(Tax policy week continues at Createquity with this doozy of an analysis from editorial-board-member-to-be John Carnwath from April 2013. Believe it or not, thanks to some stellar performance in Google search rankings, an article about tax policy is now Createquity’s most-read blog post of all time! And for good reason, as John’s article expands beyond the usual rhetoric and surfaces some creative solutions in the debate around the charitable tax deduction that just might satisfy everyone. -IDM)
In his most recent budget proposal, President Obama is seeking to impose a cap on itemized deductions in the personal income tax return – which includes the deduction for charitable contributions. This provision, part of the administration’s strategy to raise revenue to pay for government spending, has been a part of every White House budget proposal since 2009, and every year arts advocacy organizations join the rest of the nonprofit sector in opposing the changes. So far, the cap has been successfully warded off, but there’s growing concern that if Republicans and Democrats ever agree on sweeping tax reforms, the charitable deduction will be on the chopping block. The fear that limiting the tax deduction will lead to reduced donations to charitable organizations is particularly great this year due to the tax increases that were passed at the end of 2012, prompting the Charitable Giving Coalition to step up its resistance with a new website: protectgiving.org.
While it’s become a popular strategy on Capitol Hill to complain about the lack of progress while refusing to budge from one’s own policy positions, a case can be made that the nonprofit sector’s lobbying on behalf of the charitable deduction has neither improved the financial stability of the sector nor created greater legislative security. At best, it has limited the declines in individual giving in recent years. So rather than simply digging our heels as we head into the next round of budget debates, let’s take a moment to explore a broader range of policy options and see which might make the most sense for the arts.
Before we get to that, though, here’s a refresher on the mechanics of the charitable tax deduction for anyone who needs it.
What is the charitable deduction and how does it work?
The tax deduction for charitable donations was established in 1917, just four years after the federal income tax was introduced. While there have been some changes over the years, in its basic form this provision allows taxpayers to deduct donations to nonprofits and charities from their taxable income. So if a taxpayer earns $50,000 and gives $2,000 to charity, she only has to pay taxes on $48,000. The rationale behind this provision was initially that the taxpayer who gives away $2,000 doesn’t have that money available to spend on herself, so it shouldn’t be counted as part of her income. Nowadays, the deduction is more commonly thought of as an incentive dangled before taxpayers to coax them into donating more money to charity. By allowing taxpayers to deduct charitable donations from their taxable income, the government essentially agrees to pay for a portion of the donation.
Think about it this way: If you earn $1,000 and you’re taxed at a rate of 30%, you have to pay $300 to the IRS and you end up with $700 in your pocket. But if you donate $100 to charity, your taxable income is reduced to $900. Your tax bill then comes to $270 ($900 x 30%). In return for giving $100 dollars to charity the government reduces your taxes by $30, so in the grand scheme of things that $100 check that you write to your favorite opera company really only sets you back $70.
Who benefits from the charitable deduction?
While this all sounds great in principle, there’s a big catch: not all taxpayers benefit from the charitable deduction. Initially the income tax only applied to a rather small number of wealthy Americans, but during World War II it was expanded to affect roughly 75% of the population. Instead of having all of these tax filers list their deductions individually—$42 for prescription medicine here, a $100 donation to a museum there—the IRS introduced the “standard deduction” in 1944. The standard deduction lets all filers lower their taxable income by a fixed amount. For the 2012 tax year that amount is $5,950 for single taxpayers and $11,900 for couples. That means that you only have to keep track of your deductions and itemize them on your income tax return if they exceed $5,950 (or $11,900 if you’re married). That saves a lot of taxpayers (not to mention the IRS) a huge headache, but it also means that the 70% of filers who take the standard deduction don’t get to write off their charitable donations. (One might argue that the non-itemizers benefit from the charitable deduction in a roundabout way, since a typical deduction for charitable donations was factored in when the standard deduction was calculated back in 1944, but the fact remains that the current deduction for charitable contributions and any changes to it are only relevant to about 1/3 of American tax filers.)
