The Problems with Tax Credits

(Editor’s note: This article was published on September 17, 2012, by Forbes.com.)

Each year, the federal government spends billions of dollars on tuition tax credits to encourage more students to attend college. But these tax credits have little or no effect on college enrollment, have become a ripe target for abuse, and have made it easier for universities to increase prices. It’s time to end them.

Currently, the federal government offers two types of credits to offset tuition: the American Opportunity Tax Credit (AOTC) and the Lifetime Learning Credit.

The American Opportunity Tax Credit allows taxpayers to reduce their tax liability by as much as $2,500 — as long as their income doesn’t exceed $90,000 ($180,000 for joint filers). Forty percent of the AOTC is “refundable,” meaning the Treasury will send you a check if you have little or no tax liability.

The Lifetime Learning Credit allows students or parents to reduce their taxes by up to $2,000 annually for an unlimited number of years. Qualified students must be enrolled in at least one college course, but don’t have to be pursuing a degree. Individuals earning less than $60,000 — or families earning less than $120,000 — are eligible for the credit.

In addition to the tax credits, which provide beneficiaries with dollar-for-dollar reductions in their income tax bills, the government also offers a higher education tax deduction to students and families not claiming a tax credit.

While the higher-ed tax credits and deductions might make middle-income families less inclined to grumble during tax season, their cost is huge.

The president’s 2013 budget shows that the American Opportunity Tax Credit cost $14.29 billion in 2012 — far more than the program’s original estimated cost. If Congress extends the credit — which is likely — the projected cost is $137.4 billion over the next ten years. The Lifetime Learning Credit cost $3.25 billion in 2012. And the tax deduction cost $470 million in 2012.

When you add these to the $40 billion per year Pell grant program, and the cost of the federal student loan program (projected to cost $36.1 billion in fiscal 2013), the total is astronomical: about $95 billion per year.

Dollars aside, we also need to look at the effects of the subsidies. And there, the results are mixed at best.

Most researchers who have studied the impact of higher education tax credits find little or no evidence that the credits increase the number of students who enroll or graduate each year. The reason may be that since the credits are applied to tax bills many months after tuition was paid, they may not affect students’ or parents’ ability to pay. They may simply make individuals more willing to pay higher prices.

Research presented in the 2004 book, “College Choices: The Economics of Where to Go, When to Go, and How to Pay for It,”  found no evidence that credits increased the number of students attending college. This held true for both traditional college students, teenagers and young adults whose parents often benefited from the credits, and for non-traditional students, typically older students who could take the tax credits themselves.

Moreover, the programs are prone to abuse. A report from the Treasury Inspector General for Tax Administration found that more than 2 million Americans received education tax credits in error in 2010, costing taxpayers $3.2 billion. The report, “Billions of Dollars in Education Credits Appear to Be Erroneous,” found that tax credits were awarded to individuals who don’t have Social Security numbers, were in prison, or were unable to prove they attend any institution of higher learning.

“A valid Social Security Number is required for Federal student aid but not for education credits,” the report said. “Our review identified 84,754 students who did not have a valid Social Security Number but were claimed by taxpayers who received $103 million in education credits.”

Most troubling, however, is the long-term effect that tax credits and deductions appear to have on college tuition.

A 2012 study from Education Sector shows that 13 percent of tuition tax credits go to families with annual incomes in the $100,000 to $180,000 range – families that can afford college costs without subsidies.

The subsidies, however, make consumers less resistant to tuition increases, which makes it easier for universities to do just that: increase tuition, often by the amount of the federal aid. While universities may not say they are doing this explicitly, that’s how it works in practice, with the taxpayer in effect becoming a convenient pass-through for federal dollars going to universities. Over time, this contributes to soaring college costs — negating any temporary benefits that might exist.

It’s time to end higher education tax credits. The cash-strapped federal government can’t afford to spend money on programs with dubious benefits and myriad problems.