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New Tax Credits
Federal legislation presents states with important policy options

By Kristin D. Conklin

Kristin D. Conklin  

EIGHTEEN MONTHS after President Clinton signed the Taxpayers Relief Act of 1997 -- the largest single federal investment in student financial aid since the GI Bill following World War II -- the impact on students and their families, as well as the options available to the 50 states, have become clearer.

The law's tuition tax credits, college savings provisions and student loan interest deductions will cost an estimated $40 billion over the next five years, an amount that will equal, or perhaps exceed, all other federal financial aid combined.

The most important provisions of the 1997 act are the Hope and Lifetime Learning tax credits. The Hope tax credit is worth up to $1,500 per year for the first two years of college, while the Lifetime Learning credit is valued at $1,000 a year for college beyond the first two years.

Table 1 briefly outlines the act's major provisions.

Some of the effects of the new legislation are clear:

Middle and upper-middle income students and their families benefit most from the new tax credits.

The credits reduce federal taxes for eligible students or their families. If families pay no federal taxes, they will not benefit at all. This means that dependent students whose families make less than $17,500 a year in taxable income, and independent students who earn less than $6,800, will gain nothing from the tax credits.

From income information provided by the U.S. Department of Education's 1995—96 National Postsecondary Student Aid Survey, we know that 26 percent of all dependent college students, and 47 percent of all independent students, would not qualify for either the Hope or the Lifetime Learning credits.

Table 2 shows how families and students at different income levels can use both existing and new federal student aid programs to help pay for college.

In general, families who qualify for need-based support -- Pell grants and federal loan subsidies -- cannot receive a maximum Hope tax credit. For instance, a family with a student in a four-year public college, and with a taxable income of $30,000 or less, would not be eligible for the maximum Hope credit.

Students at higher-priced institutions benefit more than those who attend less expensive campuses, particularly two-year community colleges.

Students at public community colleges can get some or all of their tuition and fees paid by the federal need-based Pell grants. Only community college students with family incomes between $50,000 and $80,000 are eligible for a maximum Hope tax credit; students with family incomes of $40,000 to $50,000 would receive a partial credit. But students who attend more expensive private four-year colleges can receive the maximum Hope credit when their family income falls between $30,000 and $80,000, because the Pell grant pays only a fraction of the higher tuition and fees. Moreover, community colleges enroll more students with personal or family incomes too low to qualify for the tax credit.

Many of the same students eligible for the Hope and Lifetime Learning tax credits are also most likely to participate in the new college savings programs.

Findings from a 1995 U.S. General Accounting Office study showed that these plans are most beneficial to middle and upper income families. In fact, in no state that was studied did more than ten percent of the participants make less than $25,000 a year.

Nearly all students and families who borrow money to pay for college will benefit to some extent from the law's student loan interest deduction provision.

Last year, The U.S. General Accounting Office reported that students whose family incomes are below $45,000 are two and a half times more likely to borrow than students whose family income falls between $60,000 and $100,000. The report also found that students with higher incomes tend to borrow more, so their large interest payments would qualify them to file for larger income tax deductions. Income caps will disqualify some students, and loan volume and tax rates will determine variation in the benefit.

The Interaction of New Federal Policy and Existing State Policies
Although the federal income tax credits flow directly to individuals and families who are federal taxpayers, the 1997 act creates incentives for some states to shift financial support for higher education to the federal government while weakening policies that expand higher education opportunities. States that maintain large student financial aid programs could, by reducing need-based aid or by increasing tuition, or both, capture a larger share of federal dollars.

In general, the total dollar amount of each state's benefit will vary, depending on:

  • the income levels of college students and their families in that state

  • the distribution of students among lower and higher-priced institutions

  • the effects of state-sponsored financial aid, and

  • the number of students, or their families, who file in that state.

States with large financial aid programs (California and New York, for example) will find that residents at some income levels will not qualify for the full Hope tax credit if these residents already receive state support, because tax credit eligibility is based on tuition and fees minus all grants and scholarships.

For instance, New York State now maintains a need-based Tuition Assistance Program, which costs the state about $630 million annually. A New York family with a student in a four-year public college would not be eligible for the maximum Hope credit unless its taxable income is $45,000 or higher, about $5,000 higher than the expected national average. This has caused the New York State Higher Education Services Corporation to recommend a study to determine whether federal money can be substituted for state funds.

