In testimony yesterday before a joint hearing of two House subcommittees, I urged Congress to modernize the nation’s social welfare programs to focus on early childhood, quality teachers, more effective work subsidies, and improved neighborhoods. One way lawmakers can shift their gaze is by considering the effects of combined marginal tax rates that often rise steeply as people increase their income and lose their eligibility for benefits.
While some talk about how we live in an age of austerity, we are in fact in a period of extraordinary opportunity. On a per-household basis, our income is higher than before the Great Recession and 60 percent higher than when Ronald Reagan was elected President in 1980.
A forward-looking social welfare budget should not be defined by the needs of a society from decades past. Two examples of how our priorities have shifted: Republicans and Democrats didn’t always agree on the merits of Aid to Families with Dependent Children (AFDC) or the Earned Income Tax Credit, yet they agreed on the need to shift from welfare to wage subsidies. Ditto for moving from public housing toward housing vouchers.
I sense that both the American public and its elected representatives are united in wanting to create a 21st century social welfare budget. That budget, I believe, should and will place greater focus on opportunity, mobility, work, and investment in human, real, and financial capital.
However, for the most part, our focus has been elsewhere. As I show in my recent book Dead Men Ruling, we live at a time when our elected officials are trapped by the promises of their predecessors. New agendas mean reneging on past promises. Even modest economic growth provides new opportunities, but the nation operates on a budget constrained by choices made by dead and retired elected officials who continue to rule.
For instance, the Congressional Budget Office and others project government will increase spending and tax subsidies by more than $1 trillion annually by 2025, yet they already absorb more than all future additional revenues—the traditional source of flexibility in budget making.
I am concerned about the potential negative effects of these programs on work, wealth accumulation, and marriage of combined marginal tax rate imposed mainly on lower-income households. To see how multiple programs combine to reduce the reward to work and marriage, look at this graph.
For households with children, combined marginal tax rates from direct taxes and the phasing out of benefits from universally available programs like EITC, SNAP, and government-subsidized health insurance average about 60 percent as they move from about $15,000 to $55,000 of income. This is what happens when a head of household moves toward full-time work, takes a second job, or marries another worker.
Beneficiaries of additional housing and welfare support face marginal rates that average closer to 75 percent. Add out of pocket costs for transportation, consumption taxes, and child care, and the gains from work fall even more. Sometimes there are no gains at all.
While there is widespread disagreement on the size of these disincentive effects on work and marriage, there is little doubt that they exist. One solution: Focus future resources on increasing opportunity for young households. Make combined tax rates more explicit and make work a stronger requirement for receiving some benefits.
This post originally appeared on TaxVox.
Remember when people complained that hedge fund managers and private equity firm owners paid a lower tax rate than many workers? Or when Warren Buffett said he shouldn’t pay a lower rate than his secretary? In those cases, investors were benefiting from low capital gains rates, but at least they paid some tax.
Now, thanks to Roth accounts, a special form of retirement savings, investors and even their children pay close to zero tax on huge sums of income. While this scheme can create significant future government budget shortfalls, my attention here is on how our tax code favors those who understand how to play this Roth-account game.
You got a hint of what might be possible when Governor Romney disclosed that he had over $100 million in his individual retirement account. However, this money was in a traditional IRA, taxable upon distribution, not a Roth IRA, where once a modest tax is paid up front, then all future income from the account escapes tax. Thus, Romney missed out on some of the tax benefits available to Roth holders.
The Taxpayer Relief Act of 1997 first made such accounts possible. At about that time, I warned in Tax Notes Magazine about how some investors could use Roths to avoid almost all tax on significant amounts of income. But I didn’t have a smoking gun, since I was anticipating future accruals on this then-new option. Tax professionals who put high-return hedge fund or private equity return assets into a Roth for wealthy clients have no incentive to disclose the details of these deals.
But a recent article by Richard Rubin and Margaret Collins for Bloomberg describes a redesigned retirement plan of Renaissance Technologies that allows employees to put retirement monies into Medallion, a hedge fund that historically has produced extraordinary high returns. My colleague, Steven Rosenthal, examines the tax implications and questions the future role of the Labor and Treasury Departments in these developments.
