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Investing In Post-Secondary Education: The Impact Of The Income Tax System
The decision to undertake post-secondary education (PSE) is one of the most important that most Canadians make. That choice is influenced by many factors, including personal aptitude and preferences, cost implications, and its impact on financial prospects. Society also has a stake in the decision to invest in higher education since a well-educated population is more productive, innovative and adaptable as well as more engaged in public issues. As a result, the Government supports education through a variety of spending programs and tax measures, raising the private return to investment in PSE in order to encourage greater participation.
This paper examines the impact of taxes on decisions regarding participation in post-secondary education. In particular, it evaluates how the income tax system’s cost recognition features, such as the education, tuition, textbook, and student loan interest tax credits, reflect the cost of a post-secondary education to students and their families. The document also examines how these tax support measures compare to the additional taxes that will be generated from higher incomes resulting from that investment in education.
The paper begins by setting the evaluation context, describing:
- how an individual’s decision to embark on higher education can be considered an investment;
- why governments get involved in that decision; and
- the effective tax rate framework, which is a commonly used tool for analyzing how the tax system affects the financial return to an investment.
It proceeds by examining the costs typically incurred by post-secondary students, and assesses how well those costs are recognized by the income tax system.
The analysis concludes that the private costs incurred by most post-secondary students when they invest in education are more than adequately recognized by the income tax system. Effective tax rates on investments in higher education are nevertheless found to be positive, indicating that, even with the tax support measures, the tax system makes investment in higher education less attractive. These positive effective tax rates arise from a fundamental feature of the Canadian income tax system—graduated rates, which cause the incremental earnings of post-secondary graduates to be taxed at a higher marginal income tax rate.
The disincentive effects created by the tax system must, however, be assessed in the context of the overall level of support given to post-secondary education and how it can best be delivered. Government spending is strongly supportive of higher education, substantially reducing private costs and more than offsetting the small amount of net additional tax arising from the tax system. Taken together, the tax and spending measures provide a substantial incentive to undertake post-secondary education, while maintaining a degree of progressivity in the tax system.
Education as an Investment
Taxes affect many decisions, and evaluation of the impact of taxes is consequently very important. This is particularly true when it comes to investment decisions.
Investments can be broadly defined to include all activities where costs are incurred today with the expectation of receiving benefits in the future. Education and training decisions clearly fit within this definition. When individuals decide to go to college or university, or to undertake other types of training, they must both pay the out-of-pocket costs of their education and give up the income they might have obtained if they had decided to enter the workforce immediately instead of going to school. Individuals who opt for additional education opportunities do so for a variety of reasons, but an important one is to improve their economic prospects once their education is complete. They recognize that additional education will increase their chances of obtaining steadier employment in a higher-paying line of work.
Education is thus a classic investment, since it involves incurring costs now in order to reap a reward later. A term often used in connection with education—human capital—draws out this education-investment link. Just as a business invests in physical capital by building a factory, buying machinery, or discovering and developing a mineral deposit, a student or apprentice invests in human capital by pursuing education or training opportunities (see Box 1).
Government Involvement in the Investment-in-Education Decision
Students receive a large financial return from investing in post-secondary education, and presumably would be motivated to invest in education without extra inducement from the Government. Nevertheless, governments have traditionally supported students and post-secondary institutions through both direct spending programs and tax measures. One justification for this involvement is that the benefits of higher education flow beyond the student and spill over to society at large. Reviews of the literature suggest that these spillover effects, or externalities, result from a number of factors.
Highly educated employees are on average more productive
. Their extra productivity often exceeds the additional remuneration they command. Employers may therefore earn higher profits if their employees are more educated. Co-workers may also be more productive and more generously remunerated in the presence of educated colleagues. Employers and fellow employees therefore reap some of the payoff of a student’s decision to get an education.
New ideas that benefit businesses and society at large often come from well-educated people
. A more educated workforce may also adapt more easily to changes in technology. These innovation channels can also generate externalities from individual decisions to invest in higher education.
People with more education may make less use of social programs, to the benefit of their fellow citizens, and contribute more in terms of tax levels
. Persons with higher education generally have more stable patterns of employment and are consequently less prone to require government income and social support. With their higher incomes, they pay more taxes.
Box 1: Education: Earnings Premia, Costs and Rate of Return
Canadians with post-secondary education earn considerably more on average than those who complete high school only. "Earnings premia":
Per Cent Difference in Weekly Earnings
To obtain these payoffs, students pursuing post-secondary education incur a variety of costs, both direct costs (tuition, books, etc.) and opportunity costs, in terms of forgone earnings. As discussed later in this paper (see the section "Education Costs Incurred by Post-Secondary Students"), the magnitude of these costs varies considerably from student to student, but $21,000 roughly approximates the typical before-tax cost (including forgone earnings) of a year of post-secondary education, implying an $84,000 investment for a four-year degree.
The payoff from a post-secondary education can be weighed against the cost of obtaining it by computing a rate of return. The prospective student may then decide whether the rate of return is high enough to make education a good financial investment.
A recent C.D. Howe Institute Commentary (see footnote 3) summarized various studies of rates of return to first-degree university study over the 1970s, 1980s and 1990s. It found that over that period, the after-tax rate of return was 11-12 per cent for males and 15-16 per cent for females.
Casting the externality net even further, it can be argued that education also imparts "civic virtues" that make society function well, such as awareness and involvement in public issues, community participation and volunteerism.
The presence of these spillover benefits means that government subsidization of investments in education improves the well-being of Canadians. Government spending on education and tax measures targeted at students can encourage individuals to engage in more education than they would if they were driven only by internal, personal rewards.
