TCJA dramatically reduced the number of taxpayers who itemize and, thus, who qualify for the main federal tax incentive to donate – the itemized deduction for charitable contributions. TCJA’s dramatic increase in the standard deduction, funded largely by repealing the personal exemption, accomplished that trick. The real world effects of TCJA’s changes on charitable giving is complex to disentangle, certainly negative, but may take some time to fully play out.
According to TPC’s calculations, the percentage of households claiming itemized deductions for charitable contributions fell from 26% in 2017 (pre-TCJA) to 9% in 2019. Minnesota’s percentage is likely a bit higher than 9% because its taxpayers have higher average incomes and more of them are homeowners, both of which correlate with itemizing deductions.
As its title suggests, the TPC report is mainly about how to design an incentive – one that applies to more givers and stimulates more charitable gifts, the presumed goal of an incentive, relative to the foregone federal tax revenues. That goal naturally leads to setting a “floor” of contributions that do not qualify for the incentive so that less of the incentive money is tied to contributions that would be made anyway.
Most of this is predictable. The report has some nice tables showing giving relative to incomes across the income distribution. One interesting nugget is that TPC estimates a “universal” deduction (i.e., one that applies to those taking the standard) can be made revenue neutral by imposing a 1.9% of AGI floor on the deduction – that’s relative 2019 law. Here’s the full quote with more detail about their estimates of the effects on charitable giving and revenue neutrality compared to pre-TCJA law:
We estimate that a universal deduction with a floor of 1.9 percent of AGI would be approximately revenue neutral relative to 2019 law and would raise charitable giving by about $2.5 billion a year. If revenue neutrality had been sought under the pre-TCJA law, a revenue-neutral floor would have been a smaller percentage of AGI than it would be today. After all, the provision of a more universal deduction would have increased incentives for a smaller set of nonitemizers under that older law. Indeed, we estimate that a floor of 1 percent of AGI in 2017 would have led to an increase in charitable contributions in excess of the revenue loss. Therefore, the revenue-neutral floor relative to that law would be less than 1 percent of AGI.
C. Eugene Steuerle, Robert McClelland, Nikhita Airi, Chenxi Lu, and Aravind Boddupalli, Designing an Effective and More Universal Charitable Deduction p. 9 (Tax Policy Center, March 17, 2021).
Given TPC’s goal (and maybe because it is a 501(c)(3) nonprofit that relies on charitable contributions), it lands on a deduction. Deductions provide a bigger incentive for givers with higher marginal tax rate and economic research tends to show that higher income households give more and are more responsive to incentives. So if the single-minded goal is to increase aggregate giving, a deduction’s inherent favoring of more affluent givers with bigger incentives may be the way to go. I have misgiving about that on several levels – it violates some of my basic norms (like equal treatment); my instinct is that gifts by high income givers tend to have self-serving elements (putting names on “charitable” buildings and other things comes to mind) or are for suboptimal purposes (if the benchmark is lessening the burdens of government); TCJA’s capped the SALT, but not the charitable contribution, deduction, so the notion that charitable contributions are a legitimate adjustment to or measure of income is harder for me to swallow to justify the deduction (Footnote 4 of the TPC report makes that general point).
As I have written before, I think TCJA and Minnesota’s response to it strongly argue for reforming, simplifying, and refocusing Minnesota’s incentive (discussed here) and have outlined how I would do that (discussed here). My favored approach for a new Minnesota incentive follows TPC’s suggestions somewhat (e.g., as to the desirability of a floor), but deviates in preferring the more equalitarian credit and in disqualifying gifts of property. To recap my prior post, I would:
Use a credit rather than a deduction, so all contributors get the same percentage benefit/incentive.
Set a threshold of 2% of AGI so more of the incentive applies at the margin and less to contributions that would be made anyway. I think that might come close to allowing a 15% credit rate on a revenue neutral basis – maybe higher based on the TPC analysis.
