The problematic charitable-donation tax deduction

By Felix Salmon
November 28, 2011
David Kocieniewski has a long article about Ronald Lauder as sophisticated consumer of tax-avoidance advice.

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David Kocieniewski has a long article about Ronald Lauder as sophisticated consumer of tax-avoidance advice, who has managed to become worth somewhere north of $3 billion even as he’s given away hundreds of millions of dollars to charitable causes. (In 1988 he was worth less than $250 million; he inherited a lot of money from his mother in 2004, but today his stake in Estee Lauder constitutes only about one fifth of his net worth.)

Kocieniewski’s article raises a salient question: should the tax deduction for charitable contributions be abolished, capped, or otherwise profoundly reworked? President Obama’s jobs bill includes an idea he’s been unsuccessfully pushing ever since he became president: that the deduction for charitable giving be capped at 28%, even if your top marginal tax rate is 35%. According to a recent paper from the Center on Philanthropy at Indiana University, this modest tweak to the tax code would produce about $20 billion per year for the public fisc, while reducing total charitable giving by about $2 billion per year. That seems like a great idea to me, whether or not the government uses some of the proceeds to support the worthy charities which lose out.

Among those worthy charities, however, I would not include the Neue Galerie. It seems that Lauder has not actually donated his $135 million portrait of Adele Bloch-Bauer to the gallery; if and when he does, however, he’ll be able to deduct the full amount from his taxes at the top marginal rate of 35%, and thereby reduce his tax bill by more than $47 million. (If he can persuade the IRS that the painting has risen in value since he bought it, the deduction would be worth more still.)

Put another way, the government will spend $47 million so that Ronald Lauder can transfer a painting from his own ownership to that of a museum he controls. The painting doesn’t even need to be moved into the museum: it’s there already, and has been there since the day the museum opened. As far as the public and the art world are concerned, nothing will have changed — but as far as Lauder is concerned, he has a “reduce your tax bill by $47 million any time you need to” card just sitting in his back pocket.

There is very little public policy served by giving Lauder such a card. At the margin, does it make him more likely to open up a lovely museum of early 20th Century German and Austrian art in a Fifth Avenue mansion? Possibly. But the connection is tenuous enough that it’s hard to have any conviction in. And two things are undeniable: no one but Ronald Lauder will ever donate a $100 million painting to the Neue Galerie; and Ronald Lauder will never donate his portrait of Adele Bloch-Bauer to anybody else. No matter what happens to the tax code.

What we have right now is a situation where non-profit organizations, especially cultural ones like art galleries and museums, get very little direct government support — and when they do get direct government support, the Republican party in particular loves to rail against such expenditure as being fiscally irresponsible. On the other hand, private museums like the Neue Gallerie are the annual beneficiary of millions of dollars in federal tax expenditures which no one ever seems to question.

There are however hints that the tax-deduction sacred cow might finally be showing the first signs of weakness. Exhibit A: a curious column by Stephen Carter, in Bloomberg View, rattling off the parade of horribles that might happen if the deduction is eliminated.

Carter talks about — without citing or linking to any examples of — “the rising mania among politicians on both sides of the aisle to adopt a policy long popular within academic circles — either eliminating or severely restricting the charitable deduction, at least in the upper-income brackets”. Without any citations or links, it’s hard to know what he’s talking about, but I assume he’s not talking about the Obama proposal: reducing a deduction from 35% to 28% is not my idea of “severely restricting” anything, and if he was talking about an on-the-table presidential policy proposal, I’m sure his editors would have forced him to come out and say so.

In any case, color me enthusiastic about this idea, if indeed there is a “rising mania” for it. There are lots of public policy reasons why the federal government should encourage charitable giving — but I can’t think of any good reasons why that encouragement should be targeted especially at higher-income taxpayers. Generalizing wildly, the poor give to churches and the needy; the rich are much more likely to give to museums or concert halls or their own bespoke charitable trusts.

Carter is absolutely right that the funds donated to charity each year go to a very different set of places than the funds which are spent by the federal government, despite the fact that both are designed “to promote the general welfare”. In that sense, government can never replace charity.

