Order Code RL32507
Higher Education Tax Credits:
An Economic Analysis
Updated January 22, 2008
Pamela J. Jackson
Specialist in Public Finance
Government and Finance Division

---

Higher Education Tax Credits: An Economic Analysis
Summary
Education tax credits, the Hope Credit and the Lifetime Learning Credit, were
introduced as new subsidies for higher education in 1997 and have cost, on average,
$4.6 billion a year in lost tax revenue since their enactment. The introduction of the
credits marked a dramatic increase in education spending through tax expenditures.
Prior to 1997, tax incentives for higher education expenses totaled less than $2
billion in estimated lost revenue. The introduction of education tax credits expanded
the number of federal agencies involved in education policy making and increased
the complexity and cost of administering the income tax system.
This report provides analysis of the education tax credit program. The report
begins with a review of the economic rationale for subsidizing education, then
describes federal subsidies for education in general and education tax credits in
particular. An analysis of the education credits follows, and the report concludes
with a discussion of education tax credit policy options.
Economists believe that education causes positive externalities since it generates
both private benefits for individuals and social benefits for the public at large. Such
social benefits may include better citizenship, higher degrees of compliance with
public laws, increased productivity, and intergenerational transfers of knowledge.
The individual does not capture these social benefits in decision making about his or
her level of educational investment and, thus, underinvests in education.
Government subsidies to finance education can stimulate private demand for
education in order to attain more optimal levels of education production that achieve
market equilibrium outcomes.
Government subsidies for higher education include indirect spending through
the tax code and direct program spending. Most programs grant aid to education
institutions and provide assistance directly to students and their families, as in the
case of the education tax credits. The Higher Education Act (HEA), which most
recently was extended through March 2008, authorizes many student aid programs
which provide grants, loans, and work-study assistance.
Tax credits for higher education, one form of government education subsidy,
can be evaluated by looking at tax policy criteria of economic efficiency, equity, and
simplicity. Tax credits are not proven to be efficient at increasing enrollment and
thus improving social welfare. Tax credits can, however, be beneficial in making
college costs more affordable. Higher income households are more able, and more
likely, to benefit from education credits, which some view as detracting from equity
in the tax code. Yet, the credits provide needed relief for the middle class, many of
whom may not qualify for any other source of financial aid. Education credits add
complexity and cost to the administration of income taxes, both for individuals and
the federal government, but may offer a less-complicated alternative to traditional
financial aid.
This report will be updated as warranted by legislative events.

---

Contents
Why Are There Government Subsidies for Higher Education Expenses? . . . . . . 1
Positive Externalities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2
Imperfect Capital Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
Income Inequality . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4
Existing Government Subsidies for Higher Education Expenses . . . . . . . . . . . . . 4
Overview of Education Tax Credits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6
Hope Credit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6
Lifetime Learning Tax Credit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6
Comparison of Education Tax Credits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7
Number and Amount of Tax Credits Claimed . . . . . . . . . . . . . . . . . . . . . . . . 7
Economic Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9
Demand-Side Response: Students and Families . . . . . . . . . . . . . . . . . . . . . . 9
Participation Effect . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12
Margin Effect . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13
Affordability . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13
Supply-Side Response: Higher Education Institutions . . . . . . . . . . . . . . . . 17
Tuition Prices . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17
Financial Aid Reductions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18
Equity Among Taxpayers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18
Simplicity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20
Taxpayers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20
Federal Government . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21
Federal Tax Policy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21
Higher Education Institutions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22
Legislative Activity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22
Proposals Made in the 108th Congress . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22
Legislation Enacted in the 109th Congress . . . . . . . . . . . . . . . . . . . . . . . . . . 23
Proposals Made in the 110th Congress . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23
Discussion of Certain Proposals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24
Refundable Tax Credits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24
Tax Credits Applicable to Total Cost of Education . . . . . . . . . . . . . . . . . . . 24
Double Benefit with Federal Grants . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25
Enhance the Hope and Lifetime Learning Tax Credits . . . . . . . . . . . . . . . . 26
Advance Loan Against the Tax Credits . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26
List of Figures
Figure 1. Illustration of a Positive Externality . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
Figure 2. Percent Change in Credits Claimed . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9

---

List of Tables
Table 1. Number and Amount of Education Tax Credits Claimed . . . . . . . . . . . 8
Table 2. By Adjusted Gross Income, the Number and Amount of
Education Credits Claimed in 2004 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10
Table 3. Participation and Margin Effects of Tuition Price Reductions . . . . . . . 11
Table 4. Estimated Cost of Attendance, before and after Hope Credit,
Four-Year, Public Institution . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15
Table 5. Estimated Cost of Attendance, before and after Hope Credit,
Four-Year, Private Institution . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16

---

Higher Education Tax Credits:
An Economic Analysis
Education tax credits were introduced as a new subsidy for higher education in
1997 and have cost, on average, $4.6 billion a year in lost tax revenue since their
enactment. The introduction of tax credits for higher education marked a dramatic
increase in education spending through tax expenditures. Prior to 1997, tax
incentives for education expenses totaled less than $2 billion annually in estimated
lost revenue.1 The education tax credit program expanded the number of federal
agencies involved in education policy making and increased the complexity and cost
of administering the income tax system.
There are many direct federal spending programs for higher education. Some
programs grant aid to state and local governments and to education institutions while
others provide assistance directly to students and their families, as in the case of the
education tax credits. The Higher Education Act (HEA; most recently extended by
P.L. 110-109), which is scheduled to expire in the 110th Congress, authorizes these
student aid programs which provide grants, loans, and work-study assistance.
Congress is considering a wide variety of issues as it faces the process of
reauthorizing the programs of the Higher Education Act. The general higher
education issues include the appropriate federal role in addressing both postsecondary
access and affordability. Congress is also considering issues specific to individual
HEA programs, like shortfalls in Pell Grant funding which provides need-based aid
for undergraduate students.
This report provides analysis of the education tax credit program in the context
of the higher education issues facing Congress. This report begins with a review of
the economic rationale for subsidizing education, then describes federal subsidies for
education in general and the education tax credits in particular. An analysis of the
education credits follows and the report concludes with a discussion of education tax
credit policy options.
Why Are There Government Subsidies for
Higher Education Expenses?
Economic theory suggests that government subsidies for higher education
expenses are desirable because individuals do not invest in sufficient levels of
1 U.S. Congress, Joint Committee on Taxation, Estimates of Federal Tax Expenditures for
Fiscal Years 1996-2000, 104th Cong., 1st sess. (Washington: GPO, 1995), p. 16.

---

CRS-2
education. This insufficient educational investment is due to market failures, which
exist when the price system is unable to generate an efficient allocation of resources.
The economic reasons most often cited for government involvement in education
include the “neighborhood” or externality effect and the presence of capital market
failure.
Positive Externalities
An externality exists when the activity of an individual directly affects,
positively or negatively, the welfare of another and that effect is not incorporated in
market prices. Economic theory suggests that education causes positive externalities
since it generates both private benefits for individuals and social benefits for the
public at large. These social benefits may take on the form of better citizenship,
higher degrees of compliance with public laws, increased productivity, and inter-
generational transfers of knowledge. The individual does not capture these social
benefits in decision making about his or her level of educational investment and,
thus, under invests in education. The private demand for education is less than social
demand and too little investment in education occurs. Government subsidies to
finance education can stimulate private demand for education in order to attain more
optimal levels of education production that achieve market equilibrium outcomes.2
The positive externality produced as a result of education investment is depicted
in Figure 1. An individual chooses an education investment level of Q*, where
marginal cost (MC) is equal to marginal private benefit (MPB). Yet, the educational
investment made by an individual creates positive marginal external benefits, (MEB).
These external benefits are not taken into account by the individual as the choice of
educational attainment, Q*, is made. The marginal external benefit can be added to
the marginal private benefit to arrive at the marginal social benefit (MSB) of
educational investment. Economic efficiency requires the equality of marginal cost
and marginal social benefit, which occurs at Q**. Since the optimal educational
level is greater than the individual’s choice, introducing a subsidy to increase
education can help correct for the difference.
2 For a more detailed discussion of externalities, see Harvey Rosen, “Externalities” in
Public Finance (Boston: McGraw-Hill, 1999), pp. 85-110.

