State Tax Subsidies for Private K-12 Education
INTRODUCTION
One of the most important functions of government is to maintain a high-quality public education system. In many states, however, this objective is being undermined by tax credits and deductions that redirect public dollars for K-12 education toward private schools. Twenty states currently divert a total of over $1 billion per year toward private schools via special tax credits and deductions.[1] These tax subsidies are essentially backdoor voucher programs, or “neovouchers,” as they use the tax code to provide what amount to private school vouchers even when traditional voucher programs are unpopular with the public or outright unconstitutional.[2]
Because of the ways that state and federal tax law interact, the subsidies offered in ten of these states turn the concept of a charitable “donation” on its head by offering upper-income taxpayers a risk-free profit on contributions they make to fund private school scholarships. In these cases, even taxpayers who would not ordinarily be interested in contributing to private schools may find the incentive too strong to ignore. Some states have seen an entire year’s allotment of tax credits claimed within days, or even hours, of being made available as wealthy taxpayers seek to capture their share of the profits associated with convoluted “neovoucher” systems. In effect, states that have encountered political or constitutional obstacles to spending public dollars on private schools have instead set up a system that allows wealthy taxpayers to enjoy a profit by facilitating such spending on the state’s behalf.
This report explains the workings, and problems, with state-level tax subsidies for private K-12 education. It also discusses how the Internal Revenue Service (IRS) has exacerbated some of these problems by allowing taxpayers to claim federal charitable deductions even on private school contributions that were not truly charitable in nature. Finally, an appendix to this report provides additional detail on the specific K-12 private school tax subsidies made available by each state.
TYPES OF TAX CREDITS AND DEDUCTIONSState-level tax provisions designed to subsidize private schools typically fall into one of two categories: those designed to facilitate the granting of private school scholarships, and those designed to offset private school expenses for families with children enrolled in such schools.
Tax subsidies for private school scholarships
The most common, and most costly, tax subsidies for private education are intended to encourage businesses and/or individuals to contribute to organizations that distribute private school scholarships to qualifying students. Seventeen states offer tax credits designed to accomplish this purpose (see Figure 1), and their design varies considerably by state:
- Sixteen states offer nonrefundable scholarship credits, with some of these limited to a certain percentage of tax liability. In Georgia, for example, the scholarship credit cannot be used to offset more than 75 percent of income tax liability in a given year. Many of these credits can be “carried forward,” however, meaning that if a taxpayer does not owe enough tax to be able to use the credit this year, they can opt to claim some or all of the credit in later years. Louisiana is the only state where the scholarship credit is refundable—actually administered as a rebate—and therefore not tied to tax liability in any way.
- Scholarship tax credits range from 50 percent of the contribution amount (Indiana and Oklahoma) to 100 percent of the total contribution (Alabama, Arizona, Florida, Georgia, Montana, Nevada, and South Carolina). Credits equal to 100 percent of the contribution are designed to allow taxpayers to redirect their tax payments toward private institutions at no cost to themselves. In practice, the actual tax benefits for credit recipients can sometimes even exceed the size of the donation. When the impact of state tax credits is combined with federal tax deductions (and sometimes state tax deductions as well), some taxpayers can actually turn a profit by making these so-called “donations”—an outcome described in detail below.
- Of the seventeen states that offer a scholarship credit, seven states only extend their credits and deductions to businesses (Florida, Kansas, Nevada, New Hampshire, Pennsylvania, Rhode Island, and South Dakota). Notably, four of these states do not levy personal income taxes. Among the ten states that allow both businesses and individuals to claim scholarship credits, four states (Arizona, Georgia, Oklahoma, and Virginia) allow businesses to claim a larger credit than individual taxpayers.
- While the scholarships funded by many of these tax credits are limited to low- or middle-income families, states such as Arizona, Georgia, and Montana offer at least some of the scholarships with no income restrictions.