Allow the credit only for contributions of cash, so the complexity of and compliance problems with valuing property and the unfairness of bigger incentives for gifts of appreciated property go away.
Disallow contributions that qualify for federal tax incentives, so the focus is on those who do not now qualify for incentives.
Cap the qualifying contributions so that individuals do not forgo federal tax incentives to get a potentially more generous Minnesota incentive.
Using a deduction as a state incentive effectively means that the incentive will be a tepid, because state rates are so low. Okay, 9.85% may not seem low as state tax rates go (it is not, obviously) but remember the lowest federal tax rate is 10%! So, it is low as a incentive – price cut – when is the last time you saw someone get excited about 9.85% off sale?
I do think the problems associated with the fair market value deduction for appreciated property need to be addressed – at both the federal and state levels. I was disappointed that the TPC publication did not even deign to mention that. Of course, it would be inconsistent with their focus on enhancing incentives and would likely not please their donors and charitable sector partners. But if we’re going to make the benefits/incentives more generous for givers and charities, we should also be talking about fixing problems. The fair market value deduction for gifts of appreciated property is a serious tax policy problem. Ignoring it undercuts the credibility of the report, in my book.
Howard Gleckman, a blogger at TPC, has a post about the charitable contribution deduction changes in the CARES Act, largely agreeing with the points in my post of a week ago. Of course, he manages to say it more succinctly than I did. He captures the effect of the above-the-line deduction as “benefit[ting] low- and middle-income households, but do[ing] little for the charities it is intended to support.” That describes it in a sentence. He notes that the AGI limit increase will encourage a handful of wealthy contributors to accelerate their contributions. Given the circumstances, I can see some justification for that – particularly if it were targeted to charities involved with COVID-19 relief, such as hospitals, clinics, and so forth (it’s not).
Gleckman points out a potential negative effect of the CARES Act’s RMD changes on charitable contributions. I expressed the view the Act’s RMD changes were unrelated to its purposes (as well as being bad policy), but had not made that argument. That effect had not occurred to me; it’s real but small. Gleckman suggests that “putting off RMDs may reduce their charitable giving somewhat.” I think that is fair, but in my judgment the financial effect is really small (a time value of money deal). It’s worth spending a paragraph to describe that. The more interesting question is whether the behavioral response reflects the financial effect or maybe bigger.
The law allows individuals who are subject to RMDs (“required minimum distributions” that must be withdrawn from IRAs each year, yielding taxable income) to transfer IRA money to a charity and thereby satisfy the RMD, while not recognizing the transfer as taxable income. The CARES Act says RMDs need not be taken in 2020. That does not, however, prevent an individual aged 70-1/2 (by June 30, 2019) from transferring IRA money to a charity and not recognizing it as income. Thus, the CARES Act leaves the tax benefit of making the transfer intact; it but just delays when the tax benefit occurs. The way to think about an IRA’s assets is that they include an embedded or deferred tax obligation that should be deducted from the nominal value to get an aftertax value. (One should do that in calculating asset allocations when holdings include taxable and Roth assets, as well as traditional IRAs. That will put the holdings of each type of account on an equal afertax footing with the others.) The timing of the recognition of those deferred tax obligations are determined by the RMD rules. So, essentially the deferred tax obligation must be discounted to present value under the RMD rules’ timing requirements, also taking into account potential changes in the account holder’s and beneficiaries’ tax rates.
In the case of the one-year delay under the CARES Act, the math is mildly complicated because making a qualified charitable transfer in 2020 does not satisfy the 2021 RMD. Rather it reduces the account value used to calculate the 2021 and later RMDs. Making the transfer will modestly reduce the 2021 RMD, the 2022 RMD, and so on. These future tax benefits must be reduced to present value. But given the low interest rate environment we’re in, the discount rate will be low and the financial effect should be small. Put another way, if you don’t think you’re going to earn a lot of income/interest by investing your IRA, why not give some of it away now (up to the limits of the qualified charitable distribution limits), rather than waiting until you’re actually subject to an RMD in 2021? That would be particularly true if one budgets for charitable contributions similarly to budgeting for other forms of consumption.
