more complicated incentives (Chetty, Raj, Looney, Adam and 

Kory Kroft. 2009. “Salience and Taxation: Theory and Evidence,” The American Economic Review, Vol. 99, p. 1145-1177. 

2009 ), yet existing tax incentives are complicated, e.g., students may be eligible for multiple tax credits and the tuition 

deduction. 

21 Turner, Nicholas. “Why Don’t Taxpayers Maximize their Tax-Based Student Aid? Salience and Inertia in Program 

Selection,” The B.E. Journal of Economic Analysis & Policy, 11.1.

22 See the “Report to Congress on Coordinating the American Opportunity Tax Credit and the Federal Pell Grant,“ U.S. 

Department of the Treasury, May 2014 for details. Available here: https://www.treasury.gov/resource-center/taxpolicy/Documents/Report-Coordinating-AOTC-2014.pdf

23 Manoli, Day and Nicholas Turner. 2014. “Cash on Hand & College Enrollment: Evidence from Population Tax Data and 

Policy Nonlinearities,” National Bureau of Economic Research Working Paper Number 19836. 
10

education expenses with after tax dollars, though they may claim the LLTC. Tax efficiency and fairness 

suggests that the tax system should treat these two cases similarly. However, allowing a limited 

exclusion for employer-provided education for any purpose eliminates the need for employers to 

distinguish between expenses that are for the benefit of the employer and those that benefit primarily the 

employee, when the expenses are below $5,250. Thus, it simplifies administration of the tax code as 

well as potentially encouraging education spending.

2. Tax benefits for prior education expenses.

As a result of the graduated income tax rates, the deduction for student loan interest paid offers a 

relatively larger benefit to higher-income families than it does to lower-income families. As a result, 

this deduction may not be consistent with distributional objectives. Allowing taxpayers to deduct 

interest paid on student loans is unlikely to encourage additional schooling because it offers only modest 

tax relief.24 The absence of the student loan interest deduction between 1986 and 1997 had little 

demonstrable effect on enrollment, persistence, degree-attainment or student loan default. In addition, 

the deduction comes after schooling has been completed and so may be less salient an incentive 

compared to benefits offered during the years of enrollment. The deduction of student loan interest also 

offers redundant incentives. Taxpayers with student loans already benefit from generous federal student 

loan programs that offer relatively low interest rates and favorable repayment options. For example, loan 

repayment options such as Income Based Repayment or Graduated Repayment plans may more 

effectively reduce the financial stress of loan repayment compared to the student loan interest deduction 

because most of the burden of monthly payments represents principal repayment, not interest expense. 

3. Tax benefits for education savings.

Families that benefit most from education savings accounts (529 plans and 530 accounts) are 

relatively high-income, which has two important implications.25 One, high income families are likely to 

send their children to college absent these programs, so that education savings accounts will not have a 

meaningful effect on college attendance. Two, these tax incentives make the tax code less progressive. 

 

24 In 2011, roughly 10 million families claimed the student loan interest deduction, with an average deduction of nearly $950. 

25 Analyzing data from the Survey of Consumer Finances, the U.S. Government Accounting Office found that families with 

college savings plans are more likely to have parents with college degrees and have greater financial assets, compared to 

families without college savings plans (“Higher Education: A Small Percentage of Families Save in 529 Plans. A report to 

the Chairman, Committee on Finance, U.S. Senate. U.S. GAO 13-64). 
11

High income families are more likely to receive greater benefits from these tax-advantaged 

savings programs for several reasons. First, the financial benefit of tax-free growth in 529 plans and 530 

accounts increase with the marginal tax rate, which increases with income.26 Second, college financial 

aid systems reduce need-based student aid for families with financial assets, including 529 plans and 530 

accounts. This reduction in aid generally does not harm higher-income students because they don’t 

receive need-based aid. However, the reduction hurts many lower-income families who could 

potentially receive larger grant awards absent their college savings.27 A third reason that wealthier 

families are able to benefit from these savings plans more than other families is that the contribution 

limits aimed to cap their benefits are ineffective. In the case of 530 accounts, wealthier families can 

avoid the income limitation by having lower-income family members, such as retired grandparents, 

make contributions. In the case of 529 plans, total contribution limits are quite high and can be avoided 

by opening accounts in multiple states.28 

IV. TAX REFORM OPTIONS 

Education tax incentives are commonly cited as an area in need of reform. Below is one tax 

reform option that maintains a limited set of tax incentives for education with reduced complexity and 

better coordination with direct spending programs that works towards important policy goals such as

increasing college enrollment and preserving the progressivity of the tax code. Many features of this tax 

reform option were included in the Administration’s FY2017 Budget.

