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Learn While You Earn

Friday, May 1, 1998

Q: What conservative idea advances tax reform,
helps families, and counters Clintonian politics?
A: Education Savings Accounts

Just when conservatives started to believe that serious tax reform was gaining momentum, along came the 1997 budget deal between President Clinton and the Republican Congress. The deal not only overlooked the whole debate over reshaping our complicat-ed and inefficient tax code, but it also created a bewildering array of new tax provisions. Worst of all, Clinton managed to enact his flawed pet proposals for education tax breaks. By effectively marrying tax relief to the issue of education, Clinton advanced a traditionally Democratic issue while making inroads into a core Republican cause.

But this need not be the political masterstroke it appears. In fact, the president’s tactics have left him open to a counterproposal that benefits education far more while advancing legitimate tax reform. Clinton has essentially endorsed tax deductions or credits to defray expenses for both preschool and higher education. He now has no principled objection to giving similar tax treatment to a family’s investment in elementary and secondary education.

Conservatives should propose tax deductibility for educational expenses and savings across the board, in the form of an expanded, tax-free educational savings account. This will cut taxes on families with children (a key voting constituency), promote parental choice and competition (a key conservative policy goal), and advance fundamental tax reform by treating education as an investment in human capital. More so than other ideas currently on the table—like eliminating the marriage penalty or expanding capital gains relief—tax-deductible ESAs combine free-market principles with political appeal. Those who seek both to reduce taxation and introduce market competition into education—policies of real value to American families—should seize this opportunity to fight for educational tax relief of their own.

Seizing an Opportunity

The various educational tax cuts in the 1997 deal are projected to yield nearly $40 billion over five years by 2002. The best known is probably Clinton’s proposal to create $1,500 educational tax credits, called "HOPE Scholarships." This program was roundly and rightly condemned as poorly drafted and targeted. For one thing, the $1,500 tax credits, available only for college, are likely to fuel tuition inflation. If past experience with tax breaks and federal student loans is any guide, colleges will soon raise tuition fees to capture at least some of the increased buying power of parents.

Other aspects of the tax package drew less attention. These included new rules allowing withdrawals from individual retirement accounts (IRAs) for education, medical care, and homebuying, and the creation of educational savings accounts (ESAs), into which parents can deposit up to $500 a year and see earnings compound tax-free until the money is withdrawn for college expenses. None of these proposals saves families much money, and, in the case of IRAs, penalty-free withdrawals for college expenses come at the expense of retirement savings.

Recognizing a good opportunity, U.S. Senator Paul Coverdell last summer proposed an amendment to the budget deal that would have allowed withdrawals from these ESAs for K-12 educational expenses as well as for higher education. In June 1997, the Senate approved Coverdell’s amendment, but Clinton squelched it by threatening to veto the entire deal.

The new "A+ Accounts," as these ESAs for K-12 education are called, would have allowed annual deposits of up to $500 per child and exempted earnings from taxes, just like ESAs for college. In October, Representative Bill Archer, the chairman of the House Ways and Means Committee, introduced a similar bill with an annual deposit cap of $2,500. It passed the House but died in the Senate in late 1997.

Coverdell has re-introduced the expanded ESA this year, with an annual cap of $2,000 per child. It’s a great first step. But it doesn’t go nearly far enough. The deposits themselves, not just the earnings on them, should be tax-deductible. This would not only make ESAs far more valuable to parents, but would simultaneously promote parental choice in education to a large degree as well as advance the cause of principled tax reform. Here’s why.

Taxes and Parental Choice

A growing chorus of Americans believe that choice and competition improve the quality of education available to their children. To agree on the goal, however, is not necessarily to agree on means. For example, while conservatives have long favored vouchers for promoting parental choice, the real action at the state level in recent years has been charter schools—independent public schools open to all families that want to apply.

The tax-free educational savings accounts is another useful tool for promoting choice. Unlike vouchers, deductible ESAs do not constitute a taxpayer subsidy for private education, yet the potential for tax savings is significant. Consider a middle-income family paying a marginal federal tax rate of 28 percent and a state income tax rate of 7 percent. An ESA allowing tax-deductible deposits of up to $2,500 a year would yield a tax savings of $875—not counting any tax-free earnings on unspent funds. According to the U.S. Department of Education, the average U.S. private elementary school costs a little more than $2,000 a year, and the average private secondary school costs about $4,500. So the annual tax savings per child amounts to between 20 percent and 44 percent of average private-school tuition, depending on the grade.

If families start saving early, the nest egg relative to expenses grows even greater. Parents making annual deposits from the birth of their child would reap tax savings, including the windfall from tax-free earnings on principal, during the child’s first 18 years equal to more than half the cost of the average private K-12 education. The A+ Account, by contrast, would yield tax savings only on accrued earnings in the ESA, a mere fraction of the benefit.

ESAs are also a much easier sell politically than vouchers or tuition tax credits. In a poll of 500 North Carolina voters commissioned by the John Locke Foundation last year, 77 percent supported tax deductions versus 56 percent supporting school vouchers. In a separate survey of school board members across the state, we found that 63 percent opposed vouchers or tuition tax credits but 59 percent supported tax deductions for educational savings and expenditures.

Taxes and Educational Investment

Tax-free ESAs are also consistent with sound tax policy. A core principle of sound policy is that all income should be taxed only once. Taxes on investments violate this principle. When individuals or firms are forced to pay income taxes on money that is invested in, say, a new computer or a new factory, and then taxed on the increased earnings that the investment generates, that constitutes double taxation. Income earned in the future, through investment in some form of income-enhancing capital, will face a higher real tax rate than income earned and consumed today.

