Charity Cynic

The Obama budget has already received vociferous opposition on its proposal to raise billions of dollars in additional revenue by capping the tax deduction for charitable contributions at 28 percent. One tv pundit predicted horrible unintended consequences and that contributions would fall "off a cliff." That analysis is actually dead wrong, and the policy is really quite brilliant.

Individuals who itemize their taxes are eligible to reduce their tax liability for charitable donations by the percent of income they pay in taxes. In other words, someone in the highest tax bracket (35 percent) is eligible to cut their taxes by 35 percent for every dollar they give to charity, up to 50 percent of their adjusted gross income. Someone in lower brackets reduces their liabilities at lower levels. Obama's proposal would cap the reductions at 28%, even for those in higher income brackets.

The chart at left (from this NBER paper) shows why this proposal will work for both the short- and long-term. It depicts charitable giving over time sorted by income. Pay particular attention to the black and red lines, because those are the income groups that will be most affected by Obama's proposed changes (the tax will technically hit those with incomes $250,000 and above, but the Alternative Minimum Tax makes many of these filers pay the 28% rate already). Note that the black and red lines take significant dips and dives. These are not random.

Upon taking office in 1981, President Reagan lowered the highest income tax bracket from 70 to 50 percent. As this rate fell, high-income tax filers had lower tax incentives to donate to charity. In 1986, Reagan proposed lowering the rate again, this time to 33 percent. Before the tax provisions took effect but while the proposal was being discussed, charitable contributions from high-income tax filers rose. That's the spike you see in 1986. The rate lowered again the following year, and it stayed relatively constant until 1993. President Clinton had campaigned on raising the highest-income tax brackets, and he set about to do that once in office. Note the big giving spikes around 1992 and 1993. President George W. Bush successfully lowered the top rate in 2002, and again, the giving rate responded.

All this is to say that tax policy works in the short-term. Givers are very responsive to changes in charitable deduction rates, and they modify the timing of their gifts. If President Obama wants to stimulate giving in the short-term, lowering the rate on deductions is the best way to do it. If donors have the option of deducting 35% of their tax liability this year or 28% next year, they're going to do it now. His proposal actually stimulates giving in the short-term.

So what about the long-term? Actually, there's not a whole lot to worry about here either. Americans have historically been the most generous donors of all industrialized societies, and in the last 50 years, growth in charitable giving per capita has outpaced GDP per capita. Some individual non-profits may have a hard time attracting donors, but on the macro level we'll be just fine. A 2006 survey found that only seven percent of high-income donors would dramatically reduce their giving if the tax benefits fell to zero. Twenty-eight is a long way from zero.

Obama's proposal stimulates short-term giving (which we desperately need), it shouldn't hurt giving in the long run, and it will bring in needed funds to the federal budget (that will be directed to health care). It's an incredibly brilliant scheme.