Avoiding the Tuition Tax

By Richard Vedder

Studying public finance and taxes for several decades has some payoff when it comes to higher education finance. I have longed believed that America's personal savings rate is low for many reasons, but one is that colleges impose a huge "tax" on college savings --often 50 percent or more at the margin (Harvard explicitly set the marginal rate at 10 percent for many students recently, considered revolutionary).

Specifically, your tuition discount is determined by information on the FAFSA form, and bank assets, stocks, etc. are all counted against you. Suppose you save $100,000 for Johnny or Joanna to go to college. Chances are your tuition discount will be reduced by $10,000 or more a year --at least a 40 percent marginal tax rate (on already taxed income). Add on a 30 percent or more federal marginal tax rate. Why save at all?

A reader has pointed out that savvy investment advisers are often having clients buy retirement annuities --that do not count against you as assets on the FAFSA form. Then people cash in these annuities early to pay the tuition bills (or borrow against these assets). Investment decisions are distorted to evade, legally, the "tax" imposed by private universities.

Of course, instead of more vigorous discounting, top schools could simply drastically reduce or eliminate tuition payments--and get out of the discounting game. In this type of situation, the aforementioned investment strategy would no longer be relevant. In such a world, we might have higher national savings, lower interest rates, a stronger dollar, and a variety of other nice things. This is getting at one of the least recognized negative spillover effects of colleges as they operate today that I often talk about.