A second reason put forth for government involvement in education investment decisions is to offset limitations in financial markets. Students may be financially constrained from acting on educational opportunities if lenders will not extend credit to them based on their increased income prospects. The Government may have a role in correcting such credit market failures by becoming directly involved in lending to students.
Effective Tax Rate Framework
The tax system can modify the attractiveness of investing in education, either by making the upfront costs less onerous or by increasing the net reward by reducing taxes on the resulting earnings. The effective tax rate framework is a helpful tool in analyzing the impact of the tax system on incentives to make such investment.
Consider the situation of individuals deciding whether or not to take part in post-secondary education. They can compute a rate of return on the investment, which measures how much more they will expect to earn over a lifetime in comparison to the direct costs (tuition, books, etc.) and income forgone during the study years. The rate of return can be computed on both a pre-tax and an after-tax basis. The proportional difference between the pre-tax and the after-tax rates of return shows the degree to which taxes alter the financial incentives to invest in education. This wedge between the pre-tax and after-tax rate of return is known as the effective tax rate on such investments (see Box 2).
The effective tax rate will be affected by a variety of factors, both tax and non-tax. Anything that alters the before-tax rate of return, such as the cost and duration of an education, the earnings premium from an education, or the time pattern of earnings with and without education, can have an impact. Holding these influences constant, tax variables such as tax rates, credit rates and deductibility rules have an effect as well.
Tax policy analysis uses the effective tax rate framework to determine the extent to which existing or proposed tax measures modify the financial attractiveness of an investment. If all of the costs of investing in education are recognized for tax purposes (i.e. fully deductible/creditable and used in the year they occur) and the incremental income earned is taxed at the same rate as the initial reference level, the effective tax rate will be zero, signalling that the tax system is not altering incentives. Progressivity is, however, a fundamental feature of Canada’s personal income tax system, so the incremental income arising from the investment will be taxed at a higher rate, making it highly likely that the effective tax rate will be greater than zero. On the other hand, as will be seen below, government spending is strongly supportive of post-secondary education, and the net effect of the two policies is to encourage educational investment while preserving an element of progressivity in the tax system.
Box 2: Rates of Return and Effective Tax Rates
The table below lays out a simple, stylized example of the financial consequences facing someone contemplating an investment in post-secondary education. It assumes:
Investing in higher education costs $110,000 during the school years in this example and, after graduation, returns $0.8 million in extra earnings. The investment occurs upfront and the reward is received later. The rate of return calculation takes the "time value of money" into account by discounting future amounts at the internal rate of return. In this example, the before-tax rate of return is calculated as 14.6 per cent.
Now introduce taxes. Taxes on earnings reduce take-home pay for both those who undertake post-secondary education and those who do not. Tax deductions or credits available during the school years reduce the cost of education.
The numbers in the table below assume that:
In this example, investing in higher education costs $93,500, after tax, during the school years. After graduation, it returns $0.6 million in additional after-tax income. Based on these figures, the after-tax rate of return is 13.1 per cent. The effective tax rate is the proportional difference between the before- and after-tax rates of return. In this example, the effective tax rate is 10 per cent, calculated as (14.6-13.1)/14.6.
Education Costs Incurred by Post-Secondary Students
One of the largest costs borne by those who decide to invest in education results from the fact that students have less opportunity to work for pay.
Data show that individuals with high school degrees who do not participate in post-secondary education earned, at the median, around $20,000 per year during the time they would otherwise be going to university (i.e. ages 19 to 22). Assuming a typical full-time student works during the summer, going to school therefore "costs" post-secondary students roughly $15,000 per year in forgone earnings. Of course, the median or average figures may not be too revealing of the forgone earnings of students in particular situations. The range of earnings of high school graduates is quite broad. An individual student might have found a $20,000-per-year job if he or she had not gone on for post-secondary education, or might have found one that paid much more, or might have found no job at all. A student with a scholarship as well as part-time and summer earnings might have done as well financially by going to school as with a $20,000-per-year full-time job. Indeed, the concept of forgone earnings is rather subjective, since it is based on a calculation involving a student’s best guess as to "what might have been."
It is important to distinguish outlays of post-secondary students that can truly be considered as their costs of choosing to invest in education in contrast to spending that would have taken place in any case, in or out of school. A good number of outlays are made by both students and non-students alike. When calculating the financial ramifications of investing in education, it is only the incremental costs associated with going to school that are relevant.
A number of expenses are inarguably incremental. Tuition fees, for example, are clearly something that students incur and non-students avoid, as are compulsory school fees. Similarly, there is no doubt that purchases of textbooks and school supplies are education costs. Another example of expenses that are indisputably educational are interest payments on student loans.
There is similar certainty about costs that are borne by both students and non-students. Both students and non-students must eat and have a roof over their heads. These costs are independent of the going-to-school decision. Indeed, if fewer non-students live with their parents in order to benefit from free accommodation and food, it may be said that these are incremental direct "benefits" of investing in education in that they reduce the reference cost level.
There are also some grey areas. Students may have a greater need for a computer and ancillary equipment than non-students. However, it could be argued that more and more these days, non-students also need a computer. Outside the classroom, the lifestyle of students and non-students may differ and bring with it differences in certain costs, such as increased entertainment expenses for students. However, these would not normally be considered costs associated with acquiring an education. More post-secondary students may live away from their hometown than non-students of the same age group, so travel from home to school and back may be regarded as an educational expense, broadly defined. On the other hand, daily commuting expenses may be higher for the working individual since a good number of students live on campus or nearby.
