Until recently, few Americans knew the names of these three Treasury officials, long-time public servants whose talent and many years of hard work elevated them to prestigious government positions. But many now recognize, if not their names, the issues with which they have been intimately associated. Each has moved into the spotlight recently after putting out a statement, report, or blog dealing with a very controversial aspect of tax administration: employer mandates under the new health care reform law, or Obamacare, in the first case; and tax exemption for social welfare organizations with such labels as “tea party” or “progressive” in the last two.
What Mazur, Lerner, and George also hold in common is the forced assumption of greater responsibility than is warranted, as elected officials and their top appointees—those who wrote or failed to fix the laws in the first place—scramble to secure a position of innocence and fault-finding in the blame game known as Washington, DC.
Mazur is the Assistant Secretary of the Treasury who first revealed in a blog posting the delayed implementation of one important feature of Obamacare, the mandate on larger employers to pay a penalty if they don’t offer health insurance to their full-time employees. Lerner is the IRS official, now threatened with criminal charges by politicians, who first noted that some of those under her had inappropriately targeted “tea party” and other groups for extra review when they applied for tax exemption as social welfare organizations. George is the Treasury Inspector General whose report on the IRS targeting of tea party groups is now being lambasted by Democrats for failing to note sufficiently that the IRS was simultaneously scrutinizing other applicants, such as progressives.
Should we focus so much attention on the talents of Mark Mazur in regulating, Lois Lerner in enforcing, or J. Russell George in inspecting? (I may be influenced by that fact that I know two of them, but I can assure you that many others would say that each is well above average in integrity, ability, and devotion to the public.) Or should we instead turn our attention to how the government turns inward when it functions poorly, the system creaks, and officials remain at an impasse to fix things everyone has long known are broken?
Every expert on nonprofit tax law will tell you that providing tax exemption for organizations operated for social welfare purposes (“exclusively” under Code section 501(c)(4), but “primarily” under the IRS’s more lenient regulations) does not mesh easily with organizations set up to engage in significant political activity. Also, delays in getting exemption have been an issue for years for nonprofits in general because of lack of IRS staffing, extensive abuse of the law, and the difficult-to-enforce boundary lines between exempt and nonexempt activities, the latter including political campaigning. And if there were an easy way to figure out which organizations really devote themselves to social welfare, why hasn’t the White House or any member of Congress come up with one? If things go amuck in some IRS Cincinnati office, wasn’t error built into the system a long time ago?
As for the health care reform law’s employer mandates, of course these were going to put extraordinary pressures on employers to hire part-time rather than full-time employees, on payroll and other reporting systems to devise ways to measure hours of work (however inaccurately), and on an understaffed IRS to somehow enforce the law’s requirements. If things go amuck, how much responsibility rests with Treasury and IRS versus a political system that can only vote thumbs up or thumbs down on Obamacare?
Rest assured, when new benefits are bestowed on citizens, messages spew forth from elected officials and their spokespersons in the White House and Congress. “Look what we have done for you,” they pronounce. Can you remember top White House and Treasury officials ever deferring preferentially to Mark Mazur to make one of these more politically appealing types of announcements?
When things unravel a bit, however, roles reverse. Elected officials and their top cadre quickly disassociate themselves from both the creation of the problem and their past failure to address it.
Wouldn’t it be a lot more honest to share responsibility for successes and failures, more helpful to reveal rather than hide the limits on tax administration, and more productive to spend more time on fixing than blaming? As long as every difficult issue threatens to become political high theatre, the Mazurs, Lerners, and Georges of long government service will be asked to play the role of clown or villain for scripts they can, at best, edit but not write.
Charitable organizations form a vital part of America’s safety net. Ideally, foundations would be able to make greater payouts in hard economic times when needs are greatest. Unfortunately, the design of today’s excise tax on foundations undermines and in fact discourages such efficiency.
Under current law, private foundations are required to pay an excise tax on their net investment income. The tax rate is 2 percent, but it can be reduced to 1 percent if the foundation satisfies a minimum distribution requirement. The dual-rate structure and distribution requirements obviously introduce complexity. The stated purpose of the tax in legislative history—to finance IRS activities in monitoring the charitable sector—has never been fulfilled.
In the recent recession, the impact of the excise tax was especially pernicious, as it penalized those that maintained their level of grantmaking.
