Universities, museums, and other tax-exempt organizations that get most of their donations from the wealthy are up in arms over President Obama’s proposal to raise revenue to help pay for much needed health reform by reducing the tax benefit the well-off get for their charitable donations. The president’s proposal isn’t actually particularly targeted at charities, but the charity angle has been what the opposition has been hanging its hat on. But by the logic that underpins their opposition to the current offering, if the proposal ends up being scuttled then charities should instead get behind raising top tax rates—which would do as much, or more, good for charities as the current proposal does them harm.
Now tax policy can be very arcane, so let’s first unpack the president’s actual proposal before we examine what the charitable groups are opposed to and where their arguments should logically lead them. President Obama proposes to limit the value of all itemized deductions for the relatively small number of taxpayers in the top two tax brackets, which in 2009 start at $208,850 and $372,950 in taxable income (note that total income is routinely greater than taxable income at these income levels because of all the deductions, exemptions and tax breaks). The president’s proposal would primarily affect deductions for state and local taxes, but would affect charitable deductions as well. The president wants to use the $318 billion that limiting high-end itemized deductions would raise between 2011 and 2019 to help pay for desperately-needed health care reform.
Currently, the value of tax deductions are a function of a taxpayer’s marginal tax rate—more precisely, the value equals the taxpayer’s marginal tax rate multiplied by the amount of the deduction. For example, taxpayers in the 15-percent tax bracket with a $100 deduction get a $15 reduction in taxes. This is because their deduction reduces the amount of income that is taxed at a 15-percent rate by $100. Since that $100 now isn’t taxed, the savings is $15. If taxpayers are in the very top tax bracket of 35 percent, however, they save $35.00 in taxes for their $100 deduction. So the more income, the higher tax rate, and the bigger the tax break.
President Obama’s proposal is to reduce the tax benefit for those in the top two brackets to 28 percent in 2011—when he plans to let President’s Bush’s 35 percent tax on the top two tax brackets expire, returning to the 39.60-percent level of the Clinton era. So for every $100 in deduction a well-off person would get a $28 tax reduction under the Obama plan instead of $39.60.
You can argue whether Obama’s plan is good tax policy. After all, half of the deductions he wants to limit are for state and local taxes. Wealthy Californians and New Yorkers who pay a lot of those taxes would seem to have a lower ability to pay federal taxes than well-off people with similar incomes who live in states such as Texas, which lightly taxes the well-off. The purpose of some itemized deductions is to level the playing field between taxpayers with similar incomes but with different amounts of income available to pay federal taxes. A similar, although less clear case can be made for charitable deductions, which are about a quarter of the deductions that the president wants to limit.
The charities opposing the Obama proposal, however, are probably not worried about good or bad tax policy. They’re worried that they might see reduced donations. But if these charities are opposed to lowering the size of the tax break for donations by the wealthy, it stands to reason that they should be enthusiastic supporters of higher tax rates on the wealthy. Why? Because if they believe that the smaller subsidy of high-end charitable deductions reduces donations, then higher tax rates with the resulting higher subsidy should result in higher levels charitable giving—which should make them very happy indeed.
Presumably, when President Clinton raised the top tax rate to 39.6 percent from 31 percent in 1993, charities should have been overjoyed. After all, their wealthy benefactors saw the value of their tax deductions go from 31 cents on the dollar up to 39.6 cents on the dollar. And they must have been dismayed when George W. Bush cut the top tax rate to 35 percent, and the capital gains top rate to 15 percent. Now, they should be thrilled that Obama’s plan is to let the Bush top rates expire.
Speaking of the tax rate on capital gains, there is a quirk (egregious loophole might be a better description) in the tax code that allows taxpayers with appreciated stock or other assets to get a much bigger tax break by giving away the asset rather than giving cash. Let’s say someone earns $500 in wages and gives the $500 away to charity. They’ll report $500 in income and the $500 deduction will offset that. So the taxpayer breaks even.
Compare that to someone with a stock worth $500 that was bought for $1. If they sell the stock and give the $500 in cash to charity then that cash will be treated much like the wages, resulting in no net tax. But if the taxpayer gives the stock directly to charity, the result is a $500 deduction while paying no tax on the $499 gain. So unlike the wage-earner who breaks even, the investor in effect gets back a tax that was never paid.
Note that the higher the capital gains tax rate, the bigger the tax break from donating appreciated stocks to charity. Thus, President Obama’s plan to let the Bush 15-percent tax rate on capital gains expire in 2011—returning the rate to 20 percent—should be a particular call for joy among charities.
In fact, if charities really want bigger incentives for the rich to donate, they ought to be promoting higher top tax rates. How about, for example, going back to the 50-percent top regular income tax rate that President Reagan was so proud of during his first term? Or the 28 percent capital gains tax rate that Reagan signed in 1986?
The evidence is that the impact of reducing the tax benefit for the well-off to 28 percent wouldn’t make a huge difference in charitable contributions—the Center on Budget and Policy Priorities estimates a 1.3 percent decline. That would be a relatively modest price to pay for much needed fundamental health care reform.
But some charities would be affected more than others because they are particularly reliant on the donors that would be affected. So if those charitable organizations want to explore other ways to raise the funds needed to enact health care reform and want to increase the benefit for their donors, then higher top tax rates should be at the top of their list.
Michael Ettlinger is Vice President for Economic Policy at the Center for American Progress. To read more of the Center’s economic analysis and policy recommendations please go to the Economy page on our website.
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Vice President, Economic Policy