Hope vs. Opportunity: Higher Education Tax Incentives 

    What should be considered in deciding if the American Opportunity Tax Credit should permanently replace the Hope Scholarship credit? 
    by Annette Nellen, CPA, Esq. 
    Published July 15, 2010

    LeAnn Luna
    Annette
    Nellen

    What should be considered in deciding if the American Opportunity Tax Credit should permanently replace the Hope Scholarship credit?

    The Administration proposes to make the temporary American Opportunity Tax Credit (AOTC) for certain higher education expenses a permanent provision starting after 2010 (Treasury Dept., General Explanations of the Administrations' Fiscal Year 2011 Revenue Proposals (PDF), February 2010, pages 21-22). This article compares the AOTC to the Hope Scholarship credit that it would replace, analyzes the proposal against principles of good tax policy and describes additional, related issues Congress might consider in evaluating the Administration's proposal.

    AOTC vs. Hope vs. Reality

    The AOTC was enacted as one of many temporary provisions of the American Recovery and Reinvestment Act of 2009 (ARRA) (PL 111-5; February 17, 2009; IRC §25A(i)). The AOTC broadens the Hope Scholarship credit for 2009 and 2010. The Hope Scholarship credit was created as a permanent provision with the Taxpayer Relief Act of 1997 (PL 105-34; August 5, 1997). It was enacted along with the Lifetime Learning credit. The AOTC is similar in approach to the Hope Scholarship credit, but is larger and applies more broadly. The chart below compares these credits and includes selected data on today's college experience.

    AOTC

    Hope

    Reality

    College years covered

    First four years

    First two years

    Less then 60% of college students graduate in six years. About 36% graduate in four years. Graduation rates vary by the institution's selectivity and whether private or public, and students' race/ethnicity, gender, and income.*

    Costs covered

    Tuition, fees and course materials

    Tuition and fees

    Tuition, fees, books, supplies, computer-related expenses, room and board, commuting expenses, study abroad, co-curricular activity expenses, insurance

    Maximum credit available

    $2,500 per year (100% of qualified expenses up to $2,000 + 25% of next $2,000 of expenses)

    $1,800 per year (100% of qualified expenses up to $1,200 + 50% of next $1,200 of expenses)

    For 2007-08, average annual tuition and fees at private universities was $21,588, and $5,950 at public universities.**

    Modified AGI phase-out starts at (MFJ)

    $160,000

    $100 ,000

    For 2007, 87% of individual returns reported AGI of $100,000 or less; 97% reported AGI of $200,000 or less.***

    No credit if modified AGI (MFJ) exceeds

    $180,000

    $200,000

    Inflation adjustments?

    Administration's proposal calls for adjustments to credit and AGI amounts.

    Credit and AGI amounts adjusted annually based on §1(f) cost-of-living adjustment.

    College costs tend to increase more rapidly than inflation rates. Tuition at public four-year universities was 6.6% higher in 2007-08 than in 2006-07.****

    Refundable?

    40% unless claimant is child with unearned income taxed at parent's rate

    No

    Usable against AMT?

    Yes

    No

    For additional information on the credits and other higher education tax incentives, see IRC 25A, IRS Publication 970 (PDF), and the IRS website Tax Incentives for Higher Education.

    * Data is available from various sources including:

    ** NCES, Table 332.
    *** IRS, Statistical Tables, Table 1.
    **** College Board, Trends in College Pricing (PDF), 2007.

    Rationale for the AOTC

    The Treasury Department suggests that the modified features of the AOTC helps more low-income families pay for college costs and better enables students to stay in school to graduation. Treasury also notes the benefit to the country of a broadened AOTC:

    "If college is not made more affordable, our nation runs the risk of losing a whole generation of potential and productivity." (General Explanation (PDF), page 21.)

    A June 2010 report by the Georgetown University Center on Education and the Workforce concludes that the U.S. will have at least three million fewer college graduates than the 22 million needed by 2018. To reach the required number of graduates, the Center estimates that colleges need to increase their number of graduates by 10 percent annually. The Center estimates continued increase in the number of jobs requiring a college degree, growing from 59 percent to 63 percent over the next decade (in 1973, the figure was 28%). (Help Wanted — Projections and Jobs and Education Requirements Through 2018.)

    A report by the Public Policy Institute of California estimates that California's workforce will be short one million college graduates by 2025. (Closing the Gap, April 2009.)

    Critique

    For decades, governments have provided significant funding to higher education via publicly financed institutions, grants for students and faculty, scholarships, and tax incentives. This history, along with a growing need to increase the number of college graduates to meet future workforce needs, indicates that government funding will continue. The question that should be addressed though is what form of funding is most effective in meeting the varying needs of students. Factors to consider include which level of government should provide the funding, how funds should be allocated between students and institutions, and the best delivery mechanism (such as grants, scholarships, loans and/or tax incentives).

