Tax-Code Overhaul Could Harm Charities

President Bush tried to persuade nonprofit leaders that his efforts to overhaul the tax code would recognize the importance of philanthropic giving to society by announcing last year that the charitable deduction would be retained. But, even if the charitable deduction stays, the ideas for overhauling the tax code could significantly damage many nonprofit organizations.

To be sure, the charitable deduction is important. In 2001, individuals and corporations received deductions for more than $151-billion in charitable contributions, thereby saving more than $40-billion in taxes. But the charitable deduction under a tax overhaul could be quite different in scope and offer fewer incentives than the charitable deduction under current law. President Bush’s goals, news-media reports say, include lower tax rates, fewer deductions and credits, and the elimination of taxes on investment income, such as interest, dividends, and capital gains.

To offset the huge loss to the federal treasury that would result from such changes, sources in the administration have floated fairly significant tax-code changes designed to bring in money. Among the ideas that Bush administration aides have suggested in news reports: repeal of the deduction for state and local income, property, and sales taxes, as well as the abolition of the deductions businesses can take when they provide health-care benefits to workers or pay interest on bonds, loans, and other debts.

Such a tax overhaul could shrink the pool of Americans who would be able to claim charitable deductions on their taxes. In particular, wealthy people with large amounts of investment income, but little wage income, would lose their tax incentive to give. Also, repeal of the deduction for state and local taxes would result in a fairly substantial increase in the number of people who don’t itemize their deductions, further reducing the number of people who would be eligible for charitable deductions.

Those effects are fairly obvious, but removing taxes on investment income would also add a new wrinkle as people decide whether it is wiser to give today than to give tomorrow.

Up to now, tax planning for charitable gifts has been guided by a simple maxim: “The earlier you give, the greater the tax benefits.” A charitable donation results in two benefits to the donor. The taxpayer receives a deduction for the amount of the donation, resulting in a tax reduction of as much as 35 percent of the value of the gift. Also, once the donation is handed over to a charity, the money or other assets can grow in value tax-free since nonprofit groups are not taxed on their investment earnings. On the other hand, if the donor retains the property and donates its income, then he or she receives only one benefit: the charitable deduction, which would offset the tax on earnings.

Because early contributions get a tax benefit, donors have sought out ways to give that allow them to claim an immediate deduction but that also allow them to retain some control over their contributions. Private foundations and donor-advised funds — which allow people to choose where their money will go — come with costs. Donor-advised funds have annual administrative fees (in addition to investment management fees) that can range from 0.1 to 2 percent of assets. Private foundations are subject to strict rules, such as an excise tax on investment earnings and a requirement that 5 percent of assets be distributed annually.

For charities, current tax law offers a measure of certainty. Because the tax system makes it wise to turn over money to a foundation or donor-advised fund or other similar giving approach, charities don’t have to worry that the donors will change their minds. Donors are able to maintain control over how their charitable goals are accomplished, but they can’t ever take their assets back.

Under a system with no taxes on investment earnings, however, a donor has little reason to make outright donations — so charities will have far less certainty that money will eventually flow to them.

If a donor had $100,000 that he or she wished to devote to charitable purposes, the donor could give the money to charity, just as he or she could now, and write off the donation. Assuming the tax rates stayed the same for those at the top of the income scale, a donor of $100,000 would get a tax deduction worth $35,000. The individual could invest that $35,000 tax savings and, assuming a rate of return of 8 percent, the individual would end up with an annual income of $2,800, all of which would be tax-free.

But the donor would do better to keep the $100,000, invest it, and get $8,000 in income tax-free in return. The donor could then give the $8,000 in income to charity, and receive a tax reduction of $2,800, the same benefit as the donor who gave away the full $100,000. However, the donor still would have the $100,000 to use as he or she pleased, and would not face any of the costs and restrictions that come with private foundations or donor-advised funds.

