How to cut the charitable deduction without hurting charities

November 15, 2012

Charitable groups like this mobile food kitchen would suffer if the charitable deduction were capped, but not if a floor was implemented (Katherine Frey-The Washington Post)

If Congress is to raise significant revenue by cutting deductions, they're probably going to have to cut back on popular provisions like the exemption for employer-provided health insurance or the deduction for mortgage interest.

Many of those provisions are viewed skeptically by policy experts. The mortgage interest deduction, for example, does not actually increase homeownership, and some argue it promotes excessive borrowing, which increases the number of people who are "underwater" on their mortgages. The employer health insurance exemption, for its part, makes workers dependent on their employers for health coverage, among many other distortions. As Brad noted last month, one of the few areas of agreement among economists of all ideological stripes is on ending these two tax breaks.

That said, there are other big tax breaks that could be worth preserving on policy grounds. Chief among them is the charitable deduction, which functions as a big subsidy for nonprofits, from actual social-service charities to arts organizations to religious groups. A tax break may not be the most effective way to subsidize those groups, but taking it away or even reforming it mildly could have major repercussions. The Tax Policy Center estimates that merely changing the deduction to a refundable credit could reduce charitable giving by as much as 10.8 percent.

For that reason, policymakers might want to exclude the charitable deduction from any limits they place on deductions as part of an austerity crisis or tax reform deal. The only problem: that sharply limits how much revenue such a cap could raise. After estimating what various deduction caps could raise last month, the Tax Policy Center on Wednesday released numbers for what caps would raise if they exempted the charitable deduction. The answer: a whole lot less than if they capped that deduction too.

Over 10 years, exempting charitable deductions raises about $400 billion less under a $25,000 cap, and about $261 billion less under a $50,000 cap. That's a big sacrifice of revenue.

One way you could make up that revenue without striking too hard a blow against nonprofits is to set a floor, rather than a ceiling, on charitable gifts. According to a Tax Policy Center paper by Roger Colinvaux, Brian Galle and Eugene Steuerle, if the tax code only allowed people who gave more than 1.7 percent of their income to charity to claim the deduction, and that deduction were placed "above the line" so filers who don't itemize could claim it too, there would be no reduction in charitable giving. However, there'd also be a big increase in revenue: about $10.4 to $11 billion per year, or up to $110 billion over a decade.

That suggests that policymakers who want to preserve the positive aspects of the charitable deductions without losing out on revenue should cap other deductions (or convert them to credits), but put a floor on the charitable deduction instead.

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Neil Irwin | November 15, 2012