Tax Credits For Charitable Contributions

Alternatives, Projections, Comparisons

Executive Summary

Our December 1995 study, Giving Credit Where Credit is Due: A New Approach to Welfare Funding, addresses the major economic issues posed by the concept of offering a tax credit for charitable contributions as a method of privatizing welfare spending. We find that a tax credit of this kind would succeed in its principal goal of making welfare spending taxpayer controlled as well as taxpayer funded.

On the basis of this finding, we proposed a 100% federal tax credit for individual contributions to eligible charities. The credit, which would be available to nonitemizers as well as itemizers and which could be taken for up to 25% of individual tax liability, would shift the delivery of up to $115 billion of federal means-tested welfare benefits from government to private charities.

This proposal has prompted a number of questions not addressed by our first study, including questions about the relative advantages or disadvantages of other tax-credit proposals. These questions and the answers that we offer in reply can be summarized as follows:

Question 1. How would the tax credit impact the current level of giving? Would taxpayers give more or not?

Answer. The tax credit would increase the current level of giving and would do so to the point that some limit on the tax credit would be necessary in order to prevent too great a loss of tax revenues from occurring. The exact effect depends on how donors respond to the tax credit and on the limit that is imposed on contributions eligible for the credit.

Giving Credit Where Credit is Due proposes a limit of 25% of the taxpayer's tax liability. Our study offers a proposal, under which $115 billion in new giving would qualify for a tax credit. Senator Dan Coats has introduced S-1079, which proposes a tax credit for contributions of up to $500 for single taxpayers and up to $1,000 for taxpayers filing jointly.

Here we offer a modified version, under which we expect the tax credit to yield $107 billion in new giving, bringing total eligible giving to $124 billion. We find that the Coats proposal would qualify $68 billion per year for tax credits.

For both our proposal and the Coats proposal, the estimates are upper limits that would be reached gradually over time. We recommend a five-year phase-out of those government welfare expenditures that the fully implemented credit is intended to replace.

Another issue, as yet unresolved, is that of possible geographic disparities in giving: Poor people who live in poor states or metropolitan regions may be made worse off as a result of a preference by donors for local giving. One solution is for Congress to rely on block grants or some other transfer mechanism to correct this imbalance. (Our original proposal suggests additional possible remedies.)

Question 2. Would giving increase under a tax credit, or would taxpayers merely substitute contributions eligible for the credit for contributions ineligible for the tax credit and pocket the saving?

Answer. We do not believe that a tax credit would cause any significant substitution of eligible for ineligible contributions. Because both the BHI and the Coats proposal permit charitable contributions not eligible for the tax credit to remain eligible for the existing tax deduction, neither increases the price of making these contributions and therefore neither creates a disincentive to make them.

Even so, there is a concern that taxpayers would reduce their tax bills by substituting eligible for ineligible contributions. The more an eligible contribution could be seen as a substitute for an ineligible one, the more likely this substitution would take place.

Our answer is that there is no incentive for taxpayers to reduce their contributions to any charity, provided only that the tax credit be implemented as proposed in our December 1995 study - that for every new dollar contributed to charities deemed qualified to receive eligible contributions, the government reduce its spending on welfare programs by one dollar.

We perform a number of empirical tests of the validity of this conclusion. An ideal empirical test would consist of an estimate of the "cross-price elasticity of demand" between eligible and ineligible charities. Because of a lack of data, we conduct other tests that provide a proxy for this elasticity.

From these tests, we find strong positive correlations between all types of charitable giving over time, both in nominal and real dollars. We find giving to religious and human-services organizations to be complementary goods, meaning that as individuals give more to the one kind of organization, they give more to the other.

Despite the foregoing assurances, there may still be concerns about possible substitution of eligible for ineligible contributions. To allay these concerns, we offer a modification of our original proposal. Under this modification, the taxpayer could not take a credit for any contribution during the current year unless ineligible contributions were at least as great as they were during the preceding year. We offer a Welfare Tax Credit worksheet that shows how this rule would work and how it would prohibit the substitution of eligible giving for ineligible giving.

Question 3. Should there be a threshold limit of giving for tax credit eligibility?

Answer. The appropriate threshold, which would both eliminate substitution and assure revenue neutrality, is the one offered above in our answer to Question 2: Contributions not eligible for a credit would have to be at least as great in any given year as they were in the previous year in order for "welfare" contributions to be eligible for a credit. A threshold of this kind brings about the desired increase in eligible giving while deterring taxpayers from decreasing ineligible giving.

Question 4. Because the BHI proposal permits qualified donations in excess of the 25% maximum to be tax deductible, it creates a potential circularity problem in computing the tax credit and thus the tax due. How can this problem be resolved?

Answer. We resolve this problem by converting donations in excess of the maximum into a partial credit based on the taxpayer's marginal tax rate. The total tax credit then equals this partial credit plus 25% of the taxpayer's tax liability.

Question 5. What is the appropriate role of solicitation organizations in delivering welfare benefits?

Answer. The BHI proposal does not permit donations to solicitation organizations (such as the United Way) to qualify for tax credits. The reason is that such organizations represent an administrative "filter" that absorbs funds better spent directly on the poor.

The Coats proposal, on the other hand, allows credits for donations to solicitation organizations. There are reasonable arguments, including economies-of-scale and quality-control arguments, that can be made in support of this approach.

We believe that charitable organizations would develop their own funding networks and quality-control arrangements without the need for solicitation intermediaries. The question is, however, open to further research.

Question 6. Is the idea of a tax credit compatible with that of a flat tax?

Answer. There is no practical incompatibility between the flat tax and the idea of offering tax incentives, even tax credits, for charitable contributions. The reason is that such incentives do not interfere with the core purpose of a flat tax, which is to shift the burden of the tax from saving to consumption and to increase economic efficiency.

Related links:
Congressional Testimony by Prof. David G. Tuerck
Policy Study: Giving Credit Where Credit is Due: A New Approach to Welfare Funding
Transcripts from BHI's Compassionate Welfare Reform Conference, December 12, 1996, Washington D.C.