- Some states place further limits on scholarship eligibility beyond income level, such as Pennsylvania where students must live in a “low-achieving” school zone and Kansas where students over six years of age must have been enrolled in a public school during the previous school year. These requirements have not always been strictly enforced, however, such as when the Georgia Department of Education signed off on parents “enrolling” their children in public schools to gain eligibility for the scholarship program, despite having no intention of allowing their children to attend the public schools in which they enrolled.[3]
- Aggregate limits on the size of these credits vary widely. Oklahoma’s credit is capped at just $3.4 million, for example, while Florida’s cap is set at almost $700 million for Fiscal Year 2018.[4]
Tax subsidies for private school tuition and/or expenses
Eight states offer tax credits or deductions to individuals to defray the cost of attending a private school (see Figure 1). The design of these tax subsidies varies considerably across states:
- Four states structure their subsidies as deductions, while five states offer tax credits (Minnesota offers both). Tax credit design also varies by state, with Illinois and Iowa allowing only “nonrefundable” credits that can offset, but not exceed, the taxpayer’s income tax bill. Alabama, Minnesota, and South Carolina offer “refundable” credits that are not dependent on earning enough to owe income tax.
- The private school expenses that qualify for the tax subsidy vary by state. Wisconsin’s deduction is limited to private school tuition, for example, while Indiana applies its deduction much more broadly to include not just tuition but also textbooks, fees, software, tutoring, and school supplies. Minnesota offers a deduction for both tuition and expenses, as well as a refundable credit that can only be applied against non-tuition expenses.
- Most state tax subsidies for private school expenses are available to all families regardless of income level or other characteristics. In South Carolina, however, the credit is only available to families with exceptional needs children. In Alabama the benefit is only available for children enrolled in a public school judged to be “failing.” And in Minnesota, the credit portion of the subsidy begins phasing out for families with incomes above $33,500.
- Each state uses a different formula for calculating the subsidy and imposes different limits on the size of the subsidy. Deductions range in size from $1,000 per dependent in Indiana to $10,000 per dependent (grades 9-12) in Wisconsin. Tax credits vary significantly as well, with more generous credits confined to states such as Alabama and South Carolina that, as mentioned above, only allow a small subset of students to claim them. The broader credits made available to all, or most, private school students vary from a maximum of $250 per dependent in Illinois and Iowa to $1,000 per dependent in Minnesota.
SUBSIDIES RUN AMOK: PROFITING FROM SCHOLARSHIP “DONATIONS”
In 2011, the IRS issued a memo indicating that taxpayers can claim a federal charitable deduction for private school scholarship donations even when those donations are also subsidized with a state tax credit.[5] While the memo states that it “may not be used or cited as precedent,” scholarship organizations in over dozen states have been advising their donors that their contributions are eligible for a federal tax deduction in addition to a state tax credit.[6] For some high-income taxpayers, this dual benefit can turn a scholarship “donation” into a profit-generating scheme where the total tax cut received significantly exceeds the size of the original donation. It should therefore come as little surprise that in some states, the entire allotment of available credits is often claimed just hours after state tax officials begin accepting applications.
A close look at South Carolina’s scholarship tax credit illustrates how this works. In the Palmetto State, taxpayers receive a dollar-for-dollar tax credit for any “donations” they make to certain nonprofit scholarship funding organizations—thereby making the donation essentially costless to the taxpayer. Assuming the taxpayer itemizes on their federal return, the immediate federal tax consequence of a donation is twofold: the taxpayer’s charitable deductions increase by the amount of the donation, and the taxpayer’s state income tax deduction falls by the amount of the tax credit they received. At first, this may appear to result in a wash for the taxpayer. But this is not always the case because in some instances, charitable deductions are more valuable than deductions for state income taxes paid.
At the federal level, one of these instances arises when taxpayers are subject to the individual Alternative Minimum Tax (AMT).[7] The AMT is designed to ensure that taxpayers receiving generous tax breaks pay at least some minimum level of federal income tax. This is accomplished by denying certain tax breaks under AMT rules, including the deduction for state and local tax payments. Charitable donations, however, are still tax deductible under the AMT. So the ability to reclassify state income tax payments as charitable donations via a scholarship tax credit can be of significant benefit to taxpayers subject to the federal AMT—a group overwhelmingly comprised of taxpayers earning over $200,000 per year.[8]
The amount of benefit that can be realized by this reclassification depends on the amount of AMT owed and the taxpayer’s marginal tax rate under the AMT. Since marginal tax rates under the AMT range as high as 35 percent (after taking into account the AMT exemption phase-out), every dollar donated can potentially result in a federal tax cut of up to 35 cents. When combined with a dollar-for-dollar state tax credit, this means that a private school “donation” in South Carolina is better than costless, and can actually result in a risk-free return as high as 35 percent of every dollar “donated.” Read more: ITEP Reports:
