The Tools of Government
Workbook 3
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Tax Expenditures Workbook
By Christopher Howard

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Overview

This workbook is a companion to The Tools of Government: A Guide to the New Governance, edited by Lester M. Salamon. It includes original source documents and forms that illustrate the operation of the tax expenditure tool. It is designed to help the reader better understand the process of creating, implementing, and managing a tax expenditure program.

As defined in The Tools of Government, a tax expenditure "is a provision in tax law that usually encourages certain behavior by individuals or corporations by deferring, reducing, or eliminating their tax obligation." Common examples include the home mortgage interest deduction, Earned Income Tax Credit, and accelerated depreciation of machinery and equipment. Tax expenditures thus differ from direct government, for they usually rely on individuals, nonprofit organizations, and for-profit companies to deliver the desired good or service. Unlike social or economic regulations, tax expenditures rely on incentives rather than commands; if taxpayers choose to behave in ways the government favors, they may reduce their tax obligations, but no one compels these behaviors. Probably the closest relative to the tax expenditure is the grant tool. To benefit from a tax expenditure, however, a taxpayer need not compete with other taxpayers, as is often the case with grant applicants. From a budgetary perspective, tax expenditures are generally entitlements while grants are classified as discretionary spending. Another difference is that "the government pursues its objectives, not by spending the tax dollars it collects, but rather by allowing individuals or corporations to keep and spend dollars they would otherwise owe the government."

Tax expenditures are complex and pervasive. They may take the form of a "deduction" that reduces the amount of income subject to taxation or they may take the form of a "credit" that reduces the amount of taxes owed. Over 100 tax expenditures exist at the national level; the cost of individual provisions varies from less than $50 million to over $50 billion each year. They underwrite objectives as diverse as oil and gas exploration, investments in new plants and equipment, home ownership, health insurance, retirement pensions, and college tuition. Thus, it is hard to pick one "typical" tax expenditure. The tax deduction for charitable contributions is a reasonable choice on several counts. Like most tax expenditures, it has social welfare objectives and most of the tax benefits are claimed by individuals and not corporations. Among individual beneficiaries, there is a decided tilt in favor of the affluent, which is true of many tax expenditures. The active involvement of third-party providers, in this case charitable organizations, is part of a larger pattern as well. It is neither the most nor least complicated provision in the tax code. Perhaps the least typical feature of this program is its size. The tax deduction for charitable contributions is larger than about 90 percent of all tax expenditures. However, a smaller tax expenditure would not have generated as rich a set of documents and policy issues as the tax deduction for charitable contributions.

The basic steps involved in implementing any tax expenditure are fairly straightforward. Typically, the process at the national level is as follows:

1. Changes to the tax code are enacted by Congress and signed by the President.

2. Those changes are converted by bureaucrats at the Treasury Department's Internal Revenue Service (IRS) to tax regulations in the Internal Revenue Code.

3. These regulations are then converted to tax forms, instructions, and publications that are made available to the general public.

4. Taxpayers, often with the help of paid tax professionals, determine their eligibility for a given tax expenditure, calculate its value, complete the relevant tax forms, and submit the forms to the IRS.

5. The IRS may challenge the completed tax forms and recalculate taxes owed or refunds due. If taxpayers want to dispute the IRS, the case may be resolved informally with the IRS or more formally through the courts.

6. Each year, a tiny fraction of individual taxpayers is selected for examination (i.e., audit), in which case they must document every source of income and every tax expenditure. Frequently taxpayers turn to tax lawyers and accountants for help when examined.

Document Listing and Description

This workbook contains 17 documents related to the operation of the tax deduction for charitable contributions, a tax expenditure run by the Treasury Department by its Internal Revenue Service. The documents are grouped into six categories, as outlined below. A list of study questions that can be used to enhance one's understanding of the operation of tax expenditures as a policy tool can be found at the end of the introductory section of the workbook.

