Does the Deduction for Charitable Contributions Really Matter?
Many charities and big donors feel that we dodged the philanthropic bullet in January when the American Taxpayer Relief Act of 2012 was signed into law by President Obama. True, for wealthy individuals, the bad news was that the top tax rate increased from 35% to 39.6%, the annoyingly-named and applied “Pease” and “PEP” limitations were restored to their full strength, and all of these changes were introduced concurrently with the Obamacare provisions taxing compensation income by an additional .9% and investment income at an additional 3.8%. BUT, HALLELUJAH, THE CHARITABLE DEDUCTION WAS PRESERVED!
Important, yes, particularly with tax increases a reality, but more importantly from a psychological standpoint than a purely rational/financial one. The question is, do the tax incentives really matter?
The single most interesting behavioral thing I have learned about taxes over the course of my career is that, no matter how large or small our marginal tax rate, as long it is positive, taxpayers will look for ways to avoid paying it. It is simple human nature. So take with a grain of salt any talk about tax collections increasing when rates decrease – the fact is, the American Taxpayer (taxpayersaurus Americanus) will go to enormous lengths to avoid paying tax — any tax — whenever and wherever possible. Think about those sales tax holidays we occasionally enjoy in some of the high tax states around the country. States will temporarily cancel their sales tax for a short period of time in order to encourage retail sales. The results are often incredible. You would think they were literally giving things away at the mall the way the consumers flock in to save, what, 8%? It’s not the amount, it’s the principle of the thing, man! Ok, it actually IS the amount, but no amount is too small.
Understanding this basic premise about taxpayersaurus Americanus explains much about why our tax system is so opaque and inefficient. Everyone wants to beat it and Congress delights in putting in “incentives” to stir the pot – and to make us THINK we are beating it. Take our current (permanent) tax policy debate. Many folks worry that a cap may be imposed on itemized deductions, including charitable contributions, limiting their deductibility to a maximum of 28%. Psychologically, this is troubling. But from a purely economic point of view it is nowhere near as bad as it seems for most taxpayers, even high income ones. Why? Well, for one thing, before anyone even tries to limit the deduction, the alternative minimum tax (AMT) will most likely kick in and do its damage, particularly for taxpayers in high tax states like New York, New Jersey, and Connecticut. [i] The AMT can impact taxpayers with income from the high five to the low seven figure range, a large group of people indeed. And what is the top marginal rate for the AMT for these folks? Interestingly, 28%! So effectively, the charitable contribution for these folks is already capped at the magic 28%. It is a very effective use of smoke and mirrors and one that would not change even if itemized deductions are limited.
The math works perversely in other ways as well, even when the taxpayer is deep into the 39.6% bracket and has broken through the shackles of the AMT. In such a case, the so-called Pease limitation (extensively derided in a previous blog) can cut down the value of the charitable deduction to almost nothing. Pease reduces total itemized deductions by 3% of excess adjusted gross income (AGI), i.e., AGI in excess of a magic number ($250,000 for singles and $300,000 for married couples filing jointly), but only to the extent of 80% of total deductions. So using just percentages, let’s take this example to the extreme — our taxpayer’s itemized deductions consist solely of charitable contributions and are fully reduced by 80%. Effectively, what this means is that only 20% of his contributions will be deductible at a rate of 39.6%. Bottom line? The true tax savings is only 7.9% (20% x 39.6%), a far cry from 28%. More smoke, more mirrors.
Even so, I do not endorse limiting the charitable deduction. Its existence sends a message that we, as a society, value charity and players in the “marketplace of philanthropic impulses” and its psychology is very powerful indeed. But, I also believe that the true financial and incentivizing value of the deduction is overstated. Psychologically, donors appreciate a deal, especially when the tax break lowers the overall cost of their contribution. But true philanthropists will continue to give regardless of tax breaks. For them, the reality is stronger than the psychology. Giving is the right thing to do and consistent with their goal to move from success to significance.