Panama: Background and U.S. Relations

Summary: The Central American nation of Panama has had five successive elected civilian governments since its return to democratic rule in 1989, and a sixth is scheduled to assume power on July 1, 2014 with the inauguration of current Vice President Juan Carlos Varela as President. Hailing from the center-right Panameñista Party, Varela won the May 4, 2014 presidential election with 39% of the vote in a three-candidate race. Significantly, Varela defeated the candidate of the ruling Democratic Change party of current President Ricardo Martinelli, who was constitutionally prohibited from running for reelection. Elected in 2009, Martinelli remained generally popular during his presidency despite criticism at various junctures for his combative style of governing. Nevertheless, his popularity ultimately was not enough to convince voters to support his party's candidate. One controversy that emerged in the campaign was that Martinelli's wife became his party's vice presidential candidate. This led to some critics complaining of an attempt by Martinelli to extend his influence in the next government.

Summary: Panama's largely services-based economy has been booming in recent years, spurred on by several large infrastructure projects, including, most significantly, the Panama Canal expansion project that began in 2007 and is expected to be completed in early 2016. A challenge for the Varela government will be how to contend with slower economic growth rates as the Canal expansion project winds down. Another challenge for the government is making more headway in combating poverty and inequality in Panama, which still remain relatively high.

Summary: U.S. Relations

Summary: The United States has close relations with Panama, stemming in large part from the extensive linkages developed when the Panama Canal was under U.S. control and Panama hosted major U.S. military installations. Relations have been strengthened by a bilateral free trade agreement that entered into force in October 2012. As noted by the State Department, Panama's central location in the hemisphere, its transportation infrastructure (most notably the Canal), and its financial sector make it an important hub for global trade and a key U.S. strategic partner, but these same characteristics also make Panama vulnerable to drug trafficking, money laundering, and organized criminal activity.

Summary: Since Panama is relatively well developed economically compared to its Central American neighbors, the United States provides just small amounts of bilateral assistance to Panama. Nevertheless, the country receives additional assistance through the Central American Regional Security Initiative (CARSI), a U.S. regional security program begun in FY2008 to help Central American states reduce drug trafficking while advancing citizen security. Panama's anti-drug cooperation with the United States is strong. While the country has made progress in improving its anti-money laundering regime, there are several factors that hinder the country's efforts to combat such activity.

Summary: The Panama Canal expansion project, which will accommodate a new generation of massive container ships, is expected to reduce shipping rates between Asia and the U.S. Gulf and East coasts, resulting in increased Canal transits and trade. A number of U.S. ports have begun readying themselves in order to take advantage of the expansion.

Summary: This report provides background on the political and economic situation in Panama and U.S.-Panama relations. An appendix provides links to selected U.S. government reports on Panama. For additional information, see CRS Report R41731, Central America Regional Security Initiative: Background and Policy Issues for Congress, by [author name scrubbed] and [author name scrubbed]. For further historical background, see the following two archived CRS reports: CRS Report RL30981, Panama: Political and Economic Conditions and U.S. Relations Through 2012, by [author name scrubbed], and CRS Report RL32540, The U.S.-Panama Free Trade Agreement.

Panama's Political and Economic Environment1

A Central American nation with a population of about 3.8 million, Panama has made notable political and economic progress since the December 1989 U.S. military intervention that ousted the military regime of General Manuel Antonio Noriega from power. The intervention was the culmination of two and a half years of strong U.S. pressure against the de facto political rule of Noriega, commander of the Panama Defense Forces. Since that time, the country has had five successive elected civilian governments, and a sixth is scheduled to assume power on July 1, 2014 with the inauguration of current Vice President Juan Carlos Varela as President. Current President Ricardo Martinelli, elected in 2009, remained generally popular during his presidency despite criticism at various junctures for his combative style of governing. Panama's largely services-based economy has been booming in recent years, spurred on by the Panama Canal expansion project that began in 2007 and is expected to be completed in early 2016.

The endurance of elected civilian democracy in Panama for almost 25 years is a significant departure from the country's previous 21-year history of military rule. This included the populist rule of General Omar Torrijos (1968-1981), who initially governed as a social reformer, and the increasingly repressive rule of General Noriega (1983-1989). In the aftermath of the ouster of the Noriega regime, the duly elected winner of the 1989 presidential election, Guillermo Endara (1989-1994), took office; his coalition government made significant progress in restoring functioning democratic political institutions, although the demilitarization process was difficult at times. The center-left government of President Ernesto Pérez Balladares (1994-1999) of the former pro-Noriega Democratic Revolutionary Party (PRD) implemented an economic reform program that included trade liberalization and privatization of state-owned enterprises. Pérez Balladares sought to amend the Constitution to allow for presidential reelection, but Panamanians rejected the proposal by a large margin in a national referendum. The center-right Arnulfista Party government of President Mireya Moscoso (1999-2004), Panama's first female President, partially reversed the trade liberalization efforts of her predecessor. The center-left PRD government of President Martín Torrijos (2004-2009), the son of the former military ruler, initiated the Panama Canal expansion project, negotiated a free trade agreement with the United States, and enacted judicial, penal, and anti-corruption reforms.

Current President Ricardo Martinelli, a businessman and former government minister from the small center-right Democratic Change (CD) party, defeated the PRD candidate by a landslide in the May 2009 presidential election. His electoral alliance, known as the Alliance for Change, also won a majority of seats in the National Assembly. Until September 2011, President Martinelli governed in a coalition with the center-right Panameñista Party (PPA, previously known as the Arnulfista Party), but the coalition fell apart in August 2011 after a rupture in relations between Martinelli and Vice President Juan Carlos Varela of the PPA. Varela was sacked as foreign minister, but continued in his elected position as Vice President, albeit as a strong critic of President Martinelli.

In the last year of his term, President Martinelli remained broadly popular in large part because of the strong performance of the Panamanian economy under his government buoyed by the ongoing Canal expansion and other large infrastructure projects (see " Economic Situation " below). Yet over the course of his tenure, Martinelli's public approval ratings had dropped several times after strong public opposition and protests over some of his policy proposals related to labor issues, mining, and the sale of land in the Colón Free Zone (the world's second largest duty free zone after Hong Kong). He was also criticized by civil society groups and political opponents for taking a heavy-handed approach toward governing and for not being more consultative.

In Panama's May 4, 2014 elections, current Vice President Varela of the center-right PPA won the presidency with 39% of the vote in what was essentially a three-candidate race. President Martinelli was ineligible to run for reelection since, according to Article 178 of Panama's Constitution, the President may not be reelected until two presidential terms have passed. Under Panama's electoral system, the President is elected by simple majority, with no provisions for a second round. Varela defeated José Domingo Arias of the ruling center-right CD party of President Martinelli, who received 31%, and Juan Carlos Navarro of the center-left PRD, who received 28%. Arias had led opinion polls during much of the campaign, but the race tightened in the month leading up to the vote.

Initially, the popularity of President Martinelli was a key factor helping Arias in the race. One controversy that emerged, however, was the selection of Martinelli's wife, Marta Linares, as the CD's vice presidential candidate. Some critics feared that the first lady's candidacy could have allowed Martinelli to retain influence in the next government and give rise to a political dynasty. There were also concerns that if Arias had won the presidency, his government could have submitted a constitutional reform to shorten the reelection ban period from 10 years to 5 years, allowing Martinelli to run again in 2019.

President-elect Varela, a long-time businessman who received a degree in industrial engineering from Georgia Tech, has served as leader of the PPA since 2006. As noted above, Varela has served as Vice President since 2009 despite his break in relations with President Martinelli in 2011. He also served as Minister of Foreign Relations from July 2009 until August 2011.

During the 2014 electoral campaign, Varela advocated programs such as emergency price controls for basic products, an electricity project with Colombia, and an integrated public transportation plan for Panama City. Varela also has vowed to combat inequality. As Vice President, Varela reportedly was instrumental in shaping some of the popular social policies of the Martinelli government, including monthly payments to Panamanian seniors without pensions as well as housing and scholarship programs for the poor. Anti-corruption was also a major campaign theme for Varela, especially since the Vice President's break with President Martinelli involved Varela's allegations of governmental corruption. Since Varela hails from the private sector, where for many years he worked for his family's rum company, Varela Hermanos, many of the pro-business economic policies of the Martinelli government are likely to remain in place. In terms of foreign policy, Varela has indicated a willingness to resume diplomatic relations with Venezuela, which had been severed in March by Venezuela because of Panama's efforts to encourage action at the OAS on Venezuela's recent political unrest.

Varela's vice presidential running mate, Isabel de Saint Malo, is a political independent who had worked developing Varela's campaign platform. She has already been tapped to become Minister of Foreign Affairs in the new government. Some reports describe her as a consensus-builder. She previously served as Panama's alternative Ambassador to the OAS under the Endara Administration in the aftermath of Panama's return to democratic rule.

In addition to the presidential race, voters selected members of Panama's 71-seat unicameral National Assembly and hundreds of local officials—all for five-year terms. While to date not all of the legislative races have been certified, reportedly the CD-led electoral coalition known as Unidos Por Más Cambios (United for More Change) won 33 of the 71 seats; the PRD won 24; President-elect Varela's PPA-led electoral alliance known as El Pueblo Primero (People First) won 13; and one independent deputy was elected. With just 13 legislative seats, Varela faces the challenge of securing legislative support for his agenda. Varela's coalition and the PRD reportedly have agreed to a pact of governance that will provide the Varela government with a majority in the legislature. Some analysts question whether such a pact will be able to hold together over the long-term given the different political orientations of the PRD and the Panameñista Party and because of the multiple factions within the PRD.

