Compromising the safety net: how limiting tax deductions for high-income donors could undermine charitable organizations.

• Author: Tolan, Patrick E., Jr.
• Position: II. Background D. How Giving Has Changed in Response to Tax Changes through V. Conclusion, with appendix and footnotes, p. 363-388

4. How Giving Has Changed in Response to Tax Changes

   "[A]lmost any change in the tax rate schedule ... will tend to have an impact on giving." (197) It is undisputed that direct consequences of a change in tax rates are twofold and include both price effects (looking at the after-tax cost of giving) and income effects (looking at the after-tax disposable income and its impact on ability to pay). What is controversial and unresolved is the relative strength of these competing effects. The salience of the change is another factor that will likely bear on the price effect, so this more recent dimension should also be considered in any tax-reform proposal. (198) To these three dimensions, the author proposes to add economic hardship as a critical consideration. As next discussed, the lessons of the Great Depression and the recent Great Recession convincingly demonstrate that harsh economic times reduce charitable giving and the magnitude of this effect can dwarf both price and income effects of any tax change.

   1. The Early Years: 1913-1940

      The only relevant changes in the early years were tax-rate changes, which fluctuated frequently and wildly, predominantly spiking due to WWI, the Great Depression, and WWII. (199) Unfortunately, there is not much data about overall giving during these turbulent times, and there appears to be no data stratified by donor income or tax rate. (200) However, because only the wealthy generally paid taxes prior to the 1940s, the overall price and income effects of any tax changes likely applied to this top group. (201)

      Estimates of overall giving indicate that donations dropped during the Great Depression from over $1 billion in 1929, to a low of $637 million in 1933, but rebounded to just over $1 billion again in 1940. (202) Although the price incentive for giving increased substantially in 1932--from 25% to 63%--donations continued to drop due to the bad economy and finally reached a low point in 1933. (203) This demonstrates that the economy might be a more influential factor than the price effect.

      In addition, when tax rates held constant from 1933 to 1935, overall giving improved annually as the economy improved, so tax incentives cannot account for this increase, but economic improvement could. (204) Then, when tax rates increased again in 1936 (from 63% to 79% top marginal rate) donations increased for two years, dropped one year, then increased again to $967 million. (205) Increased salience and timing to take advantage of the higher rates could account for some of the increased donations in response to a 1935 tax hike that was notoriously called the soak-the-rich tax. (206) But economic recovery could just as easily account for the increased donations because overall income increased in 1936 and 1937, dipped in 1938, and recovered in 1939, paralleling the overall giving trends.

   2. The 1940s and the Standard Deduction

      In 1942, tax liability was extended to the masses in the form of a 5% victory tax on income over $624 and a reduction of the personal exemption to $500. (207) The changes were accompanied by a media campaign to reach the vast newcomers now subjected to the income tax. (208) Unfortunately, the new taxes were confusing and difficult to collect, so withholding was instituted to enable taxpayers to comply without going through the "complicated" process of preparing and filing a return. (209)

      The Individual Income Tax Act of 1944 was supposed to simplify the tax code by allowing a standard deduction instead of detailed itemization of deductions. (210) But, because charitable donation was an itemized deduction, taxpayers using the standard deduction were not able to enjoy any tax benefit from making charitable donations. (211)

      Philanthropic organizations feared this would have an adverse impact on donations, but Congress believed simplification of the Code was more important. (212) However, a precipitous drop in donations was unlikely for several reasons. Prior to WWII, most Americans were not subjected to the income tax, so the giving behavior of these lower-income individuals would not likely be impacted by the standard deduction. This is because their inclination to give was not previously motivated by tax considerations so the lack of a tax incentive due to the standard deduction should not have been of consequence. Avoiding the perceived complexity of itemization requirements may have resulted in middle-income donors just taking the standard deduction even if itemizing would have yielded lower taxes due to charitable donations. (213) Finally, much like modern times, those in the highest tax brackets and making the largest donations found it most beneficial to itemize, because sizeable tax incentives remained.