How? As Martin Sullivan and I first described in 1995, the excise tax penalizes spikes in giving; under the current formula, a temporarily higher payout results in a higher excise tax when payouts fall back to previous levels. A foundation that reduced its grantmaking during the last recession would not be subject to an increased excise tax because the amount the foundation paid out would be measured as a share of current net worth.
One proposal would replace the excise tax with a single-rate tax yielding the same amount of revenue. While a flat-rate tax would remove the disincentive to raise grantmaking in bad times, it still raises taxes for some foundations and not others.
A related law applying to foundations is the required payout rate, now set at 5 percentage points. Many experts have debated how high that rate should be. The current rate is believed to approximate the long-term real rate of return on a foundation’s balanced portfolio of assets. However, if foundations follow a strict rule of paying out the minimum 5 percent every year, they, too, will be operating procyclically, paying out more in good times when stock markets are high and less in bad times.
If we wish foundations to operate more countercyclically—to pay out more when needs are greater—we need to address both the excise tax and the natural tendency, reinforced by a minimum payout requirement, to make grants and payouts as a fixed percentage of each year’s net worth.
To help clarify whether IRS incorrectly, unfairly, or illegally targeted the Tea Party and other conservative groups, here are the answers to a few basic questions.
1. Is it improper for IRS to target specific groups?
Almost every contact the IRS makes with select taxpayers derives from targeting. Because its resources are constrained, the IRS conducts only limited audits, examinations, or requests for information. For instance, if you give more than the average amount to charity, you’re more likely to be audited since there is more money at stake. If you run a small business, you have a greater ability to cheat than someone whose income is reported to IRS on a W-2 form. The only way the IRS can enforce compliance at a reasonable administrative cost is by targeting.
This is especially true for the tax-exempt arena. Because audits yield little or no revenue, the IRS tax-exempt division examines very few organizations. Therefore, the IRS must use some criteria to “target” which tax-exempt organizations to approach.
2. Does the IRS discriminate?
Picking out which organizations or taxpayers to examine meets the definition of statistical discrimination. Firms do this when they consider only college graduates for jobs; political parties do this when they offer selective access to their supporters. Discrimination is wrong when it implies unequal treatment under the law, such as when unequal punishment is meted out for the same crime, or when people of color have less access to the mortgage market.
3. Why then did IRS say it erred in targeting Tea Party and other organizations?
We don’t have all the data yet but organizations with a strong political orientation have a higher probability of pushing the borderline for what the law allows. The groups at the center of this controversy generally applied for exemption under IRS section 501 (c)(4) which requires, among other things, that its primary purpose cannot be election-related and cannot overtly support political candidates.
However, the IRS could have identified election-related activity as a practice worthy of extra attention without specifying “tea party” or similar labels to identify such organizations. Had it done so, it might not be facing a problem now.
IRS apparently initially thought it was just using these labels as a shortcut for such an identification. Had it been engaged early on, the national office might have been quicker to warn against this practice since it would tend to identify more Republican organizations than Democratic groups with similar motives. Who decided what when is still under investigation.
Remember IRS was under pressure to examine those c(4) organizations after applications grew rapidly in the wake of the Supreme Court’s 2010 Citizens United decision. If IRS waits until after an election, it’s generally too late to make any difference.
4. Why did IRS start with the exemption process rather than wait and see how the organizations behaved?
Because IRS audits so few tax-exempt organizations, noncompliance is a major problem. But often noncompliance is inadvertent. Organizations trying to do “good” fail to understand legal technicalities or why IRS should be worried about them at all. If the IRS can get these organizations to comply with the rules from the start, it has a better chance of minimizing future problems.
5. Well, then, why the heck is IRS even in this game in the first place?
A question asked by many. Unlike some other nations with charities’ bureaus or other government regulatory agencies, tax-exempt organizations in the U.S. are monitored mainly by IRS at the national level and the state attorneys general at the state level. The IRS efforts generally derive from the Congressional requirement that charitable dollars (for which there are deductions and exemptions) go mainly for charitable purposes and not others such as electioneering.
6. But c (4) or social welfare organizations don’t benefit from the charitable deduction, so why don’t those with political orientation just operate without tax exemption or c(4) status?
