The Arizona Tax-Credit Program Paradox

Successful example of a school-choice initiative

Presented at the 2002 Public Choice Society Meeting

This paper examines the paradox created when the Arizona tax-credit model used a means-tested school-choice argument for poor students for its justification, but in practice actually benefited students already enrolled in private schools first. The paper argues that the Arizona tax-credit legal structure caused private schools and parents to engage in natural rent-seeking behavior. It finds that in the end, both middle-class and lower-income students have benefited from the program. In essence, the Arizona model is an example of a school-choice program that used a means-tested argument to reach a semi-universal school-choice subsidy for all parents. The price paid for this paradox is more ammunition for school-choice critics for their favorite anti-school-choice argument-that choice programs subsidize wealthy parents and private schools.

With the recent rejections of voucher initiatives in California and Michigan and the failure to implement President Bush’s plan to sanction failing schools with vouchers, the growing trend for policymakers and legislators is to support tax-credit programs as the best method to provide parents with school-choice options. Many of these tax-credit proposals are designed to benefit low-income children.

Generally, tax-credit programs either allow parents to take a direct tax deduction for tuition they have paid or allow individuals and corporations to receive a tax deduction for contributions to private scholarship organizations that subsidize all or part of a student’s private school tuition. There are currently six states (Arizona, Florida, Illinois, Iowa, Minnesota, and Pennsylvania) that allow tax credits for educational tuition to private schools.

The most well-known plan, which has received the most attention and been the subject of several studies and critiques, is the Arizona tax-credit program. In 1997, Arizona policymakers established two nonrefundable individual income tax credits.[1] Taxpayers may claim a tax credit of up to $500 for a cash contribution of up to $500 to a nonprofit organization that distributes scholarships or tuition grants to students to use at private and parochial schools that do not discriminate on the basis of several characteristics. This contribution cannot directly benefit the taxpayer’s own child, and tuition organizations cannot designate the money to benefit students of only one private or parochial school. If the amount of the tax credit exceeds the amount of tax liability, then the taxpayer may carry the unused amount of the tax credit forward for up to five consecutive taxable years.

According to the Education Commission of the States, this year 14 states are considering some form of tax-credit legislation including: California, Colorado, Georgia, Hawaii, Illinois, Kansas, Massachusetts, Mississippi, Missouri, New York, Oklahoma, Pennsylvania, South Carolina, and Utah.[2] In 10 states (California, Colorado, Hawaii, Kansas, Mississippi, Missouri, New York, Oklahoma, South Carolina, and Utah) the legislation allows individuals or corporations to receive nonrefundable credits for donations to school tuition organizations that give out scholarships similar to the Arizona tax-credit model. Three states (Hawaii, Kansas, and Missouri) have bills proposed for both a direct tax credit to parents and a school tuition organization tax credit. Only Georgia and Massachusetts have legislation for direct tax credits to parents for private tuition expenses.

President Bush’s fiscal 2003 budget also includes a refundable tax-credit provision of up to $2,500 for parents whose children are in chronically failing public schools. It could be used for private-school tuition, sending children to better-performing public schools, and for expenses, such as books and computers.[3]

Legislative trends indicate that many states and perhaps even the federal government are considering an effort to replicate the Arizona tax-credit model. Legislators have chosen to design legislation that targets low-income children for three reasons. First, since Arizona, Florida, and Pennsylvania have actually passed this type of legislation and there are actual low-income tax-credit examples to follow, legislators will do what has worked in other places. Second, low-income families typically have the fewest school-choice options. Finally, it is seen as more politically feasible to target school-choice plans to lower-income students-especially considering the repeated failures of government to pass legislation for choice plans that offer all students more education choices.

However, public choice economic theory demonstrates how this strategy can backfire. The problem with escape hatches is that everyone wants to escape-even those students not designated as “low-income.” While the Arizona program was billed as legislation that would primarily benefit low-income children, the structure of the actual law did not optimize the chances that low-income children would be the first to benefit. This gave critics ammunition to use against the Arizona program in particular and against school choice generally. Of course many low-income children have benefited from the law, and as more tax contributions are generated, more low-income students will receive scholarships for tuition.[4]

To help enact the law, the Arizona tax-credit supporters argued that it would expand the educational opportunities for those who could not afford a private school. However, the law does not require student tuition organizations (STOs) to provide any scholarships to students based on financial need or previous inability to attend a private school. Many of the STOs do designate their scholarships based on income. However, People for the American Way and researchers from Arizona State University have been two of the loudest voices to use the Arizona tax-credit model as evidence that “those who gain from this tax law provision are generally those who have already had their children in private schools.”[5] Researchers from Arizona State University have concluded that “overall, the evidence indicates that students from wealthier families and wealthier donors are the primary beneficiaries of this tax-credit statute, rather than low-income students and families.[6] In fact, one of the unintended consequences of the Arizona tax-credit program was that initially, low-income children, who were not already enrolled in private schools, were not part of the majority of children who received the scholarships. Most of the scholarship organizations are small and serve specific students. Only a few of the organizations accept applications from all students and give scholarships to attend any private school in Arizona. While the law states that scholarship organizations cannot designate the money to benefit students of only one school, the organizations do not actually have to give out scholarships for more than one school. In other words, as long as they list more than one school as possible scholarship recipients, then they are in compliance with the law.

