Among the Australian Industry Group’s suggestions for spending $1 billion on skills (pdf) was one that gets surprisingly little discussion in the education sector: tax deductibility for education expenses.
The current rule is that you can claim self-education expenses related to your current job, but not for future jobs you might hope to get on the strength of new qualifications. According to an ABS survey (table 4) of reasons for study, that disqualifies most people from a deduction, even though three-quarters have at least some vocational rationale for their study. The AIG thinks that you should be able to deduct from current income for a future job.
The logic of tax deductibility for education is that otherwise the tax system is biased against spending on human capital. If you buy a physical asset you can normally depreciate it over time and claim the annual amount of depreciation as a tax deduction. Arguably, vocational knowledge is quite similar; it is an asset that helps you earn your income, but one that fades in value over time as technology, techniques and circumstances change. Yet unless you happen to be already working in your field of study, the tax system won’t recognise your spending as an expense involved in earning your income.
Like most aspects of education finance, these rules seem to reflect a past time. When education was free, obviously its tax status was irrelevant; similarly where there are significant subsidies it is hard to say that the government is creating a bias against human capital investment. And writing off the whole lot in one year looks like an accounting convenience from an era when education expenses rarely amounted to significant sums – just short training courses and the like, and not multi-year degrees.
When I wrote my book on higher education policy, which was published in 2002, I was sceptical of the tax deductibility idea. This was partly because I thought the progressive tax system introduced distortions of its own, as those on high tax rates would effectively pay less for their education than those on low tax rates. But the way the tax system has been reformed since reduces the impact of progressive tax, with people earning less than $75,000 a year paying 30c in the dollar. Back when I wrote the book the 30c rate ended at $50,000. With an average bachelor degree holder working full-time earning $64,000 a year, most of them will fall below the 40% tax rate, greatly reducing the potential distortions caused by the tax system.
If deductions were to occur, they should be depreciated, instead of the current – and AIG favoured – all in one year claim. The logic of human capital is that it is an asset that will earn income in the future, and therefore it should be deducted against that future income. From the prospective student’s perspective, if they plan to study full-time they probably won’t have any significant income during the study period, and so a one-off tax deduction is of no use.
The microeconomic attraction of deductibility is that directly tax-financed education is, for political reasons, bogged down in price control and Soviet-style allocation of places. By further facilitating the full-fee market through tax deductibility, more students could bypass the dysfunctional state sector and make a more appropriate investment in their human capital. In some disciplines, like law and commerce, the subsidies are down to such low levels anyway that most students would probably be better off paying full-fees in market rather than state-oriented faculties and deducting the cost later on. There are a lot of details that would need to be worked out – for example, how many years should depreciation be spread over, and its interaction with student loans schemes. But conceptually I think there is more to this idea than I did back in 2002.
Andrew Norton 
I’m struggling with the paragraph where you talk about how your views have changed since 2002. You seem to be saying that distortions in the tax system have reduced over time and therefore more of a tax inducement is needed, or a tax inducement might work now as opposed to then? Could you expand a bit on that paragraph?
LikeLike
Andrew, in principle I agree with tax deductibility. It would be very expensive, but some of the cost could be recouped through a reduction (or elimination?) of government subsidies to tertiary institutions. The only role for government could be in the provision of an income contingent financing mechanism, but even that could (should) be wound down over time as a private market developed. I’m not familiar with the literature in the area but I am extremely cynical of any greater positive externalities from people doing degrees/diplomas compared with vocational training or other alternatives.
LikeLike
Sinclair – The flatter and lower tax scale means that courses don’t end up being cheaper in after tax terms for wealthy people (an important political consideration) and that the budgetary cost will be lower.
Rajat – I certainly did not mean that this be restricted to higher education, and I am not making any externality argument here, but treating most human capital how most people in fact see it, as an investment in their own earning capacity.
The net cost need not be massive, due to cutting back on subsidies. There would also be some saving from not permitting current immediate deductions, which could put some people in lower tax brackets. Indeed, I suspect this factor partly explains low take-up of loans for p/g education even though these can be rorted through the early repayment bonus – there is an even bigger financial advantage in claiming the deduction.
LikeLike
Hi Andrew, a similar issue has recently come up in NZ, with a tax discussion paper proposing tax deductions for businesses spending on skill development. There has been a cold to lukewarm response to this, as most people feel that it would lead to a lot of cost-shifting by businesses to get the deduction, without much real impact. A deduction for individuals would, however, probably lead to better decisions. I still wonder if it is worth the administration hassle though, especially if students have access to low interest, income-contingent loans.
