Over the past several days, President Obama has released a serious of ambitious domestic policy proposals that he will more formally unveil in tonight’s State of the Union address. Most of these proposals, thankfully, will be blocked by Republicans in Congress. Their real purpose is to put a marker down – to let voters know where the president and his allies stand on higher taxes on the rich (they’re for it), tuition-free community college (they’re for that too), and dastardly cyberattacks (they’re against them). To my surprise, at least one of his proposals has some merit.
Specifically, the president is calling for paring back the benefits associated with 529 college-savings plans. Right now, these plans are quite generous, as Annamaria Andriotis of the Wall Street Journal has explained: parents contribute to 529 plans with after-tax income, and earnings that accumulate over time in the plans can be drawn tax-free, provided they are used to meet various approved college costs. Under the president’s proposal, all new contributions will be treated differently. Taxes on earnings will be deferred until earnings are withdrawn, at which point they’ll be treated like ordinary income. Suddenly, 529 plans will become far less attractive.
Why do I think this proposal has merit? Many of the analysts I trust most, like Ryan Ellis of Americans for Tax Reform, hate it, and see it as an unjustifiable middle-class tax hike. And like Ellis, I strongly favor reducing taxes on savings and investment. In my ideal world, we’d move towards something like a progressive consumption tax. So don’t get me wrong: I’m all for helping families, including well-off families, save and build wealth. The reason I’m sympathetic to paring back the benefits associated with 529 plans is that tuition tax breaks appear to be an extremely ineffective way of making higher education more affordable — indeed, one scholar I trust, Andrew Gillen of Education Sector, has actually suggested that they might contribute to tuition increases.
How, you ask? All kinds of financial aid, from direct grants to low-income students to tuition tax credits that benefit all students, including high-income students, increase demand for higher education. It is important, however, that while direct grants to low-income students only increase demand for low-income students, who are less likely to go to college than more affluent students in the first place, tuition tax credits increase demand for all students, including those who are already willing and able to spend large sums on higher education. Colleges can respond to increased demand by increasing supply (e.g., admitting more students), by becoming more selective, or by charging higher prices to capture more of the aid. Different colleges will respond to increased demand in different ways. For example, for-profit schools are particularly inclined to increase supply (mo’ students, mo’ money) while non-profit schools that hope to climb the prestige ladder are more likely to at least try to become more selective (let’s goose our U.S. News ranking!). What do you think colleges are likely to do if middle- and upper-middle- and simply upper-income households have large sums sloshing around in their 529 plans? Will they gingerly try to extract as little from these families as possible, knowing that they saved conscientiously over the years to give junior a decent education? Or will they hike tuition to extract as much as they can? And given that withdrawals from 529 plans are only tax-free if they’re used for qualified higher education expenses, guess what: we will see ever more gold-plated dormitories and other luxurious amenities on college campuses to better soak up this money.
Reliable evidence on the efficacy of tuition tax credits is scarce. I’d recommend taking a look at new findings from economists George B. Bulman and Caroline Hoxby. Bulman and Hoxby don’t find compelling evidence for Gillen’s twist on the Bennett Hypothesis, which I describe above. (I still think colleges wind up extracting the money, but I certainly don’t have rock-solid proof.) Yet they conclude that tuition tax credits have negligible effects on college attendance. Nor does it appear that students are “upgrading,” or attending “better” schools than they might have in the absence of the tax credits. So overall, we don’t appear to be getting much bang for the buck. Actually, we don’t appear to be getting any bang for the buck.
By all means, let’s look out for the interests of savers. But let’s not just look out for the interests of savers who fork over their savings to higher education institutions that are quite happy to rob them blind. They key to making higher education better and more accessible is not to help families pay exorbitant tuition — it’s to make the sector more competitive and cost-effective.