President Obama’s AOTC Plan Would Make a Bad Policy Better

President Obama is expected to announce a tax-reform plan tonight that would significantly simplify higher education tax breaks for students and their families – and make them far more accessible for low-income students.

According to a fact sheet that the White House distributed over the weekend, the president’s proposal is in line with the recommendations of the Consortium for Higher Education Tax Reform, of which New America was a member. Specifically, the plan would:

• Preserve the American Opportunity Tax Credit (AOTC) and make it the primary vehicle for tax-based student aid: Currently, student aid delivered through the tax code includes multiple tax credits and deductions. Many of these tax breaks overlap, and taxpayers often do not choose the provision that would benefit them the most. The president’s proposal would make the AOTC – an annual income tax credit of up to $2,500-a-year available to help students cover tuition, fees, and course materials – permanent, while eliminating the Lifetime Learning Tax Credit and the highly regressive Tuition and Fees Deduction. It would also index the value of the AOTC to inflation. Under current law, the AOTC will expire at the end of 2017 and will revert to the non-refundable Hope Tax Credit.

• Increase the proportion of the credit that is refundable: Today, low-income households that don’t earn enough to pay federal income tax can receive only up to 40 percent of the AOTC as a refundable credit. The consortium called for making the AOTC fully refundable so low-income students and their families could receive the full benefit. The president’s plan doesn’t go quite as far – it would increase the refundable portion of the credit to the first $1,500. This is a step in the right direction, as it would particularly help students attending the lowest-cost institutions, who currently do not receive even the full $1,000 refundable credit if they have less than $4,000 in qualified expenses.

• Expand AOTC eligibility for non-traditional students: Currently, students must be at least half-time to qualify for the AOTC, and families can claim the credit for no more than four years. Under the president’s proposal, students who are enrolled for less than half-time would be eligible for a $1,250 AOTC and all eligible students would be able to claim the AOTC for up to five years.

• Better coordinate the AOTC with the Pell Grant: As of now, Pell Grants and the AOTC often interact in a way that reduces their benefits, particularly for low-income students attending low-cost institutions. Taxpayers can only use the AOTC to cover tuition, fees, and course material expenses. However, if a student receives a Pell Grant, those costs may already be covered, leaving them without the qualified expenses needed to claim the tax credit [unless the filer knows to claim that the Pell Grant covered the student’s living expenses]. The president’s plan would apply Pell Grants first to Pell-allowable expenses (such as room and board) that are not eligible for the AOTC so that low-income students can receive all the benefits for which they are eligible. In concert with this change, the proposal would end the taxation of Pell Grants that are used for paying living expenses, as the consortium recommended. In addition, under the president’s plan, Pell Grants would be exempt from the AOTC calculation, making many more Pell recipients eligible for the full benefits.

These are all very positive changes. The president’s plan does not, however, fulfill one of the consortium’s top priorities: better targeting the tax credits to ensure that tax-based student aid goes to low- and modest-income students who have the hardest time affording college, rather than to higher-income individuals who are already very likely to attend college without a tax incentive.

The president’s plan would keep the current phase out limits in place for the AOTC. That means that families making as much as $180,000 a year would remain eligible to receive a partial credit. This is a missed opportunity. The president could have proposed lowering the limits and using the savings to make the refundable credit even more generous.

As my colleagues have pointed out (see here and here), delivering student aid through the tax code is extremely problematic. The tuition tax break programs are complicated and confusing. Because of the complexity of navigating the tax code, many low- and moderate-income families do not appear to know that they are qualified for these benefits. In addition, the tax breaks arrive months after students and their families pay their tuition bills. This disconnect in timing is not only impractical but serves to obscure the purpose of the benefits as well.

Most financial aid experts agree that it would be far better to eliminate the AOTC and the other tuition tax break programs, and use the savings to significantly boost funding for federal need-based aid. I agree. Unfortunately, the tax breaks are not going anywhere. They are just too politically popular for policy makers to have the guts to end them.

Given that reality, the president’s proposal may be the best we can to do to make a bad public policy better. If implemented, the tuition tax break programs would be simpler to navigate, and low-income students would benefit from them more – and that’s a good thing.”