The role of charity in a federal system.

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This Article critiques the prevailing justification for subsidies for the charitable sector and suggests a new alternative. Existing rationales are based on an economic model that assumes a single government whose decisions are guided by a single median voter. I argue that this theory is unpersuasive when translated to federal systems, such as the United States, in which there may instead be thousands of competing local governments.

I then attempt to construct a theory of the charitable sector that takes account of interactions between charity, local government, and national government. In this revised account, charity is most important when federalism mechanisms break down. For example, frictions on exit produce too little jurisdictional competition, and excessively easy exit produces too much competition---a race to the bottom. In both these cases, the quality of the resulting government services is predictably low, so that charity can be expected to outperform rival governments. Even if not, the threat of the charitable alternative may supply competition that is otherwise missing from the market for government services. These conclusions also have implications for the law of charitable organizations, as I detail.

TABLE OF CONTENTS INTRODUCTION I. THEORIES OF THE SUBSIDY FOR CHARITY II. INADEQUACY OF CURRENT THEORIES OF THE DEDUCTION A. Government Failure and Multiple Jurisdictions 1. Tiebout and Inframarginal Donors 2. Distortionary Effects of Subsidized Charity in Federal Systems B. Government Failure and Multiple Tiers of Government C. Government Failure and Public Choice 1. The Public Choice Critique 2. Exceptions to the Critique D. Other Rationales for Deduction 1. Federalism 2. Public Choice E. An Overview So Far III. QUALITY OF OUTPUTS A. Imperfect Horizontal Competition 1. Charity as a Substitute for Intergovernmental Competition 2. Counterarguments: Irrelevant Exit and Crowd-Out B. Inadequate Vertical Competition C. Excess Competition D. Warm Glow E. Treasury Efficiency F. Some General Objections G. Summary IV. TOWARDS A NEW FOUNDATION FOR CHARITY A. What is "Charity" Under a Comparative-Advantage Rationale? 1. Exit Costs 2. Broad-Based Services a. Vertical Competition b. Horizontal Competition c. Public vs. Private Goods 3. Redistribution 4. Objections to Weisbrod, Reconsidered 5. A Summary, and Two Examples B. Establishing Charitable Status C. Dangers of Discretion? CONCLUSION INTRODUCTION

Our contemporary theory of charity is simple and widely accepted, but incomplete. According to the dominant account, charity exists to provide goods and services that could not readily be produced in the for-profit sector. (1) Typically, in this story, the market fails because the products are public goods--their use by one person does not preclude their use by many others, so that no one person has any reason to pay for them herself. (2) Subsidies, such as the deduction for contributions to charity offered by [section] 170 of the Tax Code, (3) help to prop up the charitable production of these public goods. (4) This same story of market failure is traditionally the basis of the economic rationale for government. (5) Theorists distinguish charity from government by arguing that government meets only the needs of the majority, whereas charity can offer a diverse array of services for all segments of society. (6)

But as I will argue here, this supposed advantage of charity assumes that we have only one government, one majority. To the contrary, our federal system is designed to offer precisely the pluralism, flexibility, and responsiveness that charity theorists call for. (7) Thus, in this Article, I argue that we must reconsider charity from the ground up: in a world where both local governments and charities can provide public goods, and government has massive advantages in scale and fundraising, what role is there for charity? Put in terms of tax policy, if the goal is to subsidize production of public goods by actors other than the federal government, why should we grant a deduction for contributions to charity when there is already a deduction for taxes paid to state and local governments? (8)

My goal here is not to undermine support either for charity or local government but instead to establish both sectors on firmer intellectual footing. As it turns out, federalism often fails in its goals. Each sector--the charitable and the governmental--has distinctive strengths and weaknesses that better suit it for some tasks than others. The law of nonprofits should emphasize the sector's strengths while leaving largely to government tasks for which charities are poorly suited.

