Announcing its four-hundred wealthiest Americans for 1996, Forbes was unrestrained in its excitement about the transformation that has occurred in the nature of wealth creation in America. “Forget America’s 50 families. Forget old money. Forget silver spoons. Great fortunes are being created almost monthly in the U.S. today by young entrepreneurs who hadn’t a dime when we created this list 14 years ago.”
Indeed, new money is displacing — and out-performing — the old at an unprecedented rate in American business today. More than 60 percent of the Forbes 400 turned over between 1982 and 1990 — and since then, almost half of these elite rankings have changed hands yet again. In 1996, nearly one in nine were newcomers.
But if wealth creation has changed, what comes next — call it wealth disposal — has remained remarkably static. The American families that created some of the nation’s largest fortunes also created the nation’s largest foundations. The names are familiar: Ford, Rockefeller, Carnegie, Mellon, Kellogg, Lilly and Duke. They started out big, have endured, and are growing still more wealthy. Measured in 1992 dollars, foundation assets more than doubled between 1983 and 1994, rising from $92.7 billion to $195.8 billion. This huge stockpile of tax-exempt wealth, moreover, is highly concentrated among a very small number of giant foundations. More than 50 percent of foundation assets, says the IRS, are held by the top one-half of one percent of foundations.
As the Forbes 400 reminds us, new fortunes are being created with astonishing frequency in America these days. In addition, the tremendous wealth of the post-World War II boom is preparing to be passed to the next generation. How — and indeed, if — this wealth enters the philanthropic realm depends on many things, not the least of which is the tax code. As the endurance of the institutions of the “old” money stand in impressive testimony, the economic incentives and disincentives created by the current tax system artificially encourage foundation creation, growth and perpetuation. The conventional wisdom has long held that anything that is injurious to this is injurious to charity itself. But as the current debate over the wisdom of foundation perpetuity shows, the conventional wisdom is increasingly being challenged. For those who are concerned about the growing clout of foundations, the answers may lie, not with the institutional structure of foundations, but with the factors that influence individual giving.
NO PAIN, LOTS OF GAIN
As any unsuccessful dieter knows, when you take in more than you burn off, the results end up on your thighs. Foundations are no exception. Figure 1 shows that foundation assets are expected to double in the next decade. Under current policies — including estate, income and capital gains taxes and the rules governing foundations — foundation growth is actually outstripping the growth of the economy as a whole. From just over 1.5 percent of GDP in 1978, foundation assets are projected to reach over 3.5 percent of GDP by 2006.
The reason for this growth is straightforward. The real growth of foundation assets since 1978 has been quite impressive — 10.5 percent per year, adjusted for inflation. The rate of foundation giving, however, has been a good deal less spectacular. Since the minimum payout of five percent of invested assets was established in 1969, the ratio of foundation grants to assets has stuck stubbornly close to the grantmaking floor. In other words, foundations — particularly the largest ones — are more likely than not to treat the five percent minimum payout as the maximum.
One result of this stinginess is that, except during recessions, about 70 percent of new foundation grants (71.7 percent in 1994) are typically matched by new contributions. This means that most of the income from tax-exempt interest and dividends on foundation assets, or from tax-exempt capital gains from the sale of stocks, bonds and real property is pure fat — net additions to foundation wealth.
THE COMING “BOOMER BOOM”
In addition to accumulating ever larger asset bases, foundations will account for a rising share of philanthropic giving if current trends continue. The amount Americans give away has long remained very close to 1.9 percent of GDP (though slightly higher since 1986 than before). Foundation assets, as we have seen, are rising much faster than GDP. These two facts make it a virtual certainty that foundation grants will continue to account for a rising share of total giving. Figure 2 shows foundation grants rising from 7.3 percent of all giving in 1995 to 9.2 percent by 2006.
There is at least one good reason, however, to suspect that projected increases in the size of foundations may be too modest. As the post-World War II generation — the parents of the Baby Boomers — passes from the scene, it will transfer a very large stock of wealth to some combination of heirs, charities and foundations over the next 10-15 years. Cornell University Professor Robert Avery forecasts the bequests of Baby Boomers themselves will approach $3 trillion by 2010, and $10 trillion by 2040. To whom this wealth is transferred, and how, will depend to a significant extent on what changes are made in the federal tax code regarding taxes on income, capital gains, gifts and estates. If tax policy remains largely unchanged, that portion of the “boomer boom” that ends up on the balance sheets of foundations could be even greater — probably much greater — than what I have projected above.