The bigger issue is how the RMD holiday actually affects behavior (i.e., the willingness to give) based on perceptions or misperceptions regarding the value of the resulting tax benefits – assuming that giving is actually affected by tax benefits. Behavioral economic research has shown that perceptions can be more important that actual financial or economic effects. Answering that would require some research for which I’m not sure data is readily available (e.g., from SOI). After the Cares Act data is in, we’ll have two data points – tax years 2009 and 2020 when RMDs were suspended but qualified charitable distributions were still permitted to be made – probably not enough to reach reliable conclusions, although I have seen research predicated on even thinner slices of data.
COVID update
Below is an update of the table on the ten states with the fewest confirmed cases of COVID-19 on a population adjusted basis. Minnesota continues to have the lowest number, but these numbers are highly sensitive to testing protocols. Minnesota’s total testing numbers continue to fall farther behind the national rates. Since April 1st, Minnesota’s positive test results have increased by 80%, while its total number of tests increased by 50%. That’s obviously concerning. I have not heard an explanation for this – whether it is due to lack of supplies, testing rules, or some combination of both. As you can see from the table, other high ranked states tend to have low testing rates, even lower than Minnesota’s below average rate (particularly Texas, North Carolina, and Nebraska).
TPC and the American Tax Policy Institute jointly put on a conference last week on taxes and the future of philanthropy. Webcast and materials are available here. I have not spent the 5 or so hours to listen to the webcast but hope to do that. Reading and scanning some of the materials reminded me of the need to reform Minnesota’s incentives for charitable giving following TCJA’s enactment.
In this post, I will explain why and in a second post I will outline what I would do to fix the tax incentives. This is a recycling of ideas that I developed when I was still working and advising House members on how to respond to TCJA. During the 2019 session (when I was working part time), I was told that the idea of undertaking a reform effort was presented in general terms to the Minnesota Council of Nonprofits and they rejected the idea. As a result, it was dropped. I hope that decision just reflected a judgment by Council staff that they wanted more time to think about it and to consult with their members. (Since my idea was revenue neutral, they may have thought that they could tap new money for their own proposal to expand that the nonitemizer subtraction. That did not occur.) If it didn’t and reflected basic opposition to reform, I would hope legislators would see the need to revisit this issue and plow ahead with making some needed reforms.
As an aside, one unfortunate reality of the legislative process is that outside interest groups (with their own organizational politics and dynamics) too often have out-sized influence – more now than used to be the case, in my experience. But it’s just the reality of how politics and the legislative process seem to work. Each caucus gives (in my opinion) too much sway to their favored interest groups – the Republicans to business groups and the Democrats to unions and nonprofits. This often take the form of allowing them de facto to formulate the policy and/or to veto whether anything at all is done, rather than legislators making their own policy judgments and, then, just seeking advice.
The TPC conference materials make clear how TCJA profoundly changed federal tax incentives for giving to charities (along with making other changes that affect charities, such as to UBIT and taxing endowments, as well as other background changes that have been occurring over the last few years, such as the oversight of charitable organizations by the IRS and growth in donor advised funds). The following are the most important of those changes.
The big increase in the standard deduction, along with capping the SALT deduction, has dramatically reduced the number of taxpayers who itemize, the basic way the federal tax provides charitable giving incentives to most taxpayers. This was not the prime intent of either TCJA change but it is a big side or indirect effect.
Caveat: Older taxpayers (aged 70-½) can still make direct transfers from their IRAs to charities and get even bigger tax benefits than the deduction but that does not affect younger givers or those without traditional IRAs. And it takes savvy, awareness, and planning to use, so it typically affects only committed and regular givers.
76% of the federal tax benefits of charitable contributions go to the 5% of taxpayers with the highest incomes (59% to the top 1%).
TCJA took federal tax benefits away from 60% of the taxpayers who previously received them and reduced the tax subsidies by $17 billion annually.
