Why is Charitable Activity Tax-Protected?
(Think Freedom, Not Finances)
Periodically, some politician seeking increased government revenues will propose to chop down the tax deduction for charitable contributions. Were this to happen, U.S. charities would lose billions of dollars. We as American citizens, however, stand to lose much more than that if the tax protections long afforded to charitable giving were to be withdrawn.
The charitable deduction protects our freedom to create and operate institutions that make up a civil society separate from government. Electing representatives is not our sole means of expressing ourselves and contributing to national success. As citizens of a free country we also have the right to act directly in the public sphere. The many private organizations that act within our borders—educating, assisting individuals, influencing culture, addressing social needs—are the ultimate bedrock underlying our democratic system.
The individual deduction for donations to these civic organizations, and the income-tax exemption for charitable operations, are more than just tax rules. They form a vital legal boundary between the state and civil society. They are not subsidies for civil society, but rather fences that keep government from interfering in a sector that is vital to our national freedom.
Income taxes are the contributions we make to the public good indirectly by force of law. Charitable donations are the contributions we make to the public good directly and voluntarily. Direct giving through donations, and indirect giving through taxes, are dual aspects of our right to self-governance. Altering the charitable deduction would renegotiate the fundamental relationship between citizens and the state, and undermine our ability to shape our own society.
Is there more to the public sector than government?
In recent years, our deficit-ridden federal government has been coveting the billions of dollars that citizens send annually to charities. For several years in a row, President Obama proposed cutting the income-tax deduction for charitable giving. Congress entertained some of its own proposals for capping, eliminating, or altering the charitable deduction as part of tax reform.
Policymakers sometimes justify these changes by claiming that the charitable deduction is a government subsidy for charity. A more accurate understanding is that the charitable deduction is simply an accounting mechanism to ensure that your income is measured accurately. Money you give away for public benefit is neither part of your income nor the government’s money to claim. Any income tax requires a charitable deduction as a matter of principle, because funds given away for the public good are not part of a taxpayer’s personal resources.
The state doesn’t sponsor and subsidize civil society using tax revenue. It is individuals who create civil society using their own funds. The state simply avoids interfering when it eschews taxing of those transactions.
There is a fashionable argument at present that the charitable deduction is a subsidy from the state. That’s entirely wrong.
Some activists say that charitable contributions should be taxed because they are a form of personal consumption. If the donor feels good about himself for giving money away, he has “consumed” the warm glow that comes from being a donor. The rejoinder to this is that the economic value of the charitable contribution actually settles on the recipient of the gift, not the donor. When I buy and eat a pint of ice cream, I literally consume some of my income. When I give money to a disaster-relief fund or cancer hospital, the person whose home or body has been ravaged consumes the funds. I may get a good feeling from both experiences, but the private gulping and the giving to others are wholly different acts.
At its core, the issue of whether charitable contributions should be included in the tax base is a matter of values as much as economics. It is a question of what the relationship should be between citizen and state. If you believe that a citizen’s right to elect representatives is all that’s needed for self-governance, then interfering with citizens’ direct contributions to the public good may not bother you. Under this view, charitable contributions are a luxury that a democratic government may choose to indulge through charitable deductions when it is wealthy, or eliminate when it is poor. Not only does income belong to the state, but so does philanthropy; the donor’s choice is irrelevant.
On the other hand, if you believe that citizens should have the freedom to contribute directly to the public good without government interference, that civil society is an end in itself, and that civic engagement is healthy for democracy, then charitable contributions should not be treated as part of the tax base. The donor’s right to support independent organizations is part of his fundamental freedom, as valuable as his right to vote.
Citizen, private charity, state
Kamal Jahanbein has a vision. He believes that everyone in the world should have the right to prosper, to speak his or her mind, and to petition the government for redress. Born in Iran, Kamal derives tremendous personal satisfaction from the American system of philanthropy which enables him to enact his vision of the public good without interference from anyone, a precious freedom to those with experience living under an oppressive regime.
Kamal runs a neighborhood pub in Washington, D.C., called the Saloon. The most surprising thing about this popular business is the sign on the door that says, “The Saloon will be closed for the month of August while we go to Africa to do some good.” After 20 years of nurturing his now-profitable business, Kamal began building schools in some of the world’s poorest towns. He has now completed more than 16 schools around the world, as well as medical facilities and homes, in places like Bafang, Cameroon; Rio Dulce, Guatemala; and Pakua, Laos. By his own estimate, Kamal has given away more than $1.5 million and countless hours to his humanitarian projects. Hundreds of names on the bricks that line his pub belong to individuals who have contributed to his philanthropic projects.
