Tax reform: a friendly amendment
SUDDENLY, after languishing for months in the doldrums of politics as usual, the ship of tax reform has caught a brisk wind. The verb ``to Packwood'' has entered the lexicon of tax analysts, commemorating the Finance Committee chairman's snappy about-face to champion a lean new tax plan sporting a 27 percent maximum rate. While this is a promising course, the likely impact on charitable giving deserves further consideration. The Finance Committee's bill, to be debated on the Senate floor this week, reduces marginal tax rates -- most notably at the highest income levels -- but without sacrificing progressivity, as some of the ``flat tax'' proposals would do. It does this not with mirrors but by means of two devices almost as arcane: an exemption and a tax rate savings that ``vanish'' at upper incomes. The result is an effective marginal-rate schedule that peaks at 32 percent and levels out at 27 percent for taxpayers in the highest income brackets, dramatically lower than the current 50 percent top rate.
The rate reductions in this plan would certainly be bad news for some ``special interests,'' but there is abundant reason for Congress to give this plan a full hearing. One need not be a zealous supply-sider to believe that lowering marginal tax rates will put a crimp on the use of wasteful tax shelter activity, cut down on tax evasion, and encourage more work effort. And, combined with the proposed limits on business meals and entertainment expenses, the lower tax rates will reduce excessive expenditures now fostered by the tax code itself. There is considerable evidence that cuts in tax rates will indeed bring such benefits.
But another effect that is sure to be felt will be a decrease in the incentive to make charitable gifts. While taxes are rarely a major reason that people make contributions to churches, schools, and other nonprofit organizations, there is a large body of research indicating that taxes do affect how much is given. The charitable deduction causes taxes to go down when an individual gives more, thus reducing the after-tax cost of giving. Just about any tax law that decreases tax rates would tend to depress contributions, and the Finance Committee's proposal is no exception. For the wealthiest taxpayers, the drop from a 50 percent tax rate to 27 percent would cause the net cost of giving a dollar to increase by almost half. Added to this effect is the proposed elimination of the currently allowed charitable deduction for the two-thirds of taxpayers who do not itemize.
According to projections I have made, substituting the committee's plan for the current law would reduce the level of charitable giving by roughly 15 to 18 percent in the long run, or some $10 billion to $12 billion in 1986 dollars. Educational and cultural institutions, because they tend to be supported by wealthier taxpayers, would suffer relatively more, with contributions falling by more than 25 percent. Gifts to churches and welfare organizations would decline relatively less.
By way of comparison, these declines are more severe than the 10 or 11 percent decrease projected under the House bill, with its higher tax rates and deduction for nonitemizers. On the other hand, the Finance Committee's bill would produce a smaller decline than either the Treasury I or II plans, chiefly because fewer taxpayers would itemize under those plans. Still, a decline of 15 percent or more in private philanthropy would clearly have real impact on the income of many nonprofit institutions.
Whether one views this projected impact with concern, or simply accepts it with a shrug, depends in part on whether one sees the nonprofit sector as just another ``special interest'' and contributions to it as merely a form of private consumption. To the extent that charitable contributions bring about general benefits in society, they are decidedly not like most private consumption, and an economic purpose is served in subsidizing them. While it is quite another matter to determine exactly what the rate of subsidy should be, it is clear that some subsidy is appropriate if contributions, including those made by nonitemizers, serve the public good.
Assuming this to be the case, the implication for tax policy is that all taxpayers, not just those who itemize their deductions, should receive a tax subsidy for charitable gifts.
One obvious way to extend the subsidy is to retain the charitable deduction for nonitemizers. Since the current rules of the game require all modifications to be revenue-neutral, one could make up the lost revenue by imposing a floor on the deduction for all taxpayers. That is, taxpayers would be allowed to deduct only the contributions above a certain amount, such as the $100 allowed nonitemizers in the current House bill. For taxpayers whose contributions are above the floor, the incentive to make additional gifts is undiminished, though the incentive would be canceled for those falling below the floor. A higher floor brings in more revenue, but also inevitably leaves some taxpayers with no tax incentive to give another dollar in contributions.
To illustrate how this might work, extending the deduction and adding a floor equal to 1 percent of adjusted gross income would increase contributions on the order of $2 billion to $4 billion. Such a proposal could of course be made exactly revenue-neutral by reducing the floor amount.
By simultaneously extending the charitable deduction to nonitemizers and imposing a floor, it is therefore possible to increase contributions without losing revenue. Such a change would make a good proposal better.
Charles T. Clotfelter is professor of public policy studies and economics at Duke University.