Some 150 years ago, Alexis de Tocqueville marveled at Americans' propensity to "found seminaries, build churches, distribute books, and send missionaries. . . . I have often admired the extreme skill they show in proposing a common object for the exertions of many and inducing them voluntarily to pursue it." That charitable impulse thrives today. Last year Americans donated more than $100 billion to charities, churches, foundations and other humanitarian causes.
But some people think that those huge donations are not inspired by Tocquevillean charitable sentiments. The Council on Foundations (CoF) and Independent Sector (IS) have released a new report, "The Impact of Tax Restructuring on Tax-Exempt Organizations." According to their report, Americans are not inspired to give by empathy for their fellow man, but mainly for the tax write-off. Take away the charitable tax deduction, they warn, and we will witness the slow death of the Red Cross, the Salvation Army, civics leagues and universities.
The report assesses the potential impact of the two leading tax reform proposals: the flat tax and the national sales tax. It calculates that donations would drop by nearly a third under the flat tax. Nonprofits would fare even worse if we eliminated the income tax and replaced it with a national sales tax.
Before charitable groups rush to join the anti-tax-reform brigades, here's some reassuring news: the CoF/IS study is bunk. As Alan Reynolds noted in Philanthropy magazine, the last time IS tried to measure the impact of tax code changes on charities, it predicted that the 1986 Tax Reform Act would trigger an $8 billion decline in charitable contributions in 1987. Instead, charitable giving rose by $6.4 billion, or 7.6 percent, in 1987 after the top tax rate fell from 50 percent to 28 percent. IS underestimated the impact of the 1986 act on charitable giving over the period 1987-94 by a gigantic $40 billion. Oops.
For this year's study CoF/IS commissioned the accounting firm Price Waterhouse (PW) to calculate the impact of tax changes on charitable giving. Of course, asking an accounting firm to evaluate tax simplification creates a slight credibility problem. It’s like asking Penthouse to prepare a study on the social impact of pornography.
Still, the principal question raised by this report is important: Would a low-rate tax system with no charitable deduction slow the pace of donations? The current tax preference for gifts to charities and other nonprofits is clearly an inducement to donate money, and both leading reforms abolish this inducement.
The PW economic model suggests that the value of the tax deduction is the overriding factor in predicting the level of charitable giving. The higher the tax rates, the better. With our current 40 percent top income tax rate, wealthy givers reduce their tax liability by 40 cents for every dollar given to charity. Taken to its logical extremes, the PW model yields absurd results. The way to maximize charitable donations, according to the PW analysis, is to increase marginal income tax rates to 99 percent -- even if those high tax rates wreck the economy.
One of the problems with this report is that the conclusions highlighted in the Executive Summary assume that the economy will perform exactly the same under a flat-rate tax and under our current system. If that’s true, then the finding that charitable contributions would fall under tax reform is entirely self-evident.
But the lesson of the last 20 years in the United States and around the globe is that tax reform reduces the distortions of high tax rates, encourages more savings and investment and thus propels faster economic growth. Dale Jorgenson, Dean of the Economics Department at Harvard University, and other respected economists have estimated that a flat-rate consumption tax system would increase gross domestic product by between 5 and 15 percent. So the starting assumption of this report is wrong -- and that contaminates most of the conclusions.
Even when the PW modelers take into account the possibility that tax reform will give rise to a dynamic increase in economic output and personal incomes, the results of the report are terrifying for charities. It argues that the increase in income recovers, at most, 10 percent of the fall in donations due to the loss of the tax deduction. Why? Because "the [tax] effect swamps increases in giving as a result of increases in income."
History flatly refutes that improbable conclusion. Over the past 40 years, the level of annual donations has almost exactly tracked personal income growth. People are most likely to dig deepest into their pockets when they are feeling prosperous --regardless of whether tax rates are high or low. Conversely, during hard times, many wells run dry.
Consider the experience of the 1980s. As the accompanying figure shows, lowering tax rates from 70 percent to 28 percent actually impelled a surge in giving. Contributions rose in the 1980s no matter how you slice it: in real terms, in real per capita terms and even as a share of personal income. Either the 1980s didn't really happen, or the PW model is tragically flawed.
So nonprofit institutions can relax. Tax reform is not a danger to charities. In fact, because the economy would perform much better and incomes would rise, a flat tax or a national sales tax would raise the level of charitable giving. The only industry truly threatened by a simpler, flatter, fairer tax system is America's parasitic tax industry, where prosperity has long depended on our 8,000-page Internal Revenue Code. America's gain is Price Waterhouse's loss.