The 2014 elections were considered free and fair by independent observers, including the Organization of American States (OAS) and the Carter Center . Both organizations lauded Panama's Electoral Tribunal (TE) for its conduct of the elections, but also raised some concerns about some aspects of the electoral process, including the use of public resources by the candidates of the incumbent party. The OAS, which has observed nine elections in Panama since1972, had raised concerns in March about some attempts to discredit the TE.

Panama's services-based economy has been flourishing in recent years, in large part because of the Panama Canal expansion and other large infrastructure projects, such as a metro system for Panama City, a third bridge over the Canal, and expansion of the country's international airport, regional airports, and several roads and highways. When the Martinelli government took office in 2009, it had to deal with the fallout stemming from the global financial crisis, but the economy weathered the storm and avoided the contraction experienced by many Latin American economies. Before the financial crisis, Panama's economy had been booming, growing by over 10% in 2007 and 2008. The global financial crisis and U.S. recession slowed Panama's economic growth to 3.9% in 2009, but this still made Panama's economy one of the few in the region registering positive economic growth. Since then, the economy has rebounded. Economic growth averaged 9.4% from 2010-2013, and in 2014 the forecast is for 7% growth. The International Monetary Fund issued its latest Article IV consultation staff report on Panama in early June 2014 and concluded that the country's economic performance remains buoyant, with banks that are well capitalized, profitable, and liquid.

Strong economic growth in recent years has contributed to poverty reduction in Panama. According to the U.N. Economic Commission for Latin America and the Caribbean, the poverty rate declined from 31% in 2005 to 25% in 2011, while indigence or extreme poverty fell from 14.1% in 2005 to 12.4% in 2011. Targeted social programs have also contributed to a reduction in poverty. The Torrijos government initiated a social support program of conditional cash transfers to poor families and the elderly, and the Martinelli government established a program to provide monthly payments (now $120) to seniors over 70 years of age who do not receive a pension, as well as a universal scholarship program that provides monthly grants to students.

Nevertheless, while Panama is classified by the World Bank as having an upper-middle-income economy because of its per capita income ($8,510 in 2012), inequality still remains relatively high, with large disparities between the rich and poor. The World Bank asserts that challenges persist in the provision of public services, particularly for children in indigenous communities who have significantly less access to basic services than children in rural or urban areas. It maintains that accelerating poverty reduction depends on the country developing a more effective social protection system for the poor. Panama has received support from the World Bank for a variety of projects focused on health, social protection, rural development, environment, infrastructure, and efficiency in the public sector.

U.S. relations with Panama date to the country's independence from Colombia in 1903. While historically there were strains in relations at various times over the operation of the Panama Canal, the Panama Canal treaties negotiated in 1977 reduced tensions in the relationship and set a path for Panama's assumption of full jurisdiction over the Canal by the end of the century. Relations deteriorated significantly in the 1987-1989 period under the de facto political rule of General Manuel Noriega. Since the December 1989 U.S military intervention, however, and Panama's return to elected civilian democratic rule, U.S. relations with Panama have been close. Bilateral relations were strengthened with the approval of a bilateral free trade agreement that entered into force in October 2012.

According to the State Department, the country's central location in the hemisphere, the Panama Canal, its transportation infrastructure, and its financial sector make it an important hub for global trade and a key U.S. strategic partner, but these same characteristics make Panama vulnerable to drug trafficking, money laundering, and organized criminal activity. Upon Juan Carlos Varela's election in May 2014, Secretary of State John Kerry commented that "our longstanding cooperation and commitment to Panama and the Panamanian people will endure with the next Administration."

In terms of foreign policy, Panama has been a strong U.S. ally in the region. While many other Latin American countries had a timid response to the Venezuelan government's suppression of protests beginning in February 2014, Panama spoke out and called for a special meeting of the OAS and even made a Venezuelan opposition legislator a temporary member of its OAS delegation. In July 2013, Panama detained a North Korean freighter, which had made stops in Cuba, as it prepared to enter the Panama Canal due to suspicion that the ship was carrying illicit narcotics; instead, the ship was found to be carrying military weapons. The U.N. Security Council's Panel of Experts for North Korea visited Panama and concluded in a report issued by the Security Council in March 2014 that the military shipment destined for North Korea constituted a violation of U.N. sanctions violation. During a trip to Panama in November 2013, Vice President Biden lauded Panama for stepping up and taking on that international responsibility and contribution to global security.

Looking ahead, Panama is scheduled to host the next Seventh Summit of the Americas in 2015. At issue is a possible invitation to Cuba to participate in the summit; Panama's Minister of Foreign Affairs reportedly has suggested extending an invitation to Cuba. Several Latin American nations have vowed not to attend the summit unless Cuba is allowed to participate. The United States and Canada opposed Cuba's attendance at the 2012 summit because it was not a democracy, and ultimately Cuba was not invited.

A number of U.S. agencies provide support to Panama. The State Department, the Drug Enforcement Administration, the U.S. Coast Guard, the Department of Homeland Security, and the Department of Defense are all involved in providing counternarcotics support. The U.S. Southern Command (Southcom) provides support to Panama through military exercises providing humanitarian and medical assistance, and at times provides emergency assistance in the case of natural disasters such as floods or droughts. Southcom has sponsored annual multinational training exercises since 2003 focused on the defense of the Panama Canal. Panama also participates in the Container Security Initiative (CSI) operated by the U.S. Customs and Border Protection of the Department of Homeland Security, and the Megaports Initiative run by the National Nuclear Security Administration of the Department of Energy. Panama hosts the Smithsonian Tropical Research Institute dedicated to studying biological diversity. The Peace Corps has about 190 volunteers in the country working on a range of development projects.

Because of Panama's relatively high per capita income level and progress in economic development, the United States has not provided large amounts of foreign aid to the country in recent years. At this juncture, the United States provides just small amounts of bilateral assistance to Panama, but Panama has also received U.S. assistance through the Central American Regional Security Initiative (CARSI), a U.S. regional security program begun in FY2008 to help Central American states reduce drug trafficking while advancing citizen security.

U.S. bilateral assistance to Panama amounted to $3.4 million in FY2013 and an estimated $3 million in FY2014. The Administration's FY2015 request for bilateral assistance is for $4 million, including:

$1.8 million in Foreign Military Financing (FMF) to help support Panama's capacity to protect its borders and maritime territory from transnational threats such as drug trafficking; $720,000 for International Military Education and Training (IMET) to support training for Panamanian defense personnel at U.S. military institutions in the United States; and $1.5 million in Nonproliferation, Antiterrorism, Demining and Related Programs (NADR) assistance to support a Department of Justice program to strengthen Panama's ability to detect, investigate, and prosecute money laundering and terrorist financing cases, and to help Panama refine its strategic trade management system.

Under CARSI, approximately $51.2 million was designated for Panama from FY2008 through FY2012, a little over 10% of the almost $500 million appropriated for CARSI for those years. The assistance funds programs for crime prevention efforts, justice sector reform, counternarcotics interdiction, and law enforcement professionalization and support. Those funding figures are derived from a Government Accountability Office report on CARSI issued in September 2013. CARSI funding figures for Panama for FY2013 and FY2014, as well for the FY2015 CARSI request, are not available since the State Department does not release funding information by country. Overall funding for CARSI, however, amounted to $145.6 million in FY2013 and an estimated $161.5 million in FY2014, while the Administration's FY2015 request is for $130 million. Panama will receive a portion of this assistance. (Also see discussion on " Drug Trafficking and Money Laundering " below.)

Securing Panama's cooperation to combat drug trafficking and money laundering has been an important concern to U.S. policy makers for many years. Because of its geographic location, large maritime industry, and containerized seaports, Panama remains a major transit country for illicit drugs from South America. According to the State Department's March 2014 International Narcotics Control Strategy Report (INCSR) , transnational drug trafficking organizations, including Mexican and Colombian groups, use Panama's remote Darién province (bordering Colombia, see Figure 1 ) and the country's coastline and littoral zones to move illicit drugs. Drug traffickers also exploit the country's well-developed transportation infrastructure, including four major container seaports, the Pan-American Highway and the fourth busiest airport in Latin America. Panama's large financial sector and the Colon Free Zone (CFZ), also make the country vulnerable to money laundering, which is attributed largely to drug trafficking proceeds. According to the INCSR , lax enforcement of existing controls in the CFZ and other free trade zones leaves Panama susceptible to other illicit financial activities by various criminal groups.

Panama seized 41 metric tons of cocaine in 2013, a significant increase compared to 34 tons seized in 2012. This increase reversed a three-year downward trend for Panama's rate of interdiction. According to the State Department, this can be credited to Panama's enhanced operational readiness of its maritime interdiction vessels and continued forward deployment of U.S. air and maritime surveillance and interdiction assets.

With regard to bilateral cooperation, in a November 2013 trip to Panama, Vice President Joe Biden lauded Panama for its efforts to stop illegal drug trafficking and characterized U.S.-Panamanian law enforcement cooperation as excellent. The State Department also asserted in the INCSR that the United States enjoys a strong partnership with all Panamanian security services.

