The Tax Cuts Are a Bad Deal for Charities

Will Americans give as generously now that the incentives have completely shifted?

Philanthropic organizations have been on edge since Republicans rammed through the monumental tax bill: Will Americans give as generously now that the incentives have completely shifted? Recent research provides little hope for them.

The idea that charitable activity should receive preferential tax treatment dates back to medieval England, but Americans didn't start seeing rewards until the 20th century. That's when the government rolled out the first permanent income tax. Though modest at first, it skyrocketed after the U.S. entered World War I in 1917, eventually hitting the top income bracket at 77 percent.

Senator Henry Hollis of New Hampshire, a Democrat, feared the high rates would prompt the wealthy to curtail their giving. So he proposed exempting up to 15 percent of a taxpayer's income donated to charity. Congress swiftly and unanimously approved it. Subsequent generations of legislators expanded the deduction and broadened the definition of a qualifying charity until it was a common write-off for millions of Americans.

The core belief was simple: Every dollar donated to charity would do just as much good, if not more, than a dollar paid into the U.S. Treasury. That kept politicians from questioning the wisdom of the policy, even as a more taxpayers took advantage of it. (That is, until last year's tax reform passed. It doubled the standard deduction, effectively eliminating most taxpayers' ability to itemize deductions via contributions to charity.)

On those terms, economists began testing the success of the charitable deduction in the 1970s by taking a close look at tax cost and price elasticity.

Tax cost refers to the actual, post-tax price that someone pays when they make a donation. Imagine someone with a marginal tax rate of 25 percent. Every dollar donated only "costs" the taxpayer 75 cents after he or she takes the charitable deduction.

But this begs another question: What happens when you change these "tax costs"?

Price elasticity measures these changes by comparing the percentage change in donations to the percentage change in the tax cost of giving. A price elasticity ratio of 0 means that a change to the tax code had no effect on the amount given to charity. A figure of -1, by contrast, means that a 1 percent decline in the tax cost led to a 1 percent increase in contributions. (Or to put the matter more baldly: Each dollar of tax revenue lost via the charitable deduction generates an additional dollar of charitable giving.)

This one-for-one trade-off is more or less what most people expect to happen. But what if the charitable deduction yields a disproportionate rise in charitable activity -- a price elasticity of -2, -3, or more? If that happens, then it's much easier to justify the deduction as a public good because the amount of tax revenue lost is far exceeded by the amount given to charity.

So which is it? Almost everyone who studied taxpayer behavior found that the charitable deduction encouraged people to donate more than they would if it didn't exist. But studies yielded very different price elasticity figures ranging from -0.5 (a dollar in lost tax revenue generates an additional 50 cents in donations) to -4.0 (every dollar in forgone tax revenue generates a whopping four dollars of donations). A recent meta-analysis of approximately 70 of these studies yielded a price elasticity a median of -1.2.

A recent study by Nicholas Duquette of the University of Southern California looked at the problem from the standpoint of the charities themselves, compiling data from Federal Form 990, which reports monetary contributions to registered nonprofits. Duquette then examined how taxpayer contributions changed after the Tax Reform Act of 1986, which increased the tax cost of giving by dramatically lowering marginal tax rates.

The result was eye-popping: A 1 percent rise in the tax cost of giving caused charitable donations to drop 4 percent. While Duquette's sample was focused on secular charities (religious nonprofits tend to be less sensitive to changes in the tax code), the results nonetheless raise the troubling possibility that the recent tax bill may have a bigger effect on charitable giving than many lawmakers anticipate.

But Duquette's more disquieting findings focused on what he called the "tax sensitivity" of particular kinds of charitable giving. He found that cultural institutions, museums, colleges and universities all had price elasticity rates between -2.3 and -2.5. In other words, a financial hit that is serious yet survivable.

The same cannot be said for the cash-strapped organizations that care for the needy and most helpless in society: hospitals, homeless shelters, children's aid societies, hospices and other organizations that provide social services. Health charities, for example, showed a price elasticity of -4.5; hospitals, -4.6; group home care, -4.2; K-12 education, -3.5. This finding echoes previous research that found social service charities to be twice as sensitive to changes in the tax code.

These findings suggest that the the Tax Cuts and Jobs Act of 2017 may deal a particularly devastating blow to charities that make up the private social safety net -- the very same charities that Republicans pitched as potential replacements of government programs in the coming years. But like so much about the Republican tax plan, the numbers don't add up.

By Stephen Mihm

Source: Bloomberg

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