Last week, President Obama gave American politicians of both parties exactly what they say they want: a tax reform proposal that would lower taxes overall, shift tax breaks from the rich to the middle class, simplify the tax code, and increase money for education. This week, in response to a storm of protest from politicians of both parties, the White House withdrew the proposal.
It turns out that, when push comes to shove, what politicians care about most is defending tax breaks for the rich. All it takes is a few crumbs for the “middle class” to provide symbolic cover for policies that largely benefit the wealthy. This is one reason why real tax reform is almost impossible today.
Obama’s idea was to change the way that the tax code subsidizes higher education. Today, there are at least six different tax provisions that benefit college students. His plan was to cut that number down to two but to expand the American Opportunity Tax Credit, for a net tax reduction of $50 billion—the equivalent of writing college-bound students a check for $50 billion.
The catch was that one of the tax breaks Obama wanted to eliminate was 529 plans. You’ve probably never heard of the American Opportunity Tax Credit, but you’ve probably heard of 529 plans, and that’s part of the problem. A 529 plan is a tax-preferred savings account that works like a Roth IRA: You don’t get a tax deduction when you contribute money, but all of your withdrawals are tax-free (so long as you use the money for higher education). Under this setup, you never pay tax on your investment gains within the account.
529 plans are popular, but the reason you’ve heard of 529 plans is that they are administered by private asset management companies, which market them aggressively so that they can claim fees for managing your money. They are also widely thought of as a “middle-class” tax break because, to a limited extent, they do benefit the middle class. “That’s as middle class as it gets,” one Republican representative claimed.
It’s true that many middle-income families have 529 plans—but many of them shouldn’t, and the rest aren’t getting very much out of them. If a married couple makes less than $74,900—already more than median household income—their tax rate on most investment income is zero, and they shouldn’t have a 529 plan in the first place.
Let’s say that you make more than $74,900 and you save $3,000 for your son’s college education as soon as he is born and every year thereafter through his 17th birthday. Assume that you get a seven percent nominal (before inflation) return. If you put the money in an ordinary investment account, you’ll be taxed 15 percent on your gains each year. When your son turns 18, you’ll have about $97,800 to use for college.
If you instead put the money in a 529 plan, you’ll only get a 6.5 percent return, because 529 plans have higher average fees than ordinary index mutual funds, but you won’t pay any taxes on the account's gains. After 18 years, you’ll have about $103,600 in your account, so the 529 plan is saving you $5,800—assuming you can save $3,000 per year, which is a lot.
But that’s not how you do things if you’re rich. If you're rich, you put $140,000 in the 529 plan—the maximum for a two-parent family. If you put that money in an ordinary investment account, after 18 years (using the same assumed returns as above) you’ll have $351,700 for college; in a 529 plan, you’ll have $434,900—a tax benefit of $83,200. (Since there’s a good chance that $434,900 won’t be enough for college in 18 years, you can contribute more on your son’s fifth birthday, making your tax break even bigger.)
The rich family’s tax break is 14 times as big as the middle class family’s for three reasons. First, rich people can afford to shelter more money into 529 plans. Second, they can do it earlier, so their tax benefits compound for longer. And third, they pay taxes on other investment income at a higher rate (above, I assumed the top marginal rate of 25 percent)—so they gain more from sheltering each dollar of income. The same principles hold for any tax break that is structured as a deduction or exclusion of income, like the mortgage interest tax deduction (another supposedly “middle-class” tax break that mainly benefits the rich): the more money you have and the higher your tax rate, the more those tax breaks are worth to you.
Compared to 529 plans, tax credits are a far better way to subsidize, well, anything, including college. The American Opportunity Tax Credit, for example, reduces your tax liability by up to $2,500 per year (you have to spend $4,000 on higher education to get a $2,500 credit) for up to four years (which Obama wants to increase to five years). That’s a maximum benefit of $10,000 per child, and the credit is gradually phased out for households making more than $160,000. So the AOTC helps people who need it and not people who don’t.
To summarize: If you’re poor, a 529 plan gives you nothing, since you don’t pay income taxes in the first place; the AOTC gives you $4,000 ($5,000 under Obama’s proposal) because you can take $1,000 of the credit per year even if you pay no taxes. If you’re in the “middle class” (making at least $74,900 and able to save $3,000 per year per child), a 529 plan gives you $5,800; the AOTC gives you $10,000 ($12,500 under Obama’s proposal). If you’re in the upper class, a 529 plan gives you $26,300; the AOTC gives you nothing.
To the surprise only of Pollyannas, politicians from both parties rose to the 529’s defense, claiming that Obama's proposal would hurt the middle class. The financial lobby, afraid of losing its lucrative, high-fee 529 plans, pitched in, coming up with misleading statistics about how many middle-income families have 529 plans. In the end, the White House dropped the proposal to eliminate 529 plans but kept the proposal to expand the AOTC, which fits the general pattern of tax politics: The only thing both parties can agree on is tax cuts.
American politicians routinely say they want tax reform that benefits the middle class—but they don’t. What they really do is preserve tax breaks for the rich.