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Tax the Nonprofits

A modest proposal.

Mar 11, 2013, Vol. 18, No. 25 • By CHARLES WOLF JR.
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Despite its seeming remoteness from this familiar wrangle, the independent sector might provide a modest contribution to resolving the fiscal impasse. In the 2011 edition of his authoritative work on tax-exempt, nonprofit organizations, Bruce Hopkins asserts that rules for granting tax exemptions “are a hodgepodge of statutory law that has evolved over nearly 100 years.” Nevertheless, he identifies several “rationales” for granting tax-exempt status, one of which may be relevant and useful for easing the U.S. fiscal predicament: namely, the specific rationale for NPOs that relates to their ability to “serve as an alternative to the governmental sector as a means for addressing society’s problems.”

I suggest we retain tax exemption for only that portion of the two million NPOs that directly “serves as an alternative to the governmental sector,” and can demonstrate that existing budgets of specific government agencies and programs will be reduced as a consequence of the NPO’s activities. For all the remaining NPOs, a modest excise tax (for example, 10 percent) would be levied on their income.

The fraction of NPOs that would remain tax exempt is probably small. I conjecture that perhaps 15 percent might qualify while the remainder would not​—​the qualifiers comprising only those NPOs that compete with and can substitute for government provision of services (for example, preschool and K-12 education, or R&D services). The revenue enhancement that might be expected from the levy on the no-longer-tax-exempt NPOs would be about $140 billion annually​—​a modest but significant reduction in the overall fiscal imbalance.

In this scenario, donors’ contributions to charitable organizations would remain tax-exempt for donors, although as income to the recipient NPOs, the contributions would be subject to the excise tax.

The multifaceted activities of the NPOs subject to the excise tax would obviously be scaled back, although the effect would be minimal because donors would retain their deductibility. The rich diversity that NPOs contribute to America’s civil society would still flourish. To the extent that a quasi-market mechanism operates in the NPO sector, we can expect (or at least hope) that any reductions in donations and after-tax income would mainly affect the less effective NPOs. Moreover, the tax differentiation that retains an exemption for those NPOs specifically providing services that substitute for government outlays would have several worthwhile consequences: streamlining government, incentivizing NPOs to provide services that reduce government spending, and helping to ease the acute U.S. fiscal imbalance.

The short-term effects of taxing some NPOs would make a modest contribution to reducing this imbalance. Business taxes and personal income taxes would be unaffected. In the medium to longer term, the effects of differentiated taxation of NPOs would increase the scale and activity of those that compete with government and hence would tend to curtail its expansion. Although donations to the large majority of taxed NPOs would remain deductible from the donors’ taxable income, the lower after-tax income of the NPOs would tend to reduce only slightly their numbers and scale.

It is also possible that the modest NPO contribution to reducing the overall fiscal imbalance could catalyze similarly modest contributions by reduced spending on entitlements and on defense. For example, Medicare spending might be modestly reduced by introducing scaled co-payments for all nonemergency care, and by nationwide, cross-state competition among insurers. Modest reductions in Social Security outlays might be accomplished by adopting an inflation index for cost-of-living allowances that takes account of quality improvements, and by prudently linking outpayments from the Social Security system to inpayments made to it. And reductions in defense spending might be realized by lowering some outlays for personnel and for O&M (Organization and Management), rather than outlays for procurement and for RDT&E (Research, Development, Test, and Evaluation). Summing these several sources of lower spending—each “modest” in size—along with the tax revenues from NPOs, can sufficiently reduce the overall fiscal imbalance so that a resumption of normal GDP growth rates would entirely eliminate the imbalance!

Notwithstanding these changes, America’s “civil society” would remain far-and-away the world’s most diverse, vigorous, and influential.

Charles Wolf Jr. holds the distinguished chair in international economics at the RAND Corporation, and is a senior research fellow at Stanford University’s Hoover Institution; both RAND and Hoover are nonprofit organizations.

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