But of course people wouldn’t stop giving to charity if the tax deduction went away — indeed, 70% of Americans don’t itemize their taxes at all. And there will still be plenty of millionaires and billionaires who want to save lives and/or put their names on hospital wings, or support their beloved local opera house, or help keep Central Park beautiful. The only important numbers here are the deltas: if the tax deduction went away, how much would charitable giving go down? And which charities would be hardest hit?

It’s hard to answer the first question with any specificity. But the second is easier to answer. Take a look at the $360,000 salary for the director of the Neue Galerie — or, for that matter, the $1.5 million paid to the general manager of the Metropolitan Opera, or the other seven-figure salaries paid at non-profit hospitals, universities, and foundations. There’s a rich-people money-go-round here: Jeff Raikes of the Gates Foundation doesn’t need his million-dollar salary, but the foundation is paying it anyway, as a matter of principle, presumably to encourage other foundations to start paying similar sums. These 1% salaries aren’t being paid out of small-dollar donations from the masses; they’re being paid out of large-dollar donations from other members of the 1%. And there’s no good reason for the US tax code to encourage such things.

Richard Thaler has a smart take on all this:

Having decided that charitable giving is a worthy cause, the government subsidizes charitable gifts from certain households, and for those chosen to be part of the plan, every dollar donated to a charity is increased by a specified percentage. To qualify, taxpayers must have a substantial home mortgage; the subsidy rate increases with taxable income. Low-income taxpayers receive no subsidy, but donations from qualified high-income taxpayers are subsidized by as much as 40 percent — or more…

The tax subsidy rate should be the same for everyone. This means that rather than being a deduction from income, the subsidy should take the form of a tax credit, so that if you contribute $1,000 and the subsidy rate is 15 percent, your taxes would be reduced by $150. (Ideally this credit should be “refundable,” so it is payable even if your tax bill is zero or negative.)

Carter’s response to Thaler is to say that it’s “a solution that would, of course, ‘cost’ the government more” than it’s spending right now in tax expenditures on the charitable deduction. But again, he doesn’t explain why this should be the case; it’s certainly not self-evident. A universal, refundable 15% tax credit would be a lot more democratic than the current deduction, and allow all Americans to take advantage of it, rather than only the minority who itemize their taxes. And if it did indeed end up costing more than the current system, with its deductions of 35% or more, that would only go to prove how badly skewed towards the rich the current system is.

We’re getting nowhere with respect to deep reform of the tax code, but it’s back on the table, as it is during every presidential election campaign. If we’re serious about it, then we should start taking an ax not only to the mortgage-interest deduction but also to the charitable-donation deduction. Because every time I see reports of a family charitable trust which carefully makes only the minimum outlays each year, I wonder just how charitable a lot of these donations are.

And of course Bloomberg View has a very large dog in this fight: it’s based in the headquarters of the Bloomberg Foundation offices on 78th Street, which are by some margin the most lavish offices I’ve ever seen in my life. Mike Bloomberg has every right to spend as much money as he likes on his foundation. But there’s absolutely no reason why the rest of us should subsidize those expenditures.

28 comments

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If someone gives their money to a 501-c3 then they should get the benefit of a tax deduction.

I trust individuals who gift property that they own to a cause deemed worthy more than I trust governments to reallocate those dollars. If you have a problem with a charity being controlled by the rich benefactor, existing only to generate tax deductions, or not providing real benefits to society… well then challenge the charities 501-c3 status not the tax break for all giving.

Posted by y2kurtus | Report as abusive

@y2kurtus, a tax break for all giving is precisely what I’m advocating! As opposed to the current tax break for high-income people with mortgages.

Posted by FelixSalmon | Report as abusive

INO, charities can be used for tax avoidance. I’ve seen it.
I think they should be highly regulated.
Even politicians have to show their interests.

If money is, for example, going offshore, it should be via one of a vetted st of charities.

I suspect it’s a big problem.

Posted by eachtohisown | Report as abusive

Felix, as a hard line statist whose views formed in the Alice-in-Wonderland world of the British nanny-state, it is not surprising that you dislike private sector solutions where government could be used instead.

“I trust individuals who gift property that they own to a cause deemed worthy more than I trust governments to reallocate those dollars. If you have a problem with a charity being controlled by the rich benefactor, existing only to generate tax deductions, or not providing real benefits to society‚Ķ well then challenge the charities 501-c3 status not the tax break for all giving.”