---

CRS-3
Figure 1. Illustration of a Positive Externality
The magnitude of these external benefits is difficult to determine, particularly
with regard to higher education. For example, while literacy is desirable for civic
participation and the ability to conform to laws, this literacy is gained in elementary
and secondary education. Yet, the benefits of additional higher education are more
complex. If increases in productivity due to higher education are captured by the
individual in the form of higher earnings, there are no spillover effects. It is also
sometimes the case that increases in education do not yield the increases in job
opportunities, and associated earnings, commensurate with the higher skill levels.3
Nevertheless, many economists believe that greater amounts of human capital are an
important driver of growth and it is true that discoveries and advances in knowledge
by highly skilled individuals spill over to the economy as a whole.
Imperfect Capital Markets
The imperfection of capital markets arises as a result of students being unable
to obtain commercial loans to finance their higher education. Unlike the way loans
for homes or automobiles are obtained, commercial lenders cannot mortgage a
person’s future income and, in the event of default of the loan, sell the student’s
services to the highest bidder. As a result, commercial lenders would be reluctant to
float student loans without government guarantees.4 Providing private loans
3 I. Berg and M. Freedman, “The American Workplace: Illusions and Realities”, Change 9,
Nov. 1977, vol. 62, pp. 24-30.
4 For a more thorough discussion of capital market failure, see CRS Report 97-581, Tax
(continued...)

---

CRS-4
guaranteed by the government is one solution to this failure, as is providing student
loans directly from the government.
Income Inequality
As noted previously, investment in higher education can lead to increases in
earnings. Some argue that it is appropriate to subsidize education to ensure that
educational opportunities are widely available, particularly to students from lower
income households. In this context, educational investment can be a significant
factor in reducing poverty and income inequality. Zimmerman examined this issue
and concluded that higher income students have higher marginal rates of return and
lower marginal costs of financing.5 These factors led to higher net return and lifetime
earnings for higher income students as compared to lower income students. Thus,
providing lower income students with larger subsidies would tend to equalize
earnings differentials. If the goal for education subsidies is to reduce income
inequality, the cost of subsidies should be measured in terms of the private benefits
received by targeted groups, rather than the social benefits that might be generated
by positive externalities.
Existing Government Subsidies for
Higher Education Expenses
Government subsidies for education are provided at the federal, state, and local
levels. Governments employ two types of subsidies to help families pay for higher
education. First, there are direct appropriations from state and local governments to
public postsecondary institutions. A majority of this funding is used to minimize
tuition charges for in-state students.
A second form of public subsidy is need-based aid to students and families.
This represents the largest share of student financial aid. Current education subsidies
provided by the federal government include student loans, grants, and work-study
programs. Both of the major federal grant programs, Pell Grants and Federal
Supplemental Educational Opportunity Grants (FSEOG) are need-based. There are
also many specialized federal grants and scholarship programs provided for students
at the graduate level. The Federal Work Study program and the Student Educational
Employment programs allow students to earn money while in school.
According to FY2002 data, $108 billion was spent by the federal government
on education. While the largest portion of spending occurred through the U.S.
Department of Education ($46.3 billion or 43%) large amounts of education spending
also came from the Department of Health and Human Services ($22.9 billion), the
4 (...continued)
Subsidies for Higher Education: An Analysis of the Administration’s Proposal, by Jane
Gravelle and Dennis Zimmerman. (Out of print report — Available from author.)
5 Dennis Zimmerman, “Expenditure-Tax Incidence Studies, Public Higher Education, and
Equity,” National Tax Journal, vol. 26, no. 1, Mar. 1973, p. 67.

---

CRS-5
Department of Agriculture ($11.9 billion), the Department of Labor ($6.4 billion),
the Department of Defense ($4.7 billion), and the Department of Energy ($3.6
billion).6 Twenty-two billion eight hundred million dollars of the FY2002 spending
on education was allocated to postsecondary education (21%) while another $25.7
billion was allocated to research at universities and related institutions (24%). Fifty-
three billion was allocated for elementary and secondary education (49%) and $6.2
billion for other programs (6%).7
In addition to direct spending programs administered by the U.S. Department
of Education and other executive branch agencies, government subsidies for higher
education are also made through the income tax system. From 1954 to 1978, four
tax benefits for education existed, an exclusion for scholarship and fellowship
income, a parental exemption for students age 19 to 23 who were enrolled in college,
a business expense deduction for work-related education, and the deduction of
student loan interest.8 In 1978 an exclusion for employer-provided education
assistance was enacted and 10 years later an exclusion for the interest earned on
educational savings bonds was enacted. In 1996, after the enactment of an exclusion
for earnings from qualified tuition programs, the number of tax benefits for higher
education expenses rose to seven.
The Taxpayer Relief Act of 1997 (P.L. 105-34) introduced four new tax benefits
that more than doubled the number of subsidies available through the tax system for
higher education expenses. They were two tax credits, a deduction for interest on
student loans, and an exclusion for earnings from Coverdell savings accounts. The
provisions were estimated to cost $41 billion9 over five years beginning in 1998 and
represented the largest increase in federal funding for higher education since the GI
Bill. Additionally, in the fall of 2001, an above-the-line deduction for higher
education expenses was authorized by the Economic Growth and Tax Relief
Reconciliation Act of 2001 (P.L. 107-16). This incentive increased the number of
tax benefits for higher education expenses to 12.
6 National Center for Education Statistics (NCES) Digest 2002, Chapter 4: Federal Programs
for Education and Related Activities, at [http://nces.ed.gov/] visited Feb. 23, 2004.
7 For more detailed information about federal spending programs for higher education see
CRS Report RL33040, The Higher Education Act: Reauthorization Status and Issues, by
Adam Stoll; and CRS Report RL31668, Federal Pell Grant Program of the Higher
Education Act: Background and Reauthorization, by James B. Stedman; and CRS Report
RL31618, Campus-Based Student Financial Aid Programs Under the Higher Education Act,
by David Smole.
8 The deductibility of student loan interest was eliminated in 1986 as a result of the Tax
Reform Act (P.L. 99-514), which disallowed deduction of all forms of personal interest.
9 U.S. Congress, Joint Committee on Taxation, Estimates of Federal Tax Expenditures for
Fiscal Years 1998-2002, 105th Cong., 1st sess. (Washington: GPO, 1997), p. 23.

---

CRS-6
Overview of Education Tax Credits
Two education tax credits are available to taxpayers to offset the cost of higher
education, the Hope Credit and the Lifetime Learning Credit. Unlike tax deductions,
which reduce the amount of income subject to tax, credits reduce the tax liability
itself. The extent of the credits allowed depends on many factors, including the
amount of taxpayer income and the amount of tax liability.
Hope Credit
The Hope Credit is a nonrefundable credit that may be claimed for the qualified
tuition expenses of each eligible student in the taxpayer’s family. The student must
be enrolled at least half-time in one of the first two years of postsecondary education
and must be enrolled in a program leading to a degree, certificate, or other recognized
educational credential.
The amount of credit that may be claimed is generally equal to: 100% of the first
$1,000 of the taxpayer’s out-of-pocket expenses for each student’s qualified tuition
and related expenses, plus 65% of the next $1,000 of the taxpayer’s out-of-pocket
expenses for each student’s qualified tuition and related expenses. In order for the
maximum amount of the Hope Credit to be received, assuming there is sufficient tax
liability, a minimum of $2,000 in tuition and fees per eligible student must be
expended. The maximum credit a taxpayer may claim for a taxable year is $1,650
multiplied by the number of students in the family who meet the enrollment criteria.
The amount a taxpayer may claim as a Hope Credit is gradually reduced for
higher-income taxpayers who have modified adjusted gross income between $47,000
($94,000 for married taxpayers filing jointly) and $57,000 ($114,000 for married
taxpayers filing jointly). Taxpayers with modified adjusted gross income over
$57,000 ($114,000 for married taxpayers filing jointly) may not claim the Hope
Credit. These income phase-out amounts are for tax year 2007 and are adjusted
annually for inflation.10
Lifetime Learning Tax Credit
The Lifetime Learning Credit may be claimed for the qualified tuition and
related expenses of the students in the taxpayer’s family who are enrolled at eligible
institutions. The credit amount is equal to 20% of the taxpayer’s first $10,000 of out-
of-pocket qualified tuition and related expenses. The maximum credit a taxpayer
may claim is $2,000. If a taxpayer is claiming a Hope Credit for a particular student,
none of that student’s expenses may be applied to the Lifetime Learning Credit.
The amount a taxpayer may claim as a Lifetime Learning Credit is gradually
reduced for taxpayers in the same manner as the Hope Credit.
10 CCH Editorial Staff Publication, 2006 U.S. Master Tax Guide (Chicago: CCH
Incorporated, 2005), p. 448.