 

26 High income families may also benefit from taking non-qualified distributions from 530 accounts. Non-qualified 

distributions are assigned to the beneficiary and are taxed at a relatively lower rate compared to the rate for the 

parent/guardian, even when adding the penalty for non-qualified use. Some research finds that this non-qualified use of 

education savings accounts for high-income families may actually exceed the qualified benefit for low-income families 

(Dynarski, Susan. 2004. “Who Benefits from the Education Savings Incentives? Income, Educational Expectations and the 

Value of the 529 and Coverdell,” National Tax Journal, Vol. 57, p. 359-383.).

27 While each educational institution may treat assets held in a 529 plan differently, investing in a 529 plan will generally 

reduce a student’s eligibility to participate in need-based financial aid. Beginning July 1, 2006, assets held in pre-paid tuition 

plans and college savings plans are treated similarly for federal financial aid purposes. Both are treated as parental assets in 

the calculation of the expected family contribution toward college costs (source: 

http://www.sec.gov/investor/pubs/intro529.htm)

28 A beneficiary can have plans in up to 44 states, which effectively removes any contribution limit (U.S. Treasury, 2009 “An 

Analysis of Section 529 College Savings and Prepaid Tuition Plans.”)
12

A. Simplify Tax Benefits for Current Education Expenses

1. Replace existing tax credits with an expanded American Opportunity Tax Credit.

For current education expenses, taxpayers may claim one of two tax credits or they may claim 

the tuition deduction. Selecting across these programs requires taxpayers to navigate a complex set of 

options. This complexity is exacerbated by interactions between tax incentives and direct spending 

programs such as Pell grants, as discussed below. Streamlining the existing set of options for current 

education expenses, while retaining a meaningful tax benefit, will simplify the tax code and help 

education tax benefits meet their intended policy goals. 

This option simplifies tax benefits for current expenses by replacing the existing set of programs, 

including the AOTC, the LLTC and the tuition deduction, with an expanded AOTC. The expanded 

AOTC will have a lifetime cap of $12,500 and will be available for up to five tax years. The expanded 

AOTC indexes the maximum credit amounts for inflation so that the benefit does not erode in real terms. 

For degree-seeking students enrolled at least half-time the existing formula for benefits applies,

including income limits and the partially refundable portion. Degree-seeking students enrolled less-than 

half-time and non-degree seeking students could claim the expanded AOTC, but would qualify for a 

credit that is one-half as large as they would receive if they were degree-seeking enrolled at least halftime. Retaining the AOTC will provide an important form of federal student aid for all potential 

students from income eligible families that file tax returns, including those who fail to apply for student 

aid from direct spending programs.

Streamlining and expanding education tax breaks for current expenses provides several benefits. 

First, the expanded credit may increase degree attainment and decrease time to degree by increasing the 

tax benefit per year, while limiting the total number of years it is available. The expanded AOTC 

provides a larger benefit for four school years (four school years generally span five tax years), 

compared to current law. At the same time, the proposal repeals the LLTC, which is available in any 

year of education over a taxpayer’s lifetime. Second the expanded AOTC offers a partially refundable 

credit to low-income less-than half-time students and for non-degree seeking students. Under current 

law these students could not claim the AOTC, but would qualify for a non-refundable LLTC if they have 

tax liability.
13

Not all students benefit from this reform. Under current law, the LLTC is available to graduate 

students and to students in their fifth year of education or later.

29 The proposal repeals the LLTC and 

graduate students generally do not qualify for the expanded AOTC. This change may be desirable

because private returns to graduate school are relatively higher while social returns are relatively lower

compared to undergraduate education. In addition, the LLTC is unlikely to alter the decision to attain 

graduate degrees so that the program largely subsidizes individuals who would have attended graduate 

school even in the absence of the credit. This change may also be appropriate for students enrolled in 

undergraduate education beyond the fourth school year, especially for the many non-degree seeking 

students who enroll in classes primarily for enjoyment. 

Recent legislation enacted changes to information reporting that schools must provide to students

about their enrollment and also added a requirement for taxpayers when claiming education tax credits. 

These changes are aimed at increasing program integrity. A simple change to the definition of expenses 

that qualify for the expanded AOTC could further increase program integrity. Specifically, under the 

proposal outlined here, eligible course and related expenses are capped at $500/year for full-time 

students and $250/year for all other students.30 This option, which was not included in the 

Administration’s FY2017 Budget proposal, may help improve program integrity by limiting the amount 

of non-verified expenses that qualify for the AOTC. The downside to limiting expenses is that some 

students with otherwise low-levels of tuition but higher costs for books and expenses will realize a 

smaller credit under this option.

