2.1. What is the difference between a deduction and a tax credit for charitable giving?
Most taxpayers are familiar with tax deductions. Federal tax law encourages giving by offering deductions. Federal taxpayers who itemize can take tax deductions for the amount they contribute to eligible charities. This permits them to reduce their taxable income by what they contribute to these charities. Thus, for example, an itemizing federal taxpayer who is in the 28% bracket can reduce his taxable income by $100 and his tax bill by $28 by contributing $100.
A tax credit, on the other hand, permits the taxpayer to reduce his tax bill by some fraction of what he contributes. Thus, for example, a 50% tax credit permits the taxpayer who contributes $100 to reduce his tax bill by $50.
2.2. Is the charitable tax credit compatible with a flat tax?
Some proponents of the flat tax believe that a charitable tax credit is not compatible with a flat tax. The purpose of the flat tax, they argue, is to simplify the tax code, and a charitable tax credit adds unwanted complexity. While simplicity is a worthy goal, there are other goals that make the two ideas compatible.
How can the argument for a charitable tax credit be reconciled with that for a flat tax? The answer depends in part on the goals of each. Generally, the goals of a flat tax are threefold: (1) to simplify reporting and collection, (2) to flatten the rate structure and (3) to eliminate the double-tax feature of the existing tax system. All three goals are intended to advance the broader goal of increased economic efficiency and growth.
Generally, the goals of the charitable tax credit are: (1) to shift the delivery of welfare benefits from the public to the private sector, (2) to effect a redistribution of income from the nonpoor to the poor in a fashion superior to the current system and (3) to increase efficiency by empowering both individual donors and nonprofit organizations.
Simplification. Insofar as it eliminates the use of the tax code to provide incentives or disincentives for individuals to engage in certain kinds of economic behavior, the flat tax contributes to simplification. A charitable tax credit would add another line to a streamlined postcard-sized tax form, and, by proliferating “exceptions,” threaten to turn the postcard into another 1040.
However, simplicity should be measured against the expected cost saving that would come from the privatization of welfare through the proposed system of tax credits. If shifting the delivery of welfare benefits from the public to the private sector reduces waste by encouraging voluntarism and by eliminating an unnecessary bureaucratic filter, then a longer tax return is a small price to pay for the greater efficiency achieved.
Flattening the rate structure. The charitable tax credit does not conflict with the goal of a flatter rate structure. Any tax requires the taxpayer to sacrifice a certain portion of each additional dollar of taxable income. If the marginal tax rate is 25%, the sacrifice is 25¢ regardless of income. The difference between a tax code with a charitable tax credit and a tax code without a charitable tax credit is that the former permits the taxpayer to make this sacrifice in part by donating to an eligible charity whereas the latter requires him to make it by paying all 25¢ in taxes.
In order to make this point more clearly, it may be useful to adopt a slight change in terminology. Rather than speaking of a marginal tax rate, perhaps we should speak of a “marginal sacrifice rate.”
Consider a flat tax of 30% with a personal exemption of $10,000. Taxpayers A and B each have a gross income of $50,000 and thus a taxable income of $40,000. Now suppose that taxpayers may take a 100% tax credit for contributing to organizations that help the poor. Taxpayer A makes eligible donations of $5,000, while taxpayer B makes no donations. Both make a “sacrifice” of $12,000 (= .30•$40,000), and both have a “marginal sacrifice rate” of 30¢ on each dollar earned over $10,000. The only difference is that taxpayer A makes his sacrifice by donating $5,000 to charity and $7,000 to government, whereas taxpayer B makes his entire sacrifice by paying $12,000 to government.
In this example, the institution of the flat rate imposes the same marginal sacrifice rate on all taxpayers irrespective of whether they give to eligible charities or not. There is no substantive difference, therefore, between a flat tax with a charitable tax credit and a flat tax without a charitable tax credit.
Elimination of the Double Tax. The existing tax system taxes certain income twice, once when it is earned as wages and again when it is earned as income on saving. Suppose taxpayers A and B receive $40,000 in wages in 1998 and pay a tax of 25% on this amount. Each has an after-tax income of $30,000.
Now suppose that taxpayer A spends all of his 1998 after-tax income on consumption but that taxpayer B allocates $10,000 of his after-tax income to saving. Then taxpayer A pays no additional tax as a result of economic decisions made in 1998. Taxpayer B, on the other hand, pays future taxes on income received on his 1998 saving. If, for example, taxpayer B bought a $10,000 bond yielding interest of 10%, he pays an additional tax of $250 each year over the life of the bond.
One way to eliminate this double tax is to exempt the return of interest on the bond from taxation. Another way is to exempt the purchase of the bond (saving) from taxation. In either event, the tax is paid only once. The tax falls on income only when it is consumed.
An income tax that defines taxable income as consumption is equivalent, in terms of the sacrifice it imposes, to a retail sales or value-added tax. The difference is that an income tax makes it administratively easier to allow the taxpayer to make part of his sacrifice by donating to eligible charities or to other causes that might otherwise fall to government to support.
A flat tax achieves simplification and flatness and increases economic efficiency by defining taxable income as consumption. Suppose that taxable income so defined is $40,000 and that the tax rate is 25%. The tax liability before any charitable tax credit is $10,000. If the taxpayer gives $1,000 to eligible charities, the charitable tax credit permits him to reduce his tax liability to $9,000 (making the rest of his sacrifice through donations to eligible charities). No part of the sacrifice made by the taxpayer falls on saving. The charitable tax credit does not conflict in any way with the principle that taxable income should be defined as consumption.