The list below provides some information of the quantitative importance of educational and quasi-educational expenses.
Statistics Canada data show that annual university undergraduate tuition fees will average $4,347 in 2006–07, ranging from $1,916 in Quebec to $6,571 in Nova Scotia.
Tuition fees also differ by faculty, with a year of study in a faculty of education costing on average about one-quarter as much as a year of study in dentistry ($3,334 versus $13,463). Graduate programs are generally more expensive, with tuition averaging $6,479.
In a survey of over 7,500 post-secondary students, EKOS Research Associates estimated similar results for 2003–04—average tuition of $4,134 ($4,415 in 2006 dollars).
As part of the needs assessment work undertaken to determine the adequacy of loans provided under the Canada Student Loans Program (CSLP), information is collected from applicants regarding their expenditures. In 2003–04, the nearly 400,000 applicants reported average tuition fees of $4,782 ($5,107 in 2006 dollars). The 10 per cent of applicants with the highest tuition costs spent $13,331 on average ($13,962 in 2006 dollars).
According to Statistics Canada, compulsory student fees will add another $619 to post-secondary expenses in 2006–07, varying from $341 in New Brunswick to $719 in Ontario. These additional fees include recreation and athletics, student health services and student association fees, which are not eligible for the tuition tax credit.
Books, Equipment and Supplies
EKOS reported that in 2003–04, post-secondary students spent on average $967 ($1,032 in 2006 dollars) on books and educational supplies.
The CSLP needs assessment data put books and supplies spending at a similar $936 on average for 2003–04 ($1,000 in 2006 dollars). The provincial variation in average books and supplies expenditures was relatively narrow, ranging from about $900 to $1,100, with the exception of Newfoundland and Labrador, where students got by with less than $500 worth of books and supplies. The data also showed that the top 10 per cent paid out $2,122 each on books and supplies.
Statistics Canada conducted a survey of post-secondary students and their families based on their 2001–02 experience. Respondents were asked about their total education costs (tuition, books, supplies) rather than amounts spent on individual categories of expenditures. University students reported education costs of $5,200 during the year, compared to $3,200 for college students ($5,674 and $3,492 in 2006 dollars). These numbers, while not as detailed and from an earlier year, are consistent with those obtained from Statistics Canada’s tuition report, the CSLP needs assessment and the EKOS survey.
Post-secondary students generally have higher expenses and lower incomes than those who enter the workforce immediately after high school. Consequently, they must often borrow to cover the gap between their financial needs and resources during their study years. Statistics Canada found that about half of college and university (bachelor) graduates left school owing money they had borrowed for their education. Most of the debt was incurred through government student loan programs.
Eventually, usually after graduation, those loans must be repaid. In terms of measuring loan costs of investments in education, it is important to distinguish the repayment of principal from the payment of interest.
A loan is taken out to help cover a student’s expenses. Including both the original expenses and the repayment of loan principal as separate costs would result in double counting. A student who takes out a $5,000 loan to pay a year’s tuition fee and who later repays the $5,000 to the lender does not have $10,000 in costs. If expenses (tuition fees, books, etc.) have already been included, the repayment of loan principal should be ignored in computing the costs of investing in education.
Interest payments are conceptually a different, more complicated matter.
- It could be argued that interest payments are an expense that arises only because of a decision to invest in education. Students typically borrow money and incur interest costs simply because they decide to go to school, so interest payments, following this line of reasoning, are clearly a cost of investing in education.
- When it comes to designating the costs that should be recognized for tax purposes, the case for interest payments is less compelling. If taxpayers, whether students or businesses, are allowed to deduct the full cost of an investment at the time it takes place (i.e. to use cash-flow accounting), it is not necessary to also allow deductions for interest payments on loans used to finance the investment. For example, contributions to a registered retirement savings plan are allowed as a deduction, so interest paid on money borrowed to make the contributions is not deductible.
Leaving this conceptual debate aside, arriving at an empirical estimate of typical interest payments on student debt is no simple matter.
There is wide variation among students in amount of debt, repayment schedules and interest rates attached to loans. Statistics Canada reports that graduates in 2000 who had debts two years after graduation owed on average $12,600 (college) and $19,500 (university with a bachelor’s degree), for an overall average of about $15,000 of debt. But about half of the graduates had no debt two years after graduation, implying average indebtedness of all class of 2000 graduates of about $7,500 in 2002. EKOS reports a similar figure ($7,000) for average debt for all students in 2003–04. At a 7-per-cent interest rate, interest payments on debts of this magnitude would be around $500 per year.
Averages such as these are often deceptive, particularly in the case of student debt. Given all the factors at play—amount of debt, the interest rate, the repayment schedule, government relief measures—it is difficult to say what a "typical" case might be.
Travel is one of the grey areas in terms of education costs. Post-secondary students attending school away from their hometown have to travel to school at the beginning of the academic year, usually returning home again at the end of the year, and typically make one or more trips during the school year. However, their counterparts in the workforce whose jobs are in another town may also return to their parents’ home several times per year. To the extent that students return home more often, their extra travel costs may be offset by rent savings if they stay with their parents during the summer.
Even if travel expenses were judged to be legitimate education costs, it would be difficult, as a practical matter, to estimate their magnitude. Travel costs, which vary with distance, mode of transportation and number of trips, would differ considerably from student to student. Unfortunately, none of the information sources cited above deal specifically with student travel costs.