U.S. assistance, provided largely through CARSI noted above, has included support for citizen security, law enforcement, and rule-of-law programs with the goal of expanding Panama's capabilities to interdict, investigate, and prosecute illegal drug trafficking and other transnational crimes. Under CARSI, the United States has also provided training and equipment to the Panamanian National Police (PNP) for anti-gang enforcement and community policing.

U.S. support for Panama's interdiction efforts includes assistance to modernize and maintain vessels and facilities of the Air Naval Service (SENAN), the National Border Service (SENAFRONT), and the PNP. Technical training has been provided to improve the professionalism and effectiveness of Panama's security services in such areas as small boat operations, small unit tactics, maritime interdiction, equipment, and logistics support. As a result of support from the United States and Colombia, SENAFRONT has been able to provide training to regional partners such as Belize, Costa Rica, and Honduras.

For a number of years, the leftist Revolutionary Armed Forces of Colombia (FARC), a U.S.-designated foreign terrorist organization, had a small presence in the Darién region, which they used as a safe haven. In 2013, however, Panama's SENAFRONT undertook several operations against the FARC that degraded their capabilities and Panama reports that the guerrilla group no longer has a permanent presence in the country. Nevertheless, the FARC reportedly continues to use Panamanian territory for the transit of illegal drugs.

The State Department lists Panama as a "major money laundering country," and in the 2014 INCSR maintained that numerous factors hinder the country's efforts to combat such activity, including the existence of bearer share corporations (see discussion below), a lack of cooperation among Panamanian government agencies, inconsistent enforcement of laws and regulations, and a weak judicial system susceptible to corruption and favoritism.

Taking a longer view, Panama has made significant progress in strengthening its anti-money laundering regime since the year 2000, when it was cited as a 'non-cooperative country' in combating money laundering according to the Financial Action Task Force (FATF), a multilateral anti-money laundering body. The Panamanian government subsequently took comprehensive action by enacting laws and issuing decrees to improve its operations against money laundering that led the FATF to remove Panama from its non-cooperative country list in June 2001.

Panama has also made progress in improving financial transparency. In November 2010, the government signed a Tax Information Exchange Agreement (TIEA) with the United States as part of its negotiations for implementing a free trade agreement. By early July 2011, Panama had signed enough tax agreements with other countries that the Organization for Economic Co-Operation and Development (OECD) remove it from the so-called "gray list" of countries judged to lack an internationally agreed tax standard. (Jurisdictions with at least 12 signed agreements for exchanging tax information are considered by the OECD to have substantially implemented the tax standard, and are removed from the list). Although Panama was removed from the OECD's "gray list," its legal and regulatory system for the exchange of information for tax purposes are still subject to peer reviews.

Another issue, noted above, that arose during talks for implementing a bilateral free trade agreement was U.S. concern regarding the use of bearer shares in Panama because of their frequent use for laundering money connected to drug trafficking. In February 2011, former President Martinelli signed into law "know your client" legislation meant to immobilize (but not eliminate) bearer shares, although the law only goes into effect in 2018. The State Department's Country Reports on Terrorism 2013 maintains that continued existence of bearer share corporations in Panama remains a prime vulnerability of its regulatory framework.

On a positive note, in October 2013, Panama and the United States signed an asset-forfeiture sharing agreement that provides some $36 million from a past money laundering investigation involving the U.S. Drug Enforcement Administration and Panamanian authorities. The funds are to be used to support jointly-agreed upon projects that support anti-money laundering efforts in Panama.

Commercial Relations: Trade and Investment22

Panama is largely a services-based economy, and has historically run a merchandise trade deficit with the United States. In 2013 the United States ran a $10.1 billion trade surplus with Panama, exporting about $10.6 billion in goods and importing $449 million (see Table 1 ). Panama's major exports to the United States include repaired goods, seafood, gold, electrical machinery, and sugar. Major imports from the United States include oil, machinery, electrical machinery, iron and steel products, aircraft, and agricultural products. The stock of U.S. foreign direct investment (FDI) in Panama was estimated at $5.1 billion in 2012 (based on a historical-cost basis), led by the nonbank holding and manufacturing sectors, and accounted for about 44% of all U.S. FDI in Central America.

As noted above, Panama and the United States originally negotiated a free trade agreement (FTA) in 2007. While Panama's National Assembly approved the agreement that year, the United States did not approve and enact implementing legislation until October 2011 ( P.L. 112-43 ). Following approval of the FTA, both countries conducted a thorough review of their respective laws and regulations related to the agreement's implementation. In late September 2012, Panama's National Assembly approved a final package of laws needed for FTA implementation, including regulations on the country's copyright and intellectual property rights regime. President Martinelli signed these measures into law in October 2012, along with an executive decree tied to Panama's administration of tariff-rate quotas. This cleared the way for the exchange of letters and for the FTA to enter into force on October 31, 2012.

Panama sought the FTA to make its trade rules with the United States permanent, and as a means of increasing foreign investment in the country. The United States stressed that an FTA with Panama would not only enhance U.S. access to Panama's growing market, but also provide access to the country's large services market. According to U.S. officials, Panama's strategic location as a major shipping route (with some 10% of U.S. international trade passing through the Canal) enhanced the significance of a free trade agreement for the United States.

The FTA includes disciplines related to customs administration and trade facilitation, technical barriers to trade, government procurement, investment, telecommunications, electronic commerce, intellectual property rights and labor and environmental protection. Since the FTA entered into force in October 2012, over 87% of U.S. exports for consumer and industrial goods to Panama have been duty-free, as well as over 50% of U.S. agricultural goods. Panama will gradually phase out remaining tariffs over the next decade, although tariffs on most U.S. farm products will be phased out within 15 years. The agreement also provides improved access for U.S. companies to Panama's $22 billion services market, which includes financial, telecommunications, computer, express delivery, energy, environmental, and energy services.

Panama has no formal restrictions on capital flows or discrimination between foreign and domestic investment. According to the Department of State, however, several factors add risk and complication to doing business in the country; these include poor rule of law, lack of judicial independence, a shortage of skilled workers, high levels of corruption, and poorly staffed government institutions. The U.S. Embassy also has received numerous reports of fraud and corruption in connection with titles to property purchased by U.S. investors as well as complaints from U.S. companies about inconsistent treatment of their concessions. Nevertheless, U.S. companies are well represented in Panama's various sectors, including its largest container port facility, multiple financial institutions, transportation firms, and manufacturing facilities.

After Panama's independence from Colombia in 1903, it concluded a treaty with the United States ceding rights to build, administer, and defend a canal cutting across the country and linking the Pacific and Atlantic oceans. The Hay-Buneau-Varilla Treaty established the so-called Canal Zone (about 10 miles wide and 50 miles long) to be managed by the United States "as if it were sovereign" and "in perpetuity." Subsequent construction of the Canal was completed in 1914. However, this treaty soon became a source of conflict between the U.S. and Panamanian governments. In the 1960s, growing Panamanian resentment over the extent of U.S. rights in the country led to riots that spurred negotiations for a new treaty arrangement for the operation of the Canal. Draft treaties were completed in 1967, but rejected in 1970 by Panama.

New negotiations, however, ultimately led to agreement on two Panama Canal Treaties that were signed in September 1977 by U.S. President Jimmy Carter and Panama's head of government, General Omar Torrijos. Under the first treaty, known as the Treaty on the Permanent Neutrality and Operation of the Panama Canal, or simply the Neutrality Treaty, the two countries agreed to maintain a regime of neutrality for keeping the Canal open to ships of all nations. The Neutrality Treaty has no termination date, and under the first condition to the treaty (known as the DeConcini condition), if the Canal is closed or its operations are interfered with, both countries independently have the right to take steps as each deems necessary, including the use of military force, to reopen the Canal or restore its operations. The second treaty, known simply as the Panama Canal Treaty, gave primary responsibility for operating and defending the Canal to the United States until December 31, 1999. The U.S. Senate gave its advice and consent to the Neutrality Treaty in March 1978, and to the Panama Canal Treaty in April 1978; Panama and the United States exchanged instruments of ratification for the two treaties in June 1978, and the two treaties entered into force on October 1, 1979.

After the treaties were signed, U.S. officials consistently affirmed over the years their commitment for ensuring a smooth transition of the Canal to Panamanian control. At the end of 1999, when the Panama Canal Treaty terminated, the U.S. agency operating the Canal, the Panama Canal Commission (PCC), was succeeded by its Panamanian government counterpart, the Panama Canal Authority (ACP).

Since the ACP has run the Canal beginning in 2000, it has been lauded for increasing Canal safety and efficiency. In September 2012, Jorge Quijano was appointed by the ACP's Board of Directors to become the new Canal administrator for a seven-year term, succeeding Alberto Alemán Zubieta who had served as administrator since 1996. Quijano, an engineer, has worked at the Canal since 1975, and led the Canal expansion project beginning in 2006.

In April 2006, the ACP presented to then-President Martin Torrijos its recommendation to build a third channel and new set of locks (one on the Atlantic and one on the Pacific) that would double the capacity of the Canal and allow it to accommodate giant container cargo ships known as post-Panamax ships. The estimated cost of the seven-year project was $5.25 billion, to be self-financed by the ACP through graduated toll increases and external bridge financing. According to the ACP, the overall objectives of the expansion project are to (1) achieve long-term sustainability and growth for the Canal's financial contributions to the Panamanian national treasury; (2) maintain the Canal's competitiveness; (3) increase the Canal's capacity to capture the growing world tonnage demand; and (4) make the Canal more productive, safe, and efficient. The Canal expansion project was approved by a national referendum in October 2006 with 78% support, and officially launched in September 2007.