It should be noted, finally, that every practical flat-tax proposal permits the taxpayer to take a large personal exemption. The purpose of this exemption is much the same as that of government welfare spending: to effect a redistribution of income from the nonpoor to the poor. Insofar as a charitable tax credit represents a superior way of carrying out this redistribution, then it is compatible with the idea of a flat tax. Indeed, it reduces the required size of the personal exemption.
2.3. How would the tax credit impact the current level of giving? Would taxpayers give more or not?
The tax credit would increase the current level of giving. In fact, some limit on the credit would be necessary to prevent too great a loss of tax revenues. In section 7, we estimate both the price and income “elasticities” of giving, where the price elasticity is the percentage change in giving that results from a 1% change in price and the income elasticity is the percentage change in giving that results from a 1% change in income.
Our results suggests that individuals give more to charity as the “tax price” of giving (the before-tax price less tax saving) decreases. Suppose that there is no tax incentive to give. Then the before-tax price of giving a dollar is the same as the after-tax price – $1. If Smith gives a dollar it costs him a dollar. Now suppose that Smith can take a 50% tax credit for giving. Then the after-tax price falls by 50%. If Smith gives a dollar it costs him 50¢.
BHI research shows that people give more as the tax price of giving falls. The “elasticity” of giving with respect to tax price is about 1.12, which means that a 10% reduction in the tax price of giving causes giving to rise by 11.20%. It also shows that people give more as their incomes increase, with a 10% increase in income leading to a 3.5% increase in contributions.
The exact impact depends on the size of the tax credit and on the limit placed on the tax credit. BHI has developed a model to predict eligible giving under different tax credit scenarios. In section 7, we estimate giving for two states, Oklahoma and Massachusetts, under a 50% tax credit, with no limits. Our model shows that Oklahoma taxpayers would increase eligible giving by $90 million, from $70 million to $160 million. Eligible giving by Massachusetts taxpayers would increase by $167 million, from $143 million to $310 million.
2.4. What do taxpayers think of tax credits?
According to BHI survey research, the idea of tax credits for charitable contributions draws support from every demographic category including ethnic background, political party affiliation, age, income, educational attainment and gender. See Appendix I.
In the fall of 1997, BHI, with the cooperation of Commonwealth Consulting and Clark University, asked Massachusetts residents if they would “favor or oppose a proposal that gives taxpayers the right to deduct $200 from their state taxes if they gave the same amount up to $200 to a private charity that helps the poor?” A resounding 81% favored the idea while 14% opposed. Eighty percent (80%) of those with incomes under $30,000 supported the proposal; while 87% of those with incomes over $50,000 expressed support. See Question 1 in Appendix I.
In January 1998, we asked two complementary questions. First we asked: “Would you be more inclined to give to charities that help the poor if you got a more generous tax break for giving?” Sixty-nine percent (69%) said they would be more inclined while 25% said they would not be inclined. Support among those earning between $15,000 and $30,000 (69%) was as strong as among those earning between $50,000 and $75,000 (68%).
In addition, we asked: “If the government cut back on welfare spending, would you be more inclined to give to charities that helped the poor?” Voters by a margin of 59% to 29% said they would be inclined to give more. Those with lower incomes were particularly responsive. Persons on the lower income scale (income between $15,000 and $30,000) were more likely to give (74%) than those with incomes between $30,000 and $50,000 (56%) and those with incomes over $100,000 (51%).
These results underscore a willingness by the public to provide private funds to help the poor if the cost of giving decreases. They also counter, in part, the criticism that the private sector is incapable of meeting the needs of the poor in light of welfare reform.
With regard to tax credits, taxpayers are joined in their support by providers of services to the poor: the individuals who manage local nonprofit organizations. In the fall of 1996, BHI asked 250 nonprofit executives in six states what they thought about tax credits. They registered strong support: 87% voiced their support while only 13% opposed or did not know. See Appendix II.
Our polls show that taxpayers strongly support giving to local, community-based organizations. In January 1998, we asked: “If you were to donate $100 to help the poor, to which one of the following would you be most likely to give all the money?: Catholic Charities, The Salvation Army, Habitat for Humanity, or a local food pantry or homeless shelter?” A plurality of respondents chose food pantries or local shelters.
2.5. Which taxpayers will be eligible to claim the credit?
2.6. What types of contributions qualify for the credit?
Options available to legislators and policymakers include cash, in-kind and appreciated property. Most proposals, however, restrict qualification for the credit to cash contributions. Some proposals do allow for in-kind contributions, either to nonprofit organizations or directly to the poor. BHI recommends restricting contributions to cash contributions.
BHI recommends against appreciated property because it would allow the taxpayer, in substance if not in form, to “sell” the asset to the charity without recognizing a capital gain. This practice would result in massive revenue losses, since taxpayers could give all their appreciated assets to qualified charities rather than selling them. The motivation to give to charity would be pure tax avoidance, rather than altruism. A gift of stock worth $1,000, for example, with a cost basis of $300, would yield a deduction of $1,000, and the state would never see the tax revenue that the $700 of appreciation would have yielded.
2.7. Should taxpayers be allowed to take both the deduction and the credit?
2.8. What fraction of giving should count as a credit?
A charitable tax credit increases giving by reducing the tax price of giving. Is it appropriate to reduce that price to zero by offering a 100% tax credit, or is there an argument for a more limited reduction in tax price to, say, 50¢? The argument for a more limited credit stems from the assumption that, unless taxpayers must make some additional sacrifice they will not take an interest in how their contributions are used by the charities to which they contribute. When Smith must pay for a cup of coffee, he pays more attention to the quality of the coffee he drinks than he would if coffee were free. The same idea applies, so it might be argued, to charitable giving.
Table of Contents
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.
© March 1998 Beacon Hill Institute at Suffolk University
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