Education Tax Incentives and Direct Expenditures – The Hard Choices

by Ernie C. Jolly

Federal student financial aid is an asset-building program that has proven its value in enabling young people from low-income families to find success and build wealth over time.  Although an intangible asset, a college degree quadruples a low-income student’s chances of entering the wealthiest income tax bracket, according to a Pew Economic Mobility study.  A college education also may enable a graduate to better weather economic downturns.  As the American Opportunity Tax Credit (“AOTC”), which provides tax credits and refunds for college costs, nears its expiration on January 1, 2013, it is time to consider its impact on college attendance among low-income students, as well as its efficiency when compared to targeted, direct expenditure programs such as Pell Grants.  When analyzed, it becomes clear that the AOTC is a beneficial tax credit for low-income individuals primarily because of its refund feature.  However, its expiration may be warranted if the tax expenditures saved as a result of its expiration are diverted directly to needs-based programs such as the Pell Grant program.

Authorized by the American Recovery and Reinvestment Act (“ARRA”), the AOTC supplanted the Hope Scholarship Credit.  The Hope Credit provided $1,800 in tax credits to individuals who incurred postsecondary education costs.  Since none of its benefits were refundable, the Hope Credit was highly regressive and favored students from wealthier families over low-income students.  The AOTC, on the other hand, provides as much as $2,500 in tax credits for individuals who incur various postsecondary education expenses and allows such individuals to receive a refund of as much as $1,000 for these costs.  If the AOTC expires, the less generous benefits of the Hope Credit would again be in effect.  With these less generous benefits, it will become more difficult for a low-income student to offset the price of textbooks alone, which in many cases can exceed $1,000.

In spite of its refund feature, the AOTC itself is somewhat regressive.  Although low-income individuals benefit more from the AOTC than from the Hope Credit, the AOTC also has shifted its tax benefits to students from higher income households.  This is not surprising since studies have shown that 93 percent of recipients of tax-based educational aid would attend college without receiving these incentives.  Therefore, it is understandable why the AOTC, which will cost 14 billion dollars if extended over 10 years, has become a topic of debate for lawmakers in the midst of budget talks.

On the other hand, the Pell Grant program targets students who are less likely to attend college.  Pell Grants are needs-based awards to undergraduate students, most of whom come from low-income households.  In 2008, more than 60 percent of Pell Grant funds were awarded to students from families with incomes less than $20,000.  Unfortunately, despite their efficiency at aiding low-income students, the portion of college costs covered by Pell Grants is at its lowest point in history.  Additionally, the cost of the Pell Grant program is slated to increase, partly due to a poor economy that has increased the number of eligible applicants.

President Obama’s FY2013 budget called on Congress to make the AOTC permanent, as well as to sustain funding for the Pell Grant program.  Congressional leadership is likely to take on the issue during the lame-duck session.  For low-income individuals aspiring to attend college, the AOTC’s extension would certainly be beneficial.  The troubling alternative would be a reversion to the Hope Scholarship Credit, deemed to be highly regressive due to its nonrefundable nature.  Nonetheless, talks of budget cuts and eliminating tax credits are imminent given the general desire in Washington to cut spending.  If the AOTC is allowed to expire as a matter political compromise, the outcome could be beneficial for low-income students, but only if  its expiration results in more support for targeted programs such as Pell Grants.

Ernie C. Jolly is a fall 2012 intern at the Joint Center for Political and Economic Studies and a second-year law student at American University’s Washington College of Law.

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