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Report examines effectiveness of AOTC and policy alternatives

Congressional Research Service, “The American Opportunity Tax Credit: Overview, Analysis, and Policy Options” (R42561).

A recent report issued by the Congressional Research Service (CRS) has provided an overview of the American Opportunity Tax Credit (AOTC), including the policy goals in enacting it, the credit’s effectiveness in attaining those goals, potential ways that Congress could modify the AOTC, and alternative legislative means of reducing the costs of higher education.

Background. The American Opportunity Tax Credit (AOTC) was originally enacted on a temporary basis by the American Recovery and Reinvestment Act (ARRA; P.L. 111-5), essentially as a modified version of the pre-existing Hope credit. Enhancements to the credit were recently made permanent by the Protecting Americans from Tax Hikes Act (PATH Act). The AOTC is a partially refundable tax credit that provides financial assistance to taxpayers (or their children) seeking higher education. The credit is equal to up to 100% of the first $2,000 of qualified education tuition and related expenses, plus 25% of the next $2,000 of such expenses, for a maximum of $2,500 per student, incurred during the first four years of post-secondary education. (Code Sec. 25A(a)(1)) In addition, 40% of the credit (up to $1,000) can be received as a refund by taxpayers with little or no tax liability. (Code Sec. 25A(a)(5))

The credit phases out for taxpayers with income between $80,000 and $90,000 ($160,000 and $180,000 for joint filers). (Code Sec. 25A(a)(4)) There are a variety of other eligibility requirements associated with the AOTC, including those relating to the type of degree the student is pursuing, the number of courses the student is taking, and the type of expenses.

Before enactment of the AOTC, there were two permanent education tax credits, the Hope Credit (now essentially replaced by the AOTC) and the Lifetime Learning Credit. The Lifetime Learning Credit is 20% of up to $10,000 of qualified tuition and related expenses paid during the tax year, available for qualified expenses of any post-high school education at “eligible educational institutions,” is nonrefundable, and is available for an unlimited number of years without any degree requirement. (Code Sec. 25A(a)(2)) It also phases out for higher-income taxpayers. The Lifetime Learning Credit and AOTC can’t both be claimed in the same tax year for expenses of any one student.

In addition, there is an above-the-line deduction for tuition and fees under Code Sec. 222(e), currently in effect through 2016, which allows an eligible individual with adjusted gross income below certain thresholds to deduct up to $4,000 in higher education expenses. However, a taxpayer cannot claim both the deduction and an education credit (either the AOTC or Lifetime Learning Credit) for the same student in the same year.

Policy goals. Education tax credits were intended to provide federal financial assistance to students from middle-income families who may not benefit from other forms of traditional student aid. The enactment of the AOTC reflected a desire to continue to provide substantial financial assistance to students from middle-income families, while also expanding the credit to certain lower- and upper-income students. Another goal is to increase attendance at post-secondary educational institutions (collectively referred to as “college”).

Effectiveness. IRS statistics show that the enactment of the AOTC has resulted in a substantial increase in the amount of education credits claimed by taxpayers and that it tends to provide the greatest benefit to middle- and upper-middle income taxpayers. However, research indicates that the AOTC may not be an effective tax policy from an economic standpoint—put otherwise, many of those who claim the credit (or have the credit claimed for them) would have pursued higher education regardless of whether an AOTC could be claimed, and the AOTC thus is not necessarily providing a genuine incentive to engage in certain types of behavior but rather rewarding behavior that would have occurred absent the incentive. Also, in comparison to the Hope Credit, a greater share of the AOTC’s benefits fall to those with incomes in the $100,000 – $200,000 range.

In terms of whether the AOTC has actually increased college attendance, many studies have found that the AOTC (and other similar tax incentives) has a very limited impact on college enrollment, with recent research finding an approximate 7% increase. The CRS offers possible reasons, including that the AOTC primarily benefits middle-income taxpayers who are less sensitive to the price of college than their lower-income counterparts, that the actual financial benefit isn’t derived until up to 15 months after the education expenses are incurred, that the complexity of education tax provisions results in some taxpayers not claiming the one that would provide the greatest (or any) benefit, and the possibility that some institutions may have raised their tuition in response to the availability of education tax credits.

Errors and ineligibility. The CRS notes that taxpayers are “more likely to claim tax benefits when they are simple and straightforward to claim,” but that this ease may result in increased errors, both intentional and unintentional. A 2015 report by the Treasury Inspector General for Tax Administration (TIGTA) examined 2012 income tax returns that claimed this credit and identified 3.6 million taxpayers who received more than $5.8 billion in AOTC credits that appeared to be erroneous—including $3.2 billion where IRS couldn’t confirm that the students claimed on the taxpayers’ tax returns attended a college or university and $1.3 billion for students who didn’t attend an eligible educational institution. In its report, TIGTA suggested that the ability to timely match information on a Form 1098-T provided by the institution with the information on the Form 8863 submitted by the taxpayer would eliminate many of these errors, and proposed accelerating the due date for Forms 1098-T to January 31 to better align with tax filing season. However, TIGTA noted that IRS’s general lack of audit resources prohibit it from making any significant reduction in or recovery of erroneously paid claims.

Proposals and alteratives. The CRS outlined a number of options that Congress may consider in potentially reforming education tax incentives, including modifying the AOTC, consolidating it with other education tax benefits, or perhaps looking at alternative ways to reduce the cost of higher education.

  • Modify the AOTC. The AOTC could be modified in a number of ways, such as by expanding or limiting certain parameters of the credit—e.g., change the amount of qualifying expenses that can be used to claim the credit, adjust the portion of the credit that is refundable, modify the income level at which the credit phases out, allow taxpayers to claim the credit for either more or less than four years of post-secondary education, or expand the types of programs eligible for the credit to include job-training programs. Certain changes could also expand the credit’s availability to lower-income recipients, such as making a greater percentage of the credit refundable, or changing the formula to allow the maximum credit to be claimed on a lower level of expenses.
  • Consolidate the AOTC with other education tax breaks. Policymakers may instead choose to consolidate the AOTC with the Lifetime Learning Credit and the tuition and fees deduction. The budgetary impact of consolidating higher education tax benefits into one credit is unknown, but could be designed to increase revenue, decrease revenue, or remain revenue neutral.
  • Alternative policies. In addition to modifying the AOTC, Congress may instead choose to reevaluate the federal government’s role in higher education financing more broadly by considering education tax breaks in conjunction with other forms of federal financial aid to develop a broader higher education financing policy. One potential way of doing so would be for policymakers to expand the types of expenses that would qualify for the AOTC such that a low-income student who uses a Pell Grant to pay for most or all of their tuition could still benefit from it. Alternatively, policymakers could reformulate the federal government’s role in higher education financing entirely by encouraging alternative financing mechanisms like “human capital contracts,” which allow a student to repay an investor a percentage of future earnings for a fixed period of time.

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Meet Paul Raymond

Meet Paul Raymond

Mr. Raymond is a sought after speaker in tax controversy law by many attorney, accountant, and business groups and at the request of the Internal Revenue Service, has presented programs at the IRS Nationwide Tax Forum, attended by tax professionals throughout the United States.

Additionally, he continues to be an active member in the Section of Taxation, American Bar Association, where he was the Past Chair of the Employment Taxes Committee.

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