Extending the argument, though, why not allow people tax deductions for plastic surgery, given that more attractive people earn more? I’m not sure if happy people earn more, but happy pills could maybe be deductible too.
LikeLike
Dave – It’s hard to say what impact a tax deduction would have on student study decisions; clearly there is quite high demand without it. The strongest reason for making the change, I think, is as an alternative to the current direct funding system, which comes with so many controls attached it cannot allocate capital effectively and is highly anti-competitive. I don’t think such a rationale exists for deducting plastic surgery (though I think such a deduction could perhaps be justified for people who trade directly on their looks).
If you have a link to any of the NZ discussion that would be helpful.
LikeLike
Okay, I understand. You’re making a point about the equity considerations and not the efficiency arguments.
LikeLike
A lurker has emailed me about my claim about the distortionary effects of marginal tax rates. He points out, correctly I think, that the tax deduction does not give a graduate on a high income a greater incentive to invest in higher education, since the deduction merely reduces the losses from the high rate in the first place.
LikeLike
So you occur an investment cost and claim that as a cost of earning income. Sounds right. So are capital gains as a result of that investment tax or is this effected by means of higher marginal tax rates generally?
What about investing in your children which I do to a regrettably massive extent? In this case I don’t promote my own income but probably theirs. Why can’t I claim that? Then they can be taxed on their future capital gains and the proceeds used to keep me in my old age.
LikeLike
As Harry indicates there are ‘matching’ issues to consider. Normally a tax deduction is offset in the system by a tax payment elsewhere. If Universities paid corporate income tax (as they should) then student fees could be deducted. Similarly, how do you pay capital gains tax on human capital?
LikeLike
Graduates would still pay income tax on their ‘profit’, since the number of years of depreciation would be much lower than the typical number of years spent in the workforce. I don’t think capital gains tax is possible, unless you had a scheme for selling equity in future income streams.
LikeLike
I’m not sure about your lurker’ comment on the distortion issue. Take an example where a person has a choice between a high-paying job (HPJ) and a low-paying job (LPJ). The LPJ provides physic income (which is untaxed) whereas the HPJ does not. Assume that before tax deductibility, both jobs offer the same welfare where this equals after-tax income plus physic income (ie W = ATY + PY). Tax deductibility would increase the AFT of the HPJ by more than the LPJ, thereby increasing the welfare provided by the HPJ by more than the LPJ. This means that people may be more inclined to choose HPJs than LPJs due to tax deductibility. Putting it in reverse, a person expecting to get a HPJ would have a greater incentive to invest in higher education due to deductibility. However, this would promote efficiency because it would help bring decision-making closer to what it would be in the absence of taxation. Of course, as you and Sinclair say, it may not be perceived as equitable.
LikeLike
Certainly investment in human capital should be treated in a neutral way with the tax treatment of investments in other forms of capital. Different tax treatment of investment costs, whether they can be expensed, depreciated or are not tax deductible, has important effects of the profitability of an investment and the amount undertaken. For example, with a 30 per cent tax rate an investment where the costs can be expensed can have a 30 per cent lower rate of return and still be preferred to an investment which can depreciate its costs.
Take an investment of $100 that pays $110 the following period. Without taxation the rate of return is 10 per cent. If a 30 per cent income tax is introduced and investment costs are depreciated, the tax paid is 0.3x($110 – $100) = $3 in period two. The after tax rate of return is now 7 per cent, $100 is invested to get $107 after tax. The rate of return has fallen by 30 per cent. If the investment can be expensed, the $100 investment gives a tax credit of $30 in period one, and tax of $33 (= 0.3x$110) must be paid on the income in period two. The after tax rate of return is 10 per cent
LikeLike
Mark, that was a very helpful discussion. Just to clarify my understanding, if we assume that (1) the key alternative to higher education is on-the-job training (rather than working to make an investment in physical plant); (2) foregone income from studying rather than working is relatively low; (3) tertiary fees are relatively high and subsidies low; (4) untaxed consumption benefits from tertiary education are not substantially higher than for on-the-job training; and (5) the income tax system is progressive, would you agree that tax deductibility of fees would make sense?
LikeLike
Yes, if assumptions 1, 3 and 4 hold. We know from work on physical capital that different tax treatment of close substitutes in investment can be very distorting.
Perhaps an example would be someone considering whether to do an MBA.
But I would question assumption 1. You don
LikeLike