A Radical Reform for Nonprofit Tax Exemption: A Thought Experiment

Already in America, government is tightening its grip on the independent sector. It is challenging the tax-exempt status of foundations making new efforts to “regulate” almost all private groups. An independent sector “regulated” by its competition has, at best, an uphill fight on its hands. . . . The foundation is an instrument forged by citizens who transfer profit from the commercial sector and put it directly to work as risk capital for the general betterment of the society. To say or imply that the foundation exists only on the sufferance of government is to reason from the premise that government is the whole of society.

            —Richard C. Cornuelle, Reclaiming the American Dream

The late economist Benjamin A. Rogge used to talk of “Rogge’s World,” that ideal arrangement of institutions which he would have established had he been in charge (not that he would have agreed to be put in charge if asked). This was a thought experiment he used to consider the implications of better social configurations from a free-market perspective. Rogge, I think, was aware of how difficult and even dangerous it is to approach social reform in a constructivist mode, because of unintended consequences and secondary effects. Institutions have been built up over long periods of time, and countless individuals have made life choices on the basis of existing arrangements. For many, radical changes will bring unexpected and undesired difficulties that will not be obviously balanced by the theoretically improved institutional setting. Nevertheless, thought experiments exploring ideal worlds can demonstrate interesting possibilities and help guide more incremental change.

With this in mind, let us look into the institutional setting of tax-exempt philanthropy, with improvements in mind. This is a good time to do so, because various congressionally sponsored reforms of nonprofits—reforms which are not always friendly toward philanthropy—are circulating in political circles. A list of these proposals includes: requiring greater annual payouts from charitable endowments; requiring philanthropies to spend more on politically favored minorities or minority-managed enterprises; requiring minority and female “representation” on foundation boards; and increased auditing of philanthropic accounts. Most recently, some politicians have been considering limiting the tax deductibility of charitable giving by “the rich.”

Government Entanglement

This is a thought experiment about an ideal world. It is not a plea to increase taxes on nonprofits. Indeed, this writer believes that all of America is vastly overtaxed. What is needed, however, at whatever level of taxation we settle on, is a new consideration of the effect of tax exemption on the status of American philanthropy. Upon such examination, I think we will find that the tax-exempt status cannot be justified and is not needed in order to have a vibrant nonprofit sector.

Congress grants tax exemption to certain nonprofits on the condition that they spend their resources on activities in the public interest. This tax-exempt status of philanthropic organizations and other nonprofits sets them apart from other institutions of civil society, most notably families and for-profit businesses. From the point of view of the philanthropies, this suggests that they have some superior status, and it too often produces a “do-gooder complex” that separates them from the world of getting and spending that produces the wealth off of which they live. From their perspective, they are endowed by law with a lofty public purpose that leaves them unsullied by crass materialism. In recent years this status has encouraged many philanthropies to identify closely with the actions of government, because government, whatever its real purposes, always boasts of its special devotion to serving the public good. Note how many philanthropic leaders now argue that the main purpose of their organizations is to develop a case for the further expansion of government programs. Yet as recent scholarship indicates, government on net is an insatiable consumer of personal wealth far beyond what its positive effects on the public good can possibly justify. Furthermore, government actions, more often than not, actually promote explicit and identifiable private interests in opposition to any possible public good. This is one aspect of the problem of faction, famously discussed by Madison in the Federalist Papers and under scrutiny today both in public choice theory and in the investigation of cronyism.

To put this point more bluntly, both donors and recipients, whether acting privately or through public institutions, face the temptation of moral corruption in their efforts to do good. They do not need the added endorsement of tax exemption to increase this danger.

The growing alliance between philanthropy and government is unfortunate, for we should view our diverse nonprofit organizations as constituting just one aspect of the vast civil society outside the realm of government, where work, savings, and private endeavor provide the great bulk of resources necessary for personal and social well-being and for economic and cultural progress. It is civil society, not government, that provides most of the heavy lifting that produces public goods. From this perspective, government, when confined to its proper role, should be viewed as a limited-purpose agent, or utility (as Dick Cornuelle often put it), of the larger civil society, a true servant of the people and not the dominant force in social life.

Seen in this light, it is clear that tax exemption for private philanthropy helps sustain a false sense of separateness that detracts from a proper understanding of the true place of philanthropy in a free society. It encourages the state to believe it has the power and the duty to give tax exemptions only to those nonprofits it deems as working in the public interest as defined by the state itself. It permits the government to funnel money to those nonprofits it favors (a sort of Solyndra-ization of philanthropy; see Husack 2011), while increasing the nonprofits’ dependency on the state.

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