There is considerable overlap between travel and moving expenses. It is not important here to delve into their finer definitional nuances. It is worth pointing out, however, that the same debate over whether travel expenses are true costs of investment in education pertains to moving expenses as well. Resolving that debate would leave the empirical problem of obtaining information on student moving costs unresolved. Readings on actual moving costs of post-secondary students are as difficult to come by as are their travel outlays.
Summary of Costs
In acquiring a post-secondary degree, undergraduate students forgo some earnings, pay tuition and other fees, and purchase textbooks and other supplies for their coursework. Costs for a typical student total approximately $21,000 per year of study, based on available data sources.
Annual Cost of Undergraduate Study
|Books and supplies||$1,000|
Tax Recognition of Costs
Students, who invest in post-secondary education, increase their earning power, and their extra earnings mean extra income taxes. However, the income tax system recognizes the costs of investing in post-secondary education by allowing students a tax credit or a tax deduction for expenses incurred (tax credits versus tax deductions are discussed in Box 4). If all costs are recognized fully in the year that they occur, only net extra earnings are subject to tax.
This section looks at different types of education costs and how they are reflected in the income tax system.
The tax system provides no explicit deduction for the cost of forgone earnings. Deductions are designed to remove from the ambit of taxation certain amounts of income that would otherwise be subject to tax. Since the forgone income was not taxed in the first place, there is no need for an explicit deduction.
Tuition Tax Credit
Students attending universities, colleges or other post-secondary educational institutions certified by Human Resources and Social Development Canada are entitled to a federal tax credit on the eligible tuition fees they pay. The amount of tuition is multiplied by the lowest tax bracket rate (15.5 per cent as of July 1, 2006) to calculate the value of the credit. Provincial credits are also available, with the rates varying from province to province. Unused portions of this credit can be transferred to supporting family members or carried forward by the student.
In 2003 (the latest year for which data are available, when the credit rate was 16 per cent), over 2 million students claimed federal tuition tax credits in respect of fees of nearly $4.8 billion. The average tuition amount reported was about $2,200.
If all $4.8 billion of these tuition payments had been used to generate credits to reduce 2003 tax payments (either those of the student or of a supporting person to whom they were transferred), the cost to the federal government would have been over $750 million (16 per cent of $4.8 billion). It is not always possible, however, for the student to claim the credit in the year it is earned because he or she may have insufficient taxable income. In these cases the credit can be transferred to a supporting person, or carried forward to reduce taxes in a future year.
Education Tax Credit
This credit is designed to recognize the direct costs of investing in higher education, apart from tuition. The federal tax system uses a standard monthly amount ($400 for full-time students and $120 for part-time students) to reflect these costs. Students in a qualifying educational program at a designated educational institution are entitled to a tax credit based on the number of months they are enrolled. The federal credit amount is multiplied by the lowest tax bracket rate (15.5 per cent as of July 1, 2006) to calculate the value of the credit. Provinces have similar provisions.
As with the tuition tax credit, unused portions of this credit can be transferred to supporting family members or carried forward by the student.
In 2003 (the latest year for which data are available), 1.5 million students claimed the federal education tax credit for full-time study and nearly 700,000 for part-time study. There may be some overlap in these numbers, as some students likely engaged in full-time study for some months of the year and part-time study for others. There is no duplication, however, in the total amount claimed ($4.3 billion). The average education tax credit amount for full-time study was about $2,600, or 6½ months of study at $400 per month. For part-time study, the average claim was for just under $600, or roughly 5 months of study at $120 per month.
Assuming that the entire $4.3 billion was used in 2003, the education tax credit would have cost the federal government some $700 million in reduced taxes that year (16 per cent of $4.3 billion). But the same proviso made in the case of the tuition tax credit, that some credits are not used to reduce taxes in the year that they are earned, also applies to the education tax credit.
Information on carry-forwards and transfers is not available separately for the tuition and education tax credits. In 2003, the total amount used for these two credits, including transfers and amounts brought forward from earlier years, is estimated at $1.2 billion.
Textbook Tax Credit
A federal textbook tax credit amount of $65 per month for full-time students and $20 for part-time students was introduced in the May 2006 budget. The credit amount is multiplied by the lowest tax bracket rate (15.5 per cent as of July 1, 2006) to calculate the credit. Unused portions of this credit, like the education and tuition tax credits, may be transferred to supporting family members or carried forward by the student.
The 2006 budget estimated that the cost of this new credit would be $135 million in 2006–07 and $125 million in 2007–08.
Summary of Tuition, Education and Textbook Tax Credits
In terms of cost recognition, the tuition tax credit amount covers the entire amount the student pays in tuition, without restriction. The education and textbook tax credit amounts are designed to cover the typical non-tuition costs of post-secondary education. For a full-time student attending school for eight months a year, the combined education and textbook tax credit amount is $3,720 (see Box 3). Data show that, on average, students spend about $1,600 on textbooks, supplies, equipment and compulsory fees not eligible for the tuition tax credit. Extending the definition of education costs to allow for grey-area items such as home-to-campus travel and moving expenses would not change the conclusion that the tax provisions are ample to cover the outlays of average post-secondary students.
Box 3: Impact of the Tuition, Education and Textbook Tax Credits
A student attending a full-time program at a Canadian university for eight months of full-time study, paying tuition of $4,000, is entitled to the tax credits described in the table below. For the purposes of this table, provinces are assumed to offer credits equal to half the value of the federal education and tuition tax credits.
As a result of these credits, a student’s taxes (or that of his/her supporting family member) could be reduced by $1,754.60.
