Wednesday, June 18, 2008

Obama's Tuition Tax Credit

A reader wrote in to ask:

Obama's comments about a tuition tax credit yesterday have me confused. Don't we already have that already, more or less? Is this an additional credit? Is it refundable so starving students can use it? Won't universities just at least eat up part of it with increased tuition above what they would do already?
From the Obama website:
Obama will make college affordable for all Americans by creating a new American Opportunity Tax Credit. This universal and fully refundable credit will ensure that the first $4,000 of a college education is completely free for most Americans, and will cover two-thirds the cost of tuition at the average public college or university and make community college tuition completely free for most students. Obama will also ensure that the tax credit is available to families at the time of enrollment by using prior year's tax data to deliver the credit when tuition is due.
How about existing tuition tax credits? According to this site from the National Association of Student Financial Aid Administrators, the existing Hope Scholarship Tax Credit paid a maximum of $1650 in 2007. Unlike Obama's proposed new credit, the existing Hope credit is not refundable. The existing credit also phases out at higher incomes. It's not clear if Obama's new credit would be additional to the Hope credit.

As for the last question--will the new credit cause tuition to increase, partially eating up the value of the credit?--I'm glad you asked! This is a question to which we can bring to bear the mighty power of Econ 1 reasoning. The extent to which tuition increases depends on the supply and demand elasticies for education, i.e. how steep the curves are. A good guess is that the demand for higher education is downward sloping while the supply curve is pretty flat. In the short-term, schools can always squeeze in a few extra students, while in the longer term there's plenty of scope to hire new teachers and establish new schools. (Note that his analysis applies to higher education in general, not to very specific goods, e.g. a law school education at Harvard, for which the supply is highly inelastic.)

Below I've drawn the supply and demand curves for the case of a totally flat (perfectly elastic) supply curve. In this case, the credit shifts up the demand curve vertically by the amount of the credit, there is no change in the price of tuition, and enrollment expands. If the supply curve is not quite entirely flat, the subsidy would increase tuition a bit, and enrollment would increase not quite as much. I think it's a good bet, however, that the supply curve is flat enough that the effect of the credit on tuition would be small.

For more details on Obama's higher education proposals, see this document.

Update: See a more recent post on this issue here.


MattYoung said...

The general argument for Obama is that the educational sector will see a higher gain in efficiency because of the lowering cost of information technology. That is the general bet in this deal.

Economists might define endogenous gain due to technology change. The test is whether the educational sector can deliver a greater variety of goods after the transition.

Anonymous said...

I think I may disagree with you on supply curves for a lot of schools. Any school without open enrollment will probably be imperfectively competitive at best. As I remember such firms do not have supply curves.

The amount you mention for the Hope credit is an annual amount and in addition the lifetime learning credit is available, but as I understand the $4000 is not an annual amount. I will get more than $4000 with the current credits for 4 years if my tax bite can support the credit. I think you need to worry about integrating this plan with the current plan before you push it too hard.

As a final matter, isn't this a subsidy to future middle and upper income earners and does not do much for the lower earners?

BigR said...

If the supply curve is not quite entirely flat, the subsidy would increase tuition a bit, and enrollment would increase not quite as much. I think it's a good bet, however, that the supply curve is flat enough that the effect of the credit on tuition would be small.

While I understand that this is a partisan site, but this post comes across as very patronizing, given that it merely repeats campaign talking points, without any real analysis. It would have been nice if you would actually cite some actual examples to prove your point, rather than make a "guess" and a "bet" on whether or not the credit would be absorbed by the schools.

Several years ago, South Carolina decided to create a LIFE scholarship that was funded by revenues from the state lottery.
As you pointed out, the supply is fairly inelastic in the short run. Of course, the problem is the long run. Faced with increased demand, the universities had two choices: maintain current supply or increase capacity. Most schools favored the latter, especially those colleges that are not constrained by physical space. So, the last several years, the LIFE Scholarship has totally been absorbed by the increased expansion costs.

If you look at the rate of growth by sectors, you will see that education and health care are head and shoulders above all others. The common ingredient? You have a government backstop that will absorb all increases in costs. The question that really needs to be addressed is college is so expensive? It is asinine to thing that the Top tier private school runs 50K/year to attend.

donpedro said...

Thanks for the comments.

I think you're confusing the supply curve for an individual school with the supply curve for the market as a whole. It's the supply curve for the market as a whole that's important.

Maybe you're right that the $4000 is a total amount, not an annual amount. I read the "first $4000 of a college education" in the Obama statement as referring to the first $4000 each year, but I could be wrong. The current credit is only available for the first two years, so even if it's in total, it will still represent a modest expansion on the current program.

Yes, this is a subsidy for middle income earners. Whether it reaches upper income households depends on how it is structured. Most likely it would include "phase outs" at higher income like the current credit. It actually does much more for lower income households than the current credit, because it is refundable, meaning that it will be paid even to household that owe little or no income tax.

I take umbrage at the suggestion that my analysis is somehow dishonest. We're not a propaganda site for the Obama campaign, and if you read past posts, you'll see plenty of occasions when we've been critical of his positions. I'm not sure what you mean by saying that I'm repeating "campaign talking points." I'd be surprised if Obama's talking points were that the supply curve for education is flat.

