Coordinating Financial Aid With Tuition Tax Benefits

President Clinton proposed and the Congress enacted earlier this year the most extensive use ever of the tax code to help families pay for college. Students in the two top income quartiles will be the principal beneficiaries of the new education tax provisions. Low- and moderate-income students—the traditional focus of federal student-aid efforts—will receive little tax relief.

Policymakers must now turn to the scheduled reauthorization of the Higher Education Act, which includes grants, loans, and work-study programs. Enactment of the education tax provisions provides an unusual opportunity to reconfigure federal student-aid programs in ways to mesh them with the new tax provisions and to enhance the historic federal goal of equalizing educational opportunities for the neediest students.


Seeking to make the first two years of post-secondary education universally available and to provide relief to overburdened middle-class parents facing rapidly rising college costs, President Clinton took the unprecedented step of making tuition tax breaks for college students a centerpiece of both his 1996 reelection campaign and his negotiations with Congress over the balanced budget legislation. The President recognized that tax-based policies provide few benefits to the neediest students, so he also proposed a rise of 10 percent to $3,000 in the Pell Grant maximum award. While this larger grant will certainly help low-income students, under the current Pell formula, any increase in the maximum award also expands eligibility to more middle-income students—the principal beneficiaries of the tax credits.

Congress modified the President’s tax plan, but the basic elements survived—the HOPE and Lifetime Learning tax credits for current educational expenses, and tax incentives for savings to help meet future college costs. Congress also reinstated tax deductibility of interest on student loans.

When fully implemented, the new education tax provisions, along with those already on the books, will become an equal partner with the traditional federal student-aid programs—grants, loans, and work-study—in assisting college students and their families. Each will cost between $10 to $15 billion annually, either in lost revenues or direct federal spending.

Now attention must turn to the required reauthorization of the Higher Education Act, which includes most of the federal student aid and support service programs. Historically, this act has sought to enhance the educational and hence the social and economic opportunities of students with the greatest need.

The education tax proposals are in place. Now the challenge is to develop policies that mesh them with the existing federal student-aid programs in ways to maximize the effectiveness of both.

At worst, policymakers will once again tinker with the traditional student-aid programs and make little effort to coordinate them with the new tax provisions. If so, the historic federal emphasis on need-based aid will be diminished if not transformed. Without entitlements of grants to low-income students, we shall have created through the tax code a new set of middle- class entitlements and rewards for those with the ability to save and borrow for college.

At best, Congress should modify federal student-aid programs to assure that they and the new tax benefits are distributed as progressively as possible. Specific steps include refocusing Pell and other federal grants and loan subsidies on those students who benefit the least from the new tax provisions; setting up college accounts at an early age for low- income students whose families do not qualify for the new $500 child tax credit; tying funding of pre-college and in-college support services to the funding of the Pell Grant program; and, possibly, paying institutions for each Pell recipient they graduate. Federal policies should also be modified to incorporate a role for states and institutions in the student-aid equation.

Impact of New Tax Provisions

Of the many new education tax provisions, the Lifetime Learning credit may have the most positive impact on enrollment decisions. It could encourage more individuals throughout their careers to seek training and retraining and also relieve the growing pressure on the student-aid programs to expand eligibility to a broader population of non-traditional and part-time students.

This positive feature, however, will be offset by a lack of progressivity in the distribution of benefits, and by additional administrative complexities for institutions as well as for students and families who will have to opt, in most cases, for just one of the many new tax provisions.

Families with incomes between $40,000 and $80,000 will be the primary beneficiaries of the nonrefundable HOPE and Lifetime Learning tax credits. Students with lower incomes will benefit far less because either they or their families do not pay enough income tax to take advantage of the credits or because, in determining eligibility for the credits, federal and other grant aid will be subtracted from tuition costs.