They could, but the tax exemption provides several benefits. The least important may be non-taxation of income from assets since many of these organizations don’t have that much in the way of assets to begin with. However, many contributors interpret (often incorrectly) tax exemption to mean that the organization has satisfied legal hurdles, thus making it easier to raise money. Some c(4) organizations are closely connected to charities or c(3) organizations that can accept charitable contributions, and sometimes there’s a synergy between the two. My colleague Howard Gleckman reminds us that c(4)s quickly became favored over an alternative “527” tax-exempt political designation because the former does not need to reveal its donors. Finally, tax exemption provides an easy way to insure that any temporary build-up of donations in excess of payouts is not interpreted as taxable income to the organization or its contributors.
7. What will be the end result of this flap?
Success at agencies like IRS is often measured by their ability to stay out of the news rather than on how well they do their job. I’m guessing this episode will only will increase the bunker-like incentives within the organization. It would be good if Congress used this as an opportunity to figure out how better to monitor tax-exempt organizations, or whether IRS has the capability under existing laws, but that isn’t likely to happen.
Extending the charitable deduction deadline is a move with precedent: the government has used it to encourage giving following a natural disaster. President Barak Obama signed a provision allowing charitable donations toward the Haiti earthquake made from January 11 to March 1, 2010, to be deducted on 2009 tax returns. President George W. Bush signed a similar law allowing donations for tsunami relief made through January 31, 2005, to be deducted in 2004.
These provisions aim to increase giving at a time when need is critical. In reality, such temporary laws have limited effect because many do not know about these one-off incentives.
Consider instead the marketing possibilities of more permanent incentives to allow charitable deductions made by April 15, aka tax day, to be applied to the previous year’s tax returns.
By making what has frequently been a temporary measure into a permanent law, you eliminate the problem of trying to publicize brief windows of opportunity. Instead, people would come to expect that at filing time they would consider how much they would save by giving to charity.
Evidence suggests that, as in other facets of life, people are prone to making their decisions concerning giving at the last minute. The Online Giving Study finds that 22 percent of online donations are made on the last two days of the December, the last possible moment to claim a tax deduction for that year. Presumably this effect could be magnified if taxpayers were able to add to their charitable giving up until the last two days before they filed their tax returns.
Think of what such tax software companies as TurboTax or H&R Block could do by showing taxpayers directly how donating an extra $100 or $1,000 to any charity would lower their taxable income. The companies could even process the donation immediately through a credit card. If such a measure were enacted, I predict some foundations and charitable-sector collaborative organizations would immediately engage software tax preparation companies, other tax preparers, banks, and online giving organizations to figure out the best way to market this opportunity to the public.
This incentive would be by far among the most effective that Congress has ever provided in almost any arena, including existing charitable incentives. Why? Essentially, the revenue loss to the government is only 30 cents or so (the tax saving) for every additional dollar of charity generated. If people don’t give more, there are no losses, outside some slight timing differences. This is triple or more the estimated effectiveness of charitable giving incentives overall.
Marketing experts immediately grasp windows of opportunity. Back-to-school sales take place in September when families are thinking about school, grocery store advertisements near the weekend when more people do their shopping, Caribbean cruises in the winter when people are cold. The very best time to advertise charitable tax saving is when people file their tax returns.
This change would also add an element of certainty. Not knowing their income and tax rates for the existing year until it is over, people can only guess at the tax effect of any contribution they make to charity. When filing taxes, they can calculate exactly how much tax an additional donation would save.
A permanent law would also encourage all areas of giving instead of only the specific causes picked by Congress. Such targeted opportunities don’t necessarily increase people’s total donations: people are more likely to switch which charity they give to, not give more overall, when Congress highlights a particular charity.
In exploring this option for a number of years, I can find only one significant concern: the increased complication that is always induced by offering people choices (the actual tax-saving calculation, as noted, is actually simpler for many). Would people, for instance, mistakenly report their contributions twice, once for the past year and once for the current year? Would charities have trouble handling an extra checkbox in which taxpayers indicate in what year the contribution was intended?
If one is really interested in making the incentive better, this complication obstacle is easy to overcome. There are options here.
One would be to improve information reporting to IRS on charitable gifts. Only gifts for which charities give formal statements to individuals and the IRS itself could be made eligible. Noncash gifts might be limited in this case to those for which a formal valuation is provided to the taxpayers or, at least initially, excluded altogether. The information reports might only apply to those contributions over $250 for which charities are already required to provide statements to individuals. If charities don’t want to participate, they don’t have to.