---

CRS-7
Comparison of Education Tax Credits
The Hope Credit is allowable for up to $1,650 per year for each eligible student
and taxpayers can claim more than one Hope Credit on a tax return, provided that
more than one individual (the taxpayer, the spouse, or a dependent) meets the
qualifications. In contrast, the Lifetime Learning Credit may be claimed only once
on a tax return for a maximum of $2,000. The Lifetime Learning Credit can include
all of the qualifying educational expenses pooled together from the taxpayer, the
spouse and/or their dependent(s). Neither tax credit is refundable, meaning that
taxpayers would not receive a tax refund if the amount of their allowable education
credit exceeded their income tax liability. The Hope Credit is indexed for inflation,
while the Lifetime Learning Credit is not.
Unlike the Hope Credit, the Lifetime Learning Credit can be used for graduate
or undergraduate school, does not require the student to be in the first two years of
undergraduate schooling, and only requires the student to be enrolled in one course
at an eligible educational institution. The Hope Credit requires that the student not
have a felony drug conviction, which is not a requirement of the Lifetime Learning
Credit.
Both credits disallow a double tax benefit for higher education expense. Some
taxpayers can deduct the expenses of higher education from their income tax by
claiming an above-the-line tuition and fees deduction or by claiming the expenses as
business related. In doing so, the taxpayer cannot also claim an education credit for
those same expenses. Taxpayers cannot claim an education credit on expenses paid
with tax-free scholarship, grant, or employer-provided educational assistance. Pell
Grants, veterans’ educational assistance, and tax-exempt scholarships are included
in this category of tax-free educational assistance. Taxpayers must reduce qualified
education expenses by the amount of any tax-free financial assistance before using
the expenses to claim an education tax credit.11
Number and Amount of Tax Credits Claimed
The number of education credits claimed and the value of the credits are shown
in Table 1. After the 1997 enactment, the credits became available in tax year 1998.
A significant increase in participation occurred between 1998 and 1999, presumably
as taxpayers learned about the existence of the education credits and learned how to
claim them. After 1999, the rate of increase in participation decreased sharply, as is
shown in Figure 1. Preliminary data for 2002, show the rate of participation
decreased from 2001 to 2002, with the number of credits being claimed decreasing
more than the amount of value of the credits. This result may be due to the
enactment of the Economic Growth and Tax Relief and Reconciliation Act of 2001
(EGTRRA, P.L. 107-16), which reduced tax liabilities for all taxpayers in 2001.
Also, a new tax benefit for higher education expenses, an above-the-line tuition and
fees deduction, was enacted by EGTRRA. Many taxpayers may have been eligible
11 Additional information about the education credits is provided in CRS Report RL31129,
Higher Education Tax Credits and Deduction: An Overview of the Benefits and Their
Relationship to Traditional Student Aid, by Adam Stoll, James Stedman, and Linda Levine.

---

CRS-8
to claim either the tax credits or the new deduction which may have contributed to
the lower number of education credits claimed, as reported preliminarily, in 2002.
As shown in Table 1, in five years, the average value claimed per tax credit has
not exceeded $760 even though the largest possible value for eligible participants is
$1,500 for the Hope Credit and $1,00012 for the Lifetime Learning Credit. These
averages suggest a large portion of claimants are not able to claim the full value of
the credits and that the maximum level of program participation available is not
being achieved.
Table 1. Number and Amount of Education Tax Credits Claimed
1998
1999
2000
2001
2002
2003
2004
2005
Number of tax
4.7 6.4 6.8 7.2 6.5 7.3
7.1
7.1
returns claiming
education credits
(millions)
Amount of
$3.4 $4.7 $4.9 $5.2 $4.9
$5.8
$6.0
$6.1
education credits
claimed
(billions)
Average amount
$723 $734
$721
$722
$753
$794
$845
$859
claimed per return
Source: CRS table created from data obtained from the IRS Statistics of Income (SOI),
[http://www.irs.gov], Table 1.3 (2002, 2001, 2000, 1999, 1998) and Table 3.3 for recent years. Most
recent data available at [http://www.irs.gov/pub/irs-soi/05in33ar.xls], visited Jan. 22, 2008.
When the tax credits were proposed, the tax revenue loss was expected to be
higher than the levels that actually occurred. In anticipation of the first year the
education tax credit program, the tax revenue loss was projected to be $6.2 billion
in 1998, then rise to $7.2 billion by 2000 and $7.6 billion by 2002.13 These estimates
were more than 30% greater than the actual tax revenue loss and reflected an
expectation of higher participation in the tax credit programs. For instance, in 1999,
the Clinton Administration estimated that nearly 13 million credits would be claimed
with a revenue loss of $7 billion,14 which was nearly 50% greater than the actual
participation for that year.
12 The maximum Lifetime Learning Credit amount of $5,000 became effective in 2003.
Prior to 2003, the maximum amount was $1,000.
13 U.S. Congress, Joint Committee on Taxation, Estimates of Federal Tax Expenditures for
Fiscal Years 1998-2002, 105th Cong., 1st sess. (Washington: GPO, 1997), p. 23.
14 U.S. Executive Office of the President, Budget of the United States Government, Fiscal
Year 2000 (Washington: GPO, 2000), p. 69.

---

CRS-9
Figure 2. Percent Change in Credits Claimed
40.0%
Percent
35.0%
change
30.0%
in
25.0%
number
20.0%
of returns
15.0%
10.0%
5.0%
Percent
0.0%
change
-5.0%
in
-10.0%
amount
1998 1999 2000 2001 2002 2003
of credit
to
to
to
to
to
to
claimed
1999 2000 2001 2002 2003 2004
Source: CRS figure created using data obtained from IRS Statistics of Income, [http://www.irs.gov],
Table 1.3 (2004, 2001, 2000, 1999, 1998).
The data show a reduction in the percentage of taxpayers claiming the education
tax credits from 2001 to 2002. It is possible that this decrease is a result of unrelated
changes made to the tax code. The Economic Growth and Tax Relief Reconciliation
Act of 2001 (EGTRRA, P.L. 107-16) reduced marginal income tax rates for
individuals, resulting in lower tax burdens. This tax relief, designed to stimulate the
economy, seems to have had the unintended consequence of reducing the number of
taxpayers eligible to claim education tax credits, as households experienced
reductions in their income tax liability or no longer owed any tax.
Economic Analysis
Tax credits are a form of federal subsidy that treats eligible activities favorably
compared to others, and channels economic resources into qualified uses. Subsidies
influence how economic actors behave and how the economy’s resources are
employed. Economic theory suggests tax credits for higher education expenses can
be evaluated by looking at the impact on economic efficiency, equity, and simplicity.
Demand-Side Response: Students and Families
Tax credits for higher education expenses provide subsidies to encourage more
investment in education than would otherwise be undertaken. As discussed at the
beginning of this report, tax subsidies for education can enhance economic efficiency
if they are successful in increasing investment in education. However, tax credits