But you don’t need to work for a private equity firm or hedge fund to benefit. Let’s start with the tax sheltering opportunity available to almost anyone willing to invest far into the future and who earns no more than the normal long-term rate of return on stocks.
Suppose a 25 year-old taxpayer puts $10,000 in Roth accounts, perhaps helped out by parents. Once he pays a small upfront tax on the contributions, the tax on these accounts is now totally prepaid. He will never owe another dime. If stocks provide a traditional historic return of, say, 9 percent per year, the portfolio would grow to $483,000 by age 70, the age at which people must withdraw from traditional retirement accounts but not Roths. Make a few such deposits, and soon millions of dollars of income can escape tax.
But 9 percent represents an average return, chicken feed compared to the successful private equity investor, inventor, entrepreneur, or small business person. If they are insiders or somehow know, they might well know that they are likely to generate 15 percent per year over time. Others might also generate this higher return because of invention, luck, or simply leveraging up their returns. If the investment returns 15 percent annually, a $10,000 deposit held for 45 years grows to $5.4 million by age 70.
Perhaps you think the example of a 25-year old depositing money until age 70 is exaggerated. But it understates the more extreme cases. A Roth IRA can be held much longer than 45 years, e.g., a 35 year old living to 90 can leave the money to his kids who must withdraw the money only gradually after the parent’s death, so in this case complete tax exemption would last 55 years, and partial exemption would extend outward toward a century.
Think what this does for the fairness of a tax system. People who turn out to make millions of dollars of income on their investments will often pay no more tax (up front or down the road) than people who make little or nothing on their saving. To be clear, I’m saying dollars of tax, not rate of tax, would often be the same. The unsuccessful will be taxed the same as the successful, violating the whole notion of proportionality, much less progressivity, in taxation. I can think of almost no other tax provision, whether in an income or consumption tax, that goes so far in violating the notion that those who either make more money or consume more can afford to pay more tax.
This post originally appeared on TaxVox.
Although the public debate on health insurance coverage centers on a thumbs-up, thumbs-down fight over the Accountable Care Act (ACA, also called Obamacare), our national system needs a lot of smaller fixes. Many items on this long list of fixes make sense under either a Republican alternative to Obamacare (like the one recently but only partially laid out by Representative Paul Ryan) or Democratic amendments to the existing plan. One example: rethinking the tax penalty on people who do not buy insurance, an issue receiving increased attention as the IRS assesses its first penalties. We can achieve the same end much more effectively by requiring households to purchase health insurance if they want to receive the other government benefits to which they are entitled. No separate tax is required.
The history of the tax penalty
A system of near-universal insurance—where most people of the same age, regardless of their health conditions, can buy insurance at approximately the same price—needs a backup. This need became clear when health reform proposals were first introduced in 2009. Without a backup, individuals have a strong incentive to avoid buying insurance until they are sick, thus effectively getting someone else to pay for their health care. This incentive exists regardless of income level: even a wealthy person who buys health insurance only after becoming sick could hoist his bills on those with lesser incomes who pay for insurance year-round and every year.
The ACA’s partial response to this incentive is to tax those who fail to buy health insurance. The tax for failure in 2014 was either 1 percent of income or $95 per person; it rises to 2.5 percent of income or $695 (adjusted for inflation) after 2015. At the beginning of 2015, millions of people discovered that they owed this tax as they started filing their federal tax returns for 2014.
Practical considerations have always led toward some individual requirement to buy insurance, simply because there are limits on how much government can spend on subsidizing everyone. Our very expensive health care system now entails average health costs per household of about $24,000. The federal government would have to spend just about all its revenues trying to cover all those costs. A mandate to purchase insurance is a partial alternative to ever-more subsidies—as Governor Romney knew when he implemented a related mandate in Massachusetts. At one point, the mandate idea was favored by conservatives even more than liberals as a way to avoid an even more expensive government-controlled system, such as Medicare for all.
What might work better
The problem with the Obamacare tax penalty isn’t the idea; it’s the design. This problem, in various forms, occupied the federal courts needlessly. The central dilemma that pre-occupied an earlier Supreme Court decision was whether government could mandate that we had to buy some particular product (maybe not, it said, but, at least in Chief Justice Roberts’ opinion, it could impose a tax).
