By Patrick Reimherr and Julie Strawn

In preparation for possible comprehensive tax legislation, the House and Senate tax-writing committees have been reviewing options for reform.  CLASP recently participated in briefings for members of the House Ways and Means Committee on reform of family tax benefits and of tax-based student aid. We also submitted written comments to both the House and Senate tax-writing committees, urging policymakers to consider reforms to make tax-based aid:

• More effective, in terms of increasing access to and completion of college by low-income underrepresented populations who not may otherwise attend,
• More efficient, in terms of maximizing the impact of limited federal dollars, and
• Simpler, for students and their families to understand and use.

An increasing share of federal student aid takes the form of tax preferences and expenditures, rather than direct payments, such as Pell Grants.  In fact, tax-based aid now accounts for nearly half of non-loan federal student aid. This expansion has happened largely under the radar, without much public attention. 

Unfortunately, the vast majority of the benefits of tax preferences go to middle and upper-income households.  This is because most tax preferences are designed as deductions, making them most valuable to taxpayers in the highest brackets and useless to households who do not have taxable income, or whose deductions are less than the value of the standard deduction. This is both unfair and inefficient.  And tax credits, while potentially more progressive than deductions, also provide limited benefit to low and middle-income households that have little or no tax liability, unless the credit is refundable.

In addition, because the value of tax incentives is not realized until the household files a return the following year, the incentive is widely separated from the actual decision it is intended to influence, reducing its impact compared to a subsidy students can count on in real-time to help cover their tuition. Many low-income households simply cannot make a significant up-front expenditure of educational or child care costs and wait until the following year to be reimbursed.

As part of its recommendations, CLASP proposed a framework for reforming tax-based student aid with three pillars: make the partially refundable American Opportunity Tax Credit (AOTC) work better for low and middle-income students, simplify and better target current tax-based aid, and improve outreach and delivery of tax-based aid. CLASP then provided three fiscally responsible options for policymakers to achieve the above goals of effectiveness, efficiency, and simplicity. All rely on improving the AOTC and simplifying the array of available tax aid. Each proposal also adjusts the AOTC for inflation to provide a buffer against price increases.

Figures in parentheses indicate the revenue raised (or lost) over a ten-year period versus a current policy baseline that assumes the extension of the AOTC and Tuition and Fees Deduction.

• Proposal One: Simplify tax aid to just the AOTC and front-load refundability (budget impact of -$0.8 billion, 2013-2022).
• Proposal Two: Simplify tax aid, but preserve both the AOTC and the Lifetime Learning Credit for undergraduates only.  Also, front load AOTC refundability ($4.8 billion, 2013-2022).
• Proposal Three: Simplify tax aid, but preserve both the AOTC and the student loan interest deduction.  Front-load refundability of the AOTC ($3.6 billion, 2013-2022).

Notes: Proposal One – adjusts the refundability rate of the AOTC to 100 percent of the first $2,000; indexes the AOTC for inflation; triples the length of the AOTC phase-out range (60-90k for single filers, 120-180k for married filing jointly); and eliminates the Tuition and Fees Deduction, the Lifetime Learning Credit, and the Student Loan Interest Deduction. Proposal Two – adjusts the refundability rate of the AOTC to 100 percent of the first $1,500; indexes the AOTC for inflation; triples the length of the AOTC phase-out range (60-90k, 120-180k); eliminates the Tuition and Fees Deduction and the Student Loan Interest Deduction; and, eliminates the Lifetime Learning Credit for graduate students only. Proposal Three – adjusts the refundability rate of the AOTC to 100 percent of the first $1,500; indexes the AOTC for inflation; triples the length of the AOTC phase-out range (60-90k, 120-180k); and, eliminates the Tuition and Fees Deduction and the Lifetime Learning Credit.

These various reform packages demonstrate that it is possible to make tax-based student more efficient and effective by simplifying and better targeting current benefits.  Furthermore, these goals can be achieved within a budget neutral framework while preserving substantial support for middle-income households. Delivering student aid through the tax system is a “second best” strategy compared to grant aid, but since nearly half of all non-loan student aid is now delivered this way, it is essential that we make it work better for students and families.

Read comments submitted by CLASP to the House Ways and Means and Senate Finance Committees.