The tax code already combats double taxation when it comes to investments in physical capital. A business can write off the purchase of computers or factories. A self-employed person can write off the expenses of a home office. Workers can write off the cost of any uniforms that they must purchase for work. These are examples of tax neutrality in action. Similarly, some business investments in human capital—in employee training, for example, or employer-paid tuition—are partially or fully tax-deductible. They increase the earnings potential of the firm or worker, and thus will be taxed as income in subsequent years as the firm or workers brings in more revenue.

Furthermore, even some private investments in human capital receive neutral tax treatment. Many families are eligible for federal and state tax deductions for preschool expenses. And now, under the 1997 budget deal, private investments in higher education will receive favorable tax treatment through HOPE Scholarships and ESAs, though not in an ideal way.

The glaring exception is family spending on elementary and secondary education. Despite the recent Clinton proposals, this form of human capital investment alone will continue to be taxed multiple times by states and the federal government. This is indefensible tax policy. By one estimate, those who graduate from high school earn at least 25 percent more, on average, than those who do not, suggesting that high school, at least, is an income-enhancing investment. Many parents pay out of pocket to increase the value of their children’s education, through private-school tuition, home-schooling, extra tutoring, and even through voluntary contributions to public school programs.

ESAs and Education Reform

If Congress were to create tax-deductible ESAs for all levels of education, it might inspire states to move forward with broader, yet compatible, reforms. Take tax relief. Minnesota and Iowa already have limited tax deductions for private school expenses. Last year, Minnesota governor Arne Carlson expanded the deduction and added a refundable tax credit of up to $1,000 to promote parental choice among families with under $33,000 a year in income. With tax-deductible ESAs, other states could easily follow Minnesota’s lead by adding refundable tax credits to the existing tax deduction, and justify them either on general school choice grounds or as tax policy.

Other states could go the route of Wisconsin and Ohio by creating targeted scholarship programs for students trapped in failing public schools. In both states, state lawmakers chose to create scholarship programs for low-income students in a single urban district (Milwaukee and Cleveland, respectively). These programs have already had much initial success, with test scores for scholarship recipients far exceeding those of similar public school students in some subjects.

For either state scholarships or state tax credits, ESAs would become a handy vehicle for administering funds. Parents could deposit vouchers or tax refunds in their ESA and earn tax-free interest until it is paid to schools. This might, by the way, also make the legal defense of vouchers easier by routing taxpayer money directly to student accounts rather than to schools.

ESAs will be of special interest to homeschoolers who fear participation in charter school or voucher systems. They want their independence, but they are also entitled to fair tax treatment of their own expenses for their children’s education.

ESAs also offer the prospect of avoiding the tuition spiral that tax credits or scholarships can fuel. By allowing families to save money in ESAs indefinitely, even to use the money for a grandchild’s education or for retirement, policymakers avoid the "use it or lose it" provision of policies like HOPE scholarships that serve to inflate the cost of tuition.

ESAs would not undermine public education. If meaningful ESAs induce even a modest number of public school students to transfer to private schools, state and local governments may even save tax dollars and increase per-pupil spending in public schools. Here’s why: Every transferring student will cost the federal treasury some money in the short run—$875 a year in lost tax revenue, in the example above—but save thousands of dollars, on average, in reduced need for public-school classrooms, teachers, and support services.

In my own state of North Carolina, I computed how many students would have to transfer out of the public schools to offset completely the revenue loss of a $2,500 federal and state tax deduction. It came to 25,000 students over five years—or an average annual increase in private-school enrollment of about 5 percent. A shift of that magnitude nationwide is not unreasonable to expect from a reform that may halve the cost to parents of a private education. Even after accounting for the revenue loss on existing private school students, it is likely that federal ESA legislation, by encouraging competition and reducing the consumption of public schooling, would save states and local school systems hundreds of millions of dollars a year.

ESAs and Tax Reform

Besides cutting taxes on families and promoting parental choice, deductible ESAs advance the cause of tax reform. Conservative tax reformers should acknowledge the high political hurdles that the flat tax and the national sales tax both face in the short term. Tax reformers need to push individual pieces of tax relief that are valuable in their own right and that advance long-term goals such as neutrality and simplicity. A prime example of this approach is a tax-deductible ESA, particularly one that starts with a small, relatively affordable deduction (say, $1,000 per child) and then gradually moves up to $2,500 per child or more. (Unlimited deductibility is unwise and unnecessary, since some education expenditures are less investments than consumption, such as certain extracurricular activities.)

The tax-deductible ESA is simultaneously tax relief and education reform, but it also establishes an important precedent, as did previous expansions of IRAs and the creation of limited medical savings accounts (MSAs) for small firms and the self-employed in 1996 and for Medicare recipients in 1997. The precedent is that the tax code should treat investment fairly. Individuals should get the same tax treatment as firms. And the tax code should remain neutral as to when taxpayers choose to consume their income.

Unlike conservatives, Clinton has no overarching goal for tax reform. But his strategy of proposing tax relief in small pieces is probably more effective than conservatives’ vague promise of something big, some time later on. Rather than trying to swallow fundamental tax reform in one gulp, it’s time to emulate Clinton’s strategy of taking periodic nibbles. With federal revenues surging and conservatives looking for tax-cut ideas in 1998, tax-deductible ESAs sure look tasty to me.

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