The Failure of Education Tax Incentives

Abstract

Federal aid to higher education has shifted over the last decade from direct subsidies to tax incentives. There are three types of Pigouvian subsidies designed to subsidize price: Nonrefundable tax credits and a deduction for tuition reduce the price of tuition; a deduction for interest on education loans lowers the cost of borrowing; and the tax-exemption of the earnings on education savings plans increases the return to saving. These tax incentives can be justified on either efficiency or equity grounds. If they increased investment in higher education, they would enhance efficiency by correcting for positive externalities. If they helped to eliminate disparities in the distribution of education consumption, they would increase equity. The paper develops models to test predicted taxpayer response to the most important education tax incentives. It concludes that the structure of the incentives is such that there will be no change in behavior in response to the subsidies. Those for who demand for education is most elastic (low income taxpayers) cannot use the incentives, those for whom demand is somewhat elastic (middle income taxpayers) will not use the incentives, and those for whom demand is inelastic (wealthy taxpayers) will reap the benefits in the form of increased consumption. The design of the credits also precludes a distributional change in education investment.