There’s been discussion in Congress recently about how the tax code can be better used to encourage college attendance among low-income students. One proposal being considered by the Senate Finance Committee is to make higher education tax credits refundable — and thus available to people who now do not benefit from them because they don’t make enough money to pay any federal income taxes.

In theory, this proposal could be a huge boon for the neediest students, providing them with as much as $2,000 to help offset tuition costs. But there’s a catch: until Congress better coordinates tuition tax credits, Pell Grants, and institutional financial aid, gains in one source of college assistance will heighten, and in some cases assure, losses in another.

How Tuition Tax Credits Work

First, a quick review of the higher education tax credits. There are twelve (do we really need that many?) but we’ll focus on the two under consideration by the Senate Finance Committee: the Hope Tax Credit and Lifetime Learning Tax Credit. A cursory glance at the way they’re calculated indicates that making them refundable should benefit low-income students.

The size of an individual's Hope or Lifetime Learning credit is calculated as a percentage of "qualified expenses" (that is tuition and fees, but not room and board or other expenses). The credits are only available to students below a certain income ceiling ($55,000, or $110,000 for joint filers).

The maximum Hope tax credit is $1,650. It’s an amount equal to 100 percent of the first $1,100 spent on qualified expenses and 50 percent of the next $1,100. The maximum Lifetime Learning credit is $2,000. It’s an amount equal to 20 percent of the first $10,000 spent on qualified expenses. For an individual student, you can only claim one of the two credits at a time.

Still sounds like a great deal for low-income students, right? Not really, because very few low-income students and families pay federal income taxes, and therefore have no tax bill to credit. According to the Congressional Budget Office (Table 2C), the two lowest income quintiles and part of the middle quintile (average income $71,200) paid no federal income tax in 2004. This includes almost half of families with children, according to the Brookings Institution.

If the tax credits were refundable irrespective of tax liability, in theory they would provide a significant financial benefit to low-income families. And because low-income students are the most sensitive to changes in the cost of higher education, the extra aid could be enough to keep many students from dropping out. The Center on Budget and Policy Priorities has estimated that even a $1,000 reduction in the cost of college (an amount less than the maximum Hope credit and half of the maximum Lifetime Learning credit) could boost enrollment by 3 to 4 percentage points. Harvard economist Tom Kane put the figure at 5 percentage points several years ago.

The Problem With Refundability

It may sound like making tax credits refundable could be a magic bullet for increasing low-income student aid, college access, affordability, and retention. But there’s a problem: other forms of federal and institutional financial aid interact negatively with tax credits, and diminish their effectiveness, and thus, efficiency.

Every dollar received in the form of a Pell Grant or institutional grant aid leads to a decrease in the maximum possible tax credit a student can claim. Why?  Because the Internal Revenue Service deducts Pell Grants and "any tax-free educational assistance," such as institutional aid, from its assessment of "qualified expenses" for college when determining the size of an individual's tax credit. 

In other words, a low-income student with $10,000 in tuition expenses would normally be eligible for a $2,000 Lifetime Learning credit. But if that same student receives a $4,050 Pell Grant, he or she would only have $5,950 in "qualified expenses." For that not untypical low-income student, the maximum Lifetime Learning credit he or she could claim would be $1,190 — a loss of $810 in benefits. And that’s assuming he or she isn’t receiving institutional aid as well, which is pretty unlikely and thus means an even lower tax credit.

Every $5 increase in Pell Grant aid leads to a $1 decrease in the maximum Lifetime Learning credit. Every $1 increase in the maximum Pell Grant leads to between a $1 and 50 cents decrease in the Hope credit, if post-Pell college costs are less than $2,200.

If the tax credits are made refundable (and they should be) absent additional changes in student aid, increases in Pell Grant and institutional financial aid will directly lead to decreases in the size of needy student tax benefits.

Lots of Left Feet

The "dollar for dollar" interplay between higher education tax credits and grant and institutional aid is but one of a series of cases in which tax benefits, traditional student aid, and institutional aid evidence poor coordination, inefficiency, and ultimately loss to needy students. Overall, we have a three-legged system that is so uncoordinated it’s rivaled only by ESPN commentator Kenny Mayne’s dancing skills on Dancing with the Stars.

We at Higher Ed Watch think it’s admirable that Congress is considering refundability, because in theory it could provide a much needed financial aid boost to low-income students. But because of the way relevant tax credits are currently structured, making them refundable alone won't provide the desired benefits to the students who need the help the most. The Congressional tax committees and education committees need a group dance lesson.

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