I used the terms "guess" and "bet" to be modest about the predictive power of basic economic models, but these are useful to provide a basic understanding of what the reaction of the market will be. I justified my assumption about the short-term supply curve: it's flat (that's elastic, not inelastic) because its always possible to squeeze additional students into existing schols. The long term supply curve for any good in a competitive market will be flat, unless there is a binding resource constraint. There are no such constraints for education: there are plenty of potential teachers and classrooms out there.

It is true that much higher education is already subsidized through direct public funding by states. Consequently a flat long-run supply curve would only hold if states governments are willing to pay these subsidies for the additional students who show up as a consequence of the new credit. I'm not sure if they will be--my guess is that this varies by state.

I would note, however, that state universities can cap enrollment at state schools, channeling the additional students to community colleges, were per student costs are low. The marginal student who attends school because of the credit is probably likely to be a community college student anyway. All that says to me that while political economy of funding does matter for the supply curve, it is still likely to be flat in the LR.

I don't think the South Carolina case demonstrates what you think it does. The article you cite says "State-assisted colleges that have seen the percentage of their revenue from the General Assembly shrink used the first few years of the lottery-funded scholarships as political cover to dramatically jack up their tuition." This does not say that the scholarships CAUSED the increase in tuition. It says that the colleges were already seeing their funding decline and were looking for an opportunity to increase tuition. Presumably, even if the scholarships had not been enacted, the colleges would have increased their tuition some other way.

Steven said...

I see reason to disagree with this conclusion as well. First, lets talk about private colleges and universities: these schools are often almost perfect price discriminators. They get pretty complete income and asset information from the FAFSA and then make financial aid offers that are appropriate. In this framework, government aid will be almost entirely swallowed up by lower financial aid offers from these schools.

Now public schools and community colleges: tuition and financial aid is primarily a state-level political matter at these places. If the federal government is paying for 2/3 of the cost of education, this will ease much of the pressure on legislators to keep tuition bills down. With that pressure released, most schools will increase their tuition steadily to offset tight budgets, which are a constant problem.

I don't see any reason for an elastic supply curve. My guess is that in the longer term it stays pretty inelastic. I suspect that someone has done research on this with previous aid programs. It would be worth exploring.

Anonymous said...

The 1st degree price discrimination argument is a good one. At my private college, the average % of tuition paid by the student is only about 2/3 of the full amount, and even tho it is 2nd-3rd tier, applications far exceed acceptances. For schools like this it seems highly likely that the Obama credit would replace other funding by the school. And for community colleges, local & state govs would leap at the opportunity to reduce their support.
The credit might however significantly increase the demand by low-income students who perceive school as having become more affordable.

donpedro said...

I agree with the general point that it is the political economy of higher education funding that matters for public education supply, and I don't have a clear model in mind for how this works.

More, importantly, however, for the schools that most students attend, $4000 in tuition is a huge amount of money. Forty-seven percent of students in higher education are in 2-year colleges, where tuition is low. According to the GAO, "Nearly half of all students in 2006-2007 attended institutions
where the average annual in-state tuition and fees was less
than $2,550." Even if states jack up tuition at public institutions by, say, 30% in response to the introduction of the credit, the price of education would still drop substantially for these students.

donpedro said...

Here's that GAO study:

Long Memory said...

"Steven" may remember when the Hope Scholarship tax credit was implemented a decade ago. So many private and public colleges began to reduce their institutional grant aid that the Secretary of Education wrote a letter to all college presidents asking them not to do so. How much effect the letter had is unknown, because the law itself was silent. If Obama is serious about this tax credit, he should include in his proposal safeguards against the practice. In fact, it would be a good idea to institute such safeguards in all federal student aid programs.

Nicholas said...

Mind explaining how supply here is perfectly elastic in both the long- and short-runs? That's a major assumption you've made. (Indeed, if it isn't valid, then tuition does increase.) True, many schools probably could add a few students in a given year, but many schools provide guaranteed, limited housing for freshman; have charters expressly capping total enrollment or yearly increases; and have admissions departments with ambitions of lower admissions rates and narrow matriculation targets. I fail to see why you think it's a good bet that suppliers of education fall contrary to general principles of at least relatively inelastic supply in the short run? And while you're at it, why is supply perfectly elastic in the long-run, too?

Anonymous said...

Obama stated one of the requirements to this tax credit would be a hundred hours of community service. How long will students have to complete the hours and what will happen if they do not fulfill this requirement?

Anonymous said...

In Obama's 30 minute infomercial, he stated that anybody who served in the military would get a college tuition credit, but doesn't that already exist as the GI Bill?

The Thinking Man's Man said...

Under Obama's plan, if every student received the tax credit, demand would increase about 10% for the highest-price schools, 67% for the average public school, and 100% for community colleges. That would mean, according to your graph, that Harvard would increase its enrollment by about 600 kids, UCLA would increase its enrollment by 17,000 students, and community colleges would double their enrollment.

There's a big difference between that and "squeezing in a few extra" students.