Perfectly said by y2kurtus

Posted by DanHess | Report as abusive

Felix

The very fact that to receive a deduction requires giving to a 501-c-3 corporation puts the government in the business of licensing charities. This makes no sense. Someone I know well has provided material assistance to several African students attending American universities by paying tuition and the like. No charity and no deduction and yet a very worthy cause with very satisfying outcomes.

There is little more rewarding than a direct connection between a donor and those in need. Tax deductions, or even tax credits, creates an incentive for donors to disconnect from those in need and funnel funds through a third party and as we see in the Lauder case, sometimes in those circumstances the donor and the donee are one and the same. Bizarre.

Get government out of the charity business and get citizen back into direct donations. We will become a more cohesive country by so doing.

Posted by OregonJon | Report as abusive

Y2k and Felix, a 501c3 can be used for all kinds of purposes – denying the validity of climate science, running a campaign that endorses creationism and evolution, or any old fairy tale that someone wants to sell to the world.

If a charity is worthy of a tax deduction, it should be worthy of the contribution without the tax deduction. The government doesn’t need to subsidize every cause, solely on the grounds of it not being designed to generate a profit.

Posted by KenG_CA | Report as abusive

Several points:

1. Mr. Lauder is simply taking advantage of the overly complex system of subsidies and breaks that we have built into a tax code that is trying to do far too much. I see no reason to vilify him (and the Times article clearly is imputing negative motive to him) over following the law as writte.

2. Felix, you seem to be advocating making the system far *more* complex. Growing bureaucracy and complexity as a solution to people finding advantage in a complex system? That sounds like the definition of insanity (eg: doing the same thing and expecting a different outcome).

3. Felix, why does it matter if Mr. Lauder controls the Neue Gallery. The museum is open to the public. He financed it. He then gave art to it that he purchased with his personal money. The art can’t be given back to him. Would it be better if he gave the Bloch-Bauer painting to MoMA or The Met where he has given hundreds of millions of dollars of other art? He is the honorary Chairman of MoMA so presumably that museum should not see any benefit from him since he “controls” it.

4. Why should we be upset that Renee Price, the Director of the Neue Galerie makes $360,000 a year. Ms. Price is a professional curator of 30 year’s experience with an MA in Art History and has risen to the top of her field. She has a specific and unique skill – an encyclopedic knowledge of Austrian art. If you would care to suggest that there is sufficient market supply for that position to justify a vastly cheaper salary, I would love to know it. Ms. Price is hardly a dilettante friend who was already part of the 1% that Mr. Lauder just picked at random to run his gallery for the past 10 years. What would you suggest is the correct price for her position and are you suggesting that the Government should set wages for every employee of any museum in the country? Why stop there? Perhaps every employee of any company! (sarcasm of course, but you get my point)

Posted by NoahMacNoah | Report as abusive

There’s a mental shift required to think that it makes sense to replace the deduction with a tax credit; the current system is based not on the idea that the government should “subsidize certain activities”, but that the government should butt out of certain activities in certain ways; it should respect a certain amount of autonomy of civil society instead of pursuing the notion that every nook and cranny of the country should be first under tight government control, with any deviation from that remarkable as a “tax expenditure”.

Posted by dWj | Report as abusive

The reason the charitable-donation tax deduction can be so easily gamed is because a donation of apples results in a deduction of oranges.

If I buy a scribbled drawing from my favorite artist (my five year old son?) for $1k and then donate it to a museum at an assessed “value” of $1M, then I write $1M off my taxable income. No capital gains. Minimal up-front cost. Massive deduction.

If I sold that drawing, I would pay capital gains tax (perhaps at the 28% “collectibles” rate?). Of course I would also need to find somebody crazy enough to pay $1M for a scribbled drawing. The deduction doesn’t net me the same gain that I would from a sale, but it also allows me far greater control over the disposition of the drawing.

There has to be a way to simplify the system without permitting a large deduction for an unrealized capital gain?

Posted by TFF | Report as abusive

Felix -

You may want to look into the rest of the literature on the economics of charitable giving. For instance, one of the papers that is cited frequently in the Center on Philanthropy paper that you mention comes to a very different conclusion. The paper (Bakija and Heim 2011: http://web.williams.edu/Economics/wp/Bak ijaHeimCharity.pdf) finds evidence of an elasticity of giving of greater than 1, which would suggest that the impact on giving of Obama’s policy could be far greater than $2B.