For those who do itemize deductions, the amount of the government’s subsidy towards charitable donations depends on the filer’s marginal income tax rate. If you’re in the 35% bracket and you donate $100 to a good cause, the government gives you $35, but if you’re in the 10% bracket you only get $10 back from Uncle Sam. Economists say that the “price of giving” is lower for the individual in the 35% bracket than for the one in the 10% bracket (e.g. note 1 here). Giving $100 to charity “costs” the former (presumably richer) person $65 and the latter $90. While this seems sort of unfair, it’s the result of having a progressive income tax system in which those who earn a lot pay a larger percentage of their incomes into the public purse.
This means wealthy taxpayers not only have more money in their bank accounts to give away, but when they donate to charity the government covers a larger portion of their donations. It is therefore no surprise that the rich are responsible for a large share of charitable giving. Although only 3% of tax filers have annual incomes over $200,000, those households contribute 36% of the money that individuals give to charity every year—a total of $73 billion in 2008. However, the federal government foots the bill for about a third of those donations through the deduction for charitable contributions (assuming that most of the individuals with incomes over $200,000 are in tax brackets with marginal rates over 30%).
One might say, “well it’s all for a good cause, so it doesn’t really matter if the government is paying for a portion of the donations,” but it turns out that taxpayers with high incomes choose to give their money to different causes than those who are less well-off, and the charitable deduction allows them to divert large amounts of government funds to their favorite organizations. The wealthy support educational institutions and the arts to a much greater extent than poor people, who tend to focus their giving on basic needs and religious organizations. The extent to which the arts depend on donors with high incomes for their contributions is quite striking. In 2005, 94% of the funds that arts organizations received through individual contributions came from households with annual incomes over $200,000.
Of course, the donors are not the only ones who benefit from the tax deduction. All of the people who receive services from nonprofits and charities may be considered indirect beneficiaries of this provision in the tax code. However, to determine whether the charitable deduction is the best way for the government to support the work of nonprofits we must take a closer look at the incentives that are created and how people respond to them.
Do donors respond to tax incentives?
The deduction for charitable contributions affects taxpayers in two different ways. On the one hand, we have the “price effect.” As noted above, higher marginal tax rates reduce the price of giving, creating a bigger incentive to contribute to charities. However, high marginal tax rates also mean that people have less money left in their pockets after paying their taxes. In general, if people’s incomes are reduced, one would expect them to become less generous donors. After paying for rent, food, and utilities, they have less money left over for nonessentials like vacations and charitable donations. This is called the “income effect.” Note that the income and price effects work in opposite directions. Higher marginal tax rates incentivize donations through the price effect, but they simultaneously create a disincentive through the income effect.
Several economists have examined donors’ responsiveness to tax incentives over the past few decades, but the results remain inconclusive. Most studies find that donors respond to tax incentives, but the historical record shows that the level of charitable contributions remains relatively constant over time when measured as a proportion of GDP regardless of the available tax incentives. Some studies suggest that higher-earning taxpayers are more responsive to the incentive than those who are less well-off and that there are differences between types of charities (religious, social, educational, etc.) that receive donations. Many policy analyses (CRS, CBO, TPC) therefore calculate the upper and lower limits of a range into which the effects of proposed policy changes are expected to fall rather than a specific estimate.
Considering policy options: goodbye deduction?
To establish the worst-case scenario as a baseline, one might ask what would happen if the charitable deduction were eliminated completely. Independent Sector, an advocacy organization for nonprofits and charities, recently put out a list of FAQs according to which “with no deduction for charitable gifts, itemized charitable giving would drop by between 25 percent and 36 percent total.” This assertion is rather misleading. The study from which Independent Sector gets these numbers states that a taxpayer in the 30% income tax bracket might reduce his contributions by 25-36% if the deduction were eliminated. Since the incentive to donate depends on the filer’s marginal tax rate and 98% of households face rates under 30%, the reduction in the total amount of individual contributions is likely to be much smaller than Independent Sector suggests.
The truth is, we have no idea what would happen if the tax deduction were eliminated. Not only have studies of the price and income effects been inconclusive, but they are all based on observations of how donors have reacted to incremental changes in tax rates and deductibility in the past. These estimates may be useful in predicting the effect of small changes within the range of what’s been observed in the past, but there’s no reason to be believe that the response would be the same once the government’s incentive approaches zero. In fact, economic theory would predict that it’s not the same.
