By Isabel Sawhill, The Brookings Institution
With the fiscal cliff looming, there is a risk that even a partial slide off the cliff will slow or reverse the recovery. One way to cope with such a risk is to provide a temporary or accelerated deduction for charitable giving. The basic idea is to provide a large incentive for people to spend money now rather than later, thereby creating jobs, but in a way that would be acceptable to both political parties.
The president has proposed that current tax rates be extended for the middle class but allowed to expire for the wealthy. Republicans are arguing that any tax increase at this time is unacceptable. Even though estimates suggest that no more than 2 percent of all households and 3 percent of all small businesses would be affected by allowing tax cuts for the wealthy to expire, the Republican concern is that this would retard economic recovery.
There are any number of possible compromises that might split the difference between these two partisan views. One would be to change the definition of "wealthy" to include just those with incomes over $500,000 or even $1,000,000. Another would be to raise revenues not by changing rates but instead by limiting deductions for those in the higher brackets as the president himself has proposed in recent budgets.
A Third Option
I want to propose still another idea that has the potential to help break the political gridlock. It would allow rates on the wealthy to rise as they are scheduled to do in January but include a new but temporarily higher deductions for charitable giving.
The new deduction for charitable giving would only be in effect for one or two years but it would be substantial. For example, a gift of $1,000 that would reduce a high-income household's taxes by almost $400 under the new top marginal rate, might be increased by 50 percent, bringing it to $600. The incentive to give now rather than later would be correspondingly heightened. Based on evidence on the responsiveness of donations to the price of giving, charitable giving might rise by as much as 50 percent as a result (although much less than this over the longer-run).
Boost the Recovery
The rationale for this proposal is threefold. First, it would create jobs. The recovery is still very fragile and by increasing the value of the charitable deduction but making it temporary we would move a lot of charitable giving into a period when increased spending is needed. The nonprofit sector is much larger than most people realize, accounting for 1 out of every 10 jobs in the economy. Under my proposal, the affluent would have less after-tax income as their taxes rose but they would also have a much bigger incentive to spend rather than save out of all of their income as well as their wealth over the next year or two. Under some reasonable assumptions the net effect on jobs and the economy would be positive.
Second, the option of keeping their taxes low by increasing their charitable giving would take some of the sting out of higher tax rates on the wealthy. If they hate seeing more of their money going to Uncle Sam, they have a new way to avoid paying taxes. Although the super-deduction for charitable giving would not last forever, it might encourage some affluent households to get off the sidelines and help to establish the philanthropic habit that has always distinguished the United States from other countries.
Third, the nonprofit sector would benefit. Given the need for major spending cuts over the next decade, the voluntary sector is going to need to fill some big holes in everything from the social safety net to community services. Charitable organizations vary enormously from those that support the arts, education, and health to those that provide assistance to the poor and to local community organizations of all kinds. Healthy competition among all of these organizations ensures that the money is spent in line with public preferences and not according to bureaucratic dictates from Washington.
Not an Impossible Dream
Some careful thought would need to be devoted to the details of such a plan. Would faith-based organizations that claim about a third of total charitable giving be eligible? Would there be limits on the amount going to endowments versus operating expenses in the affected nonprofits? Should the types of charitable entities as opposed to all 501(c)3 organizations be specified in the law? These decisions could be negotiated along with the size and timing of the super-deduction.
To be clear, this proposal is no substitute for a broader effort to reform the tax system which will likely move in the direction of limiting most, if not all, deductions. It is a short-term measure that deals with some of the fiscal drag associated with the cliff, makes raising taxes on the wealthy more palatable, and temporarily boosts the health of the voluntary sector. Over the longer term, it might be combined with a hard cap of $35,000 on deductions starting in 2014, but a cap that excludes charitable giving as proposed by the think tank, Third Way.
Isabel Sawhill is a senior fellow in Economic Studies at the Brookings Institution, where she co-directs the Center on Children and Families and the Budgeting for National Priorities Project.