Human capital investment (such as education and worker training) is an important input in the production of final goods and services, and investing in human capital is a cost of earning income. Prior to 2001, the tax treatment of education and training expenses was mixed. Some costs were fully deducted against taxable income, while others were subject to varying degrees of taxation. In addition, the treatment varied depending on whether the investment was paid for by businesses or households.

   At the household level, most human capital investment was fully deducted because the tax system does not tax the opportunity cost of education-the foregone wages of working instead of attending school. For other human capital investment costs, there was a complicated set of rules, with the tax treatment primarily determined by the income of the individual taxpayer undertaking the investment. Some costs could also be deducted under both income and payroll (Social Security and Medicare) taxes.

   The opportunity cost of working was fully deductible under both the income and payroll tax. Other costs fully deductible under both taxes were scholarships, fellowships, and reduced tuition. Costs that were fully deductible under just the income tax included education costs paid through Coverdell Education Savings Accounts (Coverdell ESAs), interest payments on student loans, and Treasury bond interest. These costs were excluded from income tax so long as they were used for tuition and related expenses such as fees, books, supplies, and the equipment required for courses of instruction.

   At the firm level, human capital investment received more efficient tax treatment than physical capital investment. Consider a $50,000 investment in office equipment. For many businesses, this cost was not fully deductible. Instead, the cost was recovered through depreciation provisions, with a fraction of the cost deducted from taxable income over a 7-year period. Alternatively, the firm and workers could have agreed to reduce cash compensation by $50,000 and invest the money in job training. In this case, the firm would have deducted the cost of training from taxable income as an ordinary business expense and workers would not have claimed the cost as taxable income for income or payroll taxes. In this way, the investment cost was fully deductible in the year the training occurred, resulting in no tax distortions to the firm's human capital investment decision.

   In addition to allowing partial deductibility of human capital investment, the tax system had two human capital investment tax credits available for use by households. In 2000, the Hope credit provided a tax credit of up to $1,500 per eligible student for the first 2 years of post-secondary education. To qualify for this credit the student had to be pursuing a degree or other recognized educational credential. The Lifetime Learning credit provided a tax credit of 20 percent of the first $5,000 in household education expenses per year. This credit was available for any post-secondary education investment for an unlimited number of years, regardless of whether the student was pursuing a degree or educational credential.