---

CRS-10
may not be effective if they subsidize activities that would have been undertaken in
the absence of the tax incentive, i.e. subsidize enrollment that would have occurred
anyway, or fail to increase enrollment at all.
To date, only one empirical study has specifically examined the education tax
credits and their impact on enrollment. Long found that,
what was intended to be a transfer to the middle class did benefit families with
incomes between $30,000 and $75,000 the most. For the 2000 tax year, nearly
half of the credits claimed in 2000 were by returns with adjusted gross income
between $30,000 and $75,000 although this group makes up only 35% of the
eligible returns. In a similar manner, although they make up only 13% of returns,
families with adjusted gross incomes between $50,000 and $75,000 claimed 22%
of all education tax credits during tax year 2000 and realized the largest credit
on average.15
An examination of the 2004 education tax credit data organized by adjusted
gross income is consistent with Long’s findings that the middle class benefitted the
most from education credits. In total, households with adjusted gross income (AGI)
of $30,001 or more claimed 64% of the credits and 73% of the credit amount, even
though these households comprise only 49% of all taxpayers. As shown in Table 2,
households with AGI of $50,001 to $100,000 had the highest portion of returns
claiming education credits (35.9%) and the highest portion of the total amount of
education credits claimed (nearly 43.3%). The AGI category of $30,000 to $50,000
was second in both the portion of credits claimed and the amount of credits claimed.
Taxpayers with incomes $15,000 or below claimed the second smallest portion of
education tax credits (8.8%) and received the second smallest portion (3.5%) of the
amount of education tax credits, while comprising the largest portion of taxpayers
(28.2%).
Table 2. By Adjusted Gross Income, the Number and
Amount of Education Credits Claimed in 2004
Percent of Amount of
Total
Percent of
Total
total
education
Percent
returns
total
Adjusted Gross
number of
returns
credit
of total
claiming
amount of
Income
returns
claiming
claimed
returns education
education
filed
education
($ in the
credits
credits
credits
thousands)
$15,000 and under
37,315,393
28.2%
641,088
8.8%
210,644
3.5%
$15,001 to $30,000
29,580,707
22.3%
1,970,286
27.2%
1,420,578
23.4%
$30,001 to $50,000
24,536,044
18.5%
1,986,654
27.4%
1,807,230
29.7%
$50,001 to $100,000
28,195,618
21.3%
2,606,261
35.9%
2,630,920
43.3%
$100,001 to $200,000
9,750,175
7.4%
48,945
0.7%
7,550
0.1%
$200,001 or more
3,006,981
2.3%
—
—
Total 132,384,919
7,253,234
6,076,920

Source: CRS table created using data obtained from IRS Statistics of Income,
[http://www.irs.gov/pub/irs-soi/04in01pl.xls], visited Feb. 20, 2007.
15 Bridget Terry Long, “The Impact of Federal Tax Credits for Higher Education Expenses,”
Harvard Graduate School of Education and the National Bureau of Economic Research
(NBER) Working Paper, September 2003, p. 45.

---

CRS-11
Long’s analysis found no enrollment responses to the tax credits three years after the
policy enactment.
General enrollment did not appear to increase nor did the proportion of students
that attended four-year institutions or were full-time. The lack of finding a
substantial response in student enrollment conforms to many forecasts by
researchers and critics. The principal benefactors [sic] of the tax credits are not
likely to be marginal students, and the disconnect between the aid and college
attendance is likely to limit the effect of credits on enrollment.16
More generally, studies of tuition price changes and enrollment response can
provide some insight into expected changes in enrollment due to the price reduction
that education tax credits provide. If students are sensitive to tuition price changes,
the net reduction in price caused by tax credits would positively affect enrollment.
If students are relatively insensitive to price changes, the net price reduction caused
by tax credits would have little impact on enrollment. Typically, students from
higher income families have the resources to finance college enrollment without
federal subsidies and are relatively insensitive to price changes.

The demand-side response of students and families can be further stratified by
distinguishing between the participation and margin effects of tuition price changes,
as depicted in Table 3. Overall investment in education would increase if students
(potential students) were induced by the tax credits to increase (begin) enrollment in
higher education. The participation effect captures students (or their families) who
would not invest in higher education without the tax credits. The margin effect
captures students who invest in higher education without the tax credits, and who
may increase their investment in response to the tax credits. That increase in
investment can occur in many ways, including increases in the hours of participation
(e.g., moving from part-time to full-time status), increases in the longevity of
participation (pursuing a bachelor’s degree rather than associate’s), or increases in
the quality of investment (transferring to a more expensive school, i.e. from public
to private institution, or from a two-year to four-year school).
Table 3. Participation and Margin Effects
of Tuition Price Reductions
Participation Effect
Margin Effect
Non-college students
College students
( never enrolled)
(currently enrolled)
Price sensitive
increase enrollment
increase expenditure
Relatively price
little response;
no response;
insensitive
thus little enrollment increase
maintain current enrollment
Source: Table created by CRS.
16 Long, pp. 30-31.

---

CRS-12
Participation Effect. In the economic literature, many studies have been
conducted of participation rates and the relationship between tuition price and college
enrollment. The studies are diverse in both their methods and their results. Some
studies estimated price elasticities of demand which reflected changes in education
demand (as proxied by changes in enrollment) due to changes in tuition price. Other
studies created student-price-response-coefficients that were defined as the change
in college participation rates in response to tuition price changes. In 1987, Leslie and
Brinkman provided a comprehensive review of studies of the relationship between
price and college enrollment.17 These studies, which were published between 1967
and 1982, examined different types of institutions, public and private, two-year and
four-year and found that, for every $100 increase in tuition price — given 1982-1983
average weighted higher education prices of $3,420 for tuition and room and board
— it was expected that the national participation rate, 33%, would fall about three-
quarters of a percentage point.18 This translated into a price elasticity of demand of
0.78 which suggests that students were slightly unresponsive to tuition price
changes.19 The authors noted, however, that “demand is known to be affected not
only by price but by the money income of the buyer, by tastes and preferences, and
by the value of the good from a consumption or an investment perspective.”20
In 1997, another review of the literature on tuition and enrollment in higher
education was published by Heller, who compared the results of 20 quantitative
studies to the Leslie and Brinkman study.21 Heller confirmed that as the price of
attending college increased, the probability of enrollment decreased. The consensus
among the studies reviewed was consistent with Leslie and Brinkman, though the
response found was smaller, in that every $100 increase in college costs caused
enrollment decline of 0.5% to 1.0% across all types of institutions. Additionally,
decreases in financial aid led to declines in enrollment with the effect differing
depending upon the type of aid awarded.22 The studies reviewed were consistent in
their conclusions that lower-income students were more sensitive to changes in
tuition and aid than students from middle- and upper-income families. These results
suggest that the benefits of the education tax credits would be greater for lower-
income students, though they are the least likely to be able to claim the credits.23
17 Larry L. Leslie and Paul T. Brinkman, “Student Price Response in Higher Education: The
Student Demand Studies,” Journal of Higher Education, vol. 58, no. 2, March/April 1987,
pp. 181-204.
18 Ibid., p. 188-189.
19 In this context, price elasticity reflects the change in the participation rate for higher
education relative to the change in tuition price [(0.0075/0.33)/(100/3420)]. A price
elasticity value greater than one would reflect elastic demand and indicate students were
very sensitive to price changes.
20 Leslie and Brinkman, p. 200.
21 Donald E. Heller, “Student Price Response in Higher Education: An Update to Leslie and
Brinkman,” Journal of Higher Education, vol. 68, no. 6, Nov./Dec. 1997, pp. 624-659.
22 Heller, p. 650.
23 Lower income students are most likely to have insufficient tax liability against which to
claim the education tax credits and, therefore, are least able to claim education tax credits.

---

CRS-13
Margin Effect. The margin effect, which captures currently enrolled students’
changes in higher educational investment, differs depending on the price paid for
tuition and fees. While all students who claim the credits will experience a favorable
price effect, those students paying higher tuition and fees are least sensitive to price
changes. For instance, a student whose total tuition and fees payments are equal to
$1,500 and who is eligible to claim the Hope Credit, will experience a net price
reduction of $1,250. An eligible student whose tuition and fee payments are equal
to $5,000, would experience a net price of $3,500 (assumes the maximum Hope
Credit amount can be taken). An educational investment elasticity can be created by
assuming both students increase investment by $1,000. For the first student, a
change in educational investment, from $1,500 to $2,500, given the net price
reduction of $1,250, would yield an elasticity of 4.125 [(1000/1500)/(250/1500)].
For the second student, a change in educational investment from $5,000 to $6,000,
given the net price reduction of $1,500 would yield an elasticity value of 0.28
[(1000/5000)/(3500/5000)]. The student currently investing at the higher price has
a high degree of insensitivity to price changes, while the student investing at the
lower price is highly sensitive to changes in price.
CRS examined the possible consequences of enacting the education credits.
This empirical work distinguished the margin effect from the participation effect as
it examined the possible responses to the education tax credits. It found that the
percentage of existing students who experience a relative price effect from the
credits would be 56.5%.24 It also concluded that students who spend large amounts
on education simply reap a “windfall gain” of about 42% since the credits would
cause no price change for additional spending.25 Thus, they would receive the tax
benefit but would not alter their level of educational investment. Federal taxpayers
would receive no offsetting social benefits in the form of increased investment.
Affordability. While credits may not, in some cases, change the price of
marginal (additional) education, they can still reduce its cost relative to income. For
some households, particularly those families with higher incomes, tax credits may be
the only source of financial aid assistance available. According to the Joint
Committee on Taxation, tax credits were enacted to make college more affordable.
To assist low- and middle-income families and students in paying for the costs
of postsecondary education, the Congress believed that taxpayers should be
allowed to claim a credit against federal income taxes for certain tuition and
related expenses incurred when a student attends a college or university (or
certain vocational schools).26
24 CRS Report 97-581, Tax Subsidies for Higher Education: An Analysis of the
Administration’s Proposal, by Jane Gravelle and Dennis Zimmerman. (Out of print report
— Available from author.)
25 Gravelle and Zimmerman, p. 22. (Out of print report — Available from author.)
26 U.S. Congress, Joint Committee on Taxation, General Explanation of Tax Legislation
Enacted in 1997, 105th Cong., 1st sess. (Washington: GPO, 1997), p.14.

