November 23, 2005

Charities and Public Goods: The Case for Reforming the Federal Income Tax Deduction for Charitable Gifts

Download Special Report No. 137

Special Report No. 137

Executive Summary
There is broad consensus that the federal tax code should subsidize charitable giving. However, beneath this consensus lies sharp disagreement over what groups should qualify as charitable organizations, and why. Since 1917, the Internal Revenue Code has expanded the definition of charity to include a wide range of groups including hospitals, magazines, cemetery companies, social clubs, think tanks, churches, universities and more. Clearly, these groups are not all equally charitable. Upon closer examination, many tax-exempt groups now subsidized by the federal tax code are charitable in name only, making it hard to justify a federal subsidy for their operations at taxpayer expense.

As Members of Congress debate the tax reform recommendations of the President’s Advisory Panel on Federal Tax Reform, a key issue they face is whether this broad tax subsidy for charities makes economic sense. The Panel’s final report defends the charitable deduction on the grounds that it benefits charities, and recommends expanding it in various ways. However, those benefits come at a real cost to society. By shrinking the federal tax base, the exemption for charitable gifts forces up tax rates for everyone. Overall, a strong case can be made that the size and scope of the current charitable deduction cannot be economically justified, and should be dramatically reduced—not expanded—as part of any fundamental tax reform.

Most studies of the charitable deduction focus on its impact on charitable giving, or whether tax reform will benefit or harm charities. This study does not address those questions. Instead we explore a more fundamental issue: what is the economic justification for subsidizing charities to begin with? And is the current charitable deduction consistent with that justification?

From the perspective of economic efficiency, we find that it is hard to justify the current size and scope of the federal charitable deduction. Most 501(c)(3) charities now benefiting from the charitable deduction are neither charitable, in the sense of relying mostly on altruistic gifts, nor providers of public goods. This analysis suggests lawmakers should explore ways to curtail the definition of tax exempt charity, and exclude groups that are now benefiting unfairly from the deduction at taxpayer expense.

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