FUNDING THE LEFT
The huge — and growing — stockpiles of wealth held by the country’s largest foundations represent enormous influence over which public policy, social program or artistic endeavor will succeed or fail. The greater the foundation asset base, of course, the greater this influence. Critics of this expanding influence are faced with an apparent dilemma: In the short run at least, legislative or regulatory efforts to encourage or compel foundations to use more of their wealth to make grants will only increase their influence.
And who are the likely recipients of increased foundation grantmaking? The broad pattern of foundation giving has traditionally been different from that of individual donors. Most significantly, foundations devote very little to religion — 1.7 percent compared with 45.3 percent for all sources. Interestingly, foundations devote a significantly smaller portion of their giving to human services, accounting for only about 6.4 percent of the funding for human service groups as compared with the 7.3 percent share of personal and corporate giving that goes to human services.
In fact, contrary to many of the claims made in the welfare debate, individuals rather than foundations contribute disproportionately to human services. While individuals account for just over 80 percent of all giving, they are the source of over 88 percent of gifts to human services — and these figures don’t include the significant human services provided by religious organizations, which receive virtually no support from foundations or corporations. Thus we arrive at a conclusion that may strike many as counter-intuitive, but which is nonetheless true: if foundation giving continues to account for a rising share of total giving, then even secular human services are likely to be relatively underfunded, as compared with, say, hospitals and universities.
Another important difference is that a much larger share of foundation giving is designed to influence public policy. This includes, according to Forbes, about $100 million every year given to state and local governments. A significant number of foundation grants, moreover, make their way into government indirectly, through state universities and quasi-governmental agencies. Three campuses of the University of California and the state of Georgia, for example, were among the recipients of the 50 largest grants made in 1993.
FACING THE TAX-EXEMPT MUSIC
Whatever the ultimate size and focus of foundation giving, all agree that foundations exist to serve the public weal. In a forthcoming study for the Independent Institute, Florida State University economist Randall Holcombe points out that the taxpaying public must make up for the diminution of public revenues created by foundations’ tax-exempt status by paying higher taxes. For this reason, the public “has a right to ask in exchange that foundations have a public purpose and that their activities in the public interest more than compensate the public for the loss of revenues.” But defining the “public interest” and thereby making philanthropic foundations more accountable is easier to say — and it is being said with increasing frequency — than to do.
If accountability is interpreted to mean making foundations accountable to political authorities, the cure could prove to be worse than the disease. Ceding discretionary authority to a political entity over which grants are acceptable and which are not would invite the most pernicious forms of abuse. The danger here is similar to the controversy surrounding selective Federal Election Commission (FEC) threats of removing 501(c)(3) status from certain organizations — the Christian Coalition, for example — said to be too involved in political activities. Even now, the IRS has the power to ban the funding of policy research which attempts to influence legislation, which could include just about anything. The IRS has usually been reasonable about this — so far.
Lacking this discretionary authority, government has attempted to enforce a kind of limited accountability on foundations through regulation. Congress has placed restrictions on how foundation assets may be managed, ostensibly to avoid “risky” investments. In addition, myriad regulations cover grantmaking.
These regulations, however, have had the unintended consequence of lessening the public accountability of foundations. The massive paperwork burden associated with any grants made directly to needy individuals or organizations which are not 501(c)(3)s, for example, has had the effect of limiting the potential for innovative alternatives in charitable organizations. Instead, foundation grants are merely channeled to existing charitable organizations, as defined by the IRS. And potential donors considering establishing new foundations are severely circumscribed, as a result of IRS regulations, in their ability to try anything new. As a practical matter, the best they can do is fund programs and projects that others have designed.
A more defensible aspect of the 1969 Act was the establishment of a minimum payout, which was generally reduced to five percent of invested assets in 1976. But here again, the purpose of this regulation — to prevent foundations from accumulating ever-increasing stockpiles of assets without spending their income for charitable purposes — has not been realized. As we have seen, the minimum payout requirement has certainly not prevented the rapid growth of foundation assets, particularly when even a conservative portfolio of stocks has yielded a return of 14 percent for many years. The current tendency for large foundations to minimize current grants in order to build larger and larger tax-exempt financial empires seems to contradict the whole purpose of foundations, which is to give money to worthy causes.