Furthermore, I’d contend that the Bakija/Heim methodology is quite a bit better. It relies on empirical data from New York and California, which actually decreased the charitable deduction in the early 90s. On the other hand, the paper you cite takes a far less direct approach at estimating the effects. As I understand it, the model attempts to measure the effects of the tax policy change on consumption and then uses historical data to predict changes in giving based on the new levels of consumption. This method is indirect and relies upon a set of charitable giving data in which the deduction rate has been basically constant for some time.

Also, it’s worth checking out the original paper on the Giving USA charitable donation prediction model (http://nvs.sagepub.com/content/32/4/548 .full.pdf+html). That model found that the effect of “tax price” was not even close to statistically significant, which suggests that something must be off about the model.

Posted by ajkatz | Report as abusive

I’d like to know how many people would like a tax system where they get to tell the government what to spend their tax dollars on. A lot of people, I’m guessing. It doesn’t work that way, except for those who can afford to make enough “charitable” contributions so they don’t have to pay any tax, effectively forcing the government to finance their favorite things.

Is that the kind of tax system you all want?

Posted by KenG_CA | Report as abusive

KenG, such a system was explored in a sci-fi short story a couple decades back. A nifty idea, though I fear it wouldn’t work terribly well in practice. (The “sexy” ideas would be overfunded while the meat-and-potatoes such as the USGS would go begging.)

You could eliminate the abuses simply by pegging the charitable deduction to the *lower* of the cost basis or value at the time of the gift. Much harder to game a cost basis than to make up some fluffy value for a unique item.

Posted by TFF | Report as abusive

Tax policy, in science fiction? OK, I can see it in some politician’s or lobbyist’s interpretation of the bible, but not sci-fi.

I don’t think it would work, either. I’m wondering how many people would want to fund the IRS.

I still don’t like the system, regardless of how the deduction is valued. I don’t like the idea of individuals getting to make government spending decisions just because they are wealthy. The next thing you know they’ll be able to pay people to talk congressmen into making laws that benefit themselves.

Posted by KenG_CA | Report as abusive

“Tax policy, in science fiction?”

A “what if” story. Sci-fi offers a vehicle from which to explore oddball ideas, since it is not forced to conform to present-day society. (Of course *good* sci-fi will be largely analogous except for the key issue in question.)

As for your objection, there is presently little distinction between giving your labor to charity and giving the fruits of your labor to charity. (The former arrangement is free of FICA taxes, but they are otherwise similar.) It seems to me a natural symmetry…

Posted by TFF | Report as abusive

TFF, when you donate time to a charity, there is no money changing hands. That’s not a fair comparison, unless the government starts taxing people on how many hours they work, and not how much money they make.

Posted by KenG_CA | Report as abusive

KenG_CA,

But your time has monetary value…

Posted by mfw13 | Report as abusive

But the government isn’t losing tax revenue when I donate it. They only lose tax revenue if I donate the money I receive for working. Your argument will only be valid if the government applies monetary value to time worked, not compensation.

Posted by KenG_CA | Report as abusive

KenG, I work for a charitable organization at a low salary. (If you priced out the hours I put in, it might come out below minimum wage, with no benefits attached.)

I could do a similar job elsewhere and would earn 2x or 3x as much, with the government receiving accordingly more revenue.

In many cases, the government DOES lose revenue when people donate their time to charities.

Posted by TFF | Report as abusive

TFF, so if a restaurant has to shut down for a day because of a power failure, can they declare lost revenue? No, you cannot deduct what you don’t receive.

What you can make is irrelevant when it comes to calculating taxable income. I could have bought more Apple stock than I did, but instead bought a bunch of other stocks with higher P/E’s and ended up losing money. Fortunately I don’t have to pay taxes on what I might have earned.

Posted by KenG_CA | Report as abusive

“if a restaurant has to shut down for a day because of a power failure, can they declare lost revenue?”

Sure, there are insurance contracts written along those lines.

Not clear why the IRS would care. Deducting “lost revenue” from “supposed revenue” gives you zero income to tax anyways.

“What you can make is irrelevant when it comes to calculating taxable income.”

Sure. But why should income forgone from a donation to charity be treated any differently from income forgone from a donation to charity? Just because the first was a donation of time while the latter was a donation of the income produced with that time?