2. Simplify interactions of AOTC and Pell grants by making Pell grants non-taxable.

Pell grants offer substantial education support for low income families.31 In the 2015-2016 

school year, the maximum Pell grant was $5,775. This amount is enough to cover all of tuition and fees 

at many postsecondary institutions, especially public two-year institutions. Low-income families who 

are the targeted beneficiaries of Pell grants may also benefit from the refundable portion of the AOTC. 

Many families who benefit from Pell grants may realize less than their maximum level of total 

education support because of complex interactions with the tax code. Allowing Pell grants to be non-

 

29 If students complete their undergraduate education in less than four years, they may claim the AOTC for graduate 

education for the remaining years.

30 The National Association of College Stores estimates that students spend roughly $650 per year on required course 

materials, and that this amount has decreased in recent years. 

http://www.nacs.org/advocacynewsmedia/pressreleases/studentspendingontextbookscontinuestodecline.aspx

31 For the 2013-14 School year, , nearly 9 million students received Pell grants and total Pell grant funds were $31.5 billion. 

http://www2.ed.gov/finaid/prof/resources/data/pell-2013-14/pell-eoy-2013-14.html
14

taxable regardless of use would simplify this interaction. Under current law, Pell grants are not taxable 

if they are used for tuition and fees, but Pell grants are taxable when used for other expenses including 

room and board. This complication is increased by interactions with the AOTC. Only education 

spending net of other tax preferences such as grants, scholarships and education savings distributions,

qualifies for the AOTC. If families allocate their tuition and fee expenses to Pell grants, the grants are 

not taxable, but the family might no longer be eligible for an AOTC because they have no remaining 

qualified expenses. Some of these families would realize a larger level of total education support from 

the federal government if they allocated a portion of their expenses to the AOTC, and then applied Pell

grants to the remaining expenses and room and board, even though it means including part or all of the 

Pell grant in taxable income. Making Pell grants nontaxable for all uses would make the interaction 

with the tax code simpler for families and help insure that the benefits from this need-based program are 

not offset by the tax system.

3. Repeal exclusion of employer provided education assistance.

This option removes current law’s unequal tax treatment of employer-provided education and 

out-of-pocket education expenses. It is unlikely that repealing the employer provided tax benefit will 

have a substantive impact on postsecondary enrollment. Many individuals who benefit from employer 

provided education have already completed most of their formal schooling. In addition, these benefits 

are not likely to be realized by individuals who would otherwise be financially unable to enroll. By 

retaining the itemized deduction for work-related education expenses, the tax code provides some relief 

to taxpayers with large expenses incurred in the generation of income.

B. Limit Tax Benefits for Prior Education Expenses and Simplify the Discharge of Student Loan Debt

1. Repeal the deduction for student loan interest for new students and exclude the discharge of student 

loan debt from gross income. 

The deduction for student loan interest does not seem to have a large impact on education 

attainment. This suggests that most of its benefit is simply a windfall to qualifying taxpayers. Many 

families with student loan debt already benefit from federal loan programs that provide relatively low 

interest rates. Individuals who struggle with student debt can avail themselves of other benefits of 

federal student loans including income-based loan repayment plans and student loan deferments that 

may be more effective than the interest deduction in reducing the burden of student loan debt. 
15

Repealing the deduction for new students allows taxpayers who currently claim the deduction to 

continue to receive a tax benefit.

For students in dire financial stress, the Department of Education may discharge federal student 

loan debt for a variety of reasons including for disability, for cases when the school closes during 

attendance and for cases when the school has been found to have made misrepresentations to students. 

In general, the amount of debt discharged is included in taxable income (because it represents an 

increase in net worth, and so is income.) However, borrowers who receive a discharge of student loan 

debt generally have low incomes and few if any assets. For these taxpayers paying the tax on 

discharged amounts may be difficult (and in many cases the amounts would still be excluded under an 

exception for insolvency). Requiring borrowers to justify their eligibility for the exclusion of the 

discharged amounts is inefficient for both taxpayers and the IRS and partially offsets the financial 

benefit of discharge.

