The New Federal Tuition Tax
Description of State Policy Alternatives
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Federal Tuition Tax Credits
Page 4 of 10

Section Two
Description of State Policy Alternatives

States are currently considering a wide range of responses to the federal tuition tax provisions (see Appendix, Tables 6 and 7, for a summary of policies being considered by each state). This section describes the most significant of these responses, as well as several other state policy options. States could combine several of these policy alternatives, or select one in isolation:

  1. Take no action,
  2. Change tuition policies,
  3. Adjust existing state student financial aid programs,
  4. Modify the existing state tax code, and
  5. Encourage maximum knowledge and use of the tax benefits.

Option 1: Take No Action
States do not have to change existing state policies or enact new ones in order for students and their families to benefit from the millions of dollars the federal government is offering through the new tax provisions. Because the new federal law represents a major change in the federal government's approach to financing higher education, some states are waiting to see how the new tax provisions will be implemented. History provides a rationale for this cautious approach; the federal government once before undertook, and later rescinded, a major program to provide financial support for middle income families.5

Effect: A decision to not act will allow the new law to meet its goal of helping to ease the cost of college for middle income families.

Option 2: Change Tuition Policies
States can raise tuition at public institutions of higher education, thereby allowing the state or its colleges and universities to "capture" the benefits that the new federal tax credits are designed to provide to students and their families.

Effects: Several states have low tuition levels that may not yield the maximum federal tax credit. If states do not increase tuition, they may be missing the opportunity to shift some costs to the federal government through the federal tuition tax credits. This option would increase the cost of college for low income families and independent students who do not qualify for the tax credits, unless financial aid were increased to meet the full needs of these students.

Option 3: Adjust Existing State Student Financial Aid Programs
Most states have established at least one need-based grant program; many states have more than one. These state grants, although growing in size, constitute a small proportion (on average, 5% or less) of total state support for higher education. There are several alternatives that states are considering in relation to adjusting their student financial aid programs in light of the new federal tax credits:

A. Consider the federal tax credits as income when calculating state student aid eligibility. Including the new tuition tax credits as income would be similar to what occurs now at the federal level, where students and families who receive the earned income tax credit have to count that credit as income when applying for federal financial aid.

Effects: Some students who would have previously qualified for state student financial aid programs would no longer qualify or would qualify for less state aid due to their participation in the federal tax credit program. This could permit the state, at no additional state cost, to concentrate financial aid on those students with more financial need.

B. Create additional financial aid programs that replicate in whole or in part the intent of the new federal tax provisions.

Effects: Creating new state financial aid programs targeted to students and families earning from $40,000 to $80,000 annually could further address the affordability concerns of the middle class. State funding for new financial aid programs, however, would not necessarily add to the benefits of those who qualify for the federal tax credits, because eligibility for the federal tax credits is limited to the cost of tuition and fees minus any grants and scholarships received. As a result, new state funding in this area would, in many cases, use state dollars to pay for benefits that students or their families would have received through the federal tax credits.

Option 4: Modify the Existing State Tax Code

A. Conform state income tax code to adopt federal tax credits at state level. States with income taxes can conform their state tax code to allow students and families to claim the same tax credits on their state income taxes as they can on their federal income taxes.

Effects: Adopting state-sponsored tuition tax credits would provide additional benefits to the middle and upper-middle income students who benefit from the federally sponsored HOPE and Lifetime Learning tax credits. Conforming the state income tax code to the new federal tax credits will result in a loss of state revenue.

B. Conform state income tax code to adopt federal tax deductions at state level. States can conform their state tax code so as to use the federal government's definition of adjusted gross income, thereby allowing student loan interest deductions at the state level. Most states with income taxes use the federal government's definition of adjusted gross income. A handful of states set the state tax rate as a percentage of total federal taxes owed. A few states with income taxes have broad definitions of income with few exclusions, deductions, exemptions, or credits.

Effects: Students of all incomes who borrow are likely to benefit from the new federal deductions for interest on student loans. Conforming the state tax code to the federal governmentâs definition of taxable income would confer these benefits at the state level. Conforming the state income tax code to adopt the federal tax deductions will result in a loss of state revenue.

C. Create a state prepayment or college savings plan. In many respects, the new federal tax credits--particularly the savings provisions--reflect the same set of perceived needs and concerns about affordability that state prepayment and college savings plans sought to address. Forty states now have either a prepaid tuition plan or a college savings plan; some states have both. But some states have neither. The new federal savings provisions provide states with an incentive for creating new prepayment or college savings plans: earnings on deposits are now free from federal taxes until withdrawal. (See Appendix, Table 7, for information about which states have these kinds of programs.)

Effects: One effect of this option would be to confer additional benefits to those students and families who already benefit from the federal tax credits. States without a savings plan miss the opportunity, at no cost, to give taxpayers the chance to save for college at federal expense.

Option 5: Encourage Maximum Knowledge and Use of the Tax Provisions

A. Publicize the availability of the federal tax credits as a means to finance college. Some state policy makers--in Ohio and Massachusetts, for instance--are considering public information campaigns to make their residents aware of the federal tax credits and savings provisions.
Effect: Increased use of the federal tax credits by state residents addresses the concerns of middle income families about college affordability.

B. Provide bridge loans to students. With either the HOPE or Lifetime Learning tax credits, families receive the benefit of the credits only after their taxes are filed, which usually will be six months or more after they complete the semester for which the tax credit was earned. Some state policy makers and institutions are considering filling this gap through offering short-term "bridge" loans, made available at the beginning of the academic year and payable when the tax credit is received.

Effect: Bridge loans could prompt more students and families to use the federal tax credits.



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