Another type of requirement avoids many past and current issues surrounding the Obamacare tax penalty. Simply deny to taxpayers other government benefits if they do not obtain insurance for themselves and their families. There has been no debate over whether government can—indeed, at some level administratively must—set conditions for determining who receives benefits.
This type of requirement could be implemented in various ways. The personal exemption or the child credit or home mortgage subsidies could be limited; some portion of low interest rates for student loans could be denied. This approach entails no new “tax” for not buying insurance; it simply adds to the conditions for receipt of other government benefits.
Designed well, the denial of any tax benefit could easily be reflected in withholding, so there are fewer end-of-year surprises. Employers, for instance, could adjust withholding for months in which employees did not declare insurance for themselves. As for the many poor receiving benefits like SNAP, most tend to be eligible for Medicaid, so the requirement than they sign up could be handled better by the related administrative offices that deal with them than by the IRS imposing some surprise penalty at the end of the year.
For both administrative and political reasons, this type of requirement can also be made stricter than the current extra tax. The IRS has always had trouble collecting money at the end of the year, and people react more negatively to an additional tax than to a requirement that they shouldn’t shift health costs onto others if they want to receive some other government benefit.
The road ahead
I doubt that any future government, Democratic or Republican, is going to deny people the ability to buy health insurance at a common community rate, even if they are sick or have failed to purchase health insurance previously. The world has already changed too much. Insurance companies have adapted, and so have hospitals. Before health reform, uninsured people could generate partial benefits or coverage by receiving treatment in emergency rooms (where such care is often required by law), and then not paying their bills. With some major exceptions, that practice has declined since the ACA was implemented. No one wants to go back to the old ways.
In a partisan world, of course, a fix of almost any type becomes difficult. Republicans are afraid to fix almost any aspect of Obamacare for fear it would involve a buy-in to the plan’s success; Democrats dread amending Obamacare because it might hint at some degree of failure. Watching the current Supreme Court battle, you sense that many enjoy the fight more than anything else. Still, this simple fix should be added to the list of reforms for consideration when and if we decide we want something better.
Politicians, researchers, and the media have given a good deal of attention recently to widening income inequality. Yet very few have paid attention to how—and how well—we measure income. Different measures of income show very different results on whether and how much inequality has risen. Without clarity, even honest and non-ideological public and private efforts to address inequality will fall short of their mark—and, in some cases, exacerbate inequality further.
How we typically measure income
Income measures tell different stories about opportunity and can be useful for different purposes. Some studies on income inequality measure income before government transfers and taxes—for instance, studies that compare workers’ earnings over time. Studies of the distribution of wealth or capital income, too, typically exclude any entitlement to government benefits. These “market” measures capture how much individuals have gained or lost in their returns from work and saving.
More comprehensive measures examine income after transfers and taxes. Transfers include Social Security, SNAP (formerly food stamps), cash welfare, and the earned income tax credit. Taxes include income and Social Security taxes. These measures best capture individuals’ net income and what living standards they can maintain, but not their financial independence or how much they are sharing directly in the rewards of the market.
Within both sets of measures (pre-tax, pre-transfer and post-tax, post-transfer), most studies still exclude a great deal. Health care often fails to be counted, even though increases in real health costs and benefits now take up about one-third of all per-capita income growth. Most of these health benefits come from government health plans (like Medicare and Medicaid) or employer-provided health insurance. Households pay directly for only a minor share of health costs, so they often don’t think about improved health care as a source of income growth.
How improving our definition of income—and using alternative measures—sharpens our view of income inequality
Starting with a more comprehensive measure of income, and then breaking out components, can improve our understanding of income inequality and its sources. As an example, let’s use some recent Congressional Budget Office (CBO) estimates, which provide perhaps the most comprehensive measure of household market incomes (consisting of labor, business, capital, and retirement income), then add the value of government transfers and subtract the value of federal taxes.
Between 1979 and 2011, the average market incomes—that is, incomes before taxes and transfers—of the richest 20 percent of the population (or the top income quintile) grew from 20 times to 30 times the incomes of the poorest 20 percent (the bottom income quintile).
When examining income after taxes and transfers, however, the relationship between the top and bottom income quintiles is more stable. It starts at a ratio of about 5.5:1 in 1979 and increases very slightly to 6:1 by 2011.