Most Arizona STOs specialize in securing specific types of students in specific types of schools. Many of the organizations give scholarships only to students attending schools affiliated with the organization. Many of the STOs are actually offshoots of specific private schools and serve the needs of those students.

The bottom line is that Arizona private schools have used the law to their advantage to benefit many students already enrolled in private schools. Again, this would not be a problem if public perception were not that the program would benefit low-income students first.

Keeping in mind that the government’s public education monopoly is the biggest rent-seeker of all, the structure of the Arizona tax-credit law created some opportunities for rent-seeking by private schools. A “rent” can be defined as a benefit or good gained by an individual, firm, or group by virtue of a favored or fortunate relationship with government.[7] Tax credits are not typically viewed as rents because people are simply keeping their own money. However, when the government specifically directs who may benefit from the tax credit, they once again take on the role of offering some institutions or individuals a favored relationship with the government. Where rents exist, individuals and institutions naturally make efforts to secure them. Private schools naturally engaged in rent-seeking behavior to get the scholarship money directed toward students already enrolled in their schools.

Parents have also been accused of gaming the system. There are widespread allegations from school-choice critics that parents are trading tax contributions to avoid the provision in the law that parents cannot receive a tax credit for their own children.[8]

Another possible unintended consequence could be a loss of other private philanthropy to the poor students who might have qualified for the tax-credit program. This is just speculation at this point, but perhaps philanthropists might perceive that their is less of a need to serve poor students in a given area because of the existence of a tax-credit program. If the program is not serving low-income students first, then this could result in a reduction in the overall resources devoted to any “escape hatch” in a given region because the tax-credit scholarships are theoretically going to low-income students. Inside sources at some private scholarship programs have indicated that funds could shift from states where tax credits are assisting low-income children to those that aren’t. However, these scholarship program administrators are mindful of disparities in the income levels for scholarship awards. For example, the Florida tax-credit program sets the income at a lower rate than the income level supported by the private scholarship program. In that case, the private program chose to continue the commitment to those families already in the program who do not qualify for the tax-credit program.

The most extensive evaluation of the Arizona tax-credit program, completed in September 2001 by the Cato Institute, argues persuasively that low-income students eventually win big from the tax-credit program. The Cato report predicts that by 2015 the scholarship tax credit could raise $58 million for scholarships per year, fund 35,000 to 61,000 scholarships annually, and help 11,000 to 37,000 students who would otherwise have to attend public schools attend nonpublic schools of choice.[9] So the question is not whether the Arizona tax-credit program works or is an effective school- choice model. It arguably is. It gives both low-income and higher income students more school choice. It is also the closest current approximation of a public school-choice program that is universally applied and benefits all students.

The Arizona case offers an opportunity to think about general school-choice strategies. One option is that if a tax-credit program is really intended to be an “escape hatch” for poor students, then the legislation should be written more restrictively. This was the case in Florida where in 2001 policymakers enacted a law to provide a tax credit for corporations that donate money to scholarship-funding organizations. The law requires scholarship-funding organizations to use 100 percent of such contributions for scholarships for children who qualify for the federal free or reduced-fee lunch program. The legislation was written with specific language to ensure that low-income students are the recipients of the scholarships. This makes it impossible for middle-class families to have their private school expenses subsidized and impossible for critics to claim that the program is just a middle-class tax subsidy.

On the other hand, the Arizona tax-credit program is closer to a “universal school-choice” program, and tax-credit programs with restrictive language will never move as quickly toward a true market for education. School-choice opponents will always be critical of every school-choice program no matter how narrowly defined. The fact is that the Arizona tax-credit program is a successful example of a school-choice initiative that benefits both middle class and lower income students.

One has to wonder which is the better strategy-following the Arizona strategy of passing legislation with a means-tested argument, then doing damage control when higher-income parents naturally try to take advantage of the program, or just passing very narrowly defined legislation to begin with, or perhaps making the tougher argument for school choice for all children to begin with.

School-choice advocates must come to terms with the irony of the Arizona case. A school choice tax-credit program that got enacted based on a means-tested argument for more choices for low-income students, that in practice benefits students who are already enrolled in private schools first, ultimately has resulted in a more universal school-choice outcome where both low-income and middle-class students receive a school-choice subsidy. Go figure.

Lisa Snell is director of education and child welfare at Reason Foundation. She formerly taught speech courses at California State University, Fullerton.