The education tax package also contains a number of provisions intended to encourage families to save for future college costs, including: permitting penalty-free withdrawals from existing IRAs, establishing new Education IRAs, and expanding existing tax advantages for participants in prepaid tuition plans. Families with incomes as high as $160,000 will be able to take advantage of the new savings provisions. These provisions could prompt an unintended shift of existing assets into designated educational accounts rather than any increase in overall savings. Allowing penalty-free withdrawals from existing IRAs could actually reduce savings and deplete parental assets needed for retirement. And, providing additional tax benefits to participants in state prepaid tuition plans could lead to higher, not lower, tuitions if institutions raise their charges for students whose families did not prepay to make up for the reduced revenues from plan participants.

Finally, families anticipating a tax credit to offset tuition expenses when their children enter college may actually be discouraged from saving when their children are younger. Thus, the two major policy thrusts—tax credits for current educational expenses and incentives to save for future costs—could actually contradict each other.

While reinstatement of the deductibility of interest on student loans may be politically popular, it could lead to even more borrowing, and the benefits will be tilted toward those who are fully capable of meeting the costs of borrowing.

Improving Access and Completion Rates

The new tax provisions were enacted to address middle-class concerns about the rising costs of college. For nearly two decades, tuitions at both private and public institutions have grown at twice the rate of inflation. As a result, more and more Americans now consider college outside their economic reach.

But hardship is relative. In reality, the burden of rising college costs has fallen disproportionately on students from families in the bottom income quartile. As Figure 1 indicates, average costs of attendance in both the public and private sectors have stayed fairly constant as a percentage of income for all families, except those in the lowest income groups, and these are the families who will benefit little from the new tax provisions because they do not pay income taxes.

The growth in college costs relative to family income is reflected in the patterns of college participation. Access to college is still uneven (Figure 2). Students from the bottom income group are still only two-thirds as likely to go to college as those from the top income group. And minority students are still only three-quarters as likely to enter college as majority students. In addition, low- and moderate-income students and those from ethnic/racial minorities continue to be disproportionately concentrated in public two-year institutions.

Falling retention and graduation rates are other vexing problems in much of American higher education. More than half of all entering students do not complete their degrees within a reasonable period of time. Graduation rates improved dramatically between 1950 and 1975—nearly a threefold increase for all students—but since then there has been little progress. As with access, there are great disparities in retention and completion rates. Low-income and minority students remain far less likely to complete their degrees.

Achieving Greater Policy Coherence

When the Higher Education Act was enacted in 1965 and the Pell Grant program established in 1972, the federal role and goals of the various programs were to equalize educational opportunities. But over time, this philosophy of aid which once guided the programs and their interrelationship has eroded. This has occurred, in part, because there is now little deliberate policy relationship among the various aid programs. What students receive in one federal program typically does not affect the amount they receive in others.

Pell Grants have not become, as originally intended, the foundation for all other student-aid programs. Instead, loans once intended to supplement Pell and other federal grants are the dominant form of aid, as they constitute two-thirds of all aid and pay for one-third of all college costs. Students borrow in multiple loan programs with no overall debt limits, helping to explain the imbalance between loans and grants.

Moreover, what students receive from the federal government is unrelated typically to the growing amount of aid they may receive from states and institutions. In the last decade, the amount of state grants to students has increased by 50 percent in constant dollars. The amount of aid that institutions provide in the form of discounts from the sticker price has doubled in real terms and now exceeds the total amount of federal grant aid. To the extent that state and institutional aid is now spread more broadly up the income scale than federal grant aid, the lack of coordination among federal, state, and institutional aid practices contributes to a lessening focus on the neediest students.

Layering a new set of tax-based provisions on top of the current array of student-aid programs will only worsen the existing lack of coherence. An important objective, therefore, in the ongoing debate over the student-aid and related programs should be to rationalize the span of federal efforts which help students and families pay for college.

Achieving a More Progressive Distribution of Benefits

One way to achieve greater coherence in federal policies is to distribute the combination of student aid and tax provisions as progressively as possible. Consider the distribution of Pell Grants, loan subsidies, and the new HOPE tax credit. More than two-thirds of all Pell Grant dollars go to students from families with incomes below $20,000, and the Pell award is far larger than what lower and moderate income students receive in loan subsidies or from the HOPE tax credit.