TPC estimates that only 9 percent of taxpayers will deduct their charitable contributions for federal income tax purposes. The TPC document has some nice graphs and tables. Because Minnesota is a higher income state than average and because of other factors, its percentage will be somewhat higher.
Gene Steuerle, an economist whose judgment I respect a lot, believes that the post-TCJA system is not politically sustainable (link). Charitable tax incentives could easily be construed as little more than a tax shelter for the affluent that will become the latest target for making the income tax more progressive.
Bottom line: TCJA took away federal tax incentives from a lot of taxpayers, concentrating the incentives at the very top of the income distribution. Federal tax incentives are now irrelevant to most contributors.
These changes combined with the Minnesota conformity changes enacted by the 2019 legislature make, in my opinion, the Minnesota charitable incentives nonsensical or at least suboptimal. To understand why, a brief explanation of the Minnesota incentives and their rationale is necessary. As a preliminary matter, this discussion assumes that the primary purpose of these provisions is to encourage or stimulate more charitable giving by lowering the aftertax cost of doing so. Other rationales can be advanced, but they are more abstract, theoretical points.
1987 reform tied Minnesota to the federal rules. In its 1987 income tax reform, Minnesota opted to follow federal law in providing tax incentives for charitable giving. To qualify, a taxpayer was required to deduct the contribution for federal purposes. This occurred mechanically because Minnesota began using federal taxable income (FTI) as the starting point to calculate its tax. FTI was reduced by federal itemized deductions, including the charitable contribution deduction. The Minnesota tax reinforced and magnified federal tax incentives. It likely reflected a judgment that a Minnesota-only incentive was not powerful enough to matter, since state effective tax rates were so low, especially when adjusted for the federal deduction for SALT.
1999 subtraction added a modest benefit for those who do not itemize deductions. In 1999, the legislature enacted an additional Minnesota incentive, the non-itemizer subtraction. It was allowed to those who do not itemize and, thus, qualified for no federal incentive. The subtraction equals one-half of qualifying contributions that meet the requirements under federal law and exceed $500 for the year. Those limits likely reflected the idea that the standard deduction amounts include an assumed average for contributions. The tax benefit is so small (maximum of less than 5% of the amount contributed) that it is hard to imagine that it affects behavior, except as a sort of signal of government approval or for people who are confused about the magnitude of the tax benefits. The calculations and limitations have some truly odd effects that are not worth describing.
After 1999, the charities have regularly lobbied the legislature to eliminate the two limits on the subtraction to expand its scope. None of these proposals have advanced to the point of passing either house of the legislature.
2019 conformity act adopted higher standard deduction amounts. The 2019 legislature enacted a federal update bill that conformed to many of TCJA’s changes. It switched Minnesota from being an FTI to an adjusted gross income (AGI) state. That required the legislature to adopt Minnesota-unique itemized and standard deduction rules. In doing so, it adopted the higher TCJA standard deduction amounts as the Minnesota standard deduction and the $10,000 limit on the SALT deduction. There are good policy reasons for both of those decisions unrelated to charitable contributions, but they have a similar impact on the tax incentives for charitable giving to TCJA’s changes on the federal system.
The net result is that as of 2019 the Minnesota charitable contribution incentive rules mirror the federal rules with the additional of the 1999 non-itemizer subtraction added on. To summarize the effects:
Full deductibility or excludability from taxable income applies only to (1) those who have enough total deductions to itemize or (2) those 70-½ or older who make direct transfers to charities from their traditional IRAs. The effects should be close to the same as reported by TPC nationally – maybe about 10 to 13 percent of taxpayers qualify and those who do will be concentrated in the very highest income levels. The estimate for Minnesota’s percentage of those who qualify is likely higher than the national estimates because Minnesota is a high-income state with relatively more homeowners (with deductible mortgage interest). As a result, more Minnesota taxpayers itemize than the national average. In sum, the most generous incentive is given to about 10 to 13 percent of the population and they typically have the highest incomes and the Minnesota incentive is layered on top of the federal incentive.