      "Although the income tax now affected the masses, in 1945 the richest one percent of households paid 32 percent of the revenue." (214) For this richest one percent, the requirement to itemize was nothing new. Undoubtedly, those already making charitable deductions in the bygone days when there was no standard deduction were familiar with and undeterred by the necessity of itemization. In addition, the value of the deduction at the highest marginal rate stood at 94%, making it inconceivable that a large, seasoned donor would choose the simpler route of the standard deduction over the more lucrative itemization route. (215)

      Estimates of overall giving suggest that introducing the standard deduction did not significantly affect donations. (216) As a percentage of personal income, the average rate of donation remained remarkably stable (in the roughly 1.61.7% range) from 1941 throughout the decade. (217) Because the national economy rebounded during and after WWII, however, charitable donations in terms of constant year dollars actually increased dramatically from $1.5 to $4.8 billion. (218) The ability of the wealthy to benefit from the deduction would have been substantial as their wealth increased and their marginal rates afforded a significant price incentive. Although price and income effects were somewhat offsetting, there was no economic hardship effect to stifle charitable donations.

   3. Changes in the 1950s-1960s

      With high tax rates as powerful incentives, the ability to donate appreciated property without paying taxes on the appreciation benefitted wealthy taxpayers. The option to donate charitable property in some cases without percentage of AGI limitations in the year of donation, and the ability to carry forward excess donations for up to five subsequent tax years, greatly benefitted some taxpayers, particularly wealthy ones. In regard to cash donations in 1960, for example, the highest marginal bracket of 91% meant that the donor only paid nine cents for every dollar the donor sent to charity and the other ninety-one cents was subsidized in the form of tax relief from the federal government. A donor in a state allowing a state tax deduction for charitable donations or basing its state income taxes on federal taxable income could easily make money by donating cash to charity. The donor could make considerably more money by donating appreciated property because each donation of property that had doubled in value (appreciation equal to basis in the property) netted the donor a refund of $1.19 for every dollar of fair market value of the appreciated item. (219) This typically applied to stocks and bonds, but could also apply to real estate or personal property. (220)

      The wealthiest individuals have a far higher income from capital gains than from wages or salary; therefore they could shelter all of their earned income with donations of appreciated assets. Some of these individuals actually avoided all tax liability in this fashion. (221) In 1966, the situation was especially dire with itemizers claiming $79 billion in charitable donations (of $130 billion in total itemized deductions) compared to $112 billion of collective AGI. (222) Worried that high-income taxpayers were dodging their fair share of tax, Congress acted to stop the abuse in 1969. "Congress in 1969 attached some significant limitations to such deductions ... [and] eliminated some abuses, [but] it actually left the larger part of the problem intact, since donors can still generally deduct gifts of appreciated property to public charities." (223)

      The ability to donate appreciated property and claim a tax deduction for 100% of the fair market value at the time the donor donated the property means the donor is never taxed on the appreciation of the asset, yet gets to claim a deduction not only for basis, but also for the appreciation. In the 1986 Act, Congress somewhat limited this advantage by treating the appreciation component as a "tax preference item" so that those affected by the Alternative Minimum Tax (AMT) (predominantly high-income taxpayers) would only be able to deduct their basis in the donated property. (224) A large gift of appreciated property could give rise to AMT liability for a taxpayer that otherwise would have avoided the AMT.

   4. Changes in the 1970s

      In the 1970s, tax rates remained stable with a 70% top marginal rate and no changes to the scope of taxpayers' entitlement to deduct their charitable donations (category two changes). (225) In addition, the only change to the AGI limitation on deductions (category one changes) occurred in 1978, when the unlimited charitable deduction was repealed. But the Tax Reform Act of 1969 had already capped the ability to deduct at 50% of AGI, so this was a formality that did not impact incentives or taxpayer behavior. As might be expected, there was no altered taxpayer behavior because there were no tax changes to motivate such behavior. Also, despite stagflation at the beginning of the decade, donations remained at a very consistent percentage of personal income, dropping almost imperceptibly from a high of 1.96% in 1970 to a low of 1.87% in 1979 and remaining consistent between 1.91-1.95% throughout the 1960s. (226)

      While...