The Trump administration’s tax reform plan would not eliminate the deduction for charitable giving. That’s too bad.
The charitable deduction is a surprisingly bad idea.
On the face of it, the charitable deduction appears incontrovertibly good. More than two-thirds of Americans support it. The deduction was first added to the tax code in 1917 (paywall) when the top income-tax rate was raised from 15% to 67%. Policy makers felt it was necessary to make sure the rich would still make charitable contributions. (Today the top rate is less than 40%.)
The deduction works like this: If an individual who makes $5 million chooses to give $1 million to a qualifying nonprofit organization, that $1 million dollars will not be taxed, and the person will only pay taxes on the remaining $4 million. A gift to a homeless shelter, Harvard University, or a think tank all count. Since that $1 million would have been taxed at a rate of about 40%, the individual ends up paying almost $400,000 less in taxes. By not taxing philanthropy, the theory goes, the government is encouraging people to share their wealth.
The problem is that, as economists are fond of saying, there is no such thing as a free lunch.
How the charitable deduction hurts
The charitable deduction sounds harmless, yet in the example above, the policy really amounts to the US federal government paying that individual $400,000 because they gave to charity. In total, according to the US Internal Revenue Service, the deduction costs the US federal government more than $60 billion annually (pdf). If it was eliminated, a tax credit of around $500 could be given to every US household.
The major beneficiaries of the deduction are the rich. The Pew Research Center found that more than two thirds of the deduction goes to households with incomes over $200,000. Most middle- and low-income families, who usually take the standard deduction of about $6,000, don’t receive any tax benefit for charitable giving, even though nearly all of them make donations.
The lost revenue for the government might be worth it if the deduction encouraged a lot more philanthropy. It’s not clear that it does.
No big boost for giving
In his 2017 book A Fine Mess: A Global Quest for Simpler, Fairer, and More Efficient Tax System, the reporter T.R. Reid recounts that, in 1968, nonprofit organizations “predicted a disastrous drop” in giving when the top tax rate was cut from 50% to 28%. A lower tax rate, they thought, would make the charitable deduction less valuable. Instead of getting $500,000 back from a charitable deduction, the rich would only get $280,000.
In the end, researchers found that lowering the tax rate had only a small negative effect on giving, limited to the most wealthy philanthropists. It turned out that donors are not quite as sensitive to tax benefits as many researchers thought. Other studies have found a larger impact from tax subsidies (pdf). Still, few suggest an effect on giving that is worth such a large loss in government revenue—unless you believe government spending is hugely inferior to the nonprofit sector.
The US is unusual among developed countries in offering such a large subsidy to charity. American households can deduct up to 50% of income given to charity. Reid points out that in Europe, few countries allow a charitable deduction of greater than 20%. Austria, Finland and Switzerland offer none at all. While it is true that the percent of income given to charity in the United States is unusually high, researchers believe this is is mostly related to relatively low taxes and the limited social safety net provided by the government, not tax subsidies.
Charitable giving is wonderful. It should be lauded. However, tax incentives to promote charity don’t actually do enough to justify higher taxes for everybody else. If the Trump administration actually wanted to engage in tax reform, rather than just a tax cut for the rich, eliminating the charitable deduction would be a good start.