Student Loan Interest Tax Credit
Interest paid on loans under the Canada Student Loans Act, the Canada Student Financial Assistance Act or similar provincial or territorial government laws for post-secondary student loans is eligible for a federal tax credit.
The credit is determined by multiplying the lowest tax bracket rate (15.5 per cent as of July 1, 2006) by the amount of interest paid.
The credit applies to interest paid on qualifying student loans. Unlike the education, textbook and tuition tax credits, the student loan interest tax credit cannot be transferred to another person. Unused portions of the credit can be carried forward for up to five years and used by the student in years when tax would otherwise be payable.
In 2003, 700,000 tax filers reported paying over $400 million in interest on student loans, or about $600 each on average. With a credit rate of 16 per cent that year, the federal tax relief provided by this measure was worth about $70 million.
Moving Expense Deduction
Students are allowed to deduct moving expenses from salary, wages or self-employment income earned at their new location. In addition, they may deduct from scholarship, fellowship, research grant and similar award income moving expenses incurred in order to study at a post-secondary institution, although it should be noted that Budget 2006 fully exempts such income from tax effective for the 2006 and subsequent taxation years.
Child Care Expense Deduction
Child care expenses are deductible, generally against earned income, by tax filers who satisfy a list of criteria. One of these is that, when the child lives with both parents, the parent with the lower income must report the deduction. This parent is likely to be in a lower tax bracket, or not have any taxable income at all, making the deduction less valuable than if it were available to the higher-income parent. However, there is an exception: the parent with the higher income may claim the deduction if the other parent is a student. This provision may ease the financial burden of paying for child care while one parent works and the other goes to school. Parallel assistance is provided to single parents studying full time (or to two-parent families, where both adults are studying full time) by allowing them to claim the child care expense deduction against all types of income.
Tax Treatment of Income
Scholarship and Bursary Income Exemption
As planned in the 2006 budget, scholarship, fellowship and bursary income received by a post-secondary student will be fully exempt from tax for the 2006 and subsequent taxation years. Previously, the exemption covered only the first $3,000 of annual income from these sources.
In 2003, when the $3,000 cap was in effect, around 106,000 post-secondary students reported receiving scholarship-type income of some $796 million; approximately $319 million of that amount was exempted from taxation.
The 2006 budget placed the benefit to students of removing the cap at $50 million of reduced federal tax payments in 2006–07 and $45 million in
Registered Education Savings Plans
Parents and others may set up a registered education savings plan (RESP) to help pay for the cost of a beneficiary’s post-secondary education. The contributor is not entitled to a tax deduction for amounts paid into an RESP, but the investment income generated within the RESP is not taxed until it is withdrawn, and then is taxed in the beneficiary’s hands rather than the contributor’s. The deferral of tax payments on the investment income and taxation in the hands of the RESP beneficiary, who is typically in a lower tax bracket, are both advantageous from the contributor’s perspective.
RESPs are estimated to have saved contributors and beneficiaries $130 million in taxes in 2003.
The Government also provides matching contributions (Canada Education Savings Grants), and in some cases support that requires no matching (Canada Learning Bonds), making RESPs even more financially attractive as a means of financing post-secondary education.
Box 4: Credits Versus Deductions
The tax credits described in this paper are all provided at the same rate at which taxes are imposed on income in the lowest tax bracket—15.5 per cent as of July 1, 2006. If a post-secondary graduate eventually earns income that places him or her in a higher tax bracket, that income will be taxed at more than 15.5 per cent. Taxing income at a higher rate than that used for recognizing costs raises the effective tax rate on investment in education.
However, allowing a deduction rather than a credit for education costs would not have much impact on the effective tax rate on investment in education. At the time they incur education costs, students generally have low incomes. They are generally in the lowest, 15.5 per cent, tax bracket. A deduction would generally be worth the same as a tax credit to them—15.5 per cent of the costs.
Unused deductions can be carried forward but, consistent with the cash-flow approach to taxing investment in education, accumulated deductions must be used in the earliest year in which the graduate would otherwise have to pay tax. A student’s income (and tax bracket) in early post-graduation years is likely to be low compared to what the graduate will experience over a lifetime, so the impact of switching from credits to deductions would be small.
Transferring the deduction to a spouse or parent in a higher tax bracket would also reduce the effective tax rate on the investment, although not necessarily from the student’s perspective. Furthermore, limits on transferability and the requirement to reduce the student’s taxable income to zero before transfers of deductions are permitted would reduce the impact.
As discussed in Box 4, positive effective tax rates may result if the direct costs of an investment are incurred and recognized at one point in time and the income payoff from the investment is realized later. This phenomenon is particularly evident in tax systems with graduated rates.
Graduated rates introduce complications even in the absence of direct costs. Recall that one of the costs of an investment in education is the income forgone by going to school rather than working immediately after high school. The income of high school graduates, particularly in the first few years on the job, is typically lower than the income their post-secondary graduate counterparts earn after graduation, and is taxed at a lower rate in a progressive tax system. As a result, when it comes to comparing with-education and without-education income streams, there is a wedge between the pre-tax and post-tax comparisons. With graduated tax rates, the after-tax return on an investment in education will be lower than the pre-tax return.
The favourable recognition of costs through the education and textbook tax credits along with the tax treatment of scholarships and RESP investment income provide a partial offset, on average, to the impact of graduated rates, thereby contributing to a lower effective tax rate on investment in
Summary of Tax Treatment
The income tax system recognizes all of the costs of investing in post-secondary education.
- Forgone earnings are implicitly recognized by the tax system. Earnings are taxed in the hands of the high school graduate comparator, while the post-secondary student who forgoes those earnings does not pay the associated taxes.