In California, 60 percent of the college population attends community colleges, where fees generally are less than $400 a year. None of these students would be eligible for the maximum Hope credit. The California Legislative Analyst has recommended that community college fees be raised to capture the full value of the Hope credit, while, at the same time, financial aid is increased for those students who are not eligible for the tax credits.

The last part of this recommendation is critical. It would be unwise for California and states with similar policies to raise tuition and fees simply to capture federal credits for eligible taxpayers without assuring access for those who are not eligible.

Policy Options for the States
Governors and legislatures should explicitly assure that the state policies they adopt because of the 1997 legislation do not diminish the overall level of state support for higher education. The new federal program creates an opportunity for many states to address the needs of low income families at the same time they are helping the more fortunate.

Options are available to the states because the legislation adds a major new revenue stream to the public financing of higher education. In this first year, for instance, California students and their families are expected to receive $1.2 billion in Hope and Lifetime Learning tax credits–the highest total of any state. By comparison, in 1995-'96 California received $785 million for all other federal financial aid combined.

Although Alaska students and families are projected to receive the lowest tax credits of any state --$19 million annually --this is about four times more than all the federal financial aid Alaska received in 1995-'96.

The sheer size of this new federal investment should lead most states to examine their own higher education financing policies. They should consider the impact of state and federal policies on existing and prospective student populations, using current state-level data. This examination should determine the impact of the new federal policies on existing state policy, not only in terms of overall dollars but also on all aspects of college opportunity.

After such an examination, a state may or may not decide to take action. The 1997 act does not require that states change existing policies or enact new ones, and most states are waiting to see how the new program will be implemented. Their caution seems justified in light of the fate of the 1978 Middle Income Student Assistance Act, which also was intended to help middle and upper income taxpayers but was repealed in 1981 because it was too expensive.

However, taking no action in response to the new tax policies means that a state accepts the federal objective of making college more affordable for middle and upper income families even if it has an adverse effect on those with less money. States should explore these implications before making final decisions.

The particular circumstances in each state will determine how that state responds to the new law. These are some of the major considerations:

  • States could consider treating the federal tax credits as income when calculating state student aid eligibility. Some middle income students who would have qualified for state financial aid previously will no longer qualify, because of their participation in the federal tax credit program. Savings gained in the state financial aid programs then would be available for lower income students who do not qualify for any or all of the tax credits. Or the savings could be used to improve college preparation in the public schools.

  • States should be cautious before creating additional financial aid programs whose primary objective is to further relieve the affordability concerns of middle and upper-middle income students and their families. In addition to providing benefits for the same students and families who are eligible to receive federal tax credits, state funding for new state financial aid programs would substitute for the federal tax credits, dollar for dollar.

  • States should revise their tax codes to incorporate the new provision for making interest on student loans deductible for state income tax purposes. This will assist in the repayment of loans, maintain simplicity for both the state and the taxpayer and facilitate auditing of state tax returns.

  • States should not conform state tax codes to accommodate the federal tuition tax credits. This would duplicate benefits already afforded to middle income students and their families by the federal credits.

  • A state without a state-sponsored prepaid tuition plan should consider establishing one. (Forty-one states now have such plans.) The 1997 act expanded eligible expenses for which withdrawals can be made to include reasonable costs of room and board.

  • States could encourage use of the federal tax credits by making "bridge loans" available at the beginning of the academic year, to be repaid when the tax credit is received.


As states examine the impact of this new legislation on their own student financial aid programs, other options undoubtedly will emerge. Although states may defer policy changes, all of them should encourage maximum knowledge about, and use of, the new federal tax benefits by making information widely available.

The new federal tax credits provide an opportunity to compensate for lost state dollars. However, states should resist the temptation to reduce their financial commitment to higher education, choosing instead to redirect resources to other areas of need within higher education. In this way, the new federal initiative can be used by governors and state legislatures as a catalyst for reaffirming and expanding access policies for all citizens.

Kristin D. Conklin is director of the Washington office of the National Center for Public Policy and Higher Education. The Center recently published her full report on the 1997 tax credit legislation.

Photo by Rod Searcey for CrossTalk

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