14 Ways the Tax Code Subsidizes Higher Education
An example of the complexity and inefficiency of the tax code.
The federal government subsidizes higher education through a multitude of grants to universities, subsidized loans, and direct scholarship funding. In addition, the tax code includes at least 14 different programs that distort the education system and complicate tax filing. All told, the tax code subsidizes higher education to the tune of $322 billion over ten years.
From an education policy perspective, the accumulation of all this federal spending has a distorting effect. Over time, the subsidies have likely contributed to the high price of college as subsidies increase demand, which drives up prices. This cycle then drives significant student debt burdens and demand for additional government subsidies.
From a tax policy perspective, the tax treatment of higher education is an example of the seemingly infinite complexity and inefficiency of the tax code. Table 1 at the end of this piece summarizes 14 different such provisions across the tax code. On their own, each provision’s rules and structure are designed for some specific policy goal or political constituency. When added together as a system, the education tax programs illustrate one of the problems with using the tax code to subsidize one activity over another—it often ends up being an incoherent mess that complicates a system designed to raise revenue, not fund college degrees.
Congress should repeal all the tax subsidies for higher education and expand the treatment for education savings to all savings. However, short of repeal, simple changes could make complying with our tax laws more straightforward.
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Subsidies for Repeal or Reform
There are nine tax subsidies for higher education that are estimated by the U.S. Treasury to lower federal revenue by $322 billion over ten years (2023–2032). Congress should repeal all these preferences to simplify the tax code.
The American Opportunity Tax Credit (AOTC) and Lifetime Learning Credit (LLC) are two of the most prominent ways the tax code subsidizes college. The AOTC is a partially refundable tax credit of up to $2,500, applying to 100 percent of the first $2,000 of qualified education expenses and 25 percent of $2,000 in additional expenses. The AOTC can only be claimed four times per student and is only available for students attending at least half‐time. Up to $1,000 of the credit is refundable for taxpayers with no income tax liability. The LLC is a nonrefundable $2,000 credit that covers 20 percent of qualified education expenses. The two credits cannot be claimed simultaneously, have different definitions of qualified education expenses, and have separate eligibility criteria.
The complexities of these two programs create an environment in which more than 3.6 million taxpayers “received more than $5.6 billion in potentially erroneous education credits” in 2012, according to the Inspector General for Tax Administration. Despite changes to the law and enforcement since 2012, the AOTC improper payment rate was 26 percent in 2020, higher than the improper payment rates for the Earned Income Tax Credit (EITC) and Child Tax Credit (CTC). While some of these payments may be outright fraud, the majority are likely due to taxpayer confusion about the rules and necessary documentation.
For some full‐time students, the tax code offers two additional benefits. Taxpayers who claim a full‐time student between ages 17 and 24 as a dependent are eligible for the $500 Credit for Other Dependents. For certain other non‐married taxpayers, the larger standard deduction from Head of Household status is also available when claiming a full‐time student child dependent under age 24.
After receiving tax credits during school, students who graduate with student loan debt get additional write‐offs. The tax code allows student loan holders to deduct up to $2,500 in interest payments from taxable income. And for those student loan holders who benefit from certain loan forgiveness or cancellation programs, they do not have to include the value of the loan in taxable income as they would for some other types of loan forgiveness.
The tax code also exempts some non‐wage compensation from the income tax if it is associated with college or graduate school. For example, certain income paid through scholarships, fellowships, and grants is excluded from income if used to pay tuition and required fees. Similarly, up to $5,250 of employer‐paid tuition or other education expenses can be excluded from taxable wages.
Policymakers who are concerned that the tax code penalizes investment sometimes favor write‐offs for education expenses, just as businesses write off equipment expenses. This is part of the rationale behind the business deduction for work‐related education expenses and similar individual deductions that were available in past years. However, today’s higher education is not just an investment, it also includes a lot of status signaling and consumption—intellectual consumption, as well as campus amenities. Given all the other ways the government subsidizes education, the cleanest answer is to remove the tax code from the education system.
Make Savings Programs Less Targeted
The second group of education‐related tax programs include different forms of savings incentives (or more accurately, the elimination of savings penalties). Removing taxes only on savings for education incentivizes people to save and then spend on education instead of other goals that do not benefit from similar tax programs.
529 Plans are the most notable of these savings vehicles, allowing taxpayers to save and invest after‐tax wages in a Roth IRA‐style account. Any earnings are tax‐free if the withdrawals go toward qualified education expenses. Coverdell Education Savings Accounts provide the same incentive but include additional rules, such as annual contribution amounts and income limits. The tax code offers similar tax‐advantaged savings for retirement through vehicles like employer‐provided 401(k)s. In certain circumstances, taxpayers are allowed to use their retirement funds for education expenses.
In general, the tax treatment of 529 Plans and retirement savings is the correct tax treatment of savings. A return on investment compensates for delaying consumption (saving rather than consuming). By taxing investment gains through taxes on capital gains and dividends, the system taxes savers at higher marginal effective rates than those who spend their income immediately. By removing taxes on account earnings, 529 Plans and retirement accounts help alleviate a double tax that hits Americans who choose to save and invest.
What Can be Done?
Congress should repeal all the tax preferences for higher education programs and expand the treatment of education savings so that all savings can get the same benefit. Short of repeal, simple changes would make complying with our tax laws more straightforward.
The AOTC, LLC, and benefits for full‐time students under 24 could be consolidated into a single nonrefundable credit with one set of rules that are simple and easy to follow. House Republicans proposed a single education credit as part of the 2017 reforms, but it kept some of the complexity by maintaining time limits and changing rules in the fifth year of the expanded credit. If Congress is going to provide subsidies through the tax code, it should strive for simplicity. Congress could also create one definition of qualified education expenses that apply across similar programs.
Instead of tinkering with the rules of 529 Plans or adding new education exceptions to 401(k)s (as Congress recently did in the SECURE 2.0 Act), Congress should create a Universal Savings Account so that taxpayers, instead of politicians, get to decide what they can spend their saving on. The 529 Plan education subsidy is not the exemption of earnings from tax; it is the rules restricting the funds to education.
Congress can tinker around the edges to make tax paying easier, or it could decide to get the tax code entirely out of the education system. Both would be an improvement, but only the latter will remove the distortions caused by the current tax system.