While the project originally was expected to be completed by October 2014, delays have pushed the completion date to the first quarter of 2016. In February 2014, the multinational consortium constructing the third set of locks known as Grupo Unidos Por el Canal (United Group for the Canal or GUPC), led by a Spanish construction company, halted its work due to disagreement with the ACP over who would pay some $1.6 billion in cost overruns. ACP officials complained that the consortium underestimated its costs when it bid $3.12 billion to build the new set of locks, well below bids from competing companies. By March 2014, however, the ACP and the GUPC settled the dispute. Another delay involved a two-week strike by construction workers that ended in early May 2014 after a wage-increase agreement was reached. According to the ACP, the expansion project was 76% complete at the end of May 2014.

The Canal expansion is expected to reduce shipping rates between Asia and the U.S. Gulf and East coasts, resulting in significant savings and increased trade using that route; it is also expected to increase Latin American trade with Asia as well as intra-Latin American trade. ACP Administrator Jorge Quijano maintains that when the expansion project is complete, it will be able to accommodate 98% of all containerships. Quijano and energy analysts expect an increase in the export of liquefied natural gas from the United States to Asian markets, particularly in light of the rapid increase in natural gas production from shale in the United States. As a result of the reduced transportation cost, U.S. grain producers are expected to gain from increased exports as they become more competitive with other world producers. A number of U.S. ports have begun readying themselves in order to take advantage of the trade expansion.

While the largest trade route using the Canal is East Coast/United States to Asia, which accounted for almost 37% of all Canal traffic in FY2013, the second largest trade route is East Coast/United States to West Coast/South America, which accounted for about 13% of all traffic. Several countries in this region – Chile, Colombia, and Peru – already have free trade agreements with the United States, and lower transportation costs resulting from the Canal expansion could further boost their trade linkages with the United States.

Panama's political and economic outlook appears promising. The country is now approaching 25 years of elected civilian democratic rule, and its services-based economy remains strong. The Panama Canal expansion project, other infrastructure projects, and the country's large financial sector position Panama to continue to play a significant role in international and regional trade. The government's challenges include efforts to combat poverty and inequality and to continue to make headway in combating threats from drug trafficking, money laundering, and organized crime. U.S. relations with Panama under the incoming government of Juan Carlos Varela are expected to continue to be strong, with extensive cooperation on drug trafficking and other security issues and robust trade and investment linkages. Panama is scheduled to host the Seventh Summit of the Americas in 2015. Several Latin American nations have vowed not to attend unless Cuba is invited to participate.

Appendix. Selected Executive Branch Reports

Bilateral Relations Fact Sheets, Panama, State Department

Date: October 15, 2013 Full Text: http://www.state.gov/r/pa/ei/bgn/2030.htm

Congressional Budget Justificati on for Foreign Operations FY2015 , Annex 3 : Regional Perspectives (pp. 693-695), State Department

Date: April 18, 2014 Full Text: http://www.state.gov/documents/organization/224070.pdf

Country Reports on Human Rights Practices 2013, Panama, State Department

Date: February 27, 2014 Full Text: http://www.state.gov/j/drl/rls/hrrpt/2013/wha/220460.htm

C ountry Reports on Terrorism 2013 (Western Hemisphere Overview), State Department

Date: April 2014 Full Text: http://www.state.gov/j/ct/rls/crt/2013/224825.htm

International Religious Freedom Report 2012, Panama, State Department

Date: May 20, 2013 Full Text: http://www.state.gov/j/drl/rls/irf/2012/wha/208496.htm

International Narcotics Control Strategy Report 2 014, Vol. I, Panama , State Department

Date: March 2014 Full Text: http://www.state.gov/j/inl/rls/nrcrpt/2014/vol1/222990.htm

International Narcotics Control Strategy Report 20 14, Vol. II, Panama , State Department

Date: March 2014 Full Text: http://www.state.gov/j/inl/rls/nrcrpt/2014/vol2/222762.htm

Investment Climate Statement, 2014, Panama, State Department

Date: June 26, 2014 Full Text: http://www.state.gov/e/eb/rls/othr/ics/2014/227928.htm

National Trade Estimate Repor t on Foreign Trade Barriers , 2014, Panama, Office of the United States Trade Representative

Date: March 31, 2014 Full Text: http://www.ustr.gov/sites/default/files/2014%20NTE%20Report%20on%20FTB%20Panama.pdf

Tr afficking in Persons Report 2014 (Panama, pp. 292-295), State Department

Date: June 20, 2014 Full Text: http://www.state.gov/j/tip/rls/tiprpt/countries/2014/226795.htm

Question: What is the state of Panama's democracy?

Answer: The Central American nation of Panama has had five successive elected civilian governments since its return to democratic rule in 1989, and a sixth is scheduled to assume power on July 1, 2014 with the inauguration of current Vice President Juan Carlos Varela as President.

Question: What did was the outcome of the 2014 Panamanian election?

Answer: Hailing from the center-right Panameñista Party, Varela won the May 4, 2014 presidential election with 39% of the vote in a three-candidate race. Significantly, Varela defeated the candidate of the ruling Democratic Change party of current President Ricardo Martinelli, who was constitutionally prohibited from running for reelection.

Question: How was Martinelli viewed during his presidency?

Answer: Elected in 2009, Martinelli remained generally popular during his presidency despite criticism at various junctures for his combative style of governing. Nevertheless, his popularity ultimately was not enough to convince voters to support his party's candidate.

Question: What was one controversy about Martinelli?

Answer: One controversy that emerged in the campaign was that Martinelli's wife became his party's vice presidential candidate. This led to some critics complaining of an attempt by Martinelli to extend his influence in the next government.

Panama's Political and Economic Environment1

Question: Why is Panama's economy booming?

Answer: Panama's largely services-based economy has been booming in recent years, spurred on by several large infrastructure projects, including, most significantly, the Panama Canal expansion project that began in 2007 and is expected to be completed in early 2016.

Question: What will be a challenge for the Varela government?

Answer: A challenge for the Varela government will be how to contend with slower economic growth rates as the Canal expansion project winds down.

Question: What will be another challenge?

Answer: Another challenge for the government is making more headway in combating poverty and inequality in Panama, which still remain relatively high.

Question: Why has the US had close relations with Panama?

Answer: The United States has close relations with Panama, stemming in large part from the extensive linkages developed when the Panama Canal was under U.S. control and Panama hosted major U.S. military installations.

Question: How have relations been strengthened?

Answer: Relations have been strengthened by a bilateral free trade agreement that entered into force in October 2012.

Question: What is the effect of Panama's location and infrastructure?

Answer: As noted by the State Department, Panama's central location in the hemisphere, its transportation infrastructure (most notably the Canal), and its financial sector make it an important hub for global trade and a key U.S. strategic partner, but these same characteristics also make Panama vulnerable to drug trafficking, money laundering, and organized criminal activity.

Question: Why does the US provide small amounts of bilateral assistance to Panama?

Answer: Since Panama is relatively well developed economically compared to its Central American neighbors, the United States provides just small amounts of bilateral assistance to Panama.

Question: What is the purpose of CARSI?

Answer: Nevertheless, the country receives additional assistance through the Central American Regional Security Initiative (CARSI), a U.S. regional security program begun in FY2008 to help Central American states reduce drug trafficking while advancing citizen security.

Question: What is the status of Panama's anti-drug cooperation with the US?

Answer: Panama's anti-drug cooperation with the United States is strong.

Question: How has Panama been with regards to it anti-money laundering regime?

Answer: While the country has made progress in improving its anti-money laundering regime, there are several factors that hinder the country's efforts to combat such activity.

U.S.-Panama Relations
U.S. Foreign Aid and Other Support

U.S.-Panama Relations
Drug Trafficking and Money Laundering


The American Opportunity Tax Credit: Overview, Analysis, and Policy Options

Summary: The American Opportunity Tax Credit (AOTC)—originally enacted on a temporary basis by the American Recovery and Reinvestment Act (ARRA; P.L. 111-5) and made permanent by the Protecting Americans from Tax Hikes Act (PATH; Division Q of P.L. 114-113)—is a partially refundable tax credit that provides financial assistance to taxpayers (or their children) who are pursuing a higher education. The credit, worth up to $2,500 per student, can be claimed for a student's qualifying expenses incurred during the first four years of post-secondary education. In addition, 40% of the credit (up to $1,000) can be received as a refund by taxpayers with little or no tax liability. The credit phases out for taxpayers with income between $80,000 and $90,000 ($160,000 and $180,000 for married couples filing jointly) and thus is unavailable to taxpayers with income above $90,000 ($180,000 for married couples filing jointly). There are a variety of other eligibility requirements associated with the AOTC, including the type of degree the student is pursuing, the number of courses the student is taking, and the type of expenses which qualify.