---

CRS-14
A 2001 study examining the Hope Credit addressed the federal policy shift from
providing access to college to making college affordable for the middle class.27 The
author found that tax credits had only a small positive impact on the affordability of
higher education for middle income families because middle-income students were
not so sensitive to changes in the cost of education as low-income students. Students
from middle income families had not significantly changed their patterns of
enrollment in higher education in response to price increases relative to income.
Instead, the greatest and most rapidly increasing burden of paying for college was on
low-income, not middle-income families, when the cost of education was compared
to household income.28 Wolanin stated that “in 1972, the burden of both the average
price of four-year public and private colleges and universities was about three times
greater for a low-income than for a middle-income family. By 2000, the burden on
the low-income family was about four times greater than the burden on the middle-
income family.”29
In a 1998 study of the education tax credits and state higher education policy,
Conklin showed that the burden of college expenses, relative to taxpayer income,
could decrease moderately in response to the Hope Credit.30 Those middle-income
families with incomes between $30,000 and $90,000 could experience a reduction
of college costs as a percentage of income from 0% to 5%, with an average of 2%.
Families with incomes below $30,000 would experience no reduction of college costs
because they would be unable to claim the education credits. Tables 4 and 5 show
the potential degree of relief provided by the Hope Credit at different levels of family
taxable income at public and private institutions respectively. At incomes of $40,000
to $60,000, the reduction in cost as a percentage of income is the highest for students
at both public and private institutions, with an average of 3 percentage points.
27 Wolanin, Thomas R., Rhetoric and Reality: Effects and Consequences of the Hope
Scholarship, The Institute for Higher Education Policy, Working Paper, April 2001, pp. 1-
34.
28 Ibid., p. 10.
29 Ibid., p. 10.
30 Kristin D. Conklin, Federal Tuition Tax Credits and State Higher Education Policy, The
National Center for Public Policy and Higher Education, Working paper, 1998, pp. 1-31.

---

CRS-15
Table 4. Estimated Cost of Attendance, before and after Hope
Credit, Four-Year, Public Institution
Average tuition: $3,000, total price of attendance: $10,000
Cost of
attendance
Cost of
Cost of
Cost of
Change in
Taxable
after Title
attendance
attendance
attendance
cost as a
family
IV aid and
as a percent after the tax as a percent
percent of
income ($)
before the
of income
credit ($)
of income
income
Hope Credit
($)
10,000
6,125
61%
6,125
61%
0%
20,000
6,125
31%
6,125
31%
0%
30,000
6,125
20%
5,575
18%
10%
40,000
8,175
20%
6,675
17%
15%
50,000
9,125
18%
7,625
15%
17%
60,000
10,000
17%
8,500
14%
18%
70,000
10,000
14%
8,500
12%
14%
80,000
10,000
13%
8,500
11%
15%
90,000
10,000
11%
9,250
10%
9%
100,000
10,000
10%
10,000
10%
0%
Source: Kristin D. Conklin, Federal Tuition Tax Credits and State Higher Education Policy, The
National Center for Public Policy and Higher Education, Working paper, 1998, pp. 22-23.
Note: Calculations are for full-time freshmen. Income is defined as adjusted gross income for
taxpayers filing jointly with two dependents. Pell Grant (Title IV) subsidy ranges from $3,000 at the
lowest level of income to $950 at the $40,000 taxable income level.
Students at higher priced institutions benefit more from education tax credits
than students at lower priced institutions. As an example, using the tuition cost
information in Tables 4 and 5, taxpayers with the same income (e.g., $30,000) and
the same Pell Grant award (e.g., $2,450) cannot claim the same amount of Hope
Credit. At the public institution, the amount of tuition and fees remaining after
receiving the Pell Grant amount is $550, which can be used to claim the Hope Credit.
Yet, at the private institution, with significantly higher tuition costs, the amount of
tuition and fees remaining after receiving the Pell Grant is $10,550 and the maximum
amount of Hope Credits of $1,500 could be claimed. If it is presumed that students
at higher priced institutions come from higher income households more often than
lower income households, this would further support that the conclusion that tax
credits contribute to regressivity in the tax system.

---

CRS-16
Table 5. Estimated Cost of Attendance, before and after Hope
Credit, Four-Year, Private Institution
Average tuition: $13,000, total price of attendance: $20,000
Cost of
attendance
Cost of
Cost of
Cost of
Change in
Taxable
after Title
attendance
attendance
attendance
cost as a
family
IV aid and
as a
after the
as a
percent of
Income ($)
before the
percent of
tax credit
percent of
income
Hope
income
($)
income
Credit ($)
10,000
16,125
161%
16,125
161%
0%
20,000
16,125
81%
16,125
81%
0%
30,000
16,125
56%
15,175
51%
7%
40,000
18,175
45%
16,675
42%
7%
50,000
19,125
38%
17,625
35%
8%
60,000
19,125
32%
17,625
31%
3%
70,000
19,125
27%
17,625
26%
4%
80,000
19,125
24%
17,625
23%
4%
90,000
19,125
21%
18,375
21%
0%
100,000
19,125
19%
19,125
19%
0%
Source: Kristin D. Conklin, Federal Tuition Tax Credits and State Higher Education Policy, The
National Center for Public Policy and Higher Education, Working paper, 1998, pp. 22-23.
Note: Calculations are for full-time freshmen. Income is defined as adjusted gross income for
taxpayers filing jointly with two dependents. Pell Grant (Title IV) subsidy ranges from $3,000 at the
lowest level of income to $950 at the $40,000 taxable income level.
Timing of Tax Payments. For those individuals who can benefit from the
tax credits, another challenge arises if their cash flow is constrained. The benefits of
tax incentives for education are realized at the time of income tax return filing which,
for most taxpayers, typically occurs in the spring by the April 15th deadline. This is
in contrast to most academic tuition and fees payments that are made at the beginning
of each academic year, typically occurring in the prior months of August or
September. This lagged difference, often up to 10 or more months, in receiving the
benefit of the tax credit cannot provide assistance to anyone trying to raise enough
funds to pay initial college bills. Lower income students may not be able to expend
the funds and wait for reimbursement. However, the issue of when the tax credit
benefit is received may not be significant if taxpayers alter their behavior in
anticipation of the benefit. Taxpayers could, for instance, reduce their income tax
withholding such that their take home income is greater than it would be otherwise.

