Why Forgiven Student Loan Debt Should Probably Be Taxed as Income

In six states, accepting student loan forgiveness is likely to result in an increased tax bill.

President Joe Biden's recently unveiled student debt forgiveness proposal might just have an unintended consequence for residents of six states: an increased tax bill. While most states plan to follow the federal government's lead and not treat one-time student loan forgiveness as taxable income, six states have no such plans. While Arkansas, Minnesota, West Virginia, and Wisconsin might decide to exempt federal student loan forgiveness from taxation, two states—Mississippi and North Carolina—have formal plans to tax loan forgiveness.

The results of this taxation could be an unexpected financial hit to many receiving loan forgiveness. According to Inc., depending on the state and the amount forgiven, individuals may see their taxes rise by $500 to $985.

However, according to Neal McCluskey, the director of the Center for Educational Freedom at the CATO Institute, low-income borrowers still stand to benefit in the long term from debt forgiveness.

"Typically, the people who are struggling the most with this debt actually have low debt, often below $10,000," McCluskey tells Reason. "So I think they'll be much better off for that debt having been forgiven even if it leads to some minor increase in their state taxes."

McCluskey argues that the largest tax increases are likely to affect those Americans with larger student loan balances—a group that is disproportionately middle and upper-middle class. According to an Education Data Initiative report, the average student debt held by a borrower in the bottom quartile of yearly incomes was over $10,000 less than the average student debt held by a borrower in the third quartile of yearly incomes. The third quartile includes individuals making up to $121,318 a year and, thus, roughly comprises the upper reaches of eligibility for Biden's loan forgiveness plan.

Though some borrowers may experience an unwelcome increase in their tax bill, it is probably fair for states to view students' debt relief as taxable income.

While Biden has announced that this particular suite of loan forgiveness will not be taxed federally, the Education Department currently views forgiveness from income-driven repayment plans, a popular option for discharging loans, as taxable income. Indeed, other forms of debt forgiveness are, generally, regarded by the IRS as taxable income.

"I think what's more objectionable is the idea that you get debt forgiven and it isn't taxable income, which is what we're seeing at the federal level. Because that money, those loans came from taxpayers to begin with." McCluskey says. "You should be repaying your debt because you've taken it from people who actually have no choice whether or not you got it, and the agreement was you would repay."

Not only would classifying student debt forgiveness as taxable income follow Education Department precedent, but it would also act as a slight penalty after what is otherwise a massive reward for a group largely experiencing the benefits of a college education.

"I think it's sort of a second slap to taxpayers to say, 'Not only have you not repaid the debt, but you won't even pay taxes on essentially what was money given to you from taxpayers,'" McCluskey says. "The people with the biggest debt tend to be in the jobs with the highest lifetime income prospects. And the people who are really struggling to repay debt, maybe people who are in bankruptcy or something like that, they probably won't pay very much [in taxes]."