When Kamal builds a school, he seeks to give the gift of self-empowerment, the strength to strive against forces that seem greater than oneself—to have the confidence of David in a world full of Goliaths. Before he begins, Kamal asks representatives from the village where the school will be built to raise 10 percent of the funds from their own pockets, “so they are invested in the project.” Then Kamal helps the village negotiate with the local government to provide the teachers, furniture, and equipment necessary to operate the school. When the project is complete, Kamal makes sure the village representatives have copies of the contract with the government so that they can enforce it. “You have never seen such a beautiful sight as a government minister’s office filled with determined mothers, waving their contracts and demanding the teachers that they were promised,” he said, smiling.
Talking to Kamal, you realize that giving to charity is a radical act. It is defining what is good for society, and putting your money where your mouth is. Marshaling resources for the good of society is also what governments do, which is why there can be a tension between charities and political officials. The ability to create an institution to accomplish a particular vision of the public good creates a locus of power that is separate and apart from the governmental authority. Government is about centralized power; charity is about local problem-solving.
Before there is government, there is charity: ordinary people gathering together to provide for the common good by helping the needy, healing the sick, teaching the ignorant. At its core, charity is about self-reliance. The charitable institutions we create are manifestations of our right to self-governance that is truly by the people, for the people.
A nation can be judged by the amount of charity it permits within its borders. A government that represents its citizens’ best interests is not threatened by the additional exercise of self-governance. On the contrary, the exercise of self-reliance by the citizenry strengthens civil society, the stuff of which democracies are made.
Competition between the government and nonprofits to best represent the public interest dates to the founding of America. It is perhaps understandable, given human jealousies, why the government should prefer to control the vast resources of the private nonprofit sector, and to manipulate their contributions to serve government purposes in public policy. But that is not the system of self-rule enshrined in our Constitution. In fact, that is just the sort of government that our founders fought and died to rebel against.
The right of self-governance
Americans tend to chafe against restraints on our liberty to speak, act, worship, or band together, even if these acts are heretical or otherwise controversial. Nor do we wait for government to become involved when we perceive a problem. We act on our own, or in concert, to solve it as we see fit. Our ability to define what is wholesome and necessary for the public good, as individuals or self-organized groups, is the essence of American freedom. And making charitable contributions without government interference or taxation is an important part of this original right.
America’s passion for self-governance is manifest in our many associations. We have more than 1.5 million tax-exempt organizations, including 900,000 public charities, 100,000 private foundations, and 600,000 other types of nonprofit organizations, including chambers of commerce, fraternal organizations, and civic leagues, and roughly 320,000 religious congregations. Many associations are effective; many are not. Some last a century; some never get off the ground. But in America, that is our business, not the government’s. We are free to create, free to operate, and free to terminate our associations as we please.
Charitable contributions are protected from taxation in order to keep government from entangling itself with the exercise of individual freedom.
Since our nation’s founding, the federal government and private associations have been rivals, and the lines of battle have shifted back and forth over the years. Today we take it for granted that private associations serving the public benefit may compete with the federal government. That, however, is a freedom that was hard-fought and won by previous generations.
In 1816, the state of New Hampshire attempted to seize control of Dartmouth College, a private university established by charitable contributions in 1754 for the purpose of educating Native Americans and other people of New Hampshire. The motivation for taking over Dartmouth was political. The Jeffersonians had won the New Hampshire governorship and state legislature in the election of 1812. The trustees of Dartmouth College, however, were members of the opposition Federalist party, and the state sought to replace them with loyal Jeffersonians.
The Jeffersonians argued that the government should have the right to control charitable contributions. As Thomas Jefferson himself explained in a letter he wrote to New Hampshire Governor William Plumer in 1816, a private gift to accomplish a public purpose such as education is, in effect, a gift to the people, and as the people’s representative, the democratically elected government of New Hampshire should have the right to oversee the gift. Jefferson believed that state control of Dartmouth was critical to ensure that Dartmouth educated the future leaders of New Hampshire in a manner meeting state approval. Why should a state controlled by Jeffersonians allow a Federalist educational agenda to continue?
Jefferson saw no need to protect Dartmouth from government interference because he believed that democracy itself guaranteed that the government’s purposes and those of Dartmouth College would always be synchronous. He wrote, “the idea that institutions, established for the use of the nation cannot be touched or modified, even to make them answer their end, because of rights gratuitously supposed to be in those employed to manage them in trust for the public, may, perhaps, be a salutary provision against the abuses of a monarch, but it is most absurd against the nation itself.”
The college challenged the state in the Supreme Court. Daniel Webster, a Dartmouth alumnus, argued the case for Dartmouth’s freedom to operate from government interference—even when that government is a democracy. He said, “Shall our state legislature be allowed to take that which is not their own, to turn it from its original use, and apply it to such ends or purposes as they, in their discretion, shall see fit? Sir, you may destroy this little institution; it is weak; it is in your hands! You may put it out; but if you do, you must carry on with your work! You must extinguish one after another, all those great lights of science, which, for more than a century, have thrown their radiance over the land! It is, sir, as I have said, a small college, and yet there are those who love it.”