I guess I just don’t see why a deduction for charitable donations is an outrage, especially when the individual contributes three times more lost income than the government in that donation.

Posted by TFF | Report as abusive

Restaurants can obtain insurance on lost revenue, but the IRS doesn’t allow the restaurant to deduct lost revenue from income. And, if they do get paid from the insurance company, they will have to declare that as revenue.

I’m not saying deduction of charitable donations is an outrage, just that I don’t want government spending to be effectively determined by individuals who choose to direct what would otherwise be tax revenue to their favorite cause. If I have $5 million in tax free income and $1 million in taxable income, but I give $1M to a non-profit that spends its money telling people that climate change is a lie, then essentially the government is spending $1M on that cause. If they want to work there for free, I don’t have a problem with that, but I don’t like tax dollars shifted to personal causes. The system breaks down, and usually in the favor of those who can afford to make big contributions.

Posted by KenG_CA | Report as abusive

KenG, look closely at what you wrote? You’ve explained in great detail the essential principle of the income tax system — you pay tax on the money that ends up in your bank account. If the restaurant ends up with the money, either through actual sales or through an insurance payment, then they pay tax on that. If the restaurant does not end up with the money, then they don’t pay tax on it.

If I work for free, then I don’t pay tax because I don’t end up with the money. If I give the money to a charity (receiving nothing in return), then I don’t pay tax because I don’t end up with the money. Exactly the same as the restaurant scenario.

Also, there are two ways of looking at Schedule A deductions. You can assert that people without mortgages or sufficient deductions to top the standard deduction do not benefit — but the standard deduction could easily be described as a no-hassle give-away for people whose limited deductible activities aren’t worth the trouble to track. Cut the standard deduction to zero, and EVERYBODY benefits from Schedule A deductions — but who would be helped by that change?

Posted by TFF | Report as abusive

“you pay tax on the money that ends up in your bank account”

No, you pay tax on money that flows through your hands. If you work for a charity, no money flows through your hands. If you work somewhere else and give money that you got from that other job to the charity, then it still flows through you. If you buy a car instead of giving it to the charity, you no longer have the money, but you still have to pay taxes on the money that flowed from you to the dealer. so we’re saying if you give your money to a charity that will spend it, you don’t have to pay tax, but if you give it to a car dealer that will spend it, you do have to pay tax.

I’m ok with cutting the schedule A deductions also. I would like people to pay tax on income over a minimum level needed to stay alive in a great nation without having to work 3 jobs, say people pay tax on all income over $25,000 – no deductions (but you know how I feel about credits for investment, which can be viewed as tax deferrals). That would be fairest and most simple, and would not distort decisions on how to use money that you earn or otherwise get possession of.

Posted by KenG_CA | Report as abusive

KenG, I am clearly not explaining myself clearly! :)

Present tax law makes a clear distinction between spending and gifting. If you spend money, it is taxable to you and taxable again to the person who sold you the goods/services. If you gift money to your brother, it is taxable to you and (within limits) not to him. If you gift money to a recognized charity, it is taxable to neither you nor the charity.

I suppose there is no essential need to differentiate between money gifted to a charity and money gifted to your brother.

Like you, I would love to have a simpler system with fewer deductions and a lower (but more consistent) marginal tax rate. The present system has very high rates in the middle (between $100k and $200k) and lower rates on either side of that bridge. Not to mention a mess of exceptions, credits, and deductions to slog through each year…

Posted by TFF | Report as abusive

TFF, I think I understand you. I get what you are saying, but I’m saying that directing the flow of money to a non-profit should be impact my taxes any differently than directing the flow of money to a for-profit. I just don’t think that donating money or an asset of dubious value should be treated the same as donating time with regards to taxes.

Posted by KenG_CA | Report as abusive

KenG, I wholly agree that donating an asset of dubious value should NOT be treated the same as donating money or more liquid assets. Limiting the charitable deduction to the cost basis of collectibles makes a ton of sense. (That, at least, is a “hard” number.) Excluding collectibles entirely might make even more sense.

Posted by TFF | Report as abusive

Donate stock now to ensure 2011 deduction. See http://www.kindshares.com/?p=383

Posted by jdex | Report as abusive

PLEASE VISIT http://donationmoneyfreetocharity.weebly .com

Posted by dharmeshjpatel | Report as abusive