We find somewhat similar trends when comparing the fourth quintile with the second quintile. After taxes and transfers, income ratios don’t change much over this period, though the market-based measures of income show increased inequality. Of course, the very top 1 percent still has gained significantly; in 2011 it had nearly 33 times the income of the bottom 20 percent, compared with about 19 times in 1979.
What’s still missing
Even the CBO measures, however, are far from comprehensive. They exclude many benefits that are harder to measure or distribute, such as the returns from homeownership and the value of public goods like highways, parks, and fire protection. As Steve Rose points out, even more elusive are the broadly shared gains in living standards brought by improved technology and new inventions.
Why getting it right matters
Though defining income may seem like merely a technical exercise, it has huge consequences. Inequality has always been a political football: all sides tend to quote statistics that support their policy stances while ignoring the statistics refuting them. Yet if we want good policy, we’ve got to be open to how well any particular policy might improve income equality by one measure or make it worse by another, often at the same time. This is not a new story: bad or misleading information almost inevitably leads to bad policy.
This column first appeared on MetroTrends.
In his budget proposal, President Obama would raise capital gains taxes as a way to finance middle class tax relief. Along with many Republicans, he also supports tax rate cuts for business and efforts to prevent multinational corporations from avoiding U. S. taxation.
This raises an intriguing possibility. Why not pay for at least some corporate tax cuts with higher taxes on individuals on their receipts of capital gains or similar returns? In effect, as it becomes increasingly difficult to find a workable way to tax profits of the largest businesses, largely multinational companies, why not tax shareholders directly?
Most proposals to deal with the complexities of international taxation wrestle with how to tax corporations based on their geographical location. But as Martin Sullivan of Tax Notes said years ago, what does it mean to base taxes on a company’s easily-reassigned mailing address when its products are produced, consumed, researched, and administered in many places?
By contrast, individuals usually do maintain residence primarily in one country. Thus, reducing corporate taxes while increasing shareholder taxes on U.S. residents largely avoids this residence problem. Indeed, many proposals, such as a recent one by Eric Toder and Alan Viard, move in this direction. While such a tradeoff is not a perfect solution, it makes the taxation of the wealthy easier to administer and less prone to today’s corporate shelter games.
Many have made the case for why cutting corporate rates is sound policy. On what policy grounds can Obama’s plan for raising taxes on capital gains fit into this story?
Much of the publicity about taxing the rich focuses on their individual tax rate. But many very wealthy people avoid paying individual taxes on their capital income simply by never selling stock, real estate, or other assets on which they have accrued gains. That’s because, at death, the law forgives all capital gains taxes on unsold assets.
The very wealthy, moreover, tend to realize a fairly small share of their accrued gains and an even smaller share than those who are merely wealthy. It makes sense: the nouveaux riche seldom become wealthy unless they continually reinvest their earnings. And when they want to consume more, they can do so through means other than selling assets, such as borrowing.
Warren Buffett was famous for claiming that he paid lower tax rates than his secretary, alluding in part to his capital gains rate versus her ordinary tax rate on salary. But Buffett doesn’t just pay a modest capital gains tax rate (it was 15 percent when he made his claim and about 25 percent now). On his total economic income, including unrealized gains, it’s doubtful that his personal taxes add up to more than 5 percent.
At the same time, many of the wealthy do pay significant tax in other ways. If they own stock, they effectively bear some share of the burden of the corporate tax. Real estate taxes can also be significant and not merely reflect services received by local governments. Decades ago I found that more tax was collected on capital income through the corporate tax than the personal tax. Today, the story is more complicated, since many domestic businesses have converted to partnerships and Subchapter S corporations, where partners and shareholders pay individual income tax on profits.
The President would raise the capital gains rate and tax accrued gains at death. This would encourage taxpayers to recognize gains earlier, since waiting until death would no longer eliminate taxation on gains unrealized until then. The proposal would effectively capture hundreds of billions of dollars of untaxed gains that forever escape taxation under current law.
Trading a lower corporate tax rate for higher taxes on capital gains could also result in a more progressive tax system since many corporate shares sit in retirement plans and charitable endowments. It would reduce to hold onto assets—in tax parlance, lock-in—and the incentive to engage in tax sheltering. There’s also a potential one-time gain in productivity, to the extent that the proposal taxes some past gains earned but untaxed, as such taxes would have less effect on future behavior than the taxation of current and future returns from business.
