The Next Step Toward Welfare Reform:

A Manual for Enacting Tax Credits

for Charitable Contributions

March 1998

3. Considerations for State Policymakers

3.1. What level of government is most likely to offer a tax credit?

A tax credit can be implemented at the federal, state or local level. Devolution argues for implementation at the state level. More than 20 states offer some form of charitable tax credits and several states are considering legislation (see section 5).
States can institute statewide or local programs. Local tax credits can be limited to a particular city, metropolitan statistical area or designated region. The geographic area covered by the local tax credit would be based on the size and scope of the program.

3.2. What would a tax credit program mean for current state welfare expenditures?

A charitable tax credit makes it possible to reduce public spending on welfare. A dollar contributed privately makes it possible to reduce by one dollar or more (depending on the cost saving achieved) the amount spent by the public sector on the provision of assistance to the poor.

3.3. What will the credit percentage and limit be?

The size of the credit percentage and the limit of the credit depend on the desired level of welfare privatization. The limit of the credit would also depend on the marital status of filers. States must determine the amount of additional giving they wish to bring about in order to fund privatized welfare programs (and, with that, the amount of revenue they are prepared to forgo) and then develop a tax credit that has the intended result.

The Beacon Hill Institute has observed, however, that taxpayer participation in state tax credit programs tends to be low, at least in the early stages. Legislators must consider this fact when deciding on the amount of giving needed to fund privatized welfare programs. For example, our research shows that between 2% and 6% of taxpayers participate in various state targeted tax credit programs.

Additionally, the size of the percentage and the limit of the credit should be set so that the proposals remain revenue neutral. That is, states should reduce spending and revenue by like amounts to avoid deficit spending.

3.4. How will the credit be set?

States have two questions to answer in setting the tax credit limit. What fraction (100%, 50%) of a contribution may the taxpayer take as a credit, and what, if any, limit should there be on the amount that may be taken as a credit? The answer depends on the expected response by the taxpayer and on how much of the state's welfare system is to be privatized. In an earlier report, ^[1] we propose a 100% tax credit limited to 25% of federal tax liability. We estimate that this limit would be enough to shift $115 billion of welfare spending (essentially all nonmedicaid federal welfare benefits) from the federal government to private charities. A number of states choose a 50% credit and limit the size of the credit that a taxpayer may take to $100 to $500.
Each option has its advantages and disadvantages. Setting the tax credit limit at a fraction of total tax liability permits the amount of giving eligible for the credit to expand with income. This kind of tax credit may be politically unattractive on the ground that it favors the wealthy, who pay more in taxes.
Alternatively, setting a tax credit limit at some dollar amount would be seen by many as more equitable. The principal objection to a dollar limit is that it artificially and unnecessarily limits contributions by the very taxpayers – the wealthy – who are most disposed to help the poor.
Several states have introduced or considered tax credits with a cap on the dollar amount that can be claimed. Arizona enacted a 100% charitable tax credit allowing taxpayers a maximum credit of $200. At the request of Representative Mark Anderson, BHI submitted a report to Arizona's House of Representatives Committee on Block Grants and Welfare Reform. We recommended a 50% tax credit. ^[2] The Arizona legislature chose the 100% tax credit because they felt that it “enables donors to essentially `give for free' which [they] felt would be easier to administer, and provide more of an incentive to give.” ^[3]
In 1997, Oklahoma considered a 15% tax credit with a limit of $200 for charitable contributions to qualifying organizations. In Colorado, a taxpayer who participates in the Enterprise Zone Credits program is allowed a 50% credit, up to a maximum credit of $100,000.

3.5. By what date must a contribution be made in order to claim a credit?

States can set the deadline for the end of the tax year or for April 15 of the year following the tax year. The April 15 deadline is consistent with the federal rules regarding individual retirement accounts.

An argument against this deadline is that the credit should be given only to those who are motivated by altruism and not by tax avoidance. Insofar, however, as the purpose of the charitable tax credit is to motivate giving, the later deadline seems appropriate.

3.6. How can state policymakers know if a tax credit program would work in their states?

A state tax credit pilot program for a specific area (county, district or metropolitan area) can assess the viability of the charitable tax credit. It can also provide a laboratory in which to determine how full implementation of the tax credit may affect taxpayers/donors, recipients and nonprofit charitable organizations.

BHI, in conjunction with a sponsor state or organization, would administer and monitor a pilot program. The observed results of the pilot program would make it possible to compare the performance of the existing welfare system with that of a full-fledged charitable tax credit program. ^[4]

BHI recommends a pilot program that extends over a period of four years. This time frame would give selected nonprofit organizations the opportunity to develop, market and implement the program, with the first year devoted to fundraising by the nonprofit organizations. Implementation would take place during the remaining three years, which would provide sufficient time for participating donors, recipients and nonprofit organizations to demonstrate measurable behavioral changes.

