Subsidies and Nonprofit Governance: Comparing the Charitable Deduction with the Exemption for Endowment Income

Abstract

Charitable subsidies are supposed to encourage positive externalities from charity. In principle, the government can pursue this goal by evaluating specific charitable initiatives and deciding how much each should receive. But this Article focuses on two income tax rules that leave the government very little discretion about which charities to fund: the deduction for donations to charity (“the deduction”) and the exemption of a charity’s investment income (“the exemption”). Under each rule, as long as charities satisfy very general criteria, federal dollars flow automatically. While both of these sibling subsidies delegate key decisions to private individuals, they create very different incentives and effects. This Article breaks new ground by showing their different effects on the governance of nonprofits. Specifically, the deduction has three advantages over the exemption. First, the deduction uses a more reliable test for determining whether a charity should receive government funding: a charity has to attract donations, which means donors believe in the charity. For the exemption, by contrast, the charity has to run a surplus, which is less dependable evidence of social value. Second, the deduction empowers donors to monitor nonprofit managers, while the exemption sometimes undercuts this monitoring. Since the exemption offers tax-free returns only to charities, and not to donors, it encourages donors to turn over assets to charities (“endowment gifts”), instead of keeping these assets and making annual gifts of the investment return (“spendable gifts”). If a donor gives an endowment to an operating charity, such as a university or a museum, she cannot redirect this money to another charity, even if she later develops doubts about the charity’s mission or management. Alternatively, if a donor gives the endowment to a grant-making charity that she can influence, such as a private foundation or a donor advised fund, she avoids committing to a particular operating charity, but she is likely to incur other costs, such as taxes, managerial fees, and agency costs (e.g., when managers disregard donor preferences in making grants). Third, in favoring endowments, the exemption exacerbates another familiar governance problem: cumbersome or stale limits on endowments. These governance issues are an important, but largely overlooked, reason to favor the deduction over the exemption. Yet although scaling back the exemption solves one set of problems, it creates another: charities would begin making tax-motivated saving and investment decisions. In deciding how much of the subsidy for charities should be delivered through the exemption, as opposed to the deduction, Congress needs to manage this tradeoff. This Article explores various ways to do so.