SHARK-INFESTED TELEOLOGICAL WATERS
One way to wring greater accountability from foundations — and recapture “donor intent” and institutional purpose — would be to remove the perpetual tax exemption. The question of whether or not “perpetuity” is a positive good for philanthropy has been dealt with elsewhere (see Should Foundations Exist in Perpetuity? by Heather R. Higgins and Michael S. Joyce, published by The Philanthropy Roundtable), and I won’t duplicate this interesting (and necessary) debate here.
But the controversy over perpetuity offers important clues as to how to manage the trend toward foundation control of a rising share of charitable giving. The idea of placing a limit on the tax-exempt lifetime of foundations forces the question of whether these institutions are, over time, inherently “good” or “bad.” If they are generally good, they should be preserved; if they are generally not a force for good, however, better to limit the damage they can do by limiting their existence.
But these are shark-infested teleological waters, with little prospect of establishing a workable consensus on one side or the other. There is, however, a more promising reform begging the attention of those concerned about the growing clout of foundations. They should consider focusing, not on the giving patterns of institutions as the perpetuity debate does, but on the giving patterns of individuals. It is with individual wealth, after all, that philanthropy begins. Foundations, considered in this context, are merely middlemen, intermediaries for good or ill between individuals and charities. It is worth taking a look, then, at the many ways in which our tax system artificially encourages individual giving through the relatively cumbersome, delayed and indirect device of foundations.
LIFE IS SHORT, GIVE HARD
Individual giving is, to a great extent, merely a question of timing. There is, after all, a trade-off between giving in life and giving in death — if you give away more during the former, you have less to leave to charities (and heirs) after the latter. The timing of giving, in turn, bears on the form of giving. Gifts in life are often smaller, direct grants of cash or assets to charities, whereas contributions in death are typically delayed gifts, gradually channeled through foundations. Taxes — particularly the gift, estate and capital gains taxes — play a critical role in both the timing and the form of individual charitable giving.
Groups of nonprofits and grantmakers have long considered taxes within a “static” economic analysis that fails to look beyond their immediate impact. This analysis has led to the belief that high taxes — particularly the estate and gift taxes — increase philanthropic giving by encouraging both charitable bequests and the creation of foundations. A higher estate tax, it is reasoned, decreases the cost of delaying giving until death and thus increases the incentive to create charitable bequests. A lower estate tax, of course, is predicted to provide the opposite incentives. The end result, Independent Sector assures us, is not different patterns of giving but less giving. A “tax policy that reduces taxation at death,” they opine, “could lead to a further decline in the amount left in charitable bequests.”
This unshakable belief that higher taxes are good for philanthropy has led groups like Independent Sector to lobby on behalf of keeping estate taxes at current high rates. But there is considerable evidence to suggest that this is not the healthiest course for charitable giving. This analysis wrongly assumes that the size of estates is unaffected by the tax on estates. A higher estate tax may increase bequests in the short run, but it does so at the expense of higher giving during life. And this change in the timing of giving, as we have seen, affects the form of giving. In other words, a higher estate tax encourages placing appreciated assets in foundations after death rather than making direct gifts of either assets or cash during life. There are no logical or empirical bases for the presumption, however, that these changes have an effect on the total amount given.
THE PARADOX OF THE 1980s
For those who cling to the belief that, when it comes to giving, higher taxes are better, the 1980s present a troubling paradox. Despite predictions that lower marginal rates on income would decrease generosity, real annual giving by individuals rose by 27.8 percent as taxes fell between 1982-89 — a rate far above the postwar trend.
But income taxes were not the only thing that fell during the 1980s. The estate tax also fell. Between 1981 and 1987, the highest tax rate on estates was gradually reduced from 70 percent to 50 percent. More important, the amount exempted from any estate tax at all was raised from $60,000 in 1976 to $600,000 by 1987. Here, again, the real-world results of lower taxes confounded expectations and giving increased. Measured in 1994 dollars, the level of annual bequests averaged $8.6 billion from 1986 to 1990, up from $6.1 billion from 1976 to 1980. And the growth of bequests (rather than the level) was most rapid from 1980 to 1987, while estate tax rates were coming down.
A THEORY OF RELATIVITY
It is interesting to note, however, how the tax changes of the 1980s affected both the timing and the form of charitable giving in a way that continued to encourage foundation growth. Although both the income and the estate taxes fell during this decade, income taxes fell even further. At the end of the decade, the highest income tax rate was down to 28 percent, while the highest estate tax was still 50 percent. The relatively higher estate tax lowered the relative price of gifts made at death rather than during life. Bequests grew, and the creation of foundations rose accordingly. More independent, family-owned foundations were created in this decade than at any time before or since. There were 2,618 foundations with assets above $1 million created in the 1980s, compared with just 811 similar foundations created in the previous decade.