To be sure, not all donors base their giving decisions on the after-tax savings. But the manner in which people make charitable donations, particularly large donations, is strongly influenced by the tax rules. Altering the system could lead to major changes in the way in which individuals make charitable contributions and could harm charitable organizations since the law would encourage Americans to hold on to their money, rather than make irrevocable gifts to charity.

Private foundations could quickly disappear as a method of making charitable contributions. When donors want to earmark money for philanthropic purposes over their lifetimes, a taxable trust would offer benefits similar to a private foundation, with none of the current restrictions that apply to private foundations. If the president is successful in making the repeal of the estate tax permanent, making a bequest to a private foundation would be extraordinarily foolish. Without the estate tax, the donor would have no tax incentive to create or supplement a foundation when he or she dies.

Contributions from individuals, foundations, and corporations account for only about 20 percent of the money that charities receive every year, according to the Congressional Budget Office. But for some types of organizations, anything that causes donors to stop giving could be extremely damaging. Religious charities, for instance, receive about 85 percent of their support in the form of charitable gifts, primarily from individuals, so changes that affect donations are very important to them.

For many other charitable organizations, other parts of the tax code may be even more important to their finances.

For instance, nonprofit groups are now able to borrow money at favorable rates by selling tax-exempt bonds. Investors accept lower interest rates on tax-exempt bonds because the interest is not subject to tax.

In a system in which no investment earnings are taxed, there will be no advantage to tax-exempt bonds. Charities would be forced to pay higher interest rates, with the result that their cost to borrow money for big projects would rise.

In addition, many tax benefits affect the demand, or the ability to pay, for goods or services provided by charitable organizations. Many of those tax incentives could be eliminated under a major tax-code restructuring of the type President Bush is considering.

Certain types of charities could be especially hard hit by changes in the tax code. Among them:

Hospitals. If companies lose the tax benefits they now receive for providing health-care coverage to workers — write-offs now worth $109-billion per year and growing rapidly — the number of Americans who have medical insurance is likely to drop by more than 6 percent. Already the nation’s nonprofit hospitals are having trouble keeping up with demands to provide free care to the 45 million people without health insurance.

Adding to the demand for free health care is not going to make it any easier for nonprofit hospitals to survive.

Colleges and universities. College students and their families are now eligible for tax credits and deductions that help make it easier for them to save for higher education and then pay tuition bills. Under a tax overhaul, many of those breaks could disappear, and colleges might have to increase the aid they provide to students or risk a decline in enrollment. Many universities also get support from corporations that sponsor research; companies could lose the tax credit they now receive for supporting research and development, and some might decide to cut back the amount they give to college researchers.

Social-service and community-development groups. The tax credit that goes to investors who finance housing for the poor has been a big help to many groups that provide low-cost housing, as have tax-exempt bonds. Other groups benefit from the tax breaks parents receive to help them pay the costs of adopting children and providing youngsters with day care. Some of those tax incentives might not survive an overhaul of the tax code.

People advocating fundamental tax changes stress the economic benefits of a tax system that does not favor one type of activity over others. But Congress has long realized that it is important to offer tax incentives that lead to social advances, such as those that benefit charities. It would be unwise to drop that idea simply to make the tax code neutral to all types of activity.

A principled argument could be made that the social objectives reflected in many of those tax benefits could be more efficiently accomplished through other means. However, nobody seriously thinks that Republican-led Congresses will increase federal spending to compensate for losses to charities under a new tax code. In fact, a repeal of the deduction for state and local taxes would increase pressure for spending cuts at state and local levels, adversely affecting charities that rely on such aid.

Charity executives and their board members should not be lulled into complacency by presidential assurances that a charitable deduction will be retained. They should analyze all aspects of the proposal, even aspects that at first glance seem totally unrelated to their concerns. If charitable organizations are not well-informed and fully engaged, they may find that keeping the charitable deduction is a painfully Pyrrhic victory.

Rep. Charles B. Rangel is the ranking Democratic member on the House Committee on Ways and Means, and John Buckley is the committee’s Democratic chief tax counsel.