Examine Student Aid's Fiscal Cliff

Learn about education tax credits that are set to expire on Jan. 1, 2013.

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President Barack Obama holds up a pen as he speaks about the economy, Nov. 9, 2012, in the East Room of the White House.

Much of the federal government's spending on student aid is highly visible and hotly debated. It comes in forms like grant aid, including the vital but always funding-challenged Pell grants, and federal work study.

Student loans are sometimes also referred to as federal student aid because provisions like fixed interest rates and in-school interest subsidies help keep down the costs of borrowing for college.

Another form of student aid that is less visible but also has an impact is the wide variety of educational tax credits and deductions. Unlike grants and loans, this aid does not appear in the federal budget and therefore doesn't appear to be spending.

But for all intents and purposes, revenue not collected is the same as revenue spent—and the Student Loan Ranger thinks the effectiveness of tax credits and deductions should be weighed as carefully.

[Find out how to pay for college.] 

And now's a good time to do it, because included in the upcoming fiscal cliff—over $500 billion in tax increases and spending cuts that will take effect after January 1 unless Congress acts—is a wide variety of educational tax credits and deductions.

According to the New America Foundation's Ed Money Watch, among the deductions that will expire or revert to lower levels are six that totaled $23 billion in 2012: the American Opportunity Tax Credit (AOTC); the exclusion from taxable income of employer-provided educational assistance; the exemption allowing parents to claim students aged 19-23 as dependents; the student loan interest rate deduction; several health care-related scholarships; and the Coverdell account provision allowing families to invest up to $2,000 annually in to an investment account for a child's educational expenses with no taxes on earnings or withdrawals.

Of these, the biggie is the AOTC, which cost $14.3 billion in 2012. Let's take a closer look at it.

As Stephen Burd reported last spring in an Education Sector report, "Moving On Up: How Tuition Tax Breaks Increasingly Favor the Upper-Middle Class," programs like the Hope Tax Credit, which allowed students and families to choose either a $10,000 tax deduction or a $1,500 tax credit, and the Lifetime Learning Credit, a $2,000 tax credit for qualified students enrolled in at least one postsecondary course, were originally created in the late 1990s to make college affordable for the middle class.

And because they contained income limits that did not allow wealthier individuals and families to benefit from them, they did just that. From 1999 to 2009, almost three quarters of the $70 billion "spent" (or not collected) on educational tax breaks went to middle class families. Only 13 percent went to families making over $100,000 a year and only 11 percent went to families making less than $25,000.

President Obama's AOTC temporarily replaced the Hope Tax Credit with a $2,500 partially-refundable tax break to help cover tuition, fees, and course material expenses for the first four years of college that is available to individuals earning up to $90,000 a year and families with incomes of up to $180,000 a year.

[See how some financial aid could change during President Obama's next term.]

One of its positive effects is that because the AOTC is partially refundable (allowing families without any income tax liability to receive up to $1,000 of the tax credit as a refund) it has benefited poor families. According to the College Board's "Trends in Student Aid 2012" report, in 2010 families with incomes below $25,000 received 24 percent of the savings from tax credits, although they only received 3 percent of the tax deduction benefits.

But with regard to the middle class, it has had exactly the opposite effect of those earlier credits and deductions, and wealthier individuals and families seem to be reaping greater benefits. Families with incomes between $100,000 and $180,000 received 23 percent of the savings from the tax credit, and families with incomes between $100,000 and $160,000 received 60 percent of the tax deduction benefits. A permanent extension of the AOTC—which President Obama has called for—would set in stone these significant benefits for high income families.

In addition, Burd reports that Congress is considering restoring the Higher Education Tax Deduction, a highly regressive tax break that recently expired. The Government Accountability Office found that taxpayers forfeited about $67 million in tax benefits in 2009 because they claimed the tuition tax deduction instead of the Lifetime Learning Credit.

Instead of simply restoring these programs, the Student Loan Ranger thinks Congress should use the impending fiscal cliff as an opportunity to bring to light the impact of these usually hidden tax credits and deductions. It has an opportunity to modify them so that the benefits go to lower and middle income families.

And the increased tax revenue from excluding wealthy families that do not need the student aid can be used to ensure that programs like Pell grants, which provide direct student aid to the neediest families—when they need it the most, at the beginning of the school year, rather than the end of the tax year—continue to be fully funded.

Isaac Bowers is a senior program manager in the Communications and Outreach unit, responsible for Equal Justice Works' educational debt relief initiatives. An expert on educational debt relief, Bowers conducts monthly webinars for a wide range of audiences; advises employers, law schools, and professional organizations; and works with Congress and the Department of Education on federal legislation and regulations. Prior to joining Equal Justice Works, he was a fellow at Shute, Mihaly & Weinberger LLP in San Francisco. He received his J.D. from New York University School of Law.