Another, lesser bargain would be to experiment first only with online contributions for which software companies could send a report to the individual, charity, and IRS alike (this could include online checks for those banks and other institutions, not just credit card companies, who would be willing to participate). Other compromises along these lines are possible, and some of them on net are likely to improve compliance because of the integrated information system—a win-win strategy.
In separate testimony, I have offered a number of ways that this type of proposal could be incorporated into broader tax and budget reform so charitable giving is increased without any loss in revenues to the government.
With the United States still locked in a recession and the government cutting back its own efforts, what better time is there to encourage greater charitable giving?
See a 2-part video of testimony and discussions before the Ways and Means Committee on “Tax Reform and Charities.” To get a sense of Ways and Means members’ views on the related policy issues, the first panel, with the following presentations, in order: myself; Kevin Murphy, Chair, Board of Directors of the Council on Foundations; David Wills, President of the National Christian Foundation; Brian Gallagher, President & CEO of United Way Worldwide; Roger Colinvaux, Professor of Catholic University DC Law School and adviser for the Tax Policy and Charities project at the Urban Institute; Eugene Tempel, Dean of the Indiana University School of Philanthropy; Jan Masaoka, CEO of California Association of Nonprofits. Copies of all testimonies can be found online.
See also our Tax Policy and Charities website for many related studies and data.
The first video begins after about 33 minutes of set up and administrative matters:
In addition, the Urban Institute will be hosting a conference on “The Charitable Deduction: A View from the Other Side of the Cliff” on Thursday, February 28, 2013. Registration is now open.
The debate over the charitable deduction mistakenly pits those who acknowledge that the government needs to get its budget in order against those who recognize the extraordinary value of the charitable sector. The tax subsidy for charitable contributions should be treated like any other government program, examined regularly, and reformed to make it more effective. In fact, the charitable deduction can be designed to strengthen the charitable sector and increase charitable giving while costing the government the same or even less than it does now.
What’s the trick? Take the revenues spent with little or no effect on charitable giving, and reallocate some or all of them toward measures that would more effectively encourage giving.
For example, to increase giving Congress can do any or all of the following:
- allow deductions to be given until April 15 or the filing of a tax return;
- adopt the same deduction for non-itemizers and itemizers alike;
- consider proposals to ease limits on charitable contributions, such as allowing contributions to be made from individual retirement accounts (IRAs) and allowing lottery winnings to be given to charity without tax penalties;
- raise and simplify the various limits on charitable contributions that can be made as a percentage of income;
- reduce and dramatically simplify the excise tax on foundations; and
- change the foundation payout rule so it does not encourage pro-cyclical giving.
Congress can more than pay for these changes with little or no reduction in revenue if it would:
- place a floor under charitable contributions so only amounts above the floor are deductible (economists generally believe that some base amount of contributions would be given regardless of any incentive, thus floors have less effect on giving);
- provide an improved reporting system to taxpayers for charitable contributions;
- limit deductibility for in-kind gifts where compliance is a problem or the net amount to the charity is so low that the revenue cost to government is greater than the value of the gift made; and
- to help the public monitor the charitable sector, require electronic filing by most or all charities.
Budget and tax reform are now unavoidably intertwined. When it comes to the tax law concerning charitable contributions, we can do a lot to make our subsidy system more effective from both a fiscal and a charitable sector standpoint.
For more details, see my congressional testimony for today’s hearing on “Tax Reform and Charitable Contributions” before the Committee on Ways and Means.
If reforms to the charitable deduction decrease giving among high-income donors, certain types of charities will be affected more than others. As the graph below from a 2012 Bank of America Study indicates, high-income donors give mostly to education, followed by organizations such as trusts and foundations that primarily support other nonprofits (referred to as giving vehicles). Thus, changes to tax law affecting only high-income taxpayers would disproportionately affect donations to educational institutions. However, the relationship isn’t as linear as this figure suggests. Take international organizations, for instance. They receive fewer donations from high-income givers than health organizations, but they rely on those donations more; many health organizations, such as hospitals, receive substantial amounts in fees for service. International organizations also may be among the primary recipients of grants from giving vehicles.
Distribution of High Net Worth Giving: More to Education
Source: 2012 Bank of America Study of High Net Worth Philanthropy.
Note: High net worth includes households with incomes greater than $200,000 and/or net worth more than $1,000,000 excluding the monetary value of their home.
