First... The parent wouldn't be the one withdrawing ideally but the student. AS you or another pointed out this puts them in a potentially lower bracket than their parents.
So your example above isn't really accurate.
Here is a solution. Yearly withdrawals exceeding $30k get taxed at the final year end income rate of the student withdrawing the funds. This allows most students their choice of school, private or public, 4 year school or something in between all that. I'm basing that on today's tuition rates of course... Part of the value of the 529 and growth potential coupled with tax free status is that we have no fucking clue what college tuition will look like in 14 years when my daughter is 18.
Why $30k? I threw that out there without much thought really. I know that there are some quality schools that are going to be close to that or well exceed that per year. You advocate community college to start. So do I. The quality of instruction in most community colleges has been studied and proven to be better than attended a four year school for the first two.
If I could plan all things out for my daughter I would hope she would choose to live at home, attend community college and then transfer up to one of our in state schools. I have no idea what she will want to do when she is 18, 19, 20, etc and what those goals mean for her educational needs. Maybe she'll just go to a trade school, maybe she'll enlist in the military. Beats me. I'll support her rational decisions fully. I won't support her getting an arts degree and going into debt for it.
If there is money left in her 529 when all is said and done (doubtful) then she or I can cash it out and pay the tax penalty for doing so.
I know you probably don't agree with my example of $30k, but it leaves room for choice. Some rich kid has a fully funded year over year 529 with $200k plus in it and wants to go to med school, etc at a prestigious school, then yeah, lets tax his/her withdrawals over a certain amount if that makes everyone happy. The problem is we'll all have different opinions at where that tax kicks in. I believe in choice even if my own approach to school would be as conservative as yours. I think you might want everyone to make the conservative choice regardless of different options present.
So the 529's "cost" the gov't $2 billion a year? No they don't. I hate that mentality. The proper context would be the gov't has an "opportunity" to collect tax revenue. The change in taxation of 529's in 2001 could be called a cost... sure. When they made the tax free status permanent, all aspects of 529's costing the gov't anything became moot. Now it is just an opportunity to tax something that is beneficial to the middle class and to the country overall. We should be encouraging all programs or incentives that allow any citizen to save for school or make the up front costs seem cheaper. Anything that prevents a child from going into obscene amounts of debt for an education should be encouraged.
Do you think it is unfair that some parent's have the option to sacrifice and save in a 529 for their child's future education?