Pay it forward? Law and the problem of restricted-spending philanthropy.

• Author: Galle, Brian
• Position: Abstract through IV. The Value of Future Spending A. Prior Justifications for Restricted Spending, p. 1143-1176

ABSTRACT

American foundations and other philanthropic giving entities hold about $1 trillion in investment assets, and that figure continues to grow every year. Even as urgent contemporary needs go unmet, philanthropic organizations spend only a tiny fraction of their wealth each year, mostly due to restrictive terms in contracts between donors and firms limiting the rate at which donations can be distributed. Law has played a critical role in underwriting and encouraging this buildup of philanthropic wealth. For instance, contributors can typically take a full tax deduction for the value of their contributions today, no matter when the foundation spends their money, and pay no tax on the investment earnings the organization reaps in the meantime.

What, if anything, justifies public support for "restricted spending" charity? This Article offers the first comprehensive assessment of that question and supplies original empirical evidence on several key aspects of it. I argue that restricted spending sacrifices crucial information, leaves superior opportunities on the table, and on average transfers funds to times when they are less useful. While there is a place for large and long lived philanthropic organizations in American society, that role does not require public support for restricted spending. As long as foundations can demonstrate their value to new donors, they will continue to thrive. I set out a series of policy recommendations aimed at better reconciling nonprofit law and the principles that justify it.

I support my claims with new evidence drawn from a data set of over 200,000 firm-year observations of private foundations. For example, I find that foundations earn about twice as much money per year as in earlier studies funded by foundation-industry lobbyists and that they are growing three times faster than those earlier studies suggested. This finding implies that the law could require a much higher annual "payout" from foundations. I also find that new laws introduced in about a dozen states since 2006 have significantly slowed foundation spending in the enacting states. Last, I offer simulations of several policy proposals for making foundations more effective at fighting recessions.

TABLE OF CONTENTS INTRODUCTION I. BACKGROUND II THE TIME VALUE OF CHARITY: A FRAMEWORK FOR ANALYSIS A. Time Discounting: A Review B. Is Time Money for Foundations? III. THE COSTS OF WAITING A. Opportunity Costs B. Diminishing Marginal Returns: Redistribution and the Growth of the Foundation Sector C. Project Selection, Agency Costs, and Information D. Let Charity Decide? IV. THE VALUE OF FUTURE SPENDING A. Prior Justifications for Restricted Spending 1. Donor Preferences for Restricted Spending 2. Firm-Specific Value 3. Real Option Value of Waiting B. New Arguments for Restricted Spending 1. Crisis Spending 2. A Federal Alternative C. A Review V. POLICY IMPLICATIONS: PAYOUT RULES AND BEYOND A. Existing Subsidies Are Hard to Repeal B. Time-Neutral Contribution Deductions C. Section 4942: Federally Required Payouts 1. New Data on Real Rates of Return 2. New Data on Growth in Overall Foundation Assets 3. Summary and Caveats D. Section 4940: Federal Tax on Net Investment Earnings E. Countercyclical Payouts F. Closing Donor-Advised-Fund Loopholes G. State Law CONCLUSION INTRODUCTION

If the US philanthropic sector were the output of a nation, it would rank as the product of the world's sixteenth-largest economy, just behind Mexico, and ahead of Turkey, Saudi Arabia, and Sweden. (1) Philanthropic institutions on this scale are uniquely American. (2) Other wealthy nations, such as Great Britain and Germany, have recently begun to develop modest philanthropic sectors, but nothing to rival ours. (3) Some of this phenomenon is cultural, an outgrowth of the ideals of the decentralized American state. (4) Much of it, though, likely owes its success to legal rules that have encouraged the accumulation of philanthropic wealth, including a set of generous federal and state tax subsidies. (5) In a modern era where wealth and power are growing ever more concentrated, what justifies this use of public funds to underwrite private, if charitable, wealth?