Summary: Before enactment of the AOTC, there were two permanent education tax credits, the Hope Credit and the Lifetime Learning Credit. The AOTC replaced the Hope Credit (the Lifetime Learning Credit remains unchanged). A comparison of these two credits indicates that the AOTC is both larger—on a per capita and aggregate basis—and more widely available in comparison to the Hope Credit. Data from the Internal Revenue Service (IRS) indicate that enactment of the AOTC contributed to an increase in both the aggregate value of education credits claimed by taxpayers and the number of taxpayers claiming these credits.

Summary: Education tax credits were intended to provide federal financial assistance to students from middle-income families, who may not benefit from other forms of traditional student aid, like Pell Grants. The enactment of the AOTC reflected a desire to continue to provide substantial financial assistance to students from middle-income families, while also expanding the credit to certain lower- and upper-income students. A distributional analysis of the AOTC highlights that this benefit is targeted to the middle class, with approximately half (46.6%) of the estimated $17 billion of AOTCs in 2015 going to taxpayers with income between $30,000 and $100,000.

Summary: One of the primary goals of education tax credits, including the AOTC, is to increase attendance at higher education institutions (for brevity, referred to as "college attendance"). Studies analyzing the impact education tax incentives have had on college attendance are mixed. Recent research that has focused broadly on education tax incentives that lower tuition costs and have been in effect for several years, including the Hope and Lifetime Learning Credits, found that while these credits did increase attendance by approximately 7%, 93% of credit recipients would have attended college in their absence. Even though the AOTC differs from the Hope Credit in key ways, there are a variety of factors that suggest this provision may also have a limited impact on increasing college attendance. In addition, a recent report from the Treasury Department's Inspector General for Tax Administration (TIGTA) identified several compliance issues with the AOTC.

Summary: There are a variety of policy options Congress may consider regarding the AOTC. (The credit was not modified or changed in the recent tax law enacted at the end of 2017, P.L. 115-97.) Alternatively, Congress may want to examine alternative ways to reduce the cost of higher education. This report discusses these issues and concludes with an overview of selected proposals to modify the AOTC.

The American Opportunity Tax Credit (AOTC) provides financial assistance to taxpayers whose children (or who themselves) are pursuing post-secondary education. This report examines how the AOTC works, its impact on encouraging attendance at higher education institutions, and issues with administering the credit. This report provides both an in-depth description of this tax credit and an analysis of its economic impact. This report is organized to first provide an overview of the AOTC, followed by a legislative history that highlights the evolution of education tax credits from proposals in the 1960s through the recent permanent extension of the AOTC at the end of 2015. This report then analyzes the credit by looking at who claims the credit, the effect education tax credits have on increasing attendance at higher education institutions, and administrative issues with the AOTC. Finally, this report concludes with a brief overview of various policy options.

The American Opportunity Tax Credit (AOTC) allows eligible taxpayers to reduce their federal income taxes by up to $2,500 per eligible student. The credit was enacted as part of the American Recovery and Reinvestment Act of 2009 ( P.L. 111-5 ), temporarily replacing the Hope Credit for 2009 and 2010. The Hope Credit was originally enacted in 1997 as part of the Taxpayer Relief Act ( P.L. 105-34 ). As outlined in Table 1 , the AOTC modified several parameters of the Hope Credit. The AOTC was extended for 2011 and 2012 by the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 ( P.L. 111-312 ). Subsequently, the AOTC was extended for five more years, through the end of 2017, by the American Taxpayer Relief Act of 2012 ( P.L. 112-240 ; ATRA). The Protecting Americans from Tax Hikes (PATH) Act (Division Q of P.L. 114-113 ), made the AOTC permanent, effectively eliminating the Hope Credit.

The AOTC is calculated as 100% of the first $2,000 of qualifying education expenses plus 25% of the next $2,000 of qualifying education expenses for each eligible student. Hence, to claim the maximum value of the credit, an eligible student will need to have incurred at least $4,000 in qualifying education expenses. The AOTC phases out for taxpayers with income above certain thresholds. Specifically, the AOTC begins to phase out when income exceeds $80,000 ($160,000 for married taxpayers filing jointly) and is completely phased out when income exceeds $90,000 ($180,000 for married taxpayers filing jointly). Thus, taxpayers with income over $90,000 ($180,000 or more for married taxpayers filing jointly) are ineligible for the AOTC.

The AOTC is a refundable credit, meaning taxpayers with little to no tax liability may still be able to benefit from this tax provision. A tax credit is refundable if, in cases where the credit is larger than the taxpayer's tax liability, the Internal Revenue Service (IRS) refunds all or part of the difference. The refundable portion of the AOTC is calculated as 40% of the value of the credit the taxpayer is eligible for based on qualifying education expenses. Therefore, if the taxpayer was eligible for $2,500 of the AOTC, but had no tax liability, they could still receive $1,000 (40% of $2,500) as a refund. For an example on how to calculate the AOTC, see Appendix B .

There are a variety of limitations concerning who can claim the AOTC and what expenses can be used to claim the credit. These provisions are outlined below.

A qualifying student is either the taxpayer, the taxpayer's spouse, or an individual whom a taxpayer can claim as a dependent (in many cases, the taxpayer's child). Other requirements include the following:

Years of Postsecondary Education: The student must be in their first four years of post-secondary education, which for most students is the first four years of undergraduate education. Number of Years Credit Can Be Claimed per Student: For a given eligible student, the AOTC is only available for four years (including any years the Hope credit was claimed). Type of Degree: The student must be enrolled in a program that results in a degree or certificate. The credit cannot be claimed for courses that do not result in a degree or certificate. For example, it cannot be used for coursework that is used to improve jobs skills. Number of Courses: The student must be enrolled at least half time for at least one academic period (e.g., semester, trimester, quarter, or other period of study like a summer school session), which began in the tax year in which the credit is claimed. (Note that for most taxpayers tax years are equivalent to calendar years for the purposes of federal individual income taxes.) Felony Drug Conviction: The student must not have been convicted of any state or federal felony offense for possessing or distributing a controlled substance when they claim the credit.

Qualifying education expenses are tuition and certain expenses required for enrollment at a higher education institution, including the cost of course materials needed for a student's studies.

A variety of common higher education expenses do not qualify for the AOTC (even if the educational institution requires such payments for attendance), including

room and board; insurance; medical expenses (including student health fees); transportation; and similar personal, living, or family expenses.

There are a variety of other requirements for education expenses used to claim the AOTC. First, qualifying education expenses used to claim the AOTC cannot generally be used to claim other education tax benefits. Second, qualifying education expenses must be reduced by the entire amount of tax-free education assistance, if that assistance can be used to pay for expenses that qualify for the AOTC. For example, if a taxpayer has $2,000 in qualifying tuition payments, but receives $500 in tax-free veterans' educational assistance, their qualifying education expenses for the AOTC are $1,500. Importantly, to the extent that the taxpayer chooses to report an otherwise tax-free grant, scholarship, or fellowship on their tax return (and hence it is subject to taxation), they may not need to reduce their education expenses by the amount of the award included in income. Third, qualifying expenses that are claimed in a given tax year must be incurred in that tax year. Those expenses must be for an academic period that begins either in the tax year for which the credit is claimed, or for an academic period that begins in the first three months of the following year. Finally, if any of the expenses used to calculate the credit value are refunded to the eligible student or taxpayer, even if they are refunded after the taxpayer files a tax return, the taxpayer must recalculate the value of the credit.

In cases where the student is claimed as a dependent by the taxpayer, any qualifying expenses paid by the dependent are to be treated as if they were paid by the taxpayer. If a taxpayer does not claim an exemption for their dependent (even if entitled to the exemption), and the dependent is a qualifying student, then the qualifying student can claim the credit based on the expenses they have paid. At the end of 2017, President Trump signed into law P.L. 115-97 which made numerous changes to the federal income tax for individuals and businesses, including setting the amount of the dependent exemption equal to zero from 2018 through the end of 2025. However, this does not affect the credit.

Identification Requirements of the Taxpayer, Student, and Educational Institution

To claim the credit, the taxpayer and student (if different) must provide their name and taxpayer identification number. For most taxpayers, their taxpayer ID number is their social security number (SSN). Other taxpayers may use their individual taxpayer identification number (ITIN). For the taxpayer and the student (if different), the taxpayer ID number must have been issued before the due date of the return on which they are claiming the AOTC. Hence, if a taxpayer did not have a taxpayer ID by the due date for filing 2017 federal income tax returns for individuals (April 17, 2018), they could not claim the AOTC on their 2017 income tax return. In addition, if a ITIN is issued after the due date of the return, the taxpayer cannot amend their return and claim the credit.

The taxpayer must also provide the employer identification number (EIN) of any institution to which qualified expenses were paid for the qualifying student. As with the ID requirements for the taxpayer and student, failure to provide the EIN may lead to the taxpayer being denied the AOTC.

Disallowance of the Credit Due to Fraud or Reckless Disregard of the Rules

A tax filer is barred from claiming the AOTC for a period of 10 years after the IRS makes a final determination to reduce or disallow a tax filer's AOTC because that individual made a fraudulent AOTC claim. A tax filer is barred from claiming the AOTC for a period of two years after the IRS determines that the individual made an AOTC claim "due to reckless and intentional disregard of the rules" of the AOTC, but that disregard was not found to be due to fraud.