But that is the end of the story. Let me begin at the beginning. The father of the modern market-failure theory of the deduction is Henry Hansmann of Yale Law School, who set it out in a series of articles in the early 1980s. (9_ Hansmann admitted that he had no particular explanation for why charity, rather than government, might be the best place to produce public goods. (10) That piece of the theory was filled in by several other commentators. Some said that government could not itself capture the diversity, pluralism, and experimental energy of society as a whole. (11) The economist Burton Weisbrod, arguing from a purely welfarist perspective, suggested instead that government services can meet only the needs of the median voter, so that charity is necessary to satisfy demand for public goods in excess of the level that the median voter is willing to vote for. (12) Weisbrod acknowledged that there could be more than one government but dismissed the significance of that fact in a single sentence. (13) And there have been only two brief mentions of federalism in the literature since. (14)

As a result, existing discussions of why we ought to choose subsidies for charity over direct government provision of public goods are, to put it mildly, incomplete. Again, the central problem for charity is that state and local governments provide alternatives to monolithic central government decisions about the kind and quantity of public goods to provide, just as charity is said to do. To be sure, there are limits on the variety that local governments will offer, and limits, too, on citizens' ability to move between those jurisdictions or reshape them to get the services they prefer. But the very possibility of such an array of options reduces the need for charity to fill in. Moreover, the legal and economic literatures have until now failed to note inefficiencies that arise when supports for charity are mixed with a federated system of government. These inefficiencies pose the danger that subsidies intended to increase overall social welfare may actually on net drag it below the level we would obtain through federalism alone.

These overlaps and losses might be justified, though, if nonprofits can produce better-quality goods and services. (15) A system that includes charity outperforms others in those cases where the inherent limitations of local government diminish the public sector's effectiveness. For instance, residents' costs of moving and gathering information about rival jurisdictions can reduce competition between localities, allowing government to be relatively slack and inefficient. (16) In other situations, there is excess competition, as where the mobility of wealthy taxpayers puts fiscal pressure on local jurisdictions that wish to regulate the mobile or redistribute wealth from them. Charity has a role to play in these scenarios, although, as I explain, it is a narrower role than the expansive one currently envisioned by federal and state law.

With this new, clearer purpose in mind, we have a better sense of how best to resolve many of the persistent puzzles of charitable law. Among the important issues my analysis here helps resolve are the question of whether the deduction should be prohibited for charities that violate "public policy," the debate over political participation by charities, and the extent to which a charity's managers can deviate from the wishes of donors. My refinement also suggests reasons to doubt Malani's, Posner's, and Henderson's arguments for for-profit charity, (17) as I have set out in more detail elsewhere. (18)

In addition to solidifying and clarifying the law of charity, my analysis also makes a case for government. By identifying where each sector has comparative advantages, I show that the privatization advocates are mistaken. Charity and government work best side-by-side, not with one or the other on the sideline. This conclusion somewhat rationalizes the current practice of allowing deductions for both charitable contributions and local taxes.

The Article proceeds in four parts. Part I offers those new to the literature a short overview of why others have claimed we should subsidize charity. Part II explains the inadequacy of these existing justifications in light of federalism and public choice theory. Part III develops a contextual explanation for charity, in which charity becomes an appealing option when there is too much or too little competition between local governments. Part IV sets out my view of the basics of a new law of charity, based on the rationale offered in Part III. The Article concludes with preliminary suggestions for other legal changes that would follow from my arguments here.


Section 501(c)(3) of the Tax Code exempts qualifying nonprofit entities from the federal tax on the income of corporations. (19) Section 170 of the Code also allows individuals who make contributions to those organizations to deduct some or all of their contribution on their federal income tax return. (20) It is this eligibility to receive deductible contributions that distinguishes 501(c)(3) nonprofits from so-called "noncharitable" nonprofit organizations, many of which also are exempt from federal corporate income tax. (21) Qualifying as a 501(c)(3) also often...

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