The deduction for charitable giving is one of the most popular features of the U.S. tax code. A poll commissioned in 2015 for the Philosophy Roundtable found that 79 percent of Americans thought the deduction should be protected, while just 16 percent thought it should be eliminated or capped. But how effective is the deduction in promoting truly charitable giving? Would it be so strongly supported if people understood it better?
The charitable deduction as tax expenditure
Some people like the charitable deduction just because it cuts their tax bill, but the deduction is not just another tax cut that leaves more money for people to spend as they wish. Instead, it is what economists call a tax expenditure. It leaves money to taxpayers only if they use it to contribute to certain tax-qualified organizations approved by the federal government.
A tax expenditure is a form of government spending, just as much as other government outlay. Other things equal, eliminating a tax expenditure would bring in more revenue that the government could use to reduce other taxes, buy something else it could not otherwise fit into the budget, or reduce the federal debt.
To decide whether any given tax expenditure is justified, we need to answer two questions: First, does it buy something that is worthy of government support? Second, does it do so effectively? Let’s look at the evidence.
How much true charity does the deduction buy?
According to the Tax Policy Center, the charitable deduction is expected to cost the federal budget $51.2 billion in fiscal 2018. However, that money buys less charity than some might think, at least if we use the word in its ordinary meaning of “generosity and helpfulness, especially toward the needy or suffering” (Merriam-Webster). A study of charitable giving from the Center for Philanthropy at Indiana University explains why.
The study estimated the total giving to various categories of organizations and the share for each that was directed toward meeting the needs of the poor. Churches accounted for four-fifths of all giving, of which an estimated 20 percent went to charitable purposes. The remaining 80 percent of church budgets went to support worship activities, salaries and cost of facilities. In contrast, combined purpose charities, such as United Way, and certain other charities specifically focused on basic needs directed nearly all of their contributions to the poor.
The study judged that about 10 percent of donations to health care and 15 percent of donations to education went to helping the poor, while the rest went to benefit patients and students of all income levels. Sixty percent of the “other” category of donations were thought to benefit the poor, and only a negligible amount of contributions to the arts. Overall, about 31 percent of donations eligible for the charitable deduction went to truly charitable purposes, as summarized in the following chart:
But charity, narrowly defined, isn’t everything. Many people consider at least some of the causes supported by the charitable deduction to be worthy of government support, even if they are not strictly focused on the needs of the poor. Public radio stations are an example. So are causes that directly benefit only the members of a limited group (sometimes called club goods), but which indirectly help strengthen civil society or build communities. Churches and service organizations fit this category. The charitable deduction helps such groups in general but leaves it up to individuals to decide which ones to support.
The problem is that any cause one person considers worthy of government support is likely to be considered frivolous by others and positively harmful by still others. Take religious organizations, for example. No doubt followers of any given faith see their own organizations as contributing to a strong society, but nonmembers might see it differently. They might think government support of religion in general to be inconsistent with the Constitution. They might be put off by religious doctrines regarding women’s rights or same-sex marriage. Or they might be unbelievers who think construction of elaborate shrines that they think do not exist is a complete waste of money.
Similarly, some people see support of environmental causes as urgent public purposes, while others see environmentalists as enemies of progress. Some people think the government should put animal rights on a par with human rights, where others might see any government action in this area as violations of the rights of chicken farmers or ranchers.
In short, almost no one endorses the full list of causes supported by tax-exempt donations. Everyone would agree that a large part of giving is misdirected, even while disagreeing as to just which part that is.
How Much Does the Charitable Deduction Increase Giving?
If the charitable deduction dramatically increased total giving, it might be possible to justify its budgetary cost of $50-odd billion per year, even if only half of the giving went to worthy causes. Let’s refer to the amount of added donations to worthy causes (however defined) per dollar of cost to the budget as the charitable efficiency of the deduction. If a dollar of foregone tax revenue produced a dollar of new giving, the efficiency would be 100 percent. However, the available evidence suggests that the charitable efficiency of the deduction is far less than that.
Charitable efficiency, in this sense, depends on three variables: The share of tax-qualified donations that go to purposes counted as worthy, tax rates themselves, and the elasticity of giving, that is, the percentage by which donations increase for each 1 percent decrease in the cost to donors of making contributions.
An example will show how these three variables interact to determine charitable efficiency. Suppose you are in a 40 percent tax bracket. Suppose that even without a tax deduction, you would make $1,000 in annual donations, half of which go to causes judged worthy by a consensus of your fellow taxpayers. Suppose that the elasticity of giving is 0.2, a value found to be reasonable in a review of the academic literature by Daniel Hungerman and Mark Otoni-Wilhelm .
Given these assumptions, if donations were deductible, the out-of-pocket cost of each dollar you give would fall to 60 cents, a 40 percent decrease. Applying an elasticity of 0.2 to that 40 percent decrease would produce an 8 percent increase in your total giving. Instead of giving $1,000, you would give $1,080 of which $540 goes to “worthy” causes — $40 more than you would have given to those causes without the deduction. The cost to the Treasury is 40 percent of the full amount you give, or $432. If that $432 “buys” an increase of just $40 in worthy donations, the charitable efficiency of the deduction is just 9.25 percent.
Do my numbers appear too conservative? Put your own numbers in and see what you get. For example, try keeping the tax rate at 40 percent but raising the elasticity of giving to 0.5 and the share of worthy donations to 80 percent. The tax deduction would then generate $160 in new worthy donations at a cost to the budget of $464. The charitable efficiency would still be just 34 percent.
In reality, these examples overstate charitable efficiency, since the 40 percent tax rate they use is unrealistically high. According to the Center for Philanthropy a third of all giving comes from households with incomes under $100,000. None of these faces a tax rate of more than 25 percent, and only 39 percent of these households itemize at all. High-income taxpayers with tax rates of 35 to 40 percent account for at most a third of donations.
In short, whether you think that charitable efficiency is 9.25 percent, or 34 percent, or even an unrealistic 50 percent, the charitable deduction is an expensive way to fund scholarships, soup kitchens, and animal shelters.
Repeal or reform?
When we look at the evidence, it is hard not to conclude that the popularity of the charitable deduction rests on a set of false premises. As things stand, only around a third of tax-qualified giving goes to meet basic needs of the poor. The remainder goes to causes ranging from religious worship to arts to environmental causes that some people consider worthy of government subsidy but others do not. Overall, the charitable efficiency of the deduction is low. On reasonable assumptions, each dollar of cost to the budget may bring in less than a dime in new money for worthy causes.
Personally, I would not be sorry to see the charitable deduction eliminated altogether as part of a broad tax reform that reduced rates and eliminated preferences. Even if some kind of tax preference for charitable giving is retained, the existing itemized deduction should be thoroughly restructured. It could, for example, be replaced with a flat tax credit available to all households, regardless of their tax bracket and regardless of whether they itemize. At the same time, the range of organizations and causes eligible to receive tax-preferred contributions could be narrowed to focus on those that are truly charitable.
According to the Philosophy Roundtable poll cited earlier, a majority of Americans believe their fellow citizens are uniquely charitable. Data supplied by the Roundtable supports that view. Charitable giving in the United States ranges from roughly twice what takes place in Britain and Canada to almost 20 times the rate of Italians and Germans. Reform of the charitable deduction would leave those generous impulses intact, direct them more effectively to truly charitable causes, and improve the equity of the tax system in the bargain.
Based in part on material posted earlier at NiskanenCenter.com