March 13, 2014

Changes in the Charitable Deduction Don’t Have to Mean Losses for Charities

It has now become a yearly ritual that members of Congress and White House officials offer proposals to limit or even eliminate charitable tax deductions.

And, as a part of the ritual, nonprofit leaders spring up as fast as they can to protest that the changes will stifle charitable giving. Vikki Spruill, head of the Council on Foundations, captured the reaction of many in response to the latest round of proposals: “This is an 'if it ain’t broke, don’t fix it’ situation” she told The Chronicle.

 Perhaps I am overly optimistic, but it’s possible that tax reform could offer the potential to expand charitable giving, or at least not cause the decline that many fear.

After all, the current system isn’t perfect. People who itemize are the only ones who can get a tax break for giving. This leaves a lot of taxpayers without a tax incentive to give. In fact, in 2011 (the most recent year for which IRS data are available), only 32 percent of people who filed tax forms claimed an itemized deduction, meaning the majority of Americans weren’t giving due to tax motivations. Admittedly, many people who don’t itemize have low incomes and thus less of an ability to make donations. However, even just looking at returns for people who earn more than $50,000, one third were not eligible to claim a charitable deduction.

And among those taxpayers who do itemize, not all get an equally generous tax benefit from giving. A $100 charitable donation by a taxpayer in the lowest income bracket who pays 10 percent of earnings in taxes can save $10, while the same donation would yield a tax reward of $39.60 for an individual in the highest income (39.6% tax) bracket. With the limited reach and uneven value of the tax break, it’s clear there is room to improve on the current system of incentives for charitable giving.

Of course, the key question is what type of tax overhaul could achieve that goal. Given the scale of the charitable deduction (representing over $174-billion in deductions in 2011), it is a natural target as lawmakers think about changing the system. While some lawmakers were at one point ready to eliminate the deduction, nobody seems interested in going that far.

Now lawmakers are thinking about new ways to encourage people to give while minimizing losses to federal coffers.

For instance, take the proposal put forth by the House Ways and Means chairman, Rep. Dave Camp, which would allow people to deduct only the amount beyond 2 percent of income they give to charity. The notion of such a “floor” is not entirely new (that approach is already in place for other deductions). The premise is that if we want to provide tax relief for certain behavior, it’s smart just to reward the excess amounts, not the normal things people would do without a tax incentive.

Since people in each income group currently give over 2 percent of income to charity on average (with a 3 percent overall average), the 2-percent limit may simply reflect a giving norm, with the tax code providing additional rewards for giving beyond the norm. Not to say that 2 percent is the magic number, but a reasonable floor may not be that harmful to giving incentives.

Or consider President Obama’s proposed 2015 budget. He would limit tax savings on charitable donations to 28 percent. So, for example, a person in the top tax bracket could claim only a $28 tax saving from a $100 donation (rather than the $39.60 currently). Though the proposal clearly reduces the incentive for the wealthiest, I am surprised those opposing it are not equally outraged at the implicit cap already in place for lower-income taxpayers who only get a $10 tax saving from the same donation. The reduction of tax incentives for the highest income brackets in the Obama plan might be more palatable if it were part of a broader plan to equalize giving incentives by expanding them for those in the lowest income brackets.

Borrowing from both the Obama and Camp proposals, one could envision a circumstance in which the tax deduction for donations is replaced with a limited tax credit. For charitable donations above a certain percentage of income (say, 2 percent), donors could directly reduce their taxes (say, by 25 percent of donations above the threshold) regardless of their tax bracket. Provided the threshold is not too high and the tax credit is not too small, current tax incentives for giving could be largely retained while new incentives could be added thanks to a tax credit being available equally to all taxpayers (i.e., it is not tied to income and not just for those who itemize deductions).

I can’t say for sure how this would affect giving, nor am I advocating for this specific reform. But I offer it as a way to suggest that nonprofits should more seriously consider proposals that change how today’s charitable deduction works. If we take as a given that an overhaul is on the horizon, it is fair to say that not all changes are alike.

By talking about new ways to approach the giving incentive, rather than simply insisting the charitable deduction be left “as is,” nonprofits may end up with a workable compromise or even better: a world in which charitable giving incentives are made stronger.

Brian Mittendorf is professor of accounting at the Fisher College of Business at Ohio State University.