---

CRS-17
Supply-Side Response: Higher Education Institutions
Increases in government aid to students allows them to pay more for college,
which could induce schools to respond by raising their tuition prices or reducing
financial aid resources. If this occurs, the education credits would not increase
overall investment in education.
Tuition Prices. At the time of the introduction of the education credits, many
economists theorized that colleges and universities would increase their tuition
prices. McPherson and Schapiro stated that for states with community college
systems in which average tuition was below $1,500, they would have incentives to
raise tuition in response to the student populations that qualify for the full credit.31
Kane concluded that with a marginal tuition subsidy between 50% and 100% for
institutions charging less than $2,000, state governments might be tempted to
capture a share of the federal subsidies by tailoring their own tuition and financial aid
policies.32
Only one study has specifically examined the institutional response to the new
education credits. Long (2003) found support for the hypothesis that colleges act
strategically to capture benefits created by the federal tax credits. The strongest
incentives to increase price are for colleges that charge tuition at or below $1,000.
For example, if a school charges $750 in tuition, its first- and second-year students
could claim the full amount of tuition in tax credits and thus incur no tuition cost.
The same scenario would also be true if the school raised tuition to $1,000 and
students would experience no difference. In particular, Long found that colleges that
cost between $1,000 and $2,000 and that had many credit-eligible students did
experience 18% faster growth in tuition prices relative to schools with fewer potential
recipients or a more expensive price. The same results were not found to be true for
public four-year colleges.33
Another institutional response could be to alter the composition of costs
students incur. Universities that charge $1,000 for tuition and $3,000 in room and
board charges may be encouraged to increase tuition costs to $2,000 and reduce room
and board costs to $2,000. The student would experience the same cost but could
receive credit for a larger portion of that cost since tuition and fees but not room and
board are eligible expenses for the tax credits.
Such increases in tuition price would constitute an adverse effect of the tax
credits on low-income students. Not only are they unable to participate in the tax
benefit programs, they may experience tuition price increases as a result of
31 Michael S. McPherson and Morton Owen Schapiro, “Financing Undergraduate Education:
Designing National Policies,” National Tax Journal, vol. 50, no. 3, Sept. 1997, pp. 558.
32 Thomas J. Kane, “Beyond Tax Relief: Long-Term Challenges in Financing High
Education,” National Tax Journal, vol. 50, no. 2, June 1997, pp. 335-49.
33 Long, p. 43.

---

CRS-18
institutional response to the tax credits. To the extent this occurred, low-income
students would be made worse off by the government subsidy for higher education.34
Financial Aid Reductions. The effects of tuition tax credits on financial aid
choices available to students vary and are dependent on institutional responses to the
availability of the tax credits. Educational costs to students are reduced by the
amount of grants and scholarships students receive from federal, state, institutional
and other programs. Most of these grants are awarded on the basis of financial need
which means that low-income students and families, who have the least tax liability
and therefore the least eligibility for tax credits, also receive the largest amount of
need-based grants which further reduces or eliminates their eligibility for tax
credits.35
Low-income students also tend to be more highly concentrated in lower priced
public two-year and four-year colleges. In 2003, 73% of full-time students were
enrolled in public colleges and universities. About 29% of full-time, undergraduate
students were enrolled at institutions charging less than $4,000 in tuition and fees.36
In 1998, students attending public two-year colleges, the lowest priced
postsecondary institutions, accounted for 32% of all first-year students but 47% of
the first-year students from families with incomes of less than $20,000.37 These low
income students pay lower amounts of tuition and related fees, which are more likely
to be offset by tax-free educational assistance such as a Pell Grant, thus rendering
them more likely to be ineligible for tax credits.
Equity Among Taxpayers
A component of fairness in taxation is vertical equity, a concept which requires
that tax burdens be distributed fairly among people with different abilities to pay.
Tax credits benefit those who have sufficient income to pay tax. Those individuals
34 An additional price effect could occur if the increase in demand for education caused by
the tax credits exceeded the capacity of the higher education community. If institutions have
fixed supply and cannot absorb additional enrollment, higher education prices would rise
in response. As institutions expand their capacity, they may have to pay higher costs (e.g.,
to attract professionals for teaching positions). This can be seen in Figure 1, which was
discussed earlier in this report. At the socially optimal level of educational investment, Q**,
the prices faced by students have risen from P*, to P**. The education credits, however,
have not been shown to significantly increase demand for education.
35 For a more in-depth discussion and analysis of tax benefits and their relationship to
traditional financial aid, see CRS Report RL31129, Higher Education Tax Credits and
Deduction: An Overview of the Benefits and Their Relationship to Traditional Student Aid
by Adam Stoll, James B. Stedman, and Linda Levine and CRS Report RL32155, Tax-
Favored Higher Education Savings Benefits and Their Relationship to Traditional Federal
Student Aid, by Linda Levine and James Stedman.
36 The College Board, Trends in College Pricing 2003 (New York: College Entrance
Examination Board, 2003) p.4.
37 Michael S. McPherson and Morton Owen Schapiro, “Financing Undergraduate Education:
Designing National Policies,” National Tax Journal, vol. 50, no. 3, Sept. 1997, pp. 557-71.

---

CRS-19
without sufficient income to pay tax do not have the opportunity to benefit from
education tax credits. The disproportionate benefit of tax expenditures to individuals
with higher incomes reduces the progressivity of the tax system, which is often
viewed as a reduction in equity.
The tax credits are regressive in that the more income taxpayers have, the more
benefits they receive (up to the maximum phase out limits of the tax provision). As
a result of their nonrefundable nature and the fact that the tax credits are not based
on need, the tax credits move the distributional balance of federal aid away from low-
income students towards middle-income students.
According to Wolanin, in 1998 40% to 45% of first and second year, low-
income students were dependents and about half of these students, 1 million, received
no benefit from the Hope Credit. Another one million students had incomes too low
to be eligible to claim the full Hope Credit amount. Independent students, those
solely responsible for their own higher education expenses, make up most of the
remaining percentage of low-income first- and second-year students. Almost 1
million of these independent students, nearly two-thirds of whom have children, have
incomes too low to be eligible for the Hope Tax Credit.38 These numbers are part of
the roughly 6.6 million students enrolled in their first two years of college in 1998.39
Tax benefits such as the education credits can result in individuals with similar
incomes paying differing amounts of tax. Conklin found that differences across
states, including average state tuition prices and the amount of state sponsored aid,
would result in an uneven distribution of tax credit use among taxpayers. 40 This
differential treatment is a deviation from what has been described as a standard of
horizontal equity, which states that people in equal positions should be treated
equally.
The total amount of tax credits received by residents of a particular state
depends on the income levels of college students and families in that state and the
number of college students or their families who file federal income taxes.
Additionally, the distribution of students among lower and higher priced institutions
and the amount of state-sponsored financial aid also affect the equitable distribution
of tax credits across states. States with a high proportion of middle- and high-income
taxpayers may have more students claiming the maximum tax credit relative to states
with high proportions of lower-income taxpayers who may not be able to claim the
credits. States with relatively high priced public and private institutions of higher
education are more likely to have more taxpayers claiming the education credits and
receiving above average amounts. States with large state-based student financial aid
programs may find that fewer taxpayers are eligible to claim the credits. This would
38 Thomas R. Wolanin, Rhetoric and Reality: Effect and Consequences of the Hope
Scholarship, The New Millennium Project on Higher Education Costs, Pricing and
Productivity, sponsored by The Institute for Higher Education Policy, April 2001.
39 National Center for Education Statistics (NCES), Digest of Education Statistics,
[http://nces.ed.gov/programs/digest/d01/index.asp#tables], visited July 21, 2004.
40 Conklin, pp. 7-9.

---

CRS-20
be due to the state-based financial aid reducing the amount of qualified education
expenses a taxpayer could claim.
Conklin cited examples of the inter-state differences. Montana, which had 38%
of its college population made up of lower and lower-middle income students in
1998, was projected to have 23% of its student population unable to participate in the
education tax credit programs. In contrast, Illinois was projected to have only 4% of
its student population ineligible to claim the education tax credits. This was due, in
part, to Illinois having one of the highest rates of students attending college out-of-
state. These rates were in comparison to the national average which was 9%.41
Simplicity
Tax credits for higher education expenses contribute to the complexity of the tax
code and raise the cost of administering the tax system. Those costs, which can be
difficult to isolate and measure, are rarely included in the cost-benefit analysis of tax
provisions. The complexity of the tax code adds to the cost of taxpayers in either
learning how to claim incentives and doing so, or an increased direct cost of paying
tax professionals to perform the service for the taxpayer.
Taxpayers. Taxpayers must be familiar with the necessary forms, the
technical language, and the bureaucratic system in order to maximize the benefits of
the tax code and minimize their required contributions, much like the financial aid
process. Both the income tax filing and the financial aid application processes can
be labor intensive, complicated and require hours of attention by households. For
both the student financial aid process and the income tax filing process, participants
must first learn how and where to obtain the correct publications and forms. They
then must learn how to complete and file the appropriate materials with the relevant
agencies. The alternative available to households is to pay someone to assist in the
process. Middle- and upper-income taxpayers have both a higher degree of interest
and potential gain from acquiring the necessary knowledge and experience, or even
paying a professional to do so for them.
The record-keeping requirements for taxpayers increase significantly for those
taxpayers claiming the education credits. Taxpayers must first determine what their
education expenses were for the tax year, then subtract ineligible expenditures, and
then reduce that amount by any tax-free assistance used to pay for those expenses.
To be eligible to claim the Hope Credit, in addition to other requirements, taxpayers
must determine that they have not claimed expenses for the same student for more
than two years and that the student is still in his or her first two years of schooling.
The administrative complexity of this process is compounded if the student has not
attended college on a consistent basis and this or her status as a first or second year
student has to be verified. For instance a student may attend college, take two classes
a year for three years and still be considered by the institution to be in the first year
of college.
41 Conklin, pp. 8-9.