Tough issues would remain. Real reform almost always means winners and losers. For instance, how would a proposal deal with higher capital gains taxes for non-corporate partners and owners of real estate? Toder and Viard, for instance, would apply higher individual taxes only on owners of publicly-traded companies.
Still, some increase in capital gains taxes could help finance corporate tax reform without reducing the net taxes on the wealthy. It is exactly the type of real world trade-off that both Democrats and Republicans must consider if they are serious about corporate tax reform.
This column originally appeared on TaxVox.
President Obama’s tax proposals for the middle class were a key element of his State of the Union address. But they represent only relatively modest efforts to create subsidies through the tax code rather than through other departments of government. Looked at broadly, many only tinker around the edges of tax policy and count on an overloaded and troubled agency, the IRS, to administer them.
Will $320 billion of tax increases finance very much?
The President proposes $320 billion in tax increases on the wealthy. It sounds like a lot. But how much would it finance in expenditures and additional tax breaks, assuming it is all spent rather than used to reduce the deficit? Well, there are approximately 320 million Americans, so the proposal would garner about $1,000 per person. But, then again, the $320 billion would be raised over ten years, so that’s about $100 per person per year that could be financed.
Now compare the $100 per year with what we already spend. Add together federal, state, and local spending plus tax subsidies (and the President would “spend” a good deal of his additional revenue on new tax subsidies), and the figure comes out to more than $20,000 per person. And that spending is scheduled to rise by an average of several thousand dollars per year over the same ten year period, due more to (hoped for) economic growth than anything else.
None of these observations speaks for or against the proposals. I like some of them, don’t like others. But if you want to have a significant impact on the budget and on the well-being of citizens, concentrate on where the money is.
Should we throw even more subsidies into the tax code?
Like almost all his recent predecessors, the President talks in his State of the Union address about tax simplification, but in almost the same breath he proposes a range of new tax subsidies. It’s an old story. Tax cuts show up as “smaller” government to those who simply count up net government revenue as a measure of government size. According to that theory, we could achieve dramatically limited government or no government at all if we put all expenditures into the tax code, thereby collecting negative taxes on people, at least as long as we run deficits.
Huge jurisdictional problems also lead to more and more being put into the tax code. Discretionary spending is capped; tax subsidies are not. Congressional tax committees can use increased revenues to pay for increased tax subsidies, but they do not have the jurisdictional authority to spend additional tax revenues on higher levels of spending, or, on the flip side, to reduce many items of direct spending to pay for lower tax rates.
Now I’m not suggesting that a new tax subsidy is necessarily more complex than a new expenditure. But it does raise the issue of whether the IRS is the right agency to administer the subsidy. All of this is coming at a time when the IRS has lost significant resources, the Taxpayer Advocate suggests we should be ready for a horrible filing season in which taxpayers will have difficulty getting ahold of someone in IRS to advise them, and many in the IRS remain disheartened and have been pushed into a bunker mentality that fears bad publicity more than bad administration.
This column originally appeared on TaxVox.
Many years ago, I began to suggest that taxpayers should have the opportunity to give to charity all the way until April 15 and then take a deduction against their previous year’s taxable income.
Now the idea is getting attention from lawmakers—but it needs the support of charities to make possible the increase in charitable giving it would foster.
In previous years, Congress approved a post-December adjustment to stimulate certain kinds of behavior: Taxpayers who add to individual retirement accounts have been offered a similar option since the mid-1970s, and Congress has occasionally extended the charitable-giving deadline to April 15 for disaster relief, as in the aftermath of Hurricane Katrina.
A great deal of evidence suggests that simply changing the charitable-deduction deadline could increase giving significantly.
Nonprofits like the Jewish Federations of North America support the option, but some other charities have expressed concern about whether it would harm end-of-year appeals.
I would suggest that these charities avoid thinking of charitable giving as a fixed amount—what I call the “clump of charity” thesis.
All the research, plus some real-life fundraising experience, suggests that the April 15 option would lead to an overall increase in the sums Americans give annually.