Moreover, the 1986 tax bill created additional incentives for foundation creation by increasing the capital gains tax from 20 percent to 28-33 percent, and by instituting an alternative minimum tax for wealthy filers who write off too high a percentage of their income. After the 1986 bill, taxpayers could easily avoid both these taxes by neither selling nor giving away property that had risen in value. This provided a strong incentive to postpone contributions of appreciated property until death, when any amount above the $600,000 tax exemption could be used to set up a foundation, thus avoiding the estate tax. (While gifts of appreciated property were subject to the alternative minimum tax after 1986, this was not true of appreciated property used to establish or enlarge a foundation.) Viewed with these incentives in mind, it is even more remarkable that inter vivos giving rose so impressively in 1988-89. Such giving, no doubt, would have risen even more if gifts of appreciated property had not been subject to the minimum tax.
But if it is true, as was posited earlier, that giving is basically a constant fraction of GDP, what difference can tax changes make on the overall level of charitable giving? The answer is simple: A lot, because marginal tax rates influence the growth of real output and real income.
It is a basically accepted fact that giving is a fixed percentage of national income. Indepen-dent Sector estimated giving at 2.28 percent of national income in 1973, 2.27 percent in 1989 and 2.29 percent in 1993. The critical variant for philanthropy, then, is national income. Anything that makes that grow faster, makes giving grow faster.
However, the outlook for future giving may actually be more optimistic than a fixed percentage of GDP would suggest. To see this, we have to compare individual giving with family income. Figure 3 shows that, even as total giving has remained a basically constant fraction of GDP, individual giving has been rising steadily relative to median family income. One likely explanation for this is the rising percentage of American families earning relatively high incomes. This growth was particularly impressive during the 1980s. The percentage of families earning more than $75,000 (measured in 1993 dollars) increased from 7.5 in 1970, to 10.9 in 1980, and to 15.9 in 1989, dropping slightly to 15.5 in 1993.
Although it may not be polite to say so, it turns out that the surest way to increase the amount of charitable giving is to increase the number of families earning high incomes. Demographics will accomplish part of this. A rapidly rising proportion of the population will become middle-aged over the coming decade. This is the age when earnings — and, consequently, giving — are usually at a lifetime peak. One 1993 estimate shows average cash contributions at $1,241 for the 45-54 age group, compared with $520 for those aged 25-34.
But what demographics will not accomplish must be achieved through public policy. In addition to altering the timing and form of charitable contributions, estate taxes affect work and saving habits in ways that have important consequences for income and, as a consequence, for philanthropy. The estate tax discourages the accumulation of assets beyond the exempt amount. This makes capital more scarce than otherwise, slowing the growth of productivity and real wages. Reducing or eliminating the death tax, accordingly, would provide greater incentives to accumulate larger estates. The result would be a larger national capital stock, and a larger future flow of capital income to be used for all purposes — including charities.
The assets of grantmaking foundations have been expanding by more than ten percent a year in real terms. This is partly due to the creation of new foundations, but more importantly to an apparent tendency among the largest foundations to treat asset accumulation as their primary objective. If past trends continue, a rising share of charitable giving will become institutionalized, channeled through increasingly professionalized foundation trustees rather then given directly to the charities that individual donors choose.
This trend has important implications for how — and indeed if — the coming intergenerational transfer of wealth finds its way into the philanthropic sector. But again, rather than spend our time trying to ferret out the flaws in foundations — be they institutional, human, or both — it may be time to shift our focus back to philanthropy’s source: individual giving.
As our experience with the tax cuts of the 1980s demonstrates, higher taxes do not encourage greater individual giving — quite the opposite, in fact. But what higher taxes do help achieve — particularly higher estate, gift and capital gains taxes — is more individual giving through foundations. Reduction of these taxes — at least to a level no higher than the highest personal and corporate income tax rates — could be expected to slow the creation of foundations, but also to increase the relative share of giving while donors are still alive.
The dynamism of the American marketplace so apparent in the Forbes 400 will not be replicated in the philanthropic sector without changes in the economic incentives and disincentives created by the tax code. There is no better time than now, as philanthropy stands on the threshold of an era of awesome growth, to consider these changes.
Alan Reynolds is Director of Economic Research at the Hudson Institute