Making Sense of the Uproar Over Obama’s 529 Proposal

President Barack Obama’s proposal to scale back tax breaks for college-savings accounts, the 529 plans, provoked an immediate uproar. There’s no doubt the proposal would make future contributions to  529s much less attractive. (It doesn’t affect money already in 529s.) But the loud opposition misses the rationale for changing the way the government encourages saving for college and underscores the reasons tax reform is so hard.

Who benefits from the 529 tax break?

The White House says about 70% of the benefits of 529 plans go to households with incomes above $200,000. That’s fewer than 4% of all tax returns, according to the latest IRS data. There are no income limits on 529 plans; anyone can use them, no matter how affluent.

In general, tax breaks that involve deductions (mortgage interest) or excluding income from taxes (401k retirement accounts) benefit upper-income taxpayers more than others because they are in the highest tax brackets. (A $1,000 deduction reduces the tax bill by $250 for a family in the 25% bracket and $396 for a family in the 39.6% bracket.) Replacing tax deductions with tax credits can give everyone the same dollar amount, regardless of tax bracket.

If we’re uneasy about widening income inequality and want to use the tax code to lean against that (which not everyone does), then swapping deductions for credits makes sense. That is the essence of the president’s proposal.  He’d curb the use of 529s, which disproportionately benefit upper-income families, to finance expansion of the American Opportunity Tax Credit, which is available only to families with pretax incomes up to $180,000.  Families that don’t make enough money to owe income taxes can get up to $1,000 in cash from the AOTC today; the president would increase that to $1,500, an obvious winner for lower-income families.  He’d also extend the benefit to part-time students and allow students to take it for up to five years (instead of the current four).

Now the tax credit isn’t a perfect substitute for the 529 tax break, but the president’s plan for 529s piece can’t be viewed in isolation. He means to move tax subsidies for college savings down the income ladder. “The plan overall would do MORE to help both middle-class and lower-income families afford college,” Bob Greenstein of the Center on Budget and Policy Priorities says in a recent defense of the president’s proposals.

If we’re going to use the tax code to encourage saving for college, then there’s a good case for targeting tax breaks at lower- and (truly) middle-class families. Government help will make more of difference for them – and certainly will reduce the amount of debt they take to go to college — instead of helping affluent families who are going to send their kids to college no matter what the government does.

Do we really prize simplicity in the tax code?

Everyone wants a simpler tax code. Almost everyone says there are too many deductions, credits, exemptions and loopholes. (What’s the difference between a deduction or credit and a loophole? If you get the benefit, it’s a deduction or credit. If someone else gets it, it’s a loophole. )

The president’s proposal is a small step towards simplicity. It would, the White House says, “consolidate education incentives into one vehicle.”  That means doing away with some tax breaks – the Coverdell college-savings accounts, the little-used deduction for interest on new student loans, the Lifetime Learning Credit – and sweetening others.  It turns out that a lot of people prefer complexity to simplicity if simplicity means doing away with a tax break they get.

Do tax breaks really encourage savings?

Much of the U.S. tax code is based on the logical economic argument that tax breaks get Americans to save. The argument: If you increase the after-tax return on savings (by giving people a tax break for putting some of their wages into a 401k or by making the capital gains, interest and dividends on a 529 tax free), people will save more than they otherwise would.

But do they? That’s long been debated by economists. Recent research from Harvard’s Raj Chetty and colleagues suggests tax breaks for retirement savings  reward people who would have saved the money anyhow and don’t increase the total amount of saving.

Better to skip the tax breaks, they say, and rely on “nudges,” such as automatically enrolling workers in retirement-savings programs. Most people are what the researchers call “passive savers.” They don’t respond much to tax incentives. Of course, that’s one risk the president is running here. One advantage of 529 plans is that they are widely marketed by states and mutual funds and that may help nudge people to save for college. Curtail the benefit and there’ll be less of that marketing.