Just for a minute, however, let’s suppose that the clump-of-charity thesis is right and that the amount of charitable giving nationwide is the same every year. If that’s the case, then it’s unwise to add this new wrinkle to the tax system. But consider the corollaries: If giving is immune to incentives or circumstances, then both the charitable deduction and fundraising more broadly are superfluous, if not wasteful.
I doubt that most fundraisers believe the clump-of-charity thesis, so the real question is whether an April option would increase giving. Here are six pieces of evidence suggesting it would be a wise policy:
Taxpayers tend to underestimate the incentive to give. Several scholarly papers, including by researchers associated with the Federal Reserve Board and the National Bureau of Economic Research, have examined how well taxpayers understand and respond to tax provisions.
It turns out that many taxpayers, particularly middle-class ones, possess only a limited idea of their marginal tax rate—that is, the rate of subsidy they would get for additional charitable gifts if they itemized. They tend to equate the marginal rate with the average rate of tax they pay on all income, not recognizing that tax law looks differently at the first dollar and the average dollar earned than at the last one.
For example, a taxpayer who earns $50,000 might owe $5,000, or 10 percent of income on average. So she might imagine at year’s end, without formally doing her taxes, that donating $100 more before April 15 would save her that average percentage, or just $10 in taxes. But if she prepared her taxes under an April 15 option, she would get a formal notice from her tax software or tax preparer telling her such a gift would save her $25 and cost just $75 out of pocket.
If people saw this information laid out clearly with a first draft of their tax return, they would quickly grasp the real benefits of an increase in giving.
Few people know their tax and income circumstances until they get that information in January and beyond. Many Americans reconcile their books when preparing their tax returns. At this time, they see whether they’ve met goals and what options they’ve passed up but should have considered. That’s why the April 15 proposal should appeal to organizations that are working to attract gifts of all sizes, not just those that get more modest contributions from the broad middle class.
Advertising works best when it is closely timed to the activity you want to promote. Marketers understand this: That is why grocery stores send flyers out near weekend shopping time, not months in advance.
There is absolutely no time like tax time, not even the end of the year, when people are so tuned into taxation after toting up their annual income and charitable gifts. What better time to promote an opportunity to them?
Charities would get tons of free marketing from influential players. Hundreds of thousands of tax preparers and tax-software designers would promote the idea of charitable giving to their clients. Tax software already walks people through ways to reduce their taxes, and my discussions with people who deal with the interaction between technology and fundraising indicate that people preparing their tax returns could easily be encouraged to make a gift with just a few clicks of a mouse while filling out their returns.
Many trained tax preparers, in turn, would give special attention to the April 15 option for reducing taxes. They want to make clients happy, and they, too, want to improve their communities and the nation.
The April 15 option would be an even better deal for the federal treasury than the basic charitable deduction.
While the charitable deduction on average increases giving by 50 cents to $1 or a bit more for every dollar of revenue lost to the government, the April 15 option would provide $3 to $5 on average to charity for every dollar of revenue loss.
Why? Much of the existing deduction subsidizes giving that would occur anyway, but the additional cost with the April 15 idea applies only to added giving. For a taxpayer in a 25-percent marginal tax bracket, for instance, each additional $100 of giving costs the Treasury just $25.
People don’t like paying taxes. Alex Rees-Jones, an assistant professor at the University of Pennsylvania’s Wharton School, has found that taxpayers seek to minimize the amount they owe when they file.
The April 15 option would allow them to pay less to Uncle Sam when they haven’t withheld enough money over the year, and it would be a good way to use some of their refund when they have. They could also avoid penalties at times by simply giving more to charity.
To be sure, people who worry about the April 15 idea do have a legitimate concern: While giving over all would almost assuredly go up, some people would simply change when they give.
Still, while some people might delay one year’s end-of-year giving until the first months of the following year, others might accelerate each year’s end-of-year giving to the beginning of the same year.
This adjustment, I believe, is a small price to pay for the gain to charities over all. And charities can maximize the benefits by promoting giving both at the emotional time when people are thinking about helping others during the holidays and then again at tax time when people are focusing on taxes and how tax incentives help them stretch their own finances to aid those in need.
