Charitable Tax Exemption: Origins, Economics and Importance

As Tax Day arrives this year, donors around the country have evaluated their charitable giving and considered whether to claim the charitable deduction when filing their annual tax returns.

A subject of scrutiny and debate over the years, the mistaken view of the modern-day charitable deduction held by critics is that the deduction is a government subsidy, which the government may adjust or eliminate as it sees fit. This view misunderstands the nature of the charitable deduction and the history behind the tax-exempt status of charitable organizations.

Rooted in centuries old laws and norms dating back to the Elizabethan era, charitable organizations have been separate and distinct from the broader private sector economy. For example, the 1601 Charitable Uses Act in the United Kingdom defined what types of charitable purposes and activities were legally valid for the proper use of charitable funds. The crown believed these activities were of general benefit to society and wanted to encourage private contributions.

The modern-day charitable deduction is based on the idea of charitable giving that originated from the English common law concept of charitable trusts. The American colonists brought this legal tradition with them, and it became an important component of maintaining a thriving civil society in the newly formed United States.

As Philanthropy Roundtable Distinguished Fellow Joanne Florino notes:

“American charity preceded, predated the charitable deduction, but it also predated the federal income tax. The charitable deduction was put in place because of an increase in the federal income tax at the time of World War I so that people would not be deterred from making charitable gifts during a time when their taxes were higher.”

When it comes to providing support for vulnerable Americans from health care to education, charities are often better equipped to meet the needs of individuals and communities than the government. This is because government entities rarely possess the necessary information or local knowledge to make effective decisions in a complex and dynamic economy.

Given knowledge is dispersed among individuals and groups with unique experiences and perspectives, charities are oftentimes best positioned to tackle social challenges by leveraging the expertise of their donors, volunteers and staff because they are closest to the people in need and problems they are trying to solve. This allows charities to have a deep understanding of their communities, work closely with individuals and families to develop programs and services tailored to their specific needs, and provide more effective solutions than government programs, which often take a one-size-fits-all approach.

Unlike the government, which must rely on centralized decision-making and bureaucratic processes, charities are able to operate with greater flexibility and adaptability. They are also better able to experiment with new approaches and respond quickly to changes in the environment.

We saw this in 2020 with the onset of the COVID-19 pandemic. The pandemic propelled U.S. charitable giving in 2020 to the highest level on record at that time. The increase in charitable donations was most concentrated in parts of the country that were hardest hit by the pandemic. A study found charitable giving increased in 78% of counties that experienced the greatest threat from COVID-19, particularly from human services charities that helped mitigate the effects of the pandemic.

Charities have a greater incentive to use resources efficiently and maximize the impact of their programs. As charitable organizations rely on the voluntary contributions of donors and supporters, charities must demonstrate a high level of accountability and transparency to maintain public trust and support. This means they are more likely to allocate resources to programs that are proven to be effective and avoid wasteful spending.

In contrast, government programs are often subject to political considerations and bureaucratic inefficiencies, which can lead to waste and mismanagement. For example, at least $163 billion of the $873 billion in unemployment insurance spent during the pandemic was spent in error. This is on top of an estimated $80 billion in COVID-19 relief fraud from the Paycheck Protection Program, and another $80 billion in potentially fraudulent loans from the Small Business Administration’s pandemic loans program.

Decades of analysis on the tax price elasticity of charitable giving consistently show that charitable dollars go much further than government dollars. One 2005 meta-analysis found that, for every $1 the U.S. treasury forgoes in not taxing charitable donations, communities supported by charitable donations receive about $1.44 in financial support. From an economic standpoint then, the tax-exempt status of the charitable sector is treasury efficient.

Whether we consider the historical origins of the tax-exempt status of charitable organizations or the economic efficiency of nonprofits effectively serving communities, we should remember that, underpinning all this, is the importance of separating the state from civil society in order to help drive innovation and progress in society.

As legal tax expert and partner at BakerHostetler Alex Reid notes:

“The charitable deduction protects our freedom to create, fund and operate the institutions that make up American civil society with minimal interference from the government. It is a negotiated bargain between citizens and the state, establishing a delicate balance of power.”