---

CRS-21
After ascertaining expenses and confirming eligibility for the tax credits,
taxpayers then have to complete the income tax forms with the addition of a separate
form (Form 8863) as part of the process to claim the credits.
This process must be followed for each student eligible for a Hope Credit and
for all of the education expenses used to determine the Lifetime Learning Credit.
Federal Government. The cost to the federal government resulting from the
introduction of education tax credits occurs in many different ways. Federal
policymaking in higher education expanded to include additional executive branch
agencies and legislative committees. The administration of the income tax system
became more complex.
Since the education tax credits were enacted, the number of federal agencies
involved in education policy increased. Prior to 1998, federal policy making for
student aid was concentrated in four congressional committees and one executive
branch agency. The tax credits caused an increase in congressional committee
involvement and executive branch agency involvement. In Congress, non-tax
education policymaking occurs in the House Education and Workforce Committee,
the Senate Health, Education, Labor and Pensions Committee, the House
Appropriations Committee and the Senate Appropriations Committee, while in the
executive branch of government, the Department of Education carries out education
policy. The introduction of education tax credits increased the roles of the Senate
Finance Committee, the House Ways and Means Committee, and the Treasury
Department.
The largest education grant program to serve middle-income students became
the tax credit program, while the largest program to serve low-income students is the
Pell Grant program. These programs are not linked in the same legislation nor are
they acted upon and implemented by the same institutions. This complicates, rather
than simplifies, financial aid systems and arguably hinders the integration of student
aid policies.
The education tax credits increased the costs of administering the income tax
system significantly as the complexity of tax returns increased. The number of forms
to file with the return increased. The IRS now has to receive forms (1098T) from
universities and other institutions of higher learning. These 1098T forms have to be
matched up with individual income tax returns.
Additionally, the IRS may now duplicate some of the work that occurs in the
Department of Education. The criterion for the education credits requires several
academic criteria be satisfied. For the Hope Credit, these include the student’s status:
of being enrolled at least part-time, for at least one academic period beginning during
the year; of pursuing an undergraduate degree or other recognized education
credential; and of being in the first two years of post-secondary education. Typically,
similar student status verification is required for participation in Title IV programs,
which are administered by the Department of Education.
Federal Tax Policy. As federal tax policies change, there are unintended
consequences for education subsidies enacted through the tax code. Several

---

CRS-22
significant tax cuts have been enacted since the introduction of the education credits
in 1997, all of which have affected the pool of potential beneficiaries of the education
tax credits. As mentioned previously, the Economic Growth and Tax Relief
Reconciliation Act of 2001 (EGTRRA, P.L. 107-16) reduced marginal income tax
rates for individuals, causing lower tax burdens. In providing tax relief that was
designed to stimulate the economy, an unintended consequence was to reduce the
number of taxpayers eligible to claim education credits. As a result of the EGTRRA
changes, households, more likely lower income households, experienced reductions
in their tax liability. These reductions may have caused them to be unable to claim
the education tax credits. This may be, at least in part, an explanation for the
reduction in credits claimed, both the number and amount, after tax year 2001 that
is shown in Table 1. Additionally, in response to continued sluggish economic
performance, another tax stimulus plan, the Jobs and Growth Tax Relief
Reconciliation Act of 2003 (JGTRRA; P.L. 108-27), was passed in May 2003.
JGTRRA accelerated many of the tax provisions of EGTRRA, causing increased tax
relief which was likely to further increase the number of taxpayers no longer able to
participate in the education tax credit program. This is more likely to be true for
lower income households than higher income households.
Higher Education Institutions. Financial aid for college through the
income tax system creates regulatory requirements for higher education institutions.
Colleges and universities must supply the IRS with the names, addresses and social
security numbers of all students enrolled at the institution. They must also indicate
whether the student is enrolled full-time or not. At the time of the enactment of the
credits, higher education institutions were required to report even more detailed
information to the IRS, for example, the identity of the taxpayer claiming each
student as a tax dependent. The National Association of College and University
Business Officers estimated that compliance with this full set of requirements could
have cost higher education institutions $137 million in 1999.42 In response to
concerns about the substantial cost of compliance, the IRS limited the reporting
requirements of higher education institutions from 1998 to 2001 and again in 2002.43
Legislative Activity
Proposals Made in the 108th Congress
In the 108th Congress, many bills were introduced to modify and/or expand the
education tax credits. The legislative proposals included making the education tax
credits refundable, allowing students to claim expenses that have been paid using Pell
Grant funds for the education tax credits, and expanding the education tax credits to
42 National Association of College and University Business Officers (NACUBO) The
Taxpayer Relief Reporting Task Force: Highlight of Activities. Prepared for the 1998
National Association of Student Financial Aid Administrators Conference, Chicago, July
15-18, 1998, p.3.
43 A detailed synopsis of the changes is provided in CRS Report RL31129, Higher
Education Tax Credits and Deduction: An Overview of the Benefits and Their Relationship
to Traditional Student Aid, by Adam Stoll, James Stedman, and Linda Levine.

---

CRS-23
include the total cost of higher education, rather than only qualified tuition and fee
expenses. Each of these possibilities would have expanded either the eligible
population for the tax credits or the amount of education credits that could be
claimed. While this would have increased tax revenue losses by the federal
government, it may also have increased social welfare by subsidizing increases in
educational investment that would not occur without the government subsidy. There
are no available cost estimates of the revenue loss.
Legislation Enacted in the 109th Congress
While fewer proposals to change tax credits were made in the 109th Congress,
the tax law was temporarily enhanced. The Gulf Opportunity Zone Act of 2005 (P.L.
109-135) temporarily increased the Hope Credit to 100% of the first $2,000 in
qualified tuition and related expenses and 50% of the next $2,000 of qualified tuition
and related expenses for a maximum credit of $3,000 per student. The Lifetime
Learning credit rate was increased from 20% to 40%. The definition of qualified
expenses was expanded to mean qualified higher education expenses as defined
under the rules relating to qualified tuition programs, including certain room and
board expenses for at least half-time students.
These provisions were applicable to qualified students attending (i.e., enrolled
and paying tuition at) eligible education institutions located in the Gulf Opportunity
Zone (GO Zone). The GO Zone was defined as that portion of the Hurricane Katrina
Disaster Area (in Mississippi, Louisiana, and Alabama) determined by the President
to warrant individual or individual and public assistance from the Federal
Government under the Robert T. Stafford Disaster Relief and Emergency Assistance
Act by reason of Hurricane Katrina.
Proposals Made in the 110th Congress
Early in 2007, legislative attention has begun to focus on proposals to merge the
Hope Credit and the Lifetime Learning Credit. For example, S. 97 and S. 614
propose to replace the two credits with one credit.44 If the credits were merged,
proposals suggest that the rules defining eligible students would be consistent with
the Hope Credit, which defines eligible students as those students who are enrolled
at least half-time in a program leading to a degree, certificate, or other recognized
educational credential and have not yet completed the first two years of
postsecondary education (thus, eligible students are generally freshmen and
sophomores). The Lifetime Learning Credit does not make these requirements.
44 S. 614 also proposes to repeal the higher education deduction.