A publicly-funded program is one option for a pilot program. A privately-funded pilot program is a second option. The state would offer recipients a chance to participate in the current public-assistance program or in the privately-funded one.

3.7. How can abuses be prevented under a tax credit program?

Abuses can arise if welfare recipients engage in “double dipping” (accepting benefits from more than one charitable organization), if charities use the additional giving to fatten salaries or otherwise to engage in wasteful spending or if taxpayers set up fictitious charities for the purpose of funneling the funds back to themselves, relatives or friends.

A state welfare department or watchdog organization could discourage double dipping by creating a central registry to track client usage of charities. The state tax department could discourage abuse by nonprofit organizations by hinging their certification on their satisfaction of standards regarding spending on salaries, fund raising and other kinds of overhead. Legislation could be included that would prevent wealthy individuals from passing tax-free dollars to their relatives. For example, a tax credit proposal in North Carolina contains language that prohibits taxpayers from having a financial interest in a nonprofit organization.

States could also require nonprofit organizations to report regularly on finances, programs and client outcomes. From these reports agencies could issue their own reports on how well the nonprofits managed their money and whether they were meeting the needs of recipients. Taxpayers would add another layer of oversight.

3.8. Would taxpayers merely substitute contributions eligible for the credit for ineligible contributions and pocket the savings?

We do not believe that a tax credit would cause measurable substitution of eligible for ineligible contributions. Because the BHI proposal permits charitable contributions ineligible for the new tax credit to qualify for existing tax deductions, it does not affect such tax incentives that already apply to those contributions. Furthermore, there is a “crowd-out” effect, whereby decreased government spending on welfare programs encourages individuals to give more to charities that assist the poor.

Even so, there is a concern that taxpayers would reduce contributions to charities that are not eligible for the credit. This is more likely, the more that an eligible contribution can be seen as a substitute for an ineligible one.

We performed a variety of statistical analyses aimed at testing for this concern. We found evidence arguing against this concern and therefore against the likelihood of substitution: There is strong positive correlation between all types of charitable giving over time, both in nominal and in real dollars. We found giving to religious and human-services organizations to be complementary, i.e. as individuals increase giving to one kind of organization, they will increase giving to the other kind of organizations.

Despite the foregoing assurances, concerns about possible substitution of eligible for ineligible contributions may persist. To answer these concerns, we offer an alternative to our original proposal: The taxpayer could not take a credit for any contribution during the current year unless total contributions exceeded some threshold.

One threshold would hinge eligibility for the tax credit on prior year giving. Eligibility for the credit would be limited to contributions in excess of the prior year's giving. A threshold of this kind would bring about the desired increase in eligible giving while deterring taxpayers from decreasing ineligible giving.

3.9. What is the definition of poor used to set qualifications?

One option is to define the poor as a percentage of the federal poverty level, for example, an income below 150% of the federal poverty level for a family of a certain size. Another option defines poor as eligible for AFDC or TANF. A third option is to limit the tax credit to organizations that provide certain goods (cash grants, food, clothing) to the poor.

North Carolina defines recipients of the tax credits as those individuals who do not rise above 150% of the federal poverty line. Arizona defines recipients of tax credits as the “working poor.” The “working poor” is defined as persons who qualify as eligible individuals for purposes of the federal earned income tax credit.

Footnotes

^[1] James P. Angelini, William F. O'Brien, Jr., and David G. Tuerck, Giving Credit Where Credit is Due: A New Approach to Welfare Funding (Boston: Beacon Hill Institute, December 1995).

² See David G. Tuerck and William F. O'Brien, Jr., A Charitable Tax Credit for Arizona: A Report to the Arizona House of Representatives Committee on Block Grants and Welfare Reform (Boston: Beacon Hill Institute, February 1997).

^[3] Ibid.

^[4] David G. Tuerck and William F. O'Brien, The Compassion Tax Credit: A Family Advocate Pilot Program (Boston: Beacon Hill Institute, November 1996).

Table of Contents

Introduction

Implications for Taxpayers and Donors (FAQ)

Implications for Nonprofit Organizations (FAQ)

Current and Proposed State Tax Credit Legislation (FAQ)

Model Legislation

Predicting Giving

Appendix I: Survey Results

Appendix I: BHI Nonprofit Organization Survey Results

The Beacon Hill Institute for Public Policy Research focuses on federal, state and local economic policies as they affect Massachusetts citizens and businesses. The institute conducts research and educational programs to provide timely, concise and readable analyses that help voters, policy makers and opinion leaders understand today's leading public policy issues.

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