This is part of a new CAP series called the “Tax Expenditure of the Week.” The series aims to explain the often-confusing constellation of tax breaks in a way the average taxpayer can understand. Every Wednesday we will focus on one tax expenditure, explaining what it is, what purpose it is intended to serve, and whether it is effective toward that purpose. We will also review relevant reform proposals.
Subjecting these dozens of tax breaks to greater scrutiny is part of our broader focus on making government work better and achieving better results for the American people, which is the goal of CAP’s “Doing What Works” project.
This week we’re looking at the IRS rule that allows taxpayers to deduct amounts they contribute to charity from their income for tax purposes. This tax break, the country’s sixth largest, will cost the U.S. Treasury $315 billion over the next five years.
What is the charitable deduction?
The tax code allows people to deduct from their income contributions to charitable organizations, including churches, schools, universities, hospitals, social services charities, and other nonprofit organizations. Give a donation, get a tax break.
The deduction functions as a federal “matching” contribution to charities. If a taxpayer in the 25 percent tax bracket contributes $100 and claims a charitable deduction, it reduces his taxes by $25. The government has essentially made a $25 match to the taxpayer’s charity of choice.
The charitable deduction is largely intended to subsidize charities, though it is also justifiable under a theory of tax fairness. An income tax system that is based on people’s ability to pay arguably shouldn’t tax them on income they give away rather than consume for their own benefit.
Why is it a “tax expenditure?”
The charitable giving deduction is considered a tax expenditure because personal expenditures and gifts are generally not deductible. It is a special exception from that rule.
Special tax breaks are considered “expenditures” because they are essentially government spending programs that give out tax breaks instead of direct payments.
Who qualifies for the charitable deduction?
The charitable deduction is claimed only by taxpayers who elect to itemize their deductions rather than take the standard deduction. (Other limits also apply. See this IRS page.) The standard deduction ($5,800 for single filers and $11,600 for couples in 2011) spares taxpayers from having to document each of their expenses while also simplifying administration for the IRS. But an odd effect of the standard deduction is that the majority of taxpayers who claim it have no marginal tax incentive for charitable giving. The tax incentive for charitable giving is therefore targeted mainly at households that have other substantial itemized deductions that exceed the standard deduction, such as mortgage interest payments, or state and local taxes.
Who benefits from this deduction?
By matching charitable gifts, the tax code subsidizes the vast array of activities performed by the charitable sector, especially by charities that rely on such donations.
These institutions serve such wide-ranging purposes—serving the poor, sustaining faith and religious life, providing public and private schooling, supporting civic and cultural activities, performing medical research—that the benefits to society of encouraging donations are impossible to quantify.
The direct benefits to taxpayers are easier to gauge. They are enjoyed largely by givers in top tax brackets.
As with other itemized deductions like the one for mortgage interest payments, the value of the charitable contribution deduction rises with income levels. For a taxpayer in the 35 percent tax bracket, making a $100 charitable donation means paying $35 less in taxes. That same $100 gift is worth only $10 in potential tax savings to a family in the 10 percent bracket (if it itemizes).
The federal match-like quality of the deduction essentially permits people to direct a small portion of federal resources to their favorite charities. This fosters a diverse and pluralistic charitable sector. As critics have noted, however, structuring the incentive as an itemized deduction tends to favor the charitable preferences of the wealthy (opera houses and elite schools are stereotypical examples) over those of lower-income givers.
The deduction also creates a special tax benefit for people who donate assets that have risen in value: Not only do donors get to deduct the current value of the property rather than what they paid for it—this is subject to certain limits—but they also permanently avoid paying tax on the gain. This results in a double tax benefit. (See example below)
The charitable deduction and appreciated assets: An illustrative example
John and Sally, both in the 35 percent tax bracket, contribute equally valuable gifts to their alma mater.
John donates $10,000 in cash from his earnings that year. Sally gives the university $10,000 worth of stock that she originally bought several years ago for $1,000 (which means she has $9,000 in “unrealized gain”).
John can claim a $10,000 tax deduction for his gift and save himself $3,500 in taxes. That’s how much he would have been taxed on the $10,000 in earnings had he not given it away.
Sally can also claim a $10,000 tax deduction for her gift and lower her tax bill by $3,500. She will also permanently avoid taxes on her $9,000 gain on the stock. At a 15 percent capital gains rate, she would have paid $1,350 had she sold the stock, so her total tax benefit is $4,850.
Should the charitable deduction be reformed?
Proposals to reform the charitable deduction must balance any design flaws against the deduction’s positive effects, which include promoting charitable giving and support of the charitable sector.
The president’s Commission on Fiscal Responsibility and Reform recently proposed transforming the tax deduction for charitable giving into a tax credit, which would give all donors the same level of tax benefit regardless of tax bracket. Under this plan, the credit would only be available for donations worth more than 2 percent of a taxpayer’s “adjusted gross income.”
A recent proposal by the Bipartisan Policy Center would also turn the deduction into a tax credit but without an income limit. The center predicts that its proposal would “broaden the pool of people who donate to charity,” and potentially benefit religious organizations and those serving the poor because those categories are generally preferred by low- and moderate-income donors.
In an innovative twist, the Bipartisan Policy Center would send the tax credit directly to the charitable institution rather than to the taxpayer. This is how charitable incentives work in the United Kingdom, and it might be a more administrable way of delivering a federal matching payment. In the United States, however, direct government payments to churches may present thorny constitutional issues.
Like all tax expenditures, the deduction for charitable contributions should be assessed periodically for effectiveness alongside other government programs.
Seth Hanlon is Director of Fiscal Reform for CAP’s Doing What Works project. We hope you’ll find this series useful, and we encourage your feedback. Please write to Seth directly with any questions, comments, or suggestions.
The Pew Charitable Trust’s Subsidyscope project has assembled additional background and data on the charitable deduction, available here.
Next week: A closer look at the tax-privileged treatment of capital gains on assets held until death.