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"AMERICAN OPPORTUNITY" TAX CREDIT

Key Points

·        Raises maximum education credit from $1,800 to $2,500 and extends to four years.

·        Makes credit partially refundable so lowest-income students could benefit.

·        Greatest impact if available at beginning of school term; timing might delay effects.

·        Expiration could leave students without adequate funding to complete studies.

·        JCT estimates that the proposal would cost $13.9 billion over 10 years.

Current Law

 

The Hope credit provides a tax credit of up to $1,800 for each of the first two years of postsecondary education. The credit equals 100 percent of the first $1,200 of tuition and fees plus 50 percent of the next $1,200. Students must attend school at least half time. The credit does not apply to expenses covered by other tax-preferred vehicles such as 529 plans and Coverdell Savings Accounts. Taxpayers may only claim one of the Hope credit, lifetime learning credit, or a deduction for tuition expenses for each qualifying student on their tax returns in one year. They may, however, use different options for different students or in different years. Because the credit is not refundable, it provides little or no assistance to low-income households.

Stimulus Proposal

The “American Opportunity” tax credit (AOTC) would provide a partially refundable tax credit in 2009 and 2010 equal to 100 percent of the first $2,000 plus 25 percent of the next $2,000 spent on tuition, fees, and course materials during each of the first four years of postsecondary education. The maximum credit would thus be $2,500 a year. As is currently the case for the Hope credit, taxpayers could not claim the credit for any expenses paid using funds from other tax-preferred vehicles such as 529 plans and Coverdell Savings Accounts, nor could they use more than one of the AOTC, the lifetime learning credit, and the deduction for tuition expenses for a student in a given year.

Forty percent of the AOTC would be refundable and thus available to households with little or no tax liability. The maximum amount of refundable credit would be $1,000.

The credit would phase out evenly for married couples filing joint tax returns with income between $160,000 and $180,000 and for others with income between $80,000 and $90,000. Couples with income above $180,000 and others with income above $90,000 would not get the credit.

The AOTC has a similar structure to President Obama’s campaign proposal for a fully refundable American Dream tax credit. However, the AOTC would be smaller (a maximum of $2,500 versus $4,000) and only partially refundable. In addition, unlike the president’s proposal, it would not go directly to educational institutions but rather would be paid as a credit claimed on the household’s tax return.

Discussion

The AOTC would provide additional financial assistance for students pursuing postsecondary education, raising the maximum tax credit from $1,800 to $2,500 per year and extending the credit to cover four years of postsecondary schooling. Because the credit would be 40 percent refundable, low-income students could benefit up to $1,000 each year; the AOTC would thus reach all the way down the income distribution, unlike the current non-refundable Hope credit. Extending the credit to cover four years of schooling for the next two years might enable some students currently enrolled to complete their postsecondary education. Research suggests that aid could increase student persistence but that the effect is not large (Hossler et al. 2008).

Because it would provide funds through the income tax, the credit might take time to become effective as a stimulus. Taxpayers generally do not adjust their tax withholding immediately when their tax liability goes down and thus would benefit from the credit only when they file their tax returns the following year. To the extent that low-income students need funds at the time they enroll, the delayed receipt of the credit could limit its value in enabling people to attend school. Paying the credit directly to the school once the student enrolls—as President Obama proposed during the election campaign—would give low-income students financial aid when they need it and could help more people to afford college, although it would create new administrative challenges to the IRS.

For students already in school or planning to attend, the credit would represent a windfall, a portion of which might be spent, albeit with a significant lag. However, because most students take out student loans to attend college, the credit might simply replace those loans and thus have no stimulative effect. If, however, students are having trouble getting loans because of the problems in financial markets, the expanded credit could increase enrollments.

With high unemployment, this might be a particularly good time to encourage people to attend college. With labor temporarily in surplus, there is little cost to the economy from encouraging more people to temporarily exit the work force. And students who attend college develop skills and credentials that add to their labor productivity and incomes over the long term.

Research suggests that the Hope credit caused colleges to raise tuition more than they otherwise would have (Long 2004). In the current economic environment with reduced state funding for colleges and shrunken endowments, the higher tuition could translate directly into increased spending by schools. That effect could enhance the AOTC’s impact as a stimulus but could also reduce enrollment of low-income students.

The long-run impact of the proposal would be mixed. On the one hand, it could induce people to begin their postsecondary education, although evidence from the use of Hope credits suggests that the credit would have little effect on enrollment (Long 2004; Baum and McPherson 2008). Once enrolled, however, students would be more likely to complete their schooling, even if the credit expired. Some students would complete their degrees using the credit and would thus be likely to get better jobs than otherwise. And even students who did not complete their schooling would have improved their skills and their job opportunities. On the other hand, expiration of the credit could leave needy students without funds to continue their studies. There would likely be strong pressure to extend the credit beyond its proposed two-year life.

Grade: C

The credit is a windfall to students who had planned to attend college anyway (or to their families) and some of that windfall would likely be spent, providing a modest stimulus. The credit could also lead colleges to raise tuition and spend the extra funds, which would also help the economy. However, much of the credit is likely to go to reduce student loan burdens. Moreover, the credits would come with a significant lag since they would generally become available only at tax filing time. Although not considered in the grade, the proposal deserves extra credit for making it easier for unemployed or underemployed workers to enhance their skills and might offset some of the student loan market’s problems caused by the financial market meltdown.

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