- Tuition costs are fully recognized under the tuition tax credit.
- Other educational expenses for the average post-secondary student total about $1,600 to $2,000 per year. The federal education and textbook tax credits are roughly twice as large, at $3,720 for eight months of study. These credits can be used even when the student is not in a tax-paying position via transfers and carry forwards.
- A credit is available for an unlimited amount of student loan interest paid. For maximum flexibility, the credit can be carried forward up to five years.
- Certain types of income—scholarships and RESPs—used to finance investments in education receive favourable tax treatment
These tax features make the decision to go to college, university or trade school more financially attractive than it would be on a without-tax basis. However, there are offsetting effects flowing through the graduated rate structure of the tax system. Where the tax system comes out on balance is an empirical matter, one that will be explored in the next section.
Effective Tax Rates on Investments in Post-Secondary Education
The rate of return on an investment in post-secondary education can be computed before and after tax. The effective tax rate is the proportional difference between the before- and after-tax rates of return (see Box 2).
The mathematical process of computing a quantitative estimate of this rate is relatively manageable. The empirical process of doing so, based on real-world experience, is more complex. As a result, there is no simple answer to the question, "What is the effective tax rate on investments in post-secondary education?"
Situations facing potential post-secondary students vary greatly. As discussed earlier, the cost of education differs from program to program, from province to province, from institution to institution and from student to student. The income forgone during the in-school years depends on the alternative job opportunities open to the particular student. The income premium resulting from attaining a post-secondary education is again student-specific. Finally, the amount borrowed to pay for the education, the loan repayment profile and the interest rate applied to the loan are far from uniform. Each of these cost, income and borrowing factors interacts with the tax system and affects estimates of actual effective tax rates.
Existing Research on Undergraduate Effective Tax Rates
A recent study by Collins and Davies computed effective tax rates for many combinations of these factors. In their base case estimations, they looked at single students with no dependants, since changes in family status would have tax ramifications that would feed back into the computed effective tax rate. Similarly, they avoided the complications that would have been introduced by allowing for tax-favoured income sources—specifically assuming no income from scholarships or RESPs and no flows into or out of registered retirement savings plans or registered pension plans. They looked only at the federal and Ontario tax systems.
Collins and Davies estimated the median employment earnings of males and of females in various age categories with different educational attainments as portrayed in Statistics Canada’s 1998 Survey of Consumer Finances. Their sample was restricted to people working full-time for the full year. Each of the 1998 earnings observations was escalated to 2003 by applying the growth rate in average earnings over the intervening period. A student’s lifetime earnings path was proxied by the estimated median earnings of people of different ages in 2003.
Collins and Davies found that effective tax rates on investments in post-secondary education are positive, as the impact of graduated tax rates more than offsets the treatment of costs by the tax system. The Department of Finance has adapted the Collins and Davies methods to produce preliminary estimates of effective tax rates using 2006 tax parameters. As shown in Chart 1, the effective tax rate on education is, however, substantially less than the marginal effective tax rate on physical capital estimated by the Department.
Differential tax treatment of human capital is appropriate given the ample evidence of externalities associated with investment in post-secondary education. In contrast, with the exception of research and development investment, which is not included in the marginal effective tax rate shown in Chart 1, there is no consensus that investment in physical capital provides significant benefits to society that are not captured by the firms making the investment.
Government Expenditures: Effective Subsidy Rates
The finding of positive effective tax rates does not mean that government is discouraging investment in post-secondary education. Collins and Davies shed light on the overall impact of government actions when they investigate expenditure-side measures that raise the return to investments in education by reducing the cost to students. They find that once the impact of both the tax system and expenditure support is taken into account, the overall influence of government action is to encourage investment in post-secondary education. This conclusion is universal, for both males and females and across all fields of study.
For example, using preliminary Department of Finance estimates for 2006, the pre-tax effective subsidy rate (the impact of direct government funding to universities on rates of return) for bachelor-level graduates is just over 20 per cent. In other words, government spending on post-secondary students and institutions increases the rate of return that students get on their education by about 20 percentage points compared to what they would have received if they had borne all the costs themselves.
Net Effects of Taxes and Subsidies
Given an effective tax rate of approximately 10 per cent, government actions encourage participation in higher education by raising the return of those who chose to invest by about 10 percentage points (20.3 per cent minus 10.3 per cent). Subsidizing investment in human capital through government expenditures is an appropriate way of addressing externalities and market imperfections, in part because it allows the progressive nature of the tax system to be maintained. Ideally, the net subsidy would be equal to the spillover effects from investing in education plus a further amount to account for limitations in the credit market for students.
Investments in higher education have been shown to be financially rewarding. Individuals deciding whether or not to attend college, university or trade school have a strong financial self-interest to do so.
Moreover, governments have good reasons for encouraging investment in education. First, society benefits from a more educated population beyond the rewards that accrue to the students themselves. Second, private lenders will not extend the optimal amount of credit to finance prospective students’ investments in education, and governments have a role in helping overcome this market imperfection.
The income tax system alters financial incentives to invest in education. The effective tax rate on the return to education is a useful summary indicator of how the tax system is affecting the decision to invest. This study has presented evidence that, despite favourable recognition of costs incurred, the tax system reduces the return to education. This disincentive arises from a fundamental feature of the Canadian tax system—graduated tax rates—which results in the incremental return from education being taxed at a higher rate.