Higher education tax credits—first enacted in 1997 by the Taxpayer Relief Act ( P.L. 105-34 )—originated decades earlier in the 1960s when Congress was considering federal financial support for higher education. During consideration of the Higher Education Act of 1965 (HEA; P.L. 89-329)—which provided financial assistance to low-income Americans in the form of grants, work study, and loans —"college tuition credits evolved as an alternative to financial aid programs." The Johnson Administration opposed tuition credits, believing that they would result in reduced revenues that could have otherwise been used for financial aid programs for the lowest-income Americans. They also believed the credit would have a limited impact in influencing whether a student did or did not attend college. According to media reports, then-Treasury Secretary Stanley Surrey stated that

a tax credit for higher education "would not result in even a single additional student going to college." The $1 billion or so that the Treasury would lose in revenue by providing a credit or several hundred dollars annually to the parents of college students can be put to better use in the form of direct financial assistance to young people who would not otherwise get to college at all.

In the late 1970s, Congress again considered higher education tax credits. At the time, college costs had risen sharply and many middle-class families were not eligible for federal financial aid programs to mitigate these costs. Ultimately, Congress did not enact higher education tax credits and instead expanded existing federal student aid programs, raising the income limits so that more middle-income families would qualify.

Nearly two decades later, in a 1996 commencement address at Princeton University, President Clinton outlined a proposal that would later become the Hope Credit, stressing that additional education beyond high school was the key to prosperity for Americans. President Clinton believed that it was essential to make the 13 th and 14 th years of education as universal as the first 12 years. To make these first two years of higher education affordable, President Clinton proposed the creation of the Hope Credit. The credit would be structured so that "if you work hard and earn a B average in high school, we [the federal government] will give you a tax credit to pay the cost of two years of tuition at the average community college." This credit was modeled on and took its name from Georgia's Help Outstanding Pupils Educationally (HOPE) Scholarship, which entitles students in Georgia with at least a B average in high school to a scholarship that covers tuition expenses at state universities and colleges. (The Georgia Hope Scholarship is not a tax credit—it is a direct spending program that is not tied to Georgia's state tax system.) Some experts voiced concerns that the main purpose of education tax credits was to provide a tax cut that would be popular with voters, rather than actually increase college attendance.

Ultimately, the Hope Credit was enacted as part of the Taxpayer Relief Act of 1997 ( P.L. 105-34 ), a law that included numerous other tax-cutting provisions. The Hope Credit (the key parameters of this provision are outlined in Table 1 ) provided eligible taxpayers with up to a $1,500 credit (adjusted for inflation) for tuition expenses for the first two years of higher education. Notably, the requirement that students maintain a B average in high school for eligibility was dropped. Beyond those first two years of higher education, the Taxpayer Relief Act of 1997 also created the Lifetime Learning Credit (see Appendix A for more information on this credit)—but for many taxpayers the value of the Lifetime Learning Credit was less than the Hope Credit.

In 2008, then-candidate Barack Obama proposed replacing the Hope and Lifetime Learning Credits with the American Opportunity Tax Credit (AOTC). As originally proposed during the presidential campaign, the AOTC would be a credit equal to up to $4,000 (100% of the first $4,000 of qualifying higher education expenses) annually. Crucially, the proposed credit was fully refundable, meaning that certain taxpayers with no tax liability—which includes many low-income Americans—would be able to benefit from this provision and receive up to $4,000 as a refund. In addition, the proposed credit would be computed by the IRS using a taxpayer's previous year tax data and provided directly to the higher education institution, not the taxpayer. Students who benefited from the credit would be required to perform 100 hours of community service when they had completed their education.

On a per capita basis, the value of the AOTC, as enacted ($2,500) as part of the American Recovery and Reinvestment Act (ARRA; P.L. 111-5 ), was not as large as originally proposed ($4,000), but it was a larger tax benefit than the Hope Credit ($1,800), which it replaced for 2009 and 2010. (The AOTC replaced the Hope Credit, but does not affect the Lifetime Learning Credit.) For more information on key parameters of the AOTC, see Table 1 . The AOTC as enacted had a maximum value of $2,500 and was partially refundable. Taxpayers with little or no tax liability were eligible to receive a part of the credit—40% of its value—as a refund. In addition, unlike the Obama-proposed AOTC, the actual credit did not go directly to educational institutions but instead was claimed by eligible households based on their qualifying education expenses. Finally, the community service requirement was not included as a provision of the final credit. The AOTC was extended for 2011 and 2012 by the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 ( P.L. 111-312 ). At the end of 2012, the AOTC was extended for five additional years, through the end of 2017, by the American Taxpayer Relief Act of 2012 ( P.L. 112-240 ; ATRA). The Protecting Americans from Tax Hikes (PATH) Act (Division Q of P.L. 114-113 ), made the AOTC permanent, effectively eliminating the Hope Credit. The PATH Act also included a number of provisions intended to reduce improper payments of the AOTC. These provisions included the disallowance of the credit due to fraud or a reckless disregard of the credit's rules and the ID requirements for the taxpayer, student, and educational institution.

The enactment of the AOTC has resulted in a substantial increase in the amount of education credits claimed by taxpayers, as illustrated in Figure 1 . The increase in education tax credits underscores a broader trend, which began in 1997, of providing federal financial assistance for higher education through the tax code. In light of the budgetary implications of the AOTC, Congress may be interested in understanding the economic impact of this provision.

The following sections provide an economic analysis of the AOTC. They include an examination of who claims the credit, its effectiveness in boosting college attendance, and a discussion of administrative issues concerning the AOTC. Analysis of who claims the AOTC indicates that it tends to provide the greatest benefit to middle-income and upper-middle-income taxpayers. From an economic standpoint, the AOTC is an effective tax policy if it causes individuals to engage in a desired behavior—in this case attaining a post-secondary education. Research suggests that the presence of the AOTC is not a major factor in increasing attendance at post-secondary institutions, especially for middle- and upper-middle-income taxpayers who are its primary beneficiaries. Hence, this credit may not be influencing behavior for many recipients and instead may be largely going to many taxpayers that would have pursued a higher education or sent their children to an institution of higher education absent the credit. In addition, the Treasury Inspector General for Tax Administration (TIGTA) has identified administrative issues with the AOTC and its predecessor, the Hope Credit.

When education tax credits were first enacted in 1997, they were expressly intended to provide financial assistance to middle-income taxpayers. Data confirm that the AOTC primarily benefits middle-income taxpayers, although lower-income taxpayers and upper-middle income taxpayers also receive the credit.

Figure 2 illustrates the distribution of the AOTC by adjusted gross income (AGI) level, underscoring that this tax credit provides the majority of its benefits to taxpayers with income between $30,000 and $100,000. Specifically, in 2015, approximately 46.6% of AOTC dollars were claimed by taxpayers with income between $30,000 and $100,000. Two components of the AOTC make the credit available to certain low- and upper-income taxpayers.

The first component of the AOTC that expanded its availability beyond middle-income taxpayers—in this case to low-income taxpayers—is its refundability. Tax credits reduce tax liability dollar for dollar of the value of the credit, but by definition cannot reduce tax liability below zero. Hence, to benefit from the credit, a taxpayer must have sufficient income to owe taxes. The AOTC is refundable such that taxpayers can receive up to 40% of the value of their AOTC—a maximum of $1,000 per qualifying student—as a refund, even if they have no tax liability. In 2015, taxpayers with income under $10,000 received 6.2% of AOTC benefits, while taxpayers with income between $10,000 and $20,000 received 12.2% of AOTC benefits. In both cases, the majority of the value of the credit was the AOTC's refundable portion.

As further underscored in Table 2 , refundability of the tax credit benefits certain low-income taxpayers. For example, more than half (an estimated 55.3%) of the refundable portion of the AOTC is claimed by taxpayers with less than $20,000 of income. In contrast, a little over a twentieth (an estimated 7.1%) of the refundable portion of the AOTC is claimed by taxpayers with incomes between $50,000 and $200,000.

The second component of the AOTC that expanded its availability beyond middle-income taxpayers—in this case to higher-income taxpayers—is the income level at which the credit phases out. As illustrated in Table 1 , the AOTC is available to taxpayers with income up to $90,000 ($180,000 for married joint filers). According to estimates provided in Table 2 , in 2015 taxpayers with income between $100,000 and $200,000 claimed an estimated $3.8 billion of the credit (22.9% of the total amount of the AOTC).

In comparison to its predecessor—the Hope Credit—the AOTC has shifted more of its benefits to higher-income taxpayers, as illustrated in Figure 3 . For example, approximately one-fifth (18.4%) of AOTC dollars was claimed by taxpayers with income under $20,000, almost three times the share of Hope Credit dollars (6.8%) claimed by taxpayers in this income class. In contrast, more than a fifth (22.9%) of AOTC dollars was claimed by taxpayers with income between $100,000 and $200,000, more than six times the share of Hope Credit dollars (3.4%) claimed by taxpayers in this income class. Notably, these gains were accompanied by the reduction in the share of AOTC dollars (in comparison to the Hope Credit) that went to taxpayers with income between $20,000 and $100,000. Specifically, 89.8% of Hope Credit dollars was claimed by taxpayers in this income range, in comparison to 58.7% of AOTC dollars.

Given that children of taxpayers at the upper end of the income scale are more likely to attend a post-secondary educational institution than their lower-income counterparts, providing education incentives to these taxpayers may not increase enrollment at higher education institutions, but instead reward behavior that would have occurred absent the incentive.