Deduction of one-half of contributions over $500 is provided to everyone else.
The differences in the marginal tax benefits for a contribution for the two groups, combining the federal and state benefits, is stark as shown in the table. I used TPC’s estimate of the federal marginal rates and blended the 2nd and 3rd bracket rates for the top quintile and the bottom two brackets for all others to calculate an approximate Minnesota state tax benefit. TPC estimates that the marginal incentive for the top 5% is 29% and that is where most of the federal benefits go (76%).
Group
Federal benefits
Minnesota
Combined
Top quintile, itemizer
22%
7.3%
29%
Top quintile, nonitemizer
0
3.5%
3.5%
All others
0
3%
3%
My Take: This structure – which treats the basic state tax incentive as a reinforcing supplement to the federal incentive – may have made sense when a large percentage of Minnesotans itemized. It no longer does. Here are five problems (and conversely five reason to reform) with the current Minnesota tax incentives that I see:
#1: Contributors treated unequally; few qualify for the full incentive. The current structure favors higher income contributors. A deduction naturally does that – the higher the tax bracket, the bigger the tax benefit. But the bigger deal is the high standard deduction amounts, which reinforce that effect by limiting itemizers to higher income taxpayers (e.g., with big mortgages) and/or large contributors. Large contributors also tend to be high income folks who have the wherewithal to make big contributions. Aside from the inherent unfairness of this, it fosters cynicism regarding the tax system as many may think it favors the wealthy and powerful. They get a full deduction, while non-itemizers can deduct only half of their contributions.
#2: Unfocused incentives, poorly targeted to where they are most needed. If there was a time for adding on to the federal tax incentives, it’s not now. Adding a small state incentive focuses state money where it is least needed – to contributions that already get a generous federal incentive. Second, TCJA’s cap on the SALT deduction makes state tax incentives more powerful and important, so it makes more sense to carefully focus them now, rather than continuing to blindly follow the federal rules.
#3:Unequal treatment of charities. The federal structure likely skews which charities benefit from tax incentives and the resulting subsidies, since affluent givers tend to favor arts, cultural, and higher education charities. Churches and social service charities, by contrast, likely do not benefit as much. Adding to the federal incentive just reinforces that effect.
#4: Confusing. By providing differing incentives to itemizers and non-itemizers, the system is confusing. Now that Minnesota is an AGI state and has its own itemized deduction rules, there is no simplicity penalty from deviating from the federal rules. The Minnesota itemized deduction for the charitable contributions and the non-itemizer subtraction can be replaced with a universal credit or deduction. That will make the incentive and tax simpler, not more complex. One incentive and one set of rules will be easier for taxpayers to understand.
#5: Inconsistent with Minnesota reputation as a very charitable state. WalletHub recently ranked Minnesota as the most charitable state (nosing out Utah by one one-hundredth of a ranking point on a scale of 100!). However, Minnesota did not rank in the top 5 states either for the percentage of income donated or in the percentage of the population who donated money. One can easily take issue with how WalletHub did its rankings (many of the factors seem like a stretch to me), but it does suggest that Minnesota needs to work on encouraging more cash donations to keep up with its good record in supporting charities in other ways (volunteering time and so forth). A better designed tax incentive is one way to do that.
Many of these reasons also support reforming or modifying the federal charitable giving incentives. This piece by Professor Roger Colinvaux makes many of the same points about the federal tax. However, Congress is likely to take years before it does anything, if it ever does. There is no sense for the legislature to wait for Congress to act and, then, follow that, since we are now an AGI state with our own itemized deduction rules.
In conclusion, I think the need for reform of Minnesota’s charitable giving incentives is clear and convincing. In my next post, I will outline how I would do that. Even if you don’t agree with me on the details of how do that, I think it is hard to defend the current arrangement.
SALT Speak - Joel Michael's Blog 