Reducing the Charitable Deduction Would Hurt Nonprofits’ Ability to Deliver Services

Editor’s Note: President Obama has proposed a plan to reduce the value of itemized deductions that wealthy people can claim for charitable gifts. To help explain the impact of Mr. Obama’s plan, The Chronicle asked four prominent economists to offer their analysis of how a change in the charitable deduction would affect giving. Following is an essay by Joseph Cordes, professor of economics, public policy and public administration, and international affairs at George Washington University.

One of the most visible ways in which the federal government supports the nonprofit sector is by allowing individuals an income-tax deduction for the value of their charitable contributions. These deductions are widely seen as encouraging private donors to make gifts to a wide range of philanthropic enterprises. Although no changes have yet been made in the charitable deduction, several proposals for scaling it back are likely to be considered in the ongoing discussions about how to address the federal budget deficit.

One important issue in the debate about what changes, if any, might be made in the charitable deduction turns on the sensitivity of individual giving to the out-of-pocket cost of giving. The charitable tax deduction reduces the out-of-pocket cost of giving by individuals. For example, a taxpayer in the current top tax bracket of 35 percent who gives a tax-deductible gift of $100 to a charity cuts his or her tax bill by $35, which effectively reduces the cost of the donation by $35.

But the financial incentive to taxpayers who claim the charitable deduction comes at a budgetary cost in the form of less tax revenue. Do taxpayers respond to the reduced cost of giving by increasing their giving by an amount that matches or exceeds the amount of federal tax revenue foregone by allowing tax deductions for contributions?

The answer to this question matters for the following reason: If taxpayers are responsive to changes in the cost of giving, then the tax revenue that is foregone by allowing the charitable deduction is likely to be matched or exceeded by increased giving to charities. If so, then proposals to scale back the charitable deductions will reduce the financial resources of charities by more than the amount of additional revenue that is raised.

Put slightly differently, the amount of additional financial resources for deficit reduction would come at a cost of an equal (or perhaps greater) drop in contributions to nonprofits that in many cases provide goods and services that complement and/or substitute for public goods and services.

If, on the other hand, taxpayers are relatively unresponsive to changes in the cost of giving, scaling back the deduction would lower charitable contributions by less than the added revenue.

It would, in principle, be possible to provide more resources to the nonprofit sector by scaling back the deduction and then using the added revenue to maintain support for nonprofits through other means—either through explicit grants or subsidies or, in the current fiscal environment, by forgoing other cuts in federal spending (which often provide financial support for charities).

Although there is general agreement that charitable giving does respond to price incentives, the evidence on the magnitude of the response is mixed. For example, charitable giving did not drop as sharply in the 1980s after marginal tax rates were cut (thereby raising the after-tax cost of giving) as many had expected based on statistical estimates of the price responsiveness of giving.

On the other hand, there is evidence that in the 1980s giving among higher-income taxpayers, who account for the lion’s share of individual contributions, did decline, as predicted. More recently, research using state-of-the-art statistical methods finds that individual giving is relatively responsive to changes in the out-of-pocket cost.

Another point that should not be overlooked is that the practical effects of scaling back the charitable contribution on the financial resources of nonprofits depend not only on how responsive charitable deductions are to the out-of-pocket cost of giving but also on the relative importance of private contributions as a source of revenue.

It is sometimes asserted that limiting the charitable deduction would have minimal effect on nonprofits because individual contributions are only a small share of nonprofit revenues.

While it is true that individual contributions are not the only or even the major source of revenue for many nonprofits, it is nonetheless also the case that contributions are an important source of financial resources for many nonprofit organizations. A reduction in contributions would therefore have a measurable effect on their capacity to deliver goods and services.