The growth of philanthropic wealth depends on law's willingness to embrace what I will call a policy of restricted spending. At many charitable organizations, managers are free to spend most or all of the firm's revenues on current needs, whether they be housing the indigent or curing deadly diseases. Foundations, in contrast, almost uniformly are governed by agreements that prohibit managers from spending more than a small portion of the value of a given donor's gift in any given year. (6) By holding spending down below the annual investment earnings and other income of the foundation, the restricted-spending rules permit the organization to grow ever larger.

Law assists the project of restricted spending in a variety of ways. (7) The federal government, and most states, award generous tax incentives for making donations to charity. Those incentives do not depend at all on when the charity spends the donated funds; the government offers the same reward at the time of donation whether the charitable acts actually occur the same year or centuries in the future. Because donors can usually invest their tax savings for a profit over time, this structure provides a powerful incentive to donate first and spend later. In some ways, as I'll detail, the tax rewards for giving are even higher for gifts to organizations that restrict their spending. Further, state organizational law imposes a duty on managers to safeguard the wishes of donors who want to see their money last in "perpetuity"; and, in more than a dozen states, the law actually presumes that managers have failed that duty simply by spending more than seven percent or so of their organization's assets in any year.

The result is that nearly a trillion dollars of philanthropic wealth now sits on the sidelines, held in abeyance not just for tomorrow, but for the indefinite future. (8) Taxes paid by current taxpayers have bolstered these funds in considerable measure. (9) Yet the benefits, if they ever arrive, will be enjoyed mostly by future generations.

Surprisingly, there has been little serious scholarly attention to law's role in restricted spending and the buildup of the philanthropic sector. A handful of think-tank white papers and public policy journal articles have batted around some basic ideas, such as whether we should care about whether public funds pay for charity now or later. (10) The closest to a complete exploration is an eight-page monograph from Stanford Professor Michael Klausner." There has been no systematic examination of the arguments for and against government support for restricted-spending foundations and little effort to link the policy arguments to concrete legal rules. This gap in theorizing has also produced a gap in empirical data: because few people have been formulating the questions, we have not had much research to tell us the answers.

This Article attempts to begin all these tasks. I critically examine prior justifications for restricted spending and offer some new possibilities for consideration. I show that in some cases theory doesn't take us all the way to a conclusion and that we need more facts about how donors and foundation managers actually behave. I attempt to fill in some of those facts with original empirical data. And I then connect these tentative findings with some basic principles for reforming the current underpinnings of the law of restricted spending.

To preview the analysis in a bit more detail, I first examine the social costs of restricted-spending rules. As others have acknowledged, setting aside funds for the future reduces the efficacy of the resulting spending by worsening the fit between society's needs and the donor's goals, and heightens the cost of separating the uses of the money from the owner's control. (12) I add that waiting imposes other kinds of costs on governments, beneficiaries, and the foundations themselves. Waiting sacrifices the opportunity to learn from and build on charitable successes and failures, and to invest in social programs with long-term rewards. It also shifts money from a time when resources are relatively scarce (now) to a period (the future) when, as I demonstrate with some new evidence, foundations will be flush with cash.

On the other side, I argue that while there are strong arguments for encouraging savings by charities, these arguments mostly don't support current restricted-spending rules. For example, it is true that foundations can develop expertise in their chosen policy areas and can serve as laboratories and incubators for new ideas. (13) But preserving these incubators doesn't demand restricted spending, as long as managers are willing to seek out new funding--as indeed most commentators believe they should. I also suggest that charity can usefully save to prepare for times of future great need--but this implies that the organization should also be free to spend profligately when the need arrives.

These analyses supply some basic principles for reforming current law. While I leave development of exact details to await later work and better data, I argue that at a minimum federal law should require many foundations to pay out a considerably larger share of their assets each year than it now does. Congress also should close the loopholes presented by lightly regulated alternatives to the foundation form, especially those offered by the so-called donor-advised funds. At the same time, good policy might additionally include rewards or other positive incentives, especially incentives for foundations to spend or loan out money during recessions. State tax law could mirror these changes, and states should likely abandon the current movement to impose a legal cap on annual foundation spending.

At each stage of the analysis...