Spoken just 40 years after the signing of the Declaration of Independence, Webster’s words resonated deeply with those present.
Writing for the Court, Chief Justice John Marshall was moved to agree with Webster. He found that the state could not replace the trustees of Dartmouth College, because doing so would interfere with the charitable contributions of Dartmouth’s donors. Dartmouth was a vehicle through which individual donors pooled their resources to accomplish public benefits they deemed appropriate, and the Constitution gave the state no right to interfere with such a private contract. A gift to accomplish a public benefit is not a gift to the government, and doesn’t allow the state to interfere with the institution created by the gift.
It would be difficult to overstate the importance of the Dartmouth decision in shaping American civil society over the past two centuries. With one stroke, the Supreme Court severed the public and private spheres, making clear that under our Constitution the government could not direct private associations to implement government policy. After Dartmouth, private associations were free to operate autonomously, to accomplish whatever public purposes they choose, constrained only by the legal framework of the tax law, general laws against fraud,
discrimination, and so forth, and their ability to obtain resources from charitable donors.
The great flourishing of private associations for the public benefit that followed the Dartmouth decision has been the hallmark of American civil society ever since. Writing a couple decades after Dartmouth, French philosopher Alexis de Tocqueville observed that public-benefit associations are the foundation on which American democracy rests. Private associations working for the public benefit are not just signs of a healthy democracy, he concluded, they are its cause.
The tax man cometh
The power struggle between charities and the government continues to this day. The difference is that today, the battle is waged through the tax law. Nearly 100 years after the Dartmouth case, Congress gained the power to tax income through ratification of the 16th Amendment to the Constitution. It enacted the corporate and individual income taxes in 1913. Previous attempts to enact an income tax, dating back to the Civil War, all exempted charitable organizations from taxation, as our current code does. The individual deduction for contributions to charities was first introduced in 1917, and has been in place since. This protection of charities and charitable contributions from taxation was a manifestation of the unwritten social contract that private giving should be excluded from the tax base out of deference to the sovereignty of American citizens.
Sacrificing the charitable deduction to improve federal finances would be a profound renegotiation of the relationship between the government and our civil society, a drastic move running counter to the spirit and longstanding practice of American democracy.
That is very different from the claim made in some quarters today that our present partial tax protections of charitable contributions are a gift from the state—a subsidy. The historic understanding is also completely at odds with today’s fashionable argument that, as a contributor, the government has a right to decide how much charity to subsidize, which recipients to support, and how best to manage them.
Those who believe the charitable contribution deduction is a subsidy from the state often argue that the purpose of subsidizing charitable goods and services such as education, poverty relief, scientific research, and health care is because the government would have to provide these things if charities did not. The problem with this view is that if the purpose of the charitable deduction is to serve governmental purposes, then the charities should also be under government control. Under this view, charities should be subject to the rules that apply to government contractors, and the government should have rights to direct and supervise charitable actions.
As yet, the government does not tell charities what goods and services to provide, when and where to provide them, or how much they should cost. The government cannot hire and fire charities at will, reward the ones it favors, or dock the ones that displease officials. The government so far has no right to appoint a charity’s board of directors or to select its officers. The government cannot refuse to subsidize charities controlled by individuals the government does not like. When a new government is elected, disfavored charities do not lose their tax benefits, and loyal charities do not get extra credit. (These are not just theoretical worries, but real dangers—as shown by recent actions like IRS discrimination against social-welfare organizations affiliated with the Tea Party, and HHS Secretary Sebelius’s phone calls asking companies to give money to new charities operated by former Obama campaign staff to help implement Obamacare.)
Under current law, anyone can form a charity, regardless of his or her experience, expertise, or political persuasion. To secure tax exemption and be eligible to receive deductible contributions, all that is required is that the organization promise the Internal Revenue Service that it will primarily conduct activities that further its charitable purpose, not intervene in political campaigns or engage in excessive amounts of lobbying, and not distribute profits to shareholders. To maintain its tax exemption, the organization simply must file annual information returns and continue to operate as promised. The government may periodically audit the organization to confirm that it is not breaking its promises, but beyond that the government is supposed to stay out of the picture, and let charities govern themselves and pursue their own purposes. All of that existing practice would be very different if the charitable deduction was accepted as a government subsidy rather than a bulwark against government intrusion.
Moreover, there is another crucial flaw in the idea that protecting charity from taxation represents a government subsidy. Many of the objects of American charity—like religious flourishing—are things our government cannot Constitutionally subsidize. That’s why the Supreme Court has expressly rejected subsidy theory as an explanation of the charitable exemption from income tax—because it cannot be reconciled with the clauses of the Constitution protecting free exercise of religion and forbidding establishment of an official church.