For example, if the deduction were eliminated completely, one might expect some donors to dig deeper into their pockets to keep their favorite charities afloat. However, some wealthy Republicans might cease all charitable donations to protest the fact that they’re having to pay more taxes, secretly hoping to blame the financial hardships of the charitable sector on the Democrats in the next elections. These types of reactions are difficult to predict. One thing is certain: if the indirect subsidy that the government provides through the charitable deduction were eliminated in order to reduce the deficit, individual donors would have to dig deeper into their pockets to sustain nonprofits at their current level of activity. And if the entire nonprofit sector were in severe financial distress, one can easily imagine that some donors would reallocate their gifts towards hospitals and basic social services, compounding the impact on the arts.
Capping the deduction
The good news is that no one has proposed eliminating the deduction altogether. Obama’s 28% cap on deductions, on the other hand, remains a very real possibility.
Obama suggests that the government could increase its revenue by capping deductions at 28% of the donor’s AGI. As mentioned above, the size of the tax incentive is generally determined by the marginal tax rate that taxpayers incur, but Obama’s proposal sets 28% as the maximum anyone can claim. For the vast majority of households, this would be of no consequence. If you’re in the 10%, 15%, or 28% tax brackets, you still get your deduction as normal. But the 2% of filers who itemize their deductions and face marginal tax rates over 28% would no longer be able to reduce the tax on their donations to zero. People in the 30% bracket, for example, would still have to pay a 2% tax on their charitable gifts. They owe 30% according to their tax bracket and they only get 28% back on the donated amount (due to the cap), so the IRS gets to keep the 2% difference.
How might this cap affect contributions to charitable causes? The short answer is that it will most likely result in a minor, but noticeable reduction in contributions. Here’s what people are saying:
- The Center on Philanthropy at Indiana University estimates that the cap will lead to an $820 million (0.4%) reduction in charitable giving in the first year of implementation, increasing to $1.31 billion (0.7%) in the second year.
- In 2010 the Congressional Research Service put the decline in charitable giving in the 0.16 – 1.28% range.
- In a back-of-an-envelope calculation for the Washington Post, Harvard economist Martin Feldstein estimates that the 28% cap could reduce charitable giving from individuals by $7 billion, which amounts to a 3% decline (relative to the $230 billion in charitable contributions from individuals reported in Giving USA 2009).
- Len Burman of the Tax Policy Center and the Center on Budget and Policy Priorities came up with similar figures in 2009.
Taking all of this together, it seems we’re talking about a 0.5% to 3% decline in gifts from individuals.
The impact on arts nonprofits is likely to be a little bit higher than that, since the cap will primarily affect the wealthy taxpayers who contribute most to the arts. The 2010 study by the Congressional Research Service includes an analysis of how the 28% cap would affect different segments of the nonprofit sector. It estimates the reduction in individual giving to the arts to be around 2.4% (compared to 0.16-1.28% overall).
The figures above were calculated based on the tax rates that applied between 2003 and 2012, but as we know, the tax rate for the highest income bracket was increased from 35% to 39.6% at the beginning of this year. How does that change things? If charitable contributions remain fully deductable, we would expect the higher marginal tax rates to increase donations due to the price effect. However, if Obama’s proposal to cap total deductions goes through, the reverse is to be expected—the higher tax rates actually exacerbate the decline in charitable giving caused by the cap. That’s because the higher tax rates reduce the taxpayers’ disposable income, bringing the income effect into play, while the cap on deductions holds the price of giving constant.
The Congressional Research Service estimates that the combined effect of the 28% cap on deductions and the higher marginal rates that Obama sought to impose on taxpayers earning more than $200,000 would reduce giving by 0.28% to 2.27%. That’s almost double the decline that they estimated for the cap on deductions alone (see above). The Center on Philanthropy arrives at similar figures when including Obama’s proposed tax hikes. Those projections still fall within the 0.5% to 3% range mentioned above. If we take the worst-case scenarios for the 28% cap and the largest estimates for the impact of the of the higher tax rates, we might be looking at a 5 or 6% decline in charitable giving.
So it looks like we don’t need to fear that individual contributions will drop by a quarter if the 28% cap were introduced, with or without increases in the top marginal tax rates. Nonetheless, a 5-6% decline is nothing to take lightly, and for organizations that are already reeling from the recent recession even a modest reduction in individual contributions could be the final straw. Moreover, the estimates apply to total charitable donations nationwide, but individual organizations could be unlucky and find that several of their major benefactors scale back their contributions more drastically than the national average, leaving gaping holes in their budgets.