V. CONCLUSION

Reforming tax incentives for higher education will help insure that support is targeted to the 

areas where it can have the largest impact. The reforms outlined here simplify the tax code for millions 

of families, while retaining important incentives for investments in education. The reform option 

streamlines overlapping programs while expanding the American Opportunity Tax Credit. The reforms 

will help maintain program integrity so that support is channeled to targeted groups. In addition, the 

reforms will improve coordination between direct spending programs and the tax system, further 

reducing burdens on students and families who are working towards their education goals.
Table 1: Cost of Education Tax Benefits (Current Law Tax Expenditure Estimates)

(millions of dollars) 2016 2017 2018 2019 2020 2021 2022 2023 2024 2

Tax Credits and deductions for postsecondary expenses* 20,160 20,150 20,020 20,220 20,380 20,440 20,480 20,520 20,530 2Dependent Exemption 4,220 4,210 4,310 4,470 4,600 4,720 4,830 4,940 5,030 5Exclusion of Scholarship Income 3,290 3,410 3,500 3,560 3,690 3,820 3,960 4,100 4,240 4Exclusion of Employer Provided Educational Assistance 850 900 950 990 1,040 1,090 1,140 1,200 1,260 1529 Saving Plans 1,740 1,920 2,110 2,300 2,490 2,700 2,910 3,140 3,390 3530 Saving Plans 30 40 40 40 40 40 40 50 50 Exclusion of Interest on Savings Bonds used for Education 30 30 30 30 30 40 40 40 40 Student Loan Interest Deduction 1,950 1,970 2,010 2,050 2,130 2,150 2,200 2,270 2,290 2Discharge of Student Loan Debt 90 100 100 100 110 110 110 110 120 Deduction for Teacher Expenses 210 210 210 210 220 220 260 270 270 Exclusion of Interest on Student Loan Bonds 440 460 480 500 560 620 680 730 760 Deductibility of Charitable Contributions 5,110 5,480 5,890 6,330 6,730 7,100 7,490 7,860 8,250 8Exclusion of Interest on Bonds for Private Non-profit Education Facilities 2,260 2,380 2,490 2,600 2,870 3,230 3,490 3,730 3,920 4Qualified School Construction Bonds* 1,330 1,380 1,380 1,380 1,380 1,380 1,380 1,380 1,380 1Credit for Zone Academy Bonds* 220 230 240 230 210 190 170 150 140 Notes: These estimates assume that all other aspects of the tax code are held fixed. *These estimates include budget outlay portion.Source: Office of Tax Analysis, unofficial tax expenditure estimates.

Programs for Current Education Expenses

Programs for Education Savings

Programs for Prior Education Expenses

Other Programs

16
Table 2A: Tax Benefits for Current Education Expenses, 2016

Program Benefit Qualifying Expenses Qualifying Education Qualifying Income Range 

American Opportunity Tax 

Credit (AOTC)

Maximum credit of $2,500 per student, 

equal to 100% of first $2,000 of spending 

plus 25% of next $2,000 of spending. Up 

to $1,000 (40 percent) of the credit may 

be refundable.

Tuition, required fees, course related 

books, supplies and equipment.

Undergraduate and graduate. May be 

claimed for up to four tax years for students

enrolled at least half-time who purse a 

degree or credential.

Benefits phase out for non-joint returns bet

$80,000-$90,000 and for joint returns betw

$160,000 - $180,000.

Lifetime Learning Tax Credit

(LLTC)

Maximum (nonrefundable) credit of 

$2,000 per return equal to 20% of the 

first $10,000 of Education spending. 

Tuition and required fees.

Undergraduate and graduate. May be 

claimed for any number of years for all 

postsecondary enrollment.

Benefits phase out for non-joint returns bet

$55,000-$65,000 and for joint returns betw

$111,000 - $131,000.

Tuition Deduction

Maximum deduction of $4,000 per return 

or $2,000 per return depending on 

income.

Tuition and required fees.

Undergraduate and graduate. May be 

claimed for any number of years for all 

postsecondary enrollment.

Maximum deduction of $4,000 for joint (

joint) returns with income not more tha

$130,000 ($65,000). Maximum deductio

$2,000 for joint (non-joint) returns with in

more than $130,000 ($65,000) and not mor

$160,000 ($80,000).

Dependendent Exemption 

for Enrolled Students

Youths ages 19-23 may be claimed as 

dependents and qualify for children for 

the Earned Income Tax Credit if they are 

full-time students.

NA

Undergraduate and graduate. Students must 

be enrolled fulltime for at least five months,

live with the taxpayer claiming the student 

as a dependent for at least half of the year. 

NA 

Exclusion of Scholarships, 

Grants and Tuition 

Reductions

Amounts received may not be taxable.

Tuition, fees, and course-related 

expenses including books, supplies and 

equipment.

K-12, undergraduate and graduate. NA 

Employer Provided 

Educational Assistance

Up to $5,250 of employer benefit is not 

taxed.

Tuition, fees, and course-related 

expenses including books, supplies and 

equipment.