For more interesting data, visit the Tax Policy and Charities project.
- Why are itemized deductions getting so much more attention in budget negotiations than other tax breaks?
- Itemized deductions show up on tax returns, so they are among the most visible of all tax subsidies or adjustments. Other tax breaks tend to be harder for politicians and the public to understand.
- Why do most proposals to limit itemized deductions focus on higher-income taxpayers?
- Politicians run from telling the middle class that they get most government benefits, pay most government taxes, and eventually will have to get less and pay more to help get our budget under control. Meanwhile, Democrats want to increase taxes on higher-income taxpayers, but Republicans don’t want to increase tax rates. Itemized deductions for higher-income taxpayers are among the few options that fit amidst these limitations.
- How much of the revenue lost from all tax expenditures or subsidies comes from the itemized deductions being discussed?
- By one estimate, individual tax expenditures will cost the government about $1.2 trillion a year in 2015. If other policies aren’t changed, itemized deductions will cost about $180 billion by then, or about 15 percent of the total. Itemized deductions taken by those making more than $200,000 as individuals or $250,000 for couples (the president’s proposed level for starting to deny deductions) make up about 8 percent of total individual tax expenditures, or about $100 billion. See this graph on the revenue gained from various tax proposals and how this compares to the deficit.
- How many taxpayers would be affected by these limits, and how much revenue would be raised?
- Many proposals to cut back on itemized deductions affect only about 2 or 3 percent of taxpayers and would raise $15–$60 billion in 2015, compared with a deficit of close to $900 billion under current policies. A tougher cap would raise more revenue but affect more taxpayers. Obviously, a lot depends upon the actual legislation.
- Are limits on other tax expenditures being discussed?
- Yes. Some proposals would increase the tax on dividends and capital gains back to its level before the Bush-era tax cuts. Some would cap the exclusion allowed to employees buying health insurance from their employers. The president has proposed a number of other, generally smaller cutbacks, including removing tax breaks for employee contributions to 401(k) and similar retirement plans. Most of these have gotten less attention.
- What’s the appeal of across-the-board limits on itemized deductions?
- Politicians think various constituencies will less strongly oppose across-the-board limits that don’t single out any particular provision. To some supporters, these limits appear to attack interest groups even-handedly.
- But do they attack various interests even-handedly?
- No. Across-the-board limits would hit charitable deductions the hardest since people can quickly offset the tax increase by giving less to charity. State and local tax deductions, on the other hand, are less discretionary. Also, higher-income taxpayers give a large portion of all charitable contributions, so that sector is hit worse than, say, housing, where mortgage interest deductions are more concentrated in a middle class usually unaffected by the proposal.
- Do different caps affect behavior differently?
- Yes. An overall limit of $50,000 on itemized deductions effectively gives a 0 percent subsidy for, say, an extra dollar of home mortgage interest above that limit. Other proposals simply limit the subsidy to 25 cents or 28 cents but generally place no extra bounds (beyond current law) on how many dollars can be deducted.
- What are the drawbacks of overall deduction caps?
- Some deductions, just like government programs, are more justifiable than others. For instance, society may want to encourage charitable giving but not want to encourage debt to buy bigger homes or second homes. Almost all tax experts—left, right, and independent—feel that the best way to reform government programs, whether hidden in the tax code or not, is to tackle each one on its own merits.
- How does tackling a particular incentive on its own merits work?
- Consider the itemized deduction for charitable contributions. Instead of discouraging giving that might be quite desirable societally, policymakers could focus on lowering deductions for items with low compliance rates. For example, the deductions that people claim for donating used clothes seem significantly larger than the value the charities derive from such donations. Congress could also restrict subsidies for the first dollars of giving, such as the first 1 or 2 percent of income—amounts taxpayers would likely give in absence of any incentive. The incentive would then remain for the more discretionary giving above that floor. Finally, some of the revenue gained could then be spent where giving would be more responsive to the incentive. For instance, Congress could allow taxpayers to take deductions for contributions made up until they file their tax returns, or it could provide a deduction above a floor to those who currently don’t itemize.
In effect, Congress could strengthen its fiscal posture and the charitable sector at the same time. The same argument could be made for allocating homeownership subsidies better. In sum, blanket rules are arbitrary when applied to programs of different effectiveness and merit.