    With respect to analyzing existing and proposed tax incentives, principles of good tax policy provide a helpful approach. Application of some of these principles to a permanent AOTC follows:

    • Equity: The principle of equity calls for similarly situated taxpayers to be treated similarly. The refundable nature of the AOTC makes it equitable in that the value of the benefit does not depend on one's tax bracket. In contrast, the time restriction on the AOTC, indicates a design that best helps higher income students attending the type of institution where graduating in four years is more likely. The AOTC is less favorable for low-income students attending institutions with a less selective admissions policy who are likely to be in college for more than four years. In addition, the high income limits for the AOTC will result in funds going to individuals who are unlikely to need the financial assistance, causing fewer funds to be available for students who need more financial assistance.
    • Simplicity: By itself, the AOTC is fairly simple. Complicating factors come into play though in that it is but one of several tax benefits for higher education expenses. IRS Publication 970 that describes the incentives is 99 pages long. A 2008 report by the Government Accountability Office (GAO) found that a good number of individuals fail to claim education tax breaks they appear to be eligible for. The GAO suggests that complexity is the likely reason. (Higher Education: Multiple Higher Education Tax Incentives Create Opportunities for Taxpayers to Make Costly Mistakes, GAO-08-717T, May 1, 2008.)
    • Convenience of Payment: A tax should be due at a time and in a manner convenient for the taxpayer. Extending this principle to the AOTC points out a shortcoming of tax incentives for higher education expenses — they do not reach the taxpayer at the time tuition is due.
    • Economy of Collection: Costs to collect a tax should be kept at a minimum for both taxpayers and the government. In 2006-07, 75 percent of full-time students attending a public four-year institution received financial aid (NCES, March 2009, supra). The federal government provides over $100 billion annually in grants (such as Pell grants), loans and work-study programs that help about 14 million students. The Federal Student Aid Office within the U.S. Department of Education has a staff of 1,100 to administer these programs. They also process approximately 14 million Free Application for Federal Student Aid (FAFSA) forms annually. Distribution of benefits for higher education expenses through both the Department of Education and the tax system increases costs. It also overlooks an existing avenue of directing funds to students most in need, as evidenced by the data collected on the FAFSA.

      The education credits also involve costs for colleges. IRC §6050S requires educational institutions to issue Form 1098-T to students and the IRS, reporting the amount paid or billed and other information. A 2009 report, Taxpayers Erroneously Claim Education Tax Credits, by the Treasury Inspector General for Tax Administration (TIGTA) found that the forms were not used by the IRS with the result that colleges were "needlessly expending approximately 5.1 million hours each year to complete Forms 1098-T and an estimated $3.8 million to mail the Forms to students.”
    • Accountability: While data exists on the amount of Hope and AOTC claimed, there is no requirement to collect data on how it affects students' ability to attend college. There is no data on whether the incentive reduces time to degree. To best ensure that the credit is meeting the desired goals, specific data should be collected and analyzed. As part of the creation of the AOTC by the ARRA, Congress directed Treasury to conduct two studies:
      1. How to coordinate the Hope and Lifetime Learning credits with the Pell grant program and
      2. Whether community service should be a requirement for claiming the credits.

    Related Issues

    In the past several years, the congressional tax-writing committees have held hearings on tax rules related to higher education and requested reports from the Congressional Budget Office. Based on these activities, it is possible that consideration of the Administration's AOTC proposal will also lead to consideration of the following matters, in addition to topics covered by the reports Congress requested as part of the ARRA.

    • How to simplify the mix of higher education incentives to make them more efficient and effective (House Ways & Means Committee hearing of May 1, 2008).
    • Rising tuition costs (Senator Charles Grassley (R-IA) testimony (PDF) at December 5, 2006 Senate Finance Committee hearing).
    • Large endowments and use of tax-exempt status and tax-exempt bonds (Senator Charles Grassley (R-IA), supra).
    • Tax arbitrage (CBO report of April 2010).
    • Tax preferences for collegiate sports (CBO report of May 2009).

    Looking Forward

    Several factors call for review and modification of the allocation and use of federal dollars for higher education. These factors include complexity of the current mix of incentives, identifying the most effective use of funds, and the expected future shortage of college graduates, which could adversely affect the economy. Expiration of the higher AOTC benefits this year will likely push the discussion. Whether the discussion will go beyond finding a revenue offset, but also addressing the issues noted in this article, remains to be seen.

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    Annette Nellen, CPA, Esq., is a tax professor and director of the MST Program at San José State University. Nellen is an active member of the tax sections of the ABA and AICPA. She serves on the AICPA’s Individual Income Taxation Technical Resource Panel. She has several reports on tax reform and a blog.

     




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