Election 2008: A Taxing Decision for Obama

On January 20, 2009, Sen. Barack Obama (D-IL) will be sworn in as the 44th president of the United States. Around the same time, millions of college students across the country will be beginning their spring semesters. And these classes will arrive with sizeable tuition bills. Obama has a plan for helping students tackle these costs — a tax credit for students who perform community service. But the president-elect should take note. Tinkering with the tax code is a less than ideal way to promote college access and affordability.

The cornerstone of Obama’s college plan is the American Opportunity Tax Credit. Worth $4,000 annually, it is available to all college students, regardless of income, so long as they complete 100 hours of public service during the academic year. The tax credit is fully refundable, meaning that if a student’s tax liability is less than $4,000, they will have their tax bill paid off and then receive a rebate for any leftover credit amount.

On paper at least, the American Opportunity Tax Credit (AOTC) appears far better than existing higher education tax credits. This is especially true with respect to the Hope and Lifetime Learning tax credits, which were championed by Obama’s Democratic predecessor Bill Clinton. The Hope credit is worth up to $1,650 (100 percent of the first $1,100 spent on higher education and 50 percent of the next $1,100) for the first two years of postsecondary enrollment. The Lifetime credit, meanwhile, is worth up to $2,000 (20 percent of the first $10,000 spent on higher education) and may be taken so long as students are enrolled.

The primary problem with these tax credits are that they are not refundable, meaning that they are largely unavailable to the low-income students who need the government’s help the most but don’t pay taxes. In addition, operating on a percentage basis makes both of these credits confusing, and the Lifetime credit’s high threshold means students with tuition bills under $10,000 will not be able to receive the full credit.

While Obama’s proposal promises to cure the issue of refundability, there are still several unanswered questions about how it would work. First, would it cover only tuition expenses, or would it include other things, such as room and board and textbooks, that are currently excluded from Hope and Lifetime calculations? Second, would it replace the existing tax credits or simply be added on top of them? The mix of tax credits is already too confusing to students. A recent report by the Government Accountability Office found that almost 30 percent of filers claiming a higher education tax credit currently choose the wrong one, providing them with a smaller benefit than they are qualified to receive. Meanwhile, the report found that several hundred thousand eligible taxpayers don’t claim the credits at all, perhaps in part because they don’t realize that they are available.

There are also questions to be asked about how the community service requirement would be implemented. The Internal Revenue Service (IRS) clearly doesn’t have the capacity to ensure that all credit recipients are actually fulfilling the 100 hour requirement, which would leave it up to the Department of Education, individual schools, or the volunteer agencies to monitor. Also, what kind of supports would it contain for students who want to serve their communities but may be limited due to the need for childcare or immediate income to support their families?

A better option, albeit more difficult to pass, would be to enact a $4,000 grant program instead. This would also create an opportunity to better target funds, make it easier to control their cost, and ensure that they go to the neediest students. Under this model, Pell Grant eligible students could be rewarded for their service and states could potentially provide matching funds. Moreover, receiving the money as a grant means students wouldn’t have to wait to file their taxes to receive funds. This is a major problem with existing tax credits, because students file for and receive them months after having to come up with the money to pay their tuition.

Admittedly, there are disadvantages to a grant program. Unlike tax changes, Congress would have to pay for the program with discretionary funding each year, subjecting it to the possibility of annual budget cuts. A yearly search for discretionary dollars will make it more difficult to enact the program and does not guarantee students will receive funds for a prolonged period of time. These are major challenges, but a grant program is still more attractive because it avoids the administrative difficulty of having the IRS track the community service requirement.

There are 74 days to go before Obama’s inauguration. As he begins forming a transition team and fleshing out policy proposals we strongly urge him to think carefully about the implementation of the American Opportunity Tax Credit. At the very least, it should replace the existing Hope and Lifetime credits and include non-tuition and fee expenses. Ideally, however, the incoming administration would take an even bolder approach and consider an overhaul of the student aid system as a whole — one that is better targeted and much simpler to understand and access.