But taxes tell only part of the story. Government expenditures in support of post-secondary students and institutions provide strong financial encouragement for investing in higher education. Indeed, the same research that uncovers positive effective tax rates on investments in education finds an effective subsidy rate pulling strongly in the other direction. The supportive impact of expenditures exceeds the disincentive of taxes, leaving the Government with a pro-education stance overall. The net result of tax and spending programs is to encourage investment in post-secondary education while maintaining a progressive tax system.
on Post-Secondary Education
The paper concentrates on government tax measures in support of post-secondary education. This annex provides a brief outline of government expenditures on post-secondary education.
The Government of Canada supports post-secondary education (PSE) primarily through transfers to provinces and territories. In 2006–07, the Government of Canada will provide approximately $15.7 billion through the Canada Social Transfer, including $8.5 billion in cash and $7.2 billion in tax transfers for PSE, social assistance and social services, and early childhood development and early learning and child care.
In addition to the tax measures outlined in this publication, the Government of Canada also provides some $3.9 billion annually in support for PSE in the form of direct spending:
- $2.0 billion helps students deal with the costs of education, through grants, scholarships and student loan programs; and
- $1.9 billion funds research and related activities in post-secondary institutions (granting councils, Canada Research Chairs, indirect costs of research).
This includes the Canada Millennium Scholarship Foundation (CMSF), which was created by the Government in 1999 with an endowment of $2.5 billion (to be spent over 10 years) to provide bursaries and scholarships to students across Canada. Since 2000 the CMSF has distributed some $300 million annually in bursaries and scholarships to approximately 95,000 PSE students.
Provinces provide support for post-secondary education through:
- funding for post-secondary institutions;
- financial assistance (loans and grants) to post-secondary students; and
- tuition and education tax credits for students.
Several provinces (Saskatchewan, Quebec, New Brunswick and Nova Scotia) have introduced tax credits/rebates for post-secondary graduates who take a job in the province.
Federal Funding for Post-Secondary Education Programs
|Support for PSE Institutions:|
|Canada Social Transfer||Transfer payments to provincial and territorial governments for PSE, social assistance and social services, and early childhood development and early learning and child care.|
|Post-Secondary Education Infrastructure Trust||$1 billion over two years for provinces and territories for infrastructure investments.|
|Direct Support for Students:|
|Canada Student Loans Program||
Interest paid by government during study.
Interest at below-market rates.
Interest and principal relief for those in financial difficulty.
|Canada Study Grants||
Non-repayable financial assistance to PSE students with particularly high levels of need.
For students with permanent disabilities, students with dependants, high-needs part-time students, and females pursuing doctoral studies.
|Canada Access Grant||Support for students from low-income families and with disabilities.|
|Canada Graduate Scholarship||Support for master’s and doctoral students.|
|Canada Millennium Scholarship Foundation||Provides bursaries and scholarships to students across Canada demonstrating need and merit.|
|Apprenticeship Incentive Grant||
Announced in 2006 budget to be effective January 1, 2007.
Cash grant to apprentices in the first two years of an apprenticeship program.
Supplements the Apprenticeship Job Creation Tax Credit, also introduced in 2006 budget.
|Support to Encourage Savings:|
|Canada Education Savings Grant||
Proportional matching of registered education savings plan (RESP) contributions.
Government matching per dollar contributed varies with family income.
|Canada Learning Bonds||Initial RESP contribution and ongoing payments.|
|Support for Research:|
Canadian Institutes of Health Research, Natural Sciences and Engineering Research Council of Canada, Social Sciences and Humanities Research Council of Canada.
Funding for research at universities, colleges and research hospitals.
|Canada Research Chairs||Federal funding for creation of university research fellowships.|
|Canada Foundation for Innovation||Funding to strengthen the capacity of Canadian universities, colleges, research hospitals and non-profit research institutions.|
See Davies, Jim, "Empirical Evidence on Human Capital Externalities," Department of Finance Working Paper 2003-11 (2003). [Return]
Most students, if they are taxable, face the lowest marginal tax rate; hence credits are roughly equivalent to deductions for this income group (see Box 4 for a more detailed discussion). [Return]
Collins, Kirk A., and James B. Davies, "Carrots & Sticks: The Effect of Recent Spending and Tax Changes on the Incentive to Attend University," C.D. Howe Institute Commentary No. 220 (October 2005). The authors estimated forgone (before-tax) earnings in 2003 of $14,715. University students are assumed to work during the summer months and earn one-third of the yearly, median income for full-time, full-year workers ($20,066), less 20 per cent to capture summer employment search time.