Tax Deduction for Charitable Contributions

A. Overview of Tax Expenditures

1. U.S. Congress, Joint Committee on Taxation, Estimates of Federal Tax Expenditures for Fiscal Years 2001-2005
http://www.house.gov/jct/s-1-01.pdf

This section should help readers learn about the definition and measurement of tax expenditures, neither of which is clear-cut. It also includes a few tables indicating the number and scope of tax expenditures, as well as the distribution of benefits for several individual programs. This material should give readers the conceptual and factual knowledge needed to make sense of the specific program chosen for study, the tax deduction for charitable contributions. The document featured in this section is published annually.

B. Origin of the Tax Deduction for Charitable Contributions

1. Interest Group Support, New York Times, June 8 and 18, 1917

2. Senate Amendment, Congressional Record, September 7, 1917

3. Public Law 65-50, War Revenue Act of 1917 (Title I and Title XII, Sec. 1201)

The origins of tax expenditures, particularly those created in the first half of the 20th century, are often murky. This pattern is important considering how many of the largest tax expenditures today (e.g., home mortgage interest, company retirement pensions) date from the early 1900s. In the case of charitable contributions, however, there is fairly clear evidence of interest group lobbying during the summer of 1917 (B1). Soon thereafter, the tax deduction for charitable contributions was offered as a floor amendment in the Senate and approved unanimously (B2). It was then incorporated as part of the War Revenue Act of 1917 (B3). For reasons of economy and clarity of presentation, the many amendments to this program since 1917 have been excluded.

C. Program Regulations

1. Public Law 103-66, Omnibus Budget Reconciliation Act of 1993, Section 13172
http://thomas.loc.gov

2. IRS temporary regulations, Federal Register, May 27, 1994 (Documents 2-4 can be accessed via http://www.access.gpo.gov/su_docs/aces/aces140.html)

3. IRS notice of proposed rulemaking and notice of public hearing, Federal Register, August 4, 1995

4. IRS final regulations, Federal Register, December 16, 1996

5. Relevant section of Internal Revenue Code, 26CFR1.170A-13, revised as of April 1, 2001
http://www.access.gpo.gov/nara/cfr/waisidx_01/ 26cfr1v3_01.html

Tax legislation passed by Congress and signed by the President must be converted to tax regulations by the Internal Revenue Service. Document C1 presents a small portion of the massive Omnibus Budget Reconciliation Act of 1993, which concerns the proper documentation of charitable contributions by taxpayers. The IRS issued some temporary regulations to guide taxpayers (C2) the following year. In the meantime, IRS officials worked to create more permanent regulations and made their recommendations public in 1995 (C3). After a period of public comment and revision, the IRS issued final regulations in 1996 (C4), which have since been incorporated into the Internal Revenue Code (C5). Readers who wish to access 26CFR1.170, which sets out all of the rules governing the tax treatment of charitable deductions, should go to the Internet site referenced for C5.

D. Tax Forms and Instructions

1. IRS Form 1040 and Schedule A, Itemized Deductions, with relevant instructions
http://ftp.fedworld.gov/pub/irs-pdf/i1040gi.pdf;
http://ftp.fedworld.gov/pub/irs-pdf/f1040sab.pdf;
http://ftp.fedworld.gov/pub/irs-pdf/i1040sa.pdf

2. IRS Publication 526, "Charitable Contributions"
http://ftp.fedworld.gov/pub/irs-pdf/p526.pdf

3. IRS Publication 5, "Your Appeal Rights and How to Prepare a Protest If You Don't Agree"
http://ftp.fedworld.gov/pub/irs-pdf/p5.pdf

4. IRS Publication 556, "Examination of Returns, Appeal Rights, and Claims for Refund"
http://ftp.fedworld.gov/pub/irs-pdf/p556.pdf

Tax regulations are in turn converted into tax forms, instructions, and publications that are distributed to taxpayers and tax professionals. Document D1 is the basic annual income tax form for individuals, with a line for recording the tax deduction for charitable contributions on Schedule A of Form 1040. Behind this number are a number of calculations and judgment calls, some of them quite difficult. Completing this schedule often raises complex questions regarding the type of contribution, the carry forward/backward issue, and the validation issue