The Court has found that tax exemption of churches is not a favor granted to churches, but a democratic necessity to ensure that the state does not infringe on individuals’ religious freedom. As Chief Justice Burger wrote in Walz v. Tax Commission of the City of New York: “The exemption creates only a minimal and remote involvement between church and state, and far less than taxation of churches. It restricts the fiscal relationship between church and state, and tends to complement and reinforce the desired separation insulating each from the other.”
In other words, churches are exempt from tax not because the government is underwriting religion, but because it is vital, Constitutionally, that a free and fair government stay out of their business—which is best accomplished by tax exemption.
Subsidy or immunity?
This, then, is the crucial point: Charitable contributions must be protected from taxation not because the government wishes to subsidize charitable activity, but because government intrusion in this sector would dangerously entangle the state with the exercise of individual freedom. Through charitable contributions, Americans make real many of our Constitutionally protected rights—creating organizations that engage in freedom of speech, freedom of association, freedom to practice religion. The civil society we build through our nonprofit institutions is not just some sweetener of our quality of life. It is fundamental to our democracy, a replenishing source of nourishment to individual freedom.
The justification for the charitable deduction is akin to the intergovernmental immunity from taxation that the Supreme Court recognized in McCulloch v. Maryland, where Justice Marshall famously wrote that “the power to tax involves the power to destroy.” Just as the principles of federalism constrain the federal government’s power to tax the states and the states’ power to tax the federal government, the individual freedoms the Constitution guarantees to American citizens who engage in civil society by creating and funding nonprofit organizations should likewise block intrusive government manipulation of charity via taxation.
Although someone focused only on the federal budget might not care whether the charitable deduction is justified as a subsidy or as an immunity from tax, these diametrically opposed justifications are built on entirely different understandings of the relationship between citizen and state. And legislative action growing out of these two different interpretations could eventually lead to dramatically different results in American society.
Tax subsidies are things the government chooses not to tax in order to encourage behavior that the government supports. The government may manipulate these as it sees fit. Tax immunity is a framework that strictly limits the government’s ability to control and collect revenue from an activity. The charitable deduction, which protects the vital role of civil society in America, should be understood as a tax immunity, not a subsidy. It is crucial that donors and lovers of liberty in America protect this traditional understanding and not fall into the trap of letting it be redefined as a subsidy, not even a benevolent one.
Charities do not normally provide goods and services to help the government. In fact, they often provide goods and services that the government cannot or will not provide, and even things the government does not like. Philanthropy in America is rich with examples of citizens acting where government has refused to act. It was charitable giving that educated Native Americans at Dartmouth and Hamilton colleges. It was private givers who set up thousands of schools for African Americans when the state was scorning them during the Jim Crow era. It was Rockefeller donations that eliminated hookworm in the U.S. when embarrassed hot-weather state governments refused to acknowledge that such parasites were endemic among their residents. Philanthropists like Bill Gates pursued vaccines for diseases like malaria when that was too costly for government or insufficiently profitable for corporations to pursue.
Charitable giving has even repeatedly spawned movements that fundamentally alter the complexion of democracy. Reforms ranging from abolition to women’s suffrage to protections for religious conscience to tort reform have all been inaugurated by philanthropy. In each case, the government has been more adversary than contributor, until the government itself was changed by the movement.
So today’s debate over the charitable deduction is about much, much more than taxes and deficits. The charitable deduction is a main artery within our body politic. It nourishes American civil society and gives strength to our democracy. It gives form and substance to our basic freedom of self-governance—a right that is not fully discharged by our ability to elect representatives. It is not a luxury we can do without.
If the charitable deduction were eliminated, Americans would no doubt continue to give generously at some level. But that is not the point. The charitable deduction does not exist to subsidize good works, though the good effects are many. Rather, we shield private donations from the brunt of taxation in order to limit government interference with our personal choices on how best to further the public interest. The charitable deduction is a mechanism for ensuring that the government does not lay claim to that which it should not own: private gifts devoted to the good of the people.
The charitable deduction is a negotiated bargain between citizens and the state, establishing a delicate balance of power. We have accepted limits on how much money we may contribute, on the types of property that can be given, on the arrangements that constitute a gift, on the broad sectors we may give to, and on what the recipients are forbidden to do with our gifts. But, historically and philosophically, there are more reasons to argue that the charitable deduction should be expanded today than that it should be further circumscribed.
Sacrificing the charitable deduction is not a wise, safe, or acceptable means of improving today’s warped federal finances. The appropriation of charitable revenue by the federal government would be a profound renegotiation of the relationship between the American government and our civil society. Bluntly, such a drastic move would run counter to the entire history and spirit of American democracy.
Alex Reid is a tax attorney in Washington, D.C., and former counsel to the Joint Committee on Taxation of the U.S. Congress.