Undergraduate and graduate. Courses do 

not have to be work-related. NA 

Gift tax exclusion for Education expenses

Up to $14,000 of gifts for tuition expenses is not taxable.

The gift tax does not apply to amounts 

paid to education institutions for tuition.

Education at qualifying education institutions.

NA 

17
Table 2B: Tax Benefits for Education Savings, 2016

Program Benefit Qualifying Expenses Qualifying Education Qualifying Income Range 

Qualified Tuition 

Plans (529s)

Earnings in accounts are not 

subject to tax. Contributions 

may be receive benefit at state 

level. Accounts are not 

necessarily the property of the 

designated beneficairy.

Tuition and fees, books, 

supplies and equipment. 

Room and board for students 

enrolled at least half-time. 

Expenses for special needs.

Undergraduate and graduate. None. 

Coverdell ESA 

(530s)

Earnings in accounts are not 

subject to tax. Up to $2,000 

may be contributed each year. 

Accounts become the property 

of the benficiary (usually the 

intended student) at age 18 

and distributions must be 

taken by age 30.

Tuition and fees, books, 

supplies and equipment. 

Room and board and special 

needs expenses for students 

enrolled at least half-time in 

postsecondary institution. 

Tutoring, room and board, 

uniforms, transportation and 

computer access for K-12 

students. 

K-12, undergraduate and 

graduate.

Individuals contributing to 530 pla

must meet an AGI threshold. 

Maximum contribution limit phas

out for non-joint returns between 

$95,000-$110,000 and for joint 

returns between $190,000 - 

$220,000.

IRA Distributions

Distributions used for 

qualifying education expenses 

are not subject to the 

additional 10% tax.

Tuition and fees, books, 

supplies and equipment. 

Room and board for students 

enrolled at least half-time. 

Expenses for special needs.

Undergraduate and graduate. None. 

Education Savings 

Bond Program

Interest on savings bonds is 

not taxed. Applies to EE 

bonds issued after 1989 or 

series I bonds.

Tuition and fees, payments to 

529 or 530 savings plan. Undergraduate and graduate.

Program phases out for non-join

returns between $77,550-$92,550 

and for joint returns between 

$116,300 - $146,300.

18
Table 2C: Tax Benefits for Proir Education Expenses, 2016

Program Benefit Qualifying Expenses Qualifying Education Qualifying Income Range 

Student Loan Interest 

Deduction

Deduction of up to $2,500 of 

student loan interest paid.

Loans used to pay for tuition, 

fees, books, supplies, 

equipment, room and board, 

transportation or other 

necessary expenses.

Undergraduate and graduate. 

Student must have been enrolled 

at least half-time.

Program phases out for non-join

returns between $65,000-$80,000 

and for joint returns between 

$130,000 - $160,000.

Discharge of Student 

Debt

Discharge of certain student 

loans is excluded from income 

subject to tax.

Loans used to pay for tuition, 

fees, books, supplies, 

equipment, room and board, 

transportation or other 

necessary expenses. Only 

loans made by the federal 

government, a state 

government, certain taxexempt public benefit 

corporations or an educational 

institution.

Undergraduate and graduate. None. 

19
Table 2D: Tax Benefits for Education Institutions, 2016

Program Benefit Qualifying Expenses Qualifying Education Qualifying Income Range 

Deductibility of 

charitable 

contributions

Taxpayers may deduct 

charitable contributions to nonprofit education institutions. 

Qualifying education 

institutions do not pay tax on 

the contributions.

Education institutions must meet 

the definition of charitable 

education institution defined in 

IRC 501(c)3. For education 

institutions, "charitable" 

includes the advancement of 

education or science and 

"educational" relates to the 

instruction or training of 

individuals.

None, but taxpayers must itemize 

order to deduct the contribution fro

their income.

Tax-exempt 

financing for 

education institutions

Interest on bonds issued by 

state and local government is 

excluded from income. 

Qualifying bonds include 

private activity bonds, 501 (c) 

3 bonds, student loan bonds 

and school construction 

bonds.

NA 

Credit for holders of 

zone academy bonds.

Tax-credit bonds provide tax 

credits to investors to replace 

a prescribed portion of the 

interest cost.

Bonds issued by a state or 

local government where 100 

percent of the proceeds are 

used at "zone academies" and 

where at least 10 percent of 

the bond proceeds are 

contributed by private entities.

Zone academies include public 

schools below the college level 

that operates in a special 

academic program with 

businesses and is located in an 

empowerment zone, or in an 

area where at least 35 percent of 

students receive free and 

reduced price lunch.

NA 

20