---

CRS-24
Discussion of Certain Proposals
Refundable Tax Credits
Education credits provide no benefit to lower income individuals who have no
tax liability. Tax credits offset tax liability directly and have become an increasingly
popular method of providing tax relief and social benefits in general. If education tax
credits were made refundable, taxpayers could receive a payment from the
government if the credit exceeded tax liability. H.R. 2150, H.R. 3251, S. 8, and S.
2087 proposed to make both the Hope Credit and the Lifetime Learning Credit
refundable. S. 1793 proposed to make only the Hope Credit refundable. S. 2360
would have allowed the Lifetime Learning Credit to be refundable, but only a certain
portion which would be determined by other credits claimed by the taxpayer. These
proposals were made in the 108th Congress.
In the 109th Congress, S. 3528 proposed making a portion of the Lifetime
Learning Credit refundable and would have directed the Secretary of the Treasury to
establish a program for making advance payments of such credits to eligible
institutions on behalf of certified individuals. S. 3902 and H.R. 1756 also included
proposals for refundable education tax credits.
Currently, the only refundable tax credits are the earned income credit and the
child tax credit (only for families with three or more children in some circumstances).
If Congress chose to make education tax credits refundable, more lower income
households would be able to claim the credits and participation rates in higher
education could increase. Refundable education tax credits would also insulate
potential beneficiaries of the credits from the effects of other tax changes. This, in
turn would increase the budgetary cost of the subsidy.
Refundable education tax credits would be very likely to satisfy the economic
criteria discussed previously in this report. If refundable tax credits increased
enrollment in higher education, they likely would increase efficiency and improve
social welfare. The increased administration required to manage the refundable
credits would add to the costs and complexity of the program, but those costs would
be offset by the increase in social welfare.
Tax Credits Applicable to Total Cost of Education
In 2003-2004, the average four-year public institution’s tuition and fees were
$4,694 and the total cost of attendance averaged in excess of $10,000. In contrast,
two-year colleges averaged $1,905 for tuition and fees.45 This suggests that many
students attending two-year institutions paid less than the $2,000 in tuition and fees
needed to qualify for the maximum tax credit even though their total expense
payment would indeed qualify them to receive the maximum allowable tax credit.
Allowing the tax credits to be applicable for all higher education expenses would
expand the benefits to students who might increase investment in education and, by
45 The College Board, Trends in College Pricing 2003 (New York: College Entrance
Examination Board, 2003) p. 3.

---

CRS-25
doing so, improve social welfare. The expansion of qualified expenses for this
program might allow for a more equitable distribution among taxpayers who
participate in the program.
However, expanding eligible expenses to include living expenses would be
complex to administer for students who do not purchase school-provided room and
board. Some students might reside at home and incur implicit costs of room and
board, which would not be eligible to be claimed for the education tax credits. Other
students may incur an explicit room and board cost, in which case taxpayers would
be responsible for providing receipts to document the expenses. This could increase
the possibility of fraudulent claims because it would be difficult for the IRS to verify
the expenses. The increase in administrative costs associated with this proposal
would likely be marginal, though the information that higher education institutions
would have to report would be increased.
H.R. 625, H.R. 1380, and S. 1697 in the 109th Congress included proposals to
expand the Hope Credit to include fees, books, supplies, and equipment.
Double Benefit with Federal Grants
As mentioned previously in this report, current law requires that expenses paid
using Pell Grant funds cannot be used in claiming the education credits. Legislation
has been introduced that would exempt federal grants from reducing expenses that
could be claimed for the education credits. In the 108th Congress, H.R. 442 and H.R.
3251 proposed to exempt Pell Grants and supplemental educational opportunity
grants from reducing expenses claimed for the Hope Credit. A similar proposal was
included in H.R. 625, H.R. 1380, and S. 1697 in the 109th Congress.
This could create a double subsidy. As an example, a student incurring $3,000
in total tuition and fees could receive a Pell Grant in the amount of $3,000 to pay
these expenses. The student could then claim the Hope Credit, assuming the student
met all other eligibility criteria, in the amount of $1,500 (100% of the first $1,000
plus 50% of the second $1,000). The student would have received both a direct
subsidy, the grant, and an indirect subsidy, the credit, for the same expenses. This
“double” subsidy benefit would not be true for students who incurred larger amounts
of tuition and fees expense.
Students with the least income, the largest Pell Grants, and the lowest price of
attendance benefit the least from tax credits as they currently exist. This proposal
would allow lower income students to benefit from a double subsidy only if they had
sufficient tax liability against which to apply the education credits. For those
students who were able to participate, their enrollment level, at the margin, may
increase if students increased their education spending in response to the proposed
benefit. The proposal might allow students at two-year colleges to enroll in programs
at four-year institutions or it might increase the number of credit hours per semester
the student is able to take.
Students with higher incomes, who do not receive Pell Grants, would not benefit
from this opportunity, though they may already have sufficient income tax liability
and higher education expenses to benefit from the tax credits.

---

CRS-26
The program would not add significantly to the complexity of administering the
program. The proposal would require that universities change the information that
is reported on the Form 1098-T that is sent to households. Taxpayers would incur
a time cost to learn about the program change but the administrative costs to file tax
returns would not likely be increased. Some would view this approach as a potential
windfall to students, particularly if it did not lead to the increased educational
outcome for which it was intended.
Enhance the Hope and Lifetime Learning Tax Credits
In the 108th Congress several pieces of legislation proposed the enhancement of
one or both of the tax credits in a variety of ways. H.R. 129 proposed that the
increase in the Lifetime Learning Credit to 20% of $10,000 of tuition, up from
$5,000, shall be effective in 2002, rather than 2003. H.R. 3251 proposed to increase
the Hope Credit and to repeal the Lifetime Learning Credit. The proposed increase
of $1,000 would have increased the maximum allowable Hope Credit amount to
$2,500. S. 2087 also proposed to increase the Hope Credit to a maximum of $2,500.
S. 174 proposed to increase the amount of the Lifetime Learning Credit from
20% of $10,000 in tuition and fees to 25% of $12,000 in tuition and fees (thus
increasing the maximum possible credit amount from $2,000 to $3,000). This bill
would have also increased the annual income limits for both credits to $55,000 for
single taxpayers (up from $51,000) and $110,000 for married taxpayers filing jointly
(up from $103,000). S. 2360 proposed to increase the Lifetime Learning Credit from
20% to 50%, but would reduce the eligible expenses from $10,000 to $4,000.
S. 1793 proposed to make the Hope Credit available for all four years of college,
as opposed to the current provisions applying only to the first two years. This bill
would also double the maximum amount of the Hope Credit, from $1,500 to $3,000.
In each of these cases, the eligible population of participants would have
increased. The modified tax credits would have contributed to making higher
education affordable, either for more individuals, or at greater amounts.
The expansion proposals would not have changed the complexity of
administering the current program, though there would be costs incurred to publicize
and learn about the changes in the program. The expansion proposals were unlikely
to improve the accessibility criteria of new students enrolling in college.
In the 109th Congress, S. 3528 proposed to increase the percentage of qualified
higher education expenses the Lifetime Learning income tax credit covers, but to also
reduce the maximum annual dollar amount.
Advance Loan Against the Tax Credits
As mentioned, the tax credit benefits are typically received by taxpayers after
the income tax filing season in the spring of each year. While educational
expenditures are made several months earlier, presumably in the early or late fall of
the prior year. Proposals were made to allow taxpayers to apply for, and receive, a
short-term loan using the anticipated tax credit benefit as collateral, which would

---

CRS-27
allow the proceeds to be used at the time tuition payments are required. H.R. 2150
proposed to allow taxpayers to obtain short-term student loans by using the future
refund of the Hope Credit and/or the Lifetime Learning Credit as collateral for the
loans.
This type of proposal would have added complexity and cost to administering
the education tax credit program and essentially created a new financial aid program
to administer for higher education institutions and/or financial institutions, who
would, presumably, be making the loans. The proposal would have increased
enrollment if the timing of the receipt of the tax benefit were a significant factor. As
mentioned previously, taxpayers may have already adjusted their behavior in
response to the benefit such that this timing factor is not a variable in the enrollment
choice. This kind of proposal also would have created potential difficulty if the
taxpayer were unable to claim the tax credits at the end of the year and thus, might
not have had the proceeds to pay back the loan.
If Congress intends that education tax credits provide relief for middle income
households and the higher education costs they incur, the tax credits may be ideal.
In this case, enhancing or altering the credits may improve the relief they provide.
If, on the other hand, Congress intends to increase access to higher education,
education tax credits are not proven to be effective at increasing enrollment. An
alternative to better achieve this objective could be to eliminate the tax credits and
allocate additional funding to alternative education funding programs, like those
authorized by the Higher Education Act, which may be more successful at increasing
enrollment and access to college.
crsphpgw

---