Expanded 529 Plans: A New Way to Divert Public Dollars to Private Schools

The Tax Cuts and Jobs Act (TCJA) passed by Congress late last year allows taxpayers to make withdrawals from 529 plans—formerly a tool used exclusively to pay for higher education expenses—to pay for tuition and other qualifying expenses at private and religious K-12 schools. As such, it diverts public resources to pay for private educational choices, but without the accountability associated with direct public expenditures. Furthermore, the tax benefit of this scheme would likely flow primarily to higher income households.  State policymakers must now decide on whether to conform to the TCJA by extending 529 tax advantages to private K-12 expenses.

Named after section 529 of the Internal Revenue Code, 529 plans are investment vehicles created to encourage college savings by granting tax breaks on higher education savings accounts. Minnesota currently exempts investment income on 529 accounts from the state income tax, provided the income is used to pay for qualifying higher education expenses. Since 2017, Minnesota allows both a non-refundable income tax credit and an income tax subtraction for contributions to a qualifying state 529 plan.

Section 529 plans fall into a broad category of off-budget spending referred to as “tax expenditures” because they have the same impact on public budgets as direct expenditures. For example, from a state budget perspective, the impact of a direct state grant that matches $1 of private spending with $1 of public money has the same impact on the state budget as a tax break that reduces taxes by $1 for each $2 of private spending. In both cases, public resources are reduced by $1. The principal difference is that in the first instance, the $1 is spent through the appropriation process, while in the second it is spent through the tax code.

Tax expenditures—such as the new federal approach to section 529 plans—typically have less public oversight than direct public expenditures. For example, public school districts that receive direct public funding must comply with standards for curriculum, testing, teacher qualifications, and school quality. State subsidies that would flow to private K-12 schools through an expanded section 529 program would be exempt from many of these requirements. In effect, this new form of tax expenditure will subsidize private K-12 educational choices with public dollars, but without the scrutiny and oversight associated with direct public expenditures.

Another feature of tax expenditure programs—including an expanded 529 program—is that they tend to be permanent fixtures of the tax code and thus continue from year to year without regular legislative scrutiny. Again, this differs from direct public expenditures—such as aid to public schools—which must be specifically appropriated by the legislature each budget cycle.

Extending 529 tax advantages to private K-12 education expenses “has numerous unproductive consequences,” according to the Institute on Taxation and Economic Policy (ITEP). ITEP notes that:

This expansion creates a tax shelter for households looking to defer paying income taxes or quickly cash-in for a tax break—families in many states can now make a contribution to a 529 account, receive a state income tax deduction or credit in exchange for their contribution, and then immediately withdraw those funds to pay for the private school tuition.  In this scenario, the 529 plan is not a savings vehicle at all, but rather a brief pit stop whose only purpose is to allow taxpayers to pay for their children’s private school educations with pre-tax dollars.

Prior to the federal extension of 529 tax breaks to private K-12 education, the extent to which families took advantage of 529 plans was heavily skewed in favor of higher income households. For example, qualifying families in the top 5% of U.S. households by income were 50 times more likely to avail themselves of 529 tax breaks than were families in the bottom half of the income distribution, based on 2013 data.* The extension of 529 tax benefits to private K-12 education expenses will likely also favor high income households and—if adopted by the State of Minnesota—increase the regressivity of the state and local tax system.

In constant 2018 dollars, state operating aid to Minnesota school districts today is nearly $1,000 per pupil (9.0 percent) less today than it was in fiscal year 2003. Meanwhile, the state budget surplus projected for the next biennium is largely illusory, since it ignores most of the impact of inflation on state spending; realistic projections beyond the current planning horizon indicate that the state could be confronting a series of structural budget deficits. Policymakers must now decide whether they want to further strain the state budget, increase tax regressivity, and reduce oversight of public resources by extending state 529 tax benefits to private K-12 expenses.

*This data is from a 2016 report from the Board of Governors of the Federal Reserve System.