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The combination of ongoing weak GDP growth and a steep rise in corporate inversions designed to reduce US corporate tax liabilities has again brought the perennial idea of tax reform to the fore. Done right tax reform is a winner. By closing loopholes and lowering marginal rates the economy can better perform and GDP growth can be raised. That said, despite the positive rhetoric coming out of Capitol Hill, don’t count on it soon. Moreover, the sharp, and short-lived seven day brawl about scaling back tax breaks for 529 college savings plans is painfully instructive and illustrative as to why.
In his State of the Union address, President Obama proposed doing away with the tax-free treatment of capital gains in 529 college savings plans. Instead, he proposed increasing the size of the American Opportunity Tax Credit, available only to families with pretax incomes of less than $180,000, from $1,000/year to $1,500/year and to allow it to be used for five years, up from four.
Looked at in isolation, the economics behind this particular policy is pretty solid. First, there is limited evidence that tax breaks designed to increase savings actually do so. Rather, the evidence generally finds that tax breaks reward individuals who would have saved anyways. Worse, the tax incentives don’t seem to increase the total amount of savings either!
Second, most of the tax shelter goes to higher income households. According to the White House, 70% of the benefits from 529 plans go to households with incomes greater than $200,000, while a GAO study from 2010 found that 47% of families with a 529 plan had incomes above $150,000. A recent College Savings Foundation study found that not quite 10% of 529 account holders have household income below $50,000. In short, these plans give tax breaks to wealthier households who already send their kids to college and would have saved as much with or without the plan. By contrast, giving all households with incomes below $180,000 slightly more money for college might raise the percentage of kids from middle- and lower-class households that attend college.
More concerning is that be it via 529 plans, the American Opportunity Tax Credit, guaranteed student loans and now increasing student loan forgiveness, government, through the tax code and elsewhere, heavily subsidizes college costs, and in the process dramatically inflates the cost of college tuition. Real tax reform would scrap these inflationary subsidies and implement a more coherent and more focused approach.
But here is the rub, taking away the advantageous tax status of 529 plans created an instant coalition of three powerful groups that rolled the administration. The groups included parents with kids bound for college fearful they were about to lose a valuable tax break that they “deserved,” higher education that was concerned it was losing a subsidy and the financial industry which feared losing the billions in fees associated with administering a huge $250 billion program.
While everyone claims that they want a simpler tax code with lower rates and bereft of deductions, loopholes and credits, taking any of these away creates winners and losers. And while the winners may be numerous, what they stand to gain is nebulous and distant. By contrast, losers quickly organize themselves and make themselves heard. If doing away with something as small as this was impossible, good luck with larger tax issues that touch deeper pockets.