Other options: expanding to non-itemizers and adding “floors”
Faced with this uncertainty, the response from arts advocacy organizations has been to dig in their heels and demand that the deduction for charitable contributions remain intact. However, as Michael Rushton notes, there’s little reason to believe that there’s anything magical about our current tax code; in fact, the charitable deduction has been criticized in the past for several reasons (notably for being inefficient, regressive, and having an unclear theoretical justification). So instead of clinging to the status quo as our only hope for survival, we might ask: what changes to the current system would lead to the best outcomes for arts organizations? How might we incentivize charitable donations while supporting the government’s goal of reducing the federal deficit?
In 2011 the Congressional Budget Office came up with 11 different policy scenarios and estimated their likely impact on tax revenue and charitable giving. These included:
- allowing all taxpayers to write off charitable gifts on their tax returns, rather than just those who itemize deductions
- creating a minimum donation (either a fixed dollar amount or a percentage of the donor’s AGI) which would have to be exceeded to qualify for the deduction
- converting the deduction into a tax credit (which would give all taxpayers the same 15 or 25% tax break on charitable contributions instead of linking it to the donor’s marginal tax rate)
This study found that by extending the deduction to all filers and simultaneously establishing $500 ($1,000 for couples) as the minimum donation required to qualify for the deduction the government would be able to increase revenues by $2.5 billion annually, while boosting contributions to charitable causes by $800 million. Or even better, by replacing the deduction with a 25% tax credit for all taxpayers, the government would save almost the same amount, while driving up donations by 1.5%.
Since the government’s objective right now is to reduce the deficit, presumably without harming the nonprofit sector unnecessarily, Eugene Steuerle of the Tax Policy Center has advocated for expanding the tax deduction to all filers, with a minimum contribution of 1.7% of the donor’s AGI required to qualify. This would net the government between $10.4 billion and $11 billion per year without reducing charitable donations by a dime. The argument for establishing a minimum contribution to qualify (often referred to as a “floor”) is that people are likely to give a small amount of money to charity regardless of whether they receive a tax break or not. It’s therefore not necessary for the government to forgo any revenue for that portion of their contributions. Further, at a certain point the administrative costs of tracking small donations—acknowledging their receipt, submitting documentation to the IRS, checking for fraud—is not worthwhile. For those who object that a $1,000 donation is a far bigger sacrifice for a couple that only earns $20,000 a year than for a millionaire, a floor that is linked to the taxpayer’s AGI might pose an attractive alternative. With a 2% floor, someone earning $20,000 could claim the deduction by making a $400 donation, while someone earning $500,000 would have to donate $10,000 to qualify.
Beyond the bottom line
Reforming the charitable tax deduction might offer other benefits as well. For example, it could provide an opportunity to change the composition of our donor lists. By giving those in lower income categories greater incentives to support our work and allowing them to leverage some of the indirect subsidy that the government provides through its tax breaks, arts organizations might be able to diversify the ranks of their donors, so as to be less dependent on a small wealthy elite. Based on the CBO’s estimates, by replacing the tax deduction with a 25% credit that is subject to a low floor (say 1% of AGI), it should be possible to maintain charitable donations at their current levels or even increase them slightly while saving the government several billions of dollars annually and allowing donors from lower income categories to acquire a bigger stake in nonprofit arts organizations. A more diverse pool of donors, both in terms of their economic status and their tastes, would reduce the financial risk of artistic experimentation and could allow companies to diversify their programming in ways that their current (predominantly wealthy) donors might not support.
All in all, reforming the deduction on charitable contributions isn’t necessarily a bad thing for the arts. There are ways of changing the tax code that could actually increase revenues and diversify the sources of income for arts organizations, even while helping to reduce the federal deficit. Since any change creates uncertainty and will likely produce losers as well as winners, I can understand arts administrators and advocates who would rather stick with an imperfect status quo than commit their careers and their organizations to an uncertain future. However, I believe that participating in the discussion and shaping the outcomes to fit our sector’s interests will ultimately prove more productive than trying to block change from the start.