Contrast this with intercommt subsidies in the federal loan programs where only one-third of the benefits go to low-income students. As Figure 3 shows, loan subsidies rather than Pell Grants are far more valuable to middle-income students. Moreover, since costs of attendance are a factor in determining eligibility for subsidized loans, students with family incomes of $100,000 or more can receive interest subsidies if they attend high-priced institutions. As Figure 3 shows, for students with family incomes above $40,000, the new tax credits provide more benefits than either Pell Grants or loan subsidies. The net result of the new tax provisions is that they will flatten the cumulative distribution of federal aid and tax benefits.

Directing Pell Grants toward students with family incomes below the median would improve the progressivity of the overall federal aid structure. This approach would recognize that the new tax provisions mostly benefit students who are not eligible for Pell Grants—those above median income, graduate and professional school students, and part-time lifelong learners.

Federal policies should also aim to reach the initial goals of Pell Grants—to raise the aspirations of low- and moderate-income students by providing them with early and certain knowledge that they can afford college. Pell Grants have not achieved this purpose, in part because under current program rules, students still have to apply in the 12th grade based on their family’s circumstances. Making Pell Grants an entitlement would not solve this timing problem.

New approaches are necessary to provide the early assurance of aid contemplated in the original Pell Grant legislation. For example, for low-income students whose families do not pay enough federal income taxes to qualify for the new $500 child and education tax credits, the federal government could deposit funds into interest-bearing accounts in a student’s name as early as the sixth grade, to be used only if the student enters college. These accounts could be supplemented through other contributions from government and philanthropy. The funds reserved should not detract from a student’s eligibility for Pell Grants.

Putting more dollars into the hands of students, however, is not the answer to improving access, retention, and degree completion. A growing number of college students arrive without adequate preparation and require remediation. Federal student-aid programs may also be contributing to poor retention rates in that they are not performance-based. Students must merely maintain the amorphous standard of satisfactory academic progress. Nor are any of the new tuition tax breaks likely to have much of a positive impact on completion rates.

Greater emphasis on support services may be more effective in promoting greater retention and completion than increased funding of the student-aid programs. The TRIO programs, often overlooked in the student-aid debates, provide a range of pre-college and in-college support services. But federal funding for TRIO is now less than 5 percent of what is spent on federal aid and serves only 10 percent or less of the eligible population.

To enhance support service efforts, a portion of Pell Grant funds could be set aside and distributed to institutions on the basis of the number of Pell Grant recipients they enroll and graduate, thereby providing an incentive for institutions to address falling completion rates among disadvantaged students.

Recognizing Only a Portion of Attendance Costs

Another way to achieve greater policy coherence and better target federal subsidies is for federal policies to recognize only a portion of a student’s total costs of attendance in calculating eligibility for subsidized loans. Since 1992, the Pell Grant formula has used a standard amount for living expenses and the two new education tax credits recognize only a portion of tuition, so there is indeed precedent for such an approach. Since 1981, the federal loan programs have used total costs of attendance in calculating eligibility for interest subsidies. As such, the existing federal-aid formulas fail to take into account the growing amount of aid which students now receive from states and institutions.

Using only a portion of the costs of attendance in determining eligibility for subsidized loans would also help to address continuing concerns that federal aid contributes to tuition inflation. Burgeoning loan availability has no doubt facilitated the ability of both public and private institutions to charge higher tuitions and also played an important role in allowing private colleges to stabilize their share of total enrollments.


To achieve greater policy coherence in federal efforts to aid post-secondary students, there should be a philosophy that: 1) seeks a progressive distribution of aid and tax benefits, and 2) recognizes the growing role of institutions and states in the aid equation by using only a portion of the total costs of attendance in the calculation of eligibility for subsidized loans.

This new philosophy could then serve as a framework for achieving the broad historic goals of federal policy: to equalize educational opportunities for low- and moderate-income students; to provide all students with a choice of a broad range of institutions; and to enable individuals throughout their lifetimes to receive both training and retraining. Realizing these goals is critical if the American work force is to remain competitive in the global marketplace.