The debate over the April 15 option reminds me of when I served as a cofounder of a community foundation in Alexandria, Va. Initially, a few charities expressed anxiety about competition, but once they saw how the foundation’s activities raised money for them and helped expand their management capacity, any fear turned to broad-based support.
The April 15 option deserves the full advocacy of all nonprofits. It would be among the most cost-efficient ways possible to increase giving.
At a time when we depend so heavily on nonprofits, that’s exactly what we need.
This post originally appeared in The Chronicle of Philanthropy.
House Ways and Means Committee Chair Dave Camp deserves credit for proposing a tax reform that takes on many special interests, something too few other elected officials are willing to do. But one provision mistakenly threatens the survival of most community foundations without improving the tax system or strengthening the charitable community.
The proposal would effectively eliminate most donor advised funds (DAFs), the major source of revenues to community foundations, so they could no longer provide long-term support for local and regional charitable activities. Instead, those funds would need to pay out all their assets over a period of five years.
DAFs support community foundations in two ways. First, donors pay about one percent of asset value to the foundation for sponsoring the fund. Second, community foundations distribute donor gifts to many local charities. By simplifying giving and reducing costs, they make it possible for people who are not wealthy to endow charitable activities.
Requiring a community foundation to pay out all its assets over five years is equivalent to telling the Ford Foundation that it, too, must pay out all of its endowment over a short period of time. But the draft bill only targets those with limited funds, while it leaves the really big guys like Ford alone.
Usually, I analyze tax policy as a disinterested observer. But as chair of a community foundation called ACT for Alexandria, I have a personal interest in this issue.
So let me tell you how this proposal would lead to the demise of many of our activities and, likely, the community foundation itself.
Each year we engage in a one-day fundraising effort for the charities of Alexandria, VA, a city of about 145,000 across the Potomac River from Washington, DC. This year we raised over $1 million for 121 local charities, and many contributions to support the effort itself, not just the charitable contributions themselves, came from our donor advised funds.
The fees we earned from the funds supported our program to train local charities on how to better use social media and do online fundraising. No one else in the community does this coordination and training.
In addition, several of our donors create DAFs, often small, to engage their families in philanthropic efforts. By doing so, they encourage a new generation to make charitable giving part of their lifestyles.
DAFs give donors flexibility to vary their gifts as circumstances change. For instance, one of our funds provides long-term support for schools in Afghanistan through U.S.-based charities, but there is no guarantee that any particular Afghanistan project would be strong enough to merit a direct permanent endowment. Other funds support a long-term examination of early childhood education opportunities in Alexandria, a project likely to change as needs change. DAFs or equivalent funds also allow “giving circles” that combine small gifts to assist an activity without having to create a new charity every time.
Without these funds, we likely would be unable to support a grant program for capacity building and training of local nonprofit leaders.
I doubt seriously that Chairman Camp’s staff saw fully how they would wipe out most community foundations and confine endowment giving only to the rich. By making it more complicated and expensive to engage in such activity, they would move almost all endowment decision-making to elite, often established institutions where the average citizen has little or no voice and where the operational expenses are greater.
Why are critics of DAFs so worried about someone having a say over an annual grant of $5,000 out of an endowment but not when the President of Harvard decides over time how to spend billions of dollars out of the income from an endowment?
There are legitimate concerns over how such donor advised funds should be regulated. It may even be possible to design a proposal for a minimum annual payout, though, if badly designed, such a limitation could curb the ability of some people to build up assets to make a major gift to try to achieve some large charitable purpose.
The very small literature I have seen arguing for this type of proposal entangles DAFs and community foundations with separable issues. For instance, one can argue about the extent to which givers to charity should be allowed special capital gains treatment. But those discussions go well beyond DAFs, and removing DAFs as a source of more endowed funds hardly targets the perceived problem.
Still, I also understand why tax staff and policymakers sometimes see charities as just another special interest. The charitable sector needs to go beyond its “we’re all good, leave us alone” mantra, and address real problems as they arise.
There are ways for Congress to reform the tax laws that would raise revenues and strengthen the charitable sector. But this DAF proposal would wipe out most community foundations, increase administrative costs, and raise nothing or almost nothing for Treasury.
This post originally appeared on TaxVox. An earlier version of this column stated that a fund-raising effort by ACT for Alexandria supported over 200 charities; the corrected number is 121 charities