Not adjusting for wage growth or inflation, median male and female high school graduates at 23 years of age earned $23,000 and $18,200, respectively, in 1997. See Collins, Kirk A., and James B. Davies, "Tax Treatment of Human Capital in Canada and the United States: An Overview and Examination of the Case of University Graduates," North American Linkages: Opportunities and Challenges for Canada, The Industry Canada Research Series, edited by Richard G. Harris. Calgary: University of Calgary Press (2003). [Return]
EKOS Research Associates, Investing in Their Future: A Survey of Student and Parental Support for Learning (2006). In 2003–04, summer employment earnings were $4,847 on average among students who worked, or $3,461 on average for all students, including those without summer earnings. Earnings from jobs while at school were $6,612 on average for all students who worked ($4,881 for full-time students with part-time jobs). It is debatable whether pay from part-time jobs while at school should enter the calculation of forgone earnings. On the one hand, it clearly does narrow the in-school/not-in-school earnings gap. On the other hand, students only realize these earnings by working beyond normal hours, assuming normal working hours and normal study hours are similar. Students with part-time jobs are forgoing the earnings that non-students make during normal working hours, plus the free time that non-students enjoy after working hours. The wages students receive for part-time work is compensation for the sacrifice of free time and, it can be argued, does not affect the calculation of forgone, normal working hour, earnings. [Return]
Statistics Canada, "University Tuition Fees," The Daily (September 1, 2006). [Return]
EKOS Research Associates, Investing in Their Future: A Survey of Student and Parental Support for Learning (2006). [Return]
Analysis provided by Human Resources and Social Development Canada based on needs assessment data from Canada Student Loan applicants. [Return]
Statistics Canada, "University Tuition Fees," The Daily (September 1, 2006). [Return]
Ouellette, Sylvie, "How Students Fund Their Postsecondary Education: Findings from the Postsecondary Education Participation Survey," Statistics Canada, Catalogue No. 81-595-MIE2006042 (2006). [Return]
Allen, Mary, and Chantal Vaillancourt, "Class of 2000: Profile of Postsecondary Graduates and Student Debt," Statistics Canada, Catalogue No. 81-595-MIE2004016 (2004). [Return]
Unfortunately, Statistics Canada’s survey on student debt (see footnote 9) did not deal with repayment. The figures on debt load cited here refer to the total debt (government and non-government), two years after graduation, of graduates who pursued no further education. Only graduates who had some government debt are included in this calculation. [Return]
Eligible tuition fees include admission fees, charges for library and laboratory facilities, exam fees, application fees, charges for certificates, and membership or seminar fees related to programs. Some fees are specifically identified as ineligible—social and athletic, medical care or health services, transportation and parking, board and lodging, cost of goods of enduring value retained by students (e.g. microscope, uniform), initiation into professional organizations and penalties. For students taking correspondence courses, the eligible course fees may include books, cassettes, CDs, etc., that the students are required to buy. For students at flight training schools, the cost of flying time may be eligible. (Canada Revenue Agency, Interpretation Bulletin IT-516R2, Tuition Tax Credit). [Return]
Designated educational institutions include universities, colleges and other post-secondary institutions. A qualifying program must involve at least 10 hours of instruction or work per week for the duration of the program. Full-time students are enrolled in 60 per cent or more of the usual course load. (Canada Revenue Agency, Interpretation Bulletin IT-516R2, Tuition Tax Credit).
Part-time students who qualify for the disability amount or were enrolled part-time due to mental or physical impairment can claim the full-time education tax credit amount for each month of study. Under the medical expense tax credit, people with disabilities are also able to claim expenses related to education and employment, such as tutoring, note-taking services and talking textbooks. [Return]
Estimates appear in "Table 1—Personal Income Tax Expenditures" in Part 1 of this publication. [Return]
The impact of graduated tax rates would be attenuated if students were allowed to carry back some of their post-graduation income for tax purposes and report it in the years when they had been at school. The benefits in terms of reducing tax-induced distortions would have to be balanced against considerations of fairness as well as the increased complexity and administrative burden created. [Return]
Given that other education-related expenses are recognized as they are incurred, the credit for student loan interest could also be viewed as a preference that offsets the impact of rising marginal tax rates. [Return]
Collins, Kirk A., and James B. Davies, "Carrots & Sticks: The Effect of Recent Spending and Tax Changes on the Incentive to Attend University," C.D. Howe Institute Commentary No. 220 (October 2005). See also, by the same authors, "Measuring Effective Tax Rates on Human Capital: Methodology and an Application to Canada," Measuring the Tax Burden on Capital and Labor, edited by Peter Birch Sorensen. Cambridge, Mass.: MIT Press (2004). [Return]
Collins and Davies were obliged to simplify their representation of the tax system in order to have a manageable model for computing effective tax rates. Some of the measures they omitted would have reduced calculated effective rates. For example, Saskatchewan, Quebec, New Brunswick and Nova Scotia have tax rebate/credit schemes that either reduce taxes for, or provide grants to, new post-secondary graduates who work in the province. [Return]
The calculation for physical capital refers to an investment by a large firm that is small relative to its ongoing operations, hence the term "marginal effective tax rate." In the case of education, the investment is a four-year university degree, which represents a substantial fraction of all years of schooling and makes the expression "effective tax rate" more appropriate. [Return]
See Davies, Jim, "Empirical Evidence on Human Capital Externalities," Department of Finance Working Paper 2003-11 (2003). [Return]
See Davies, Jim, "Empirical Evidence on Human Capital Externalities," Department of Finance Working Paper 2003-11 (2003) for a review of the literature on the size of spillovers from investment in education. [Return]
The Government of Canada also provides support to help fund the post-secondary studies of Aboriginal students. [Return]
Human Resources and Social Development Canada, "Canada Student Loans Program," www.hrsdc.gc.ca/en/gateways/nav/top_nav/program/cslp.shtml. [Return]
CanLearn, Human Resources and Social Development Canada, "Canada Study Grants," www.canlearn.ca/cgi-bin/gateway/canlearn/template.asp?sc=pay/school/grants/index.shtml. [Return]
Human Resources and Social Development Canada, "Canada Education Savings Grant," www.hrsdc.gc.ca/en/gateways/nav/top_nav/program/cesg.shtml. [Return]
Canadian Institutes of Health Research, www.cihr-irsc.gc.ca/e/193.html;
Natural Sciences and Engineering Research Council of Canada, www.nserc.gc.ca/sf_e.asp?nav=sfnav;
Social Sciences and Humanities Research Council of Canada, www.sshrc.ca/web/home_e.asp. [Return]