Does the AOTC Increase Attendance at Post-Secondary Educational Institutions?

One of the primary goals of the AOTC is to increase attendance at post-secondary educational institutions. (For brevity, this report may refer to institution of higher education as "college," although the AOTC is available for students attending eligible colleges, universities, and trade schools. ) Increased college attendance may not only lead to benefits for individuals in terms of higher wages, but also may provide societal benefits including increased productivity and innovation. , There are a variety of factors that may determine whether a student attends an institution of higher education, including family socioeconomic level, student educational aspirations, peer support, academic performance, and the cost of college.

The AOTC, like other forms of traditional student aid and other forms of tax-based financial aid, subsidizes some of the costs associated with higher education and thus reduces its cost. The effect that a cost reduction has on post-secondary attendance will depend on how sensitive a student's (and his family's) decision to attend college is to price. Some students will be very sensitive to price and insofar as the AOTC reduces cost, this tax benefit would be expected to induce them to attend college. On the other hand, certain students will attend college irrespective of price. In this case, the AOTC rewards students and their families for an action—attending college—that they would have made regardless of the credit's availability, and the credit is simply a windfall gain to certain taxpayers.

Historically, studies analyzing the effect of education tax incentives on college attendance were mixed. Because of the limited amount of data available concerning the AOTC, research instead focused more broadly on education tax incentives that lower tuition costs and that have been in effect for several years—namely the Hope Credit, the Lifetime Learning Credit, and the above-the-line tuition and fees deduction (see Appendix A for more information on these tax benefits). Analysis by the Congressional Budget Office (CBO) conducted two years after the Hope and Lifetime Learning Credits were enacted concluded that "tax credits are unlikely to cause substantial increases in college enrollment." A later study echoed the CBO's conclusion, finding that the Hope and Lifetime Learning Credits had no impact on college enrollment, although there were possible limitations with the analysis.

More recent research has found that while tax-based aid did have an impact on college attendance, a significant proportion of recipients—93%—would have attended college in the absence of these benefits. One study noted which included analysis of the AOTC found that education credits had "a meager effect on college-going." Another succinctly states that "the tax credit and tax deduction [the tuition and fees deduction, see Table A -1 ], which account for most of the tax expenditures for postsecondary education, do not affect school decisions."

Based on the available research and current data on who receives the AOTC, there may be several factors that limit the AOTC's impact on college attendance.

Income Level of Beneficiaries: Research indicates that students from lower-income households are more sensitive to the price of college when deciding whether to attend college, in comparison to their higher-income counterparts. Policies that reduce the price of college, like the AOTC, would then be expected to increase enrollment if they were targeted towards lower-income students. However, as previously discussed, the AOTC primarily benefits middle-income taxpayers, and hence may result in a windfall to many of these taxpayers. Timing of Tax Benefit: Unlike aid and loans received before or at the time of attendance, the AOTC, like other education tax benefits (e.g., the Lifetime Learning Credit and tuition and fees deductions, see Appendix A ) may be received up to 15 months after education expenses are incurred. For families who have limited resources to pay education expenses up front (e.g., they have insufficient savings to pay for college costs), tax credits will provide little benefit in financing their college costs and so will play an insignificant role in whether they attend college or not. , However, the AOTC may enable families that do receive loans to ultimately reduce their loan balances by applying the credit amounts to loan balances. Complexity of Benefit: There are a variety of tax benefits that students or their families can claim when they file their taxes, including the AOTC, the Lifetime Learning Credit, and the tuition and fees deduction. These tax preferences differ in a variety of ways including eligibility criteria, benefit levels, and income phase-outs (see Table 1 and Appendix A ). The value of the tax benefit may also depend on the amount of student aid taxpayers or their children receive. Given these numerous factors, taxpayers may not know which tax preference provides the most benefit until they file their taxes—and calculating the tax benefit of each provision can "place substantial demands on the knowledge and skills of millions of students and families." This complexity may result in some taxpayers choosing not to claim a tax benefit like the AOTC, or not claiming the tax provision that provides the greatest benefit. Studies have found that between 27% and 37% of taxpayers failed to claim eligible education tax benefits. In addition, uncertainty in the amount of the credit they may receive may result in many families excluding the credit when making decisions about college attendance. Institutional Response: Some experts have expressed a concern that colleges and universities—especially those with tuition below the maximum amount subsidized by education tax credits—may respond to the availability of education tax credits like the AOTC by increasing their tuition. This would lessen the ability of education tax credits to lower the after-tax price of college. For example, if a student is eligible for a $2,000 credit, but their college increases tuition by $2,000, the price of college will effectively be unchanged and the credit will entirely benefit the college. If the college raises tuition for all students, irrespective of whether they are eligible for the credit, some students may actually see the cost of college rise. Studies of the Hope and Lifetime Learning Credits have found little evidence that they resulted in tuition increases. More recent research has also found no evidence of this effect.

While there are a variety of factors that may limit the ability of the AOTC to increase college attendance, research indicates that other forms of student aid including Pell Grants may have a similar impact as the AOTC on college attendance. Hence, some of the limitations of the AOTC in increasing college attendance may apply more broadly to other forms of federal financial assistance.

Finally, federal financial assistance for higher education may reduce the after-tax price of college, but cost is just one factor that influences college attendance. Other factors, like college preparedness, may also influence not only whether students attend college, but whether they graduate. Research indicates that college preparedness tends to be correlated with income, with lower-income students less prepared for college than their higher-income counterparts. Thus, other societal factors that exist prior to college may limit the impact aid has on increasing college attendance, especially among needier students.

Are Ineligible Taxpayers Erroneously Claiming the AOTC?

Taxpayers are more likely to claim tax benefits when they are simple and straightforward to claim. However, the trade-off for ease in claiming tax benefits is that it may result in increased errors—both intentional and unintentional—as illustrated in a 2015 Treasury Inspector General for Tax Administration (TIGTA) report on the AOTC.

The 2015 TIGTA report examined 2012 income tax returns that claimed this credit and identified 3.6 million taxpayers who received more than $5.8 billion in AOTC credits that appeared to be erroneous. Of these potentially erroneous credits, the majority ($3.2 billion) were a result of the IRS being unable to confirm that the students claimed on the taxpayers' tax returns attended a college or university. In addition, the TIGTA report found that $1.3 billion in potentially erroneously claimed credits could be attributed to students not attending an eligible educational institution (i.e., they were not certified by the Department of Educations to receive federal student aid funding). One way the IRS could verify that a student attended a college or university would be to match information returns provided by colleges and universities—the 1098-T—with information provided on a tax return. The 1098-T provides the name and taxpayer identification number of the student and the name and employer identification number (EIN) of the college or university. On a federal income tax return, the taxpayer must fill out Form 8863 which also includes the name and taxpayer ID of the student and the name and EIN of the college or university. A discrepancy between these two forms could indicate an erroneous claim for the credit. However, as TIGTA noted in its report, the IRS does not always receive the 1098-T at the time tax returns are filed. For example, colleges and universities are required to file the form 1098-T electronically by March 31. The deadline for most taxpayers to file their federal income tax return is April 15, and many file earlier. Tax filing season generally begins at the end of January. TIGTA proposed the introduction of legislation to require that 1098-Ts be filed no later than January 31. To date, this proposal has not been enacted into law.

TIGTA also suggested the IRS use Department of Education databases on education institutions to verify that a college or university listed on a Form 8863 is a qualifying institution for the credit. While the IRS does not currently have statutory authority to use these databases to verify AOTC claims and deny the credit before a refund is issued, TIGTA recommended using these databases in post-refund examinations of tax returns that claimed the AOTC.

Reducing erroneous claims of the AOTC may require higher that education institutions provide information to the IRS before tax returns are filed. It may also necessitate that the IRS improve its compliance checks, perhaps by coordinating with the Department of Education to share additional information that can be used by the IRS to flag questionable returns for audit. However, as TIGTA highlights "the IRS does not have the audit resources it needs to make any significant reduction in the loss of funds to the Government resulting from paying erroneous claims." Hence even with better data, the IRS may still be limited in recovering erroneously claimed credits. While it may be more beneficial to use third-party data to verify taxpayer eligibility for the AOTC during the filing season, the IRS does not currently have the authority to do so. Legislation would be needed to provide the IRS with the authority to use databases—like those at the Department of Education—during tax filing so that erroneous claims are denied before tax refunds are issued.

Congress may also want to consider modifying the AOTC, or consolidating the AOTC with other education tax benefits. Finally, Congress may want to consider federal financial aid for higher education holistically, which could include alternative ways to reduce the cost of higher education.

Policymakers may choose to modify the AOTC. The AOTC could be modified in a variety of ways. Policymakers may choose to either expand or limit certain parameters of the credit, for example, by using a different credit formula, changing the amount of qualifying expenses that can be used to claim the credit, adjusting the portion of the credit (currently 40%) that is refundable, modifying the income level at which the credit phases out, allowing taxpayers to claim the credit for either more or less than four years of post-secondary education, changing the definition of qualifying expenses (for example to include room and board), and providing nondegree-seeking students (such as students in job-training programs) eligibility for the credit.

If desired, certain changes to the AOTC may expand the credit's availability to lower-income recipients. For example, policymakers could make a greater percentage of the credit refundable. They could also modify the credit such that a lower level of expenses would be necessary to claim the maximum credit (for example, the formula could be 100% of the first $2,500 of qualifying expenses). In contrast, other modifications, like increasing the income level at which the credit phases out, may expand the credit to additional upper-income taxpayers. These changes may increase confusion among taxpayers, especially when trying to determine which higher education tax credit (or the above-the-line deduction for tuition and fees) provides the greatest benefit.

Consolidate the AOTC with Other Education Tax Benefits

Policymakers may instead choose to consolidate the AOTC with other education tax incentives that reduce tuition costs—the Lifetime Learning Credit and tuition and fees deduction. Prior to enactment of the AOTC, there have been several legislative proposals to consolidate these tax benefits. For example, in the 109 th Congress, Senator Baucus introduced the Education Competitiveness Act of 2006 ( S. 3902 ), which repealed the Hope and Lifetime Learning Credits and replaced them with a fully refundable $2,000 higher education tax credit. In the 110 th Congress, the bipartisan Universal Higher Education and Lifetime Learning Act of 2007 ( H.R. 2458 ) consolidated the Hope and Lifetime Learning Credits and the tuition and fees deduction into one partially refundable credit with a maximum value of $3,000 (50% or up to $1,500 was available as a refund). In addition, this legislation set a lifetime limit of $12,000 per student for the credit (the credit could be claimed for no more than two years of graduate education). More recently, the House-passed version of H.R. 1 (the version of the bill which passed the House as amended on November 16, 2017) would have eliminated the Lifetime Learning Credit while simultaneously expanding the AOTC to a five-year credit, with a smaller credit in the fifth year. The Joint Committee on Taxation estimated that this change would have cost $17.8 billion between 2017 and 2028. (Policymakers could, however, consolidate and modify education tax credits in such a way that would increase revenue, decrease revenue, or remain revenue neutral.) Ultimately, this change was not included in the final bill, which was signed into law on December 22, 2017.

Alternative Policies to Reduce the Cost of Higher Education

The AOTC is one of a variety of policies designed to lower the cost of education to students and their families and hence increase accessibility to higher education. Policymakers may pursue several options concerning the AOTC. Alternatively, they may choose to reevaluate the federal government's role in higher education financing more broadly by considering education tax incentives like the AOTC in context with other forms of federal financial aid to develop a broader higher education financing policy. For example, policymakers could expand the types of expenses that would qualify for the AOTC such that a low-income student who uses a Pell Grant to pay for most or all of their tuition could still benefit from the AOTC. Or policymakers may choose to reformulate the federal government's role in higher education financing entirely by encouraging alternative financing mechanisms like human capital contracts, which allow a student to repay an investor a percentage of future earnings for a fixed period of time. Although there may be shortfalls with this particular proposal, approaching higher education policy holistically—instead of tax policy versus traditional financial aid—may provide more benefit to low- and middle-income students.

Appendix A. Other Tax Provisions for Current-Year Higher Education Expenses

Under current law, there are a variety of benefits available to taxpayers for current-year higher education expenses. A complete list can be found in CRS Report R41967, Higher Education Tax Benefits: Brief Overview and Budgetary Effects , by [author name scrubbed].

Of these benefits, the AOTC, the Hope Credit, the Lifetime Learning Credit, and the above-the-line deduction for tuition and fees are often discussed together as the main tax benefits for current-year higher education expenses (under current law, the tuition and fees deduction is scheduled to expire at the end of 2017). A taxpayer cannot claim both the deduction and an education credit (Lifetime Learning or AOTC) for the same student in the same year. Details on the Lifetime Learning Credit and the tuition and fees deduction are provided below.

Appendix B. Calculating the AOTC: A Stylized Example

The Smiths pay $8,000 of college expenses for Sarah. Of the $8,000 in expenses, $6,000 are for tuition and are considered qualifying expenses, while $2,000 are for room and board expenses, which are not qualifying expenses.

The Smiths' daughter Sarah attends University X in the same year her parents incur the $8,000 in college expenses. The Smiths file their tax return as married joint filers. They have a combined income of $100,000, which is below the level at which the credit begins to phase out ($160,000).

To help pay for these costs, the university gives Sarah a $4,000 tax-free scholarship (i.e., none of the scholarship is subject to taxation), which can be used to pay for any part of Sarah's university expenses. The remainder of the cost is paid for with student loans. Sarah is a first-year undergraduate at University X enrolled full-time in a degree program and is eligible to claim the AOTC. She is claimed as a dependent by the Smiths.

Step 1. Qualifying Expenses: Sarah has $6,000 in qualifying expenses that are reduced by the entire value of her tax-free scholarship. Importantly, even though the tax-free scholarship can be used for expenses aside from tuition and fees, because it is tax-free, she must reduce her qualifying expenses by the total value of the award. If she had used the $4,000 award to pay for room and board (not a qualifying expense) and she had also reported it on her (or her parent's income tax return), she would not need to reduce her qualifying expenses by the value of the award. However, because the award is entirely tax-free, her $6,000 in qualifying expenses are reduced by $4,000 and she has $2,000 in qualifying expenses.

Step 2. Calculating the AOTC: Because Sarah has $2,000 in qualifying expenses, her parents can claim a $2,000 AOTC (100% x first $2,000 of qualifying expenses).

Question: What does the AOTC do?

Answer: The American Opportunity Tax Credit (AOTC)—originally enacted on a temporary basis by the American Recovery and Reinvestment Act (ARRA; P.L. 111-5) and made permanent by the Protecting Americans from Tax Hikes Act (PATH; Division Q of P.L. 114-113)—is a partially refundable tax credit that provides financial assistance to taxpayers (or their children) who are pursuing a higher education.

Question: What expenses qualify for the AOTC?

Answer: The credit, worth up to $2,500 per student, can be claimed for a student's qualifying expenses incurred during the first four years of post-secondary education. In addition, 40% of the credit (up to $1,000) can be received as a refund by taxpayers with little or no tax liability.

Question: What are the eligibility requirements for the AOTC?

Answer: The credit phases out for taxpayers with income between $80,000 and $90,000 ($160,000 and $180,000 for married couples filing jointly) and thus is unavailable to taxpayers with income above $90,000 ($180,000 for married couples filing jointly). There are a variety of other eligibility requirements associated with the AOTC, including the type of degree the student is pursuing, the number of courses the student is taking, and the type of expenses which qualify.

Current Law
Eligibility Requirements
Qualifying Student

Current Law
Eligibility Requirements
Qualifying Education Expenses

Question: What permanent education tax credits existed before the AOTC?

Answer: Before enactment of the AOTC, there were two permanent education tax credits, the Hope Credit and the Lifetime Learning Credit.

Question: How does the AOTC compared to the Hope Credit?

Answer: A comparison of these two credits indicates that the AOTC is both larger—on a per capita and aggregate basis—and more widely available in comparison to the Hope Credit.

Question: What does the IRS data indicate about the effects of the enactment of the AOTC?

Answer: Data from the Internal Revenue Service (IRS) indicate that enactment of the AOTC contributed to an increase in both the aggregate value of education credits claimed by taxpayers and the number of taxpayers claiming these credits.

Does the AOTC Increase Attendance at Post-Secondary Educational Institutions?

Question: Why are education tax credits targeted at students from middle-income families?

Answer: Education tax credits were intended to provide federal financial assistance to students from middle-income families, who may not benefit from other forms of traditional student aid, like Pell Grants.

Question: What is the goal of the AOTC specifically?

Answer: The enactment of the AOTC reflected a desire to continue to provide substantial financial assistance to students from middle-income families, while also expanding the credit to certain lower- and upper-income students.

Question: What benefits are the middle class seeing from AOTCs?

Answer: A distributional analysis of the AOTC highlights that this benefit is targeted to the middle class, with approximately half (46.6%) of the estimated $17 billion of AOTCs in 2015 going to taxpayers with income between $30,000 and $100,000.

Question: What is one of the primary goals of education tax credits?

Answer: One of the primary goals of education tax credits, including the AOTC, is to increase attendance at higher education institutions (for brevity, referred to as "college attendance").

Question: What have studies shown about the impact of education tax incentives on college attendance?

Answer: Studies analyzing the impact education tax incentives have had on college attendance are mixed. Recent research that has focused broadly on education tax incentives that lower tuition costs and have been in effect for several years, including the Hope and Lifetime Learning Credits, found that while these credits did increase attendance by approximately 7%, 93% of credit recipients would have attended college in their absence. Even though the AOTC differs from the Hope Credit in key ways, there are a variety of factors that suggest this provision may also have a limited impact on increasing college attendance.

Question: What did the TIGTA find in their report on the AOTC?

Answer: In addition, a recent report from the Treasury Department's Inspector General for Tax Administration (TIGTA) identified several compliance issues with the AOTC.

Are Ineligible Taxpayers Erroneously Claiming the AOTC?

Question: What actions has Congress recently taken regarding the AOTC?

Answer: There are a variety of policy options Congress may consider regarding the AOTC. (The credit was not modified or changed in the recent tax law enacted at the end of 2017, P.L. 115-97.)

Question: What options does this report discuss regarding the future of the AOTC?

Answer: Alternatively, Congress may want to examine alternative ways to reduce the cost of higher education. This report discusses these issues and concludes with an overview of selected proposals to modify the AOTC.

Current Law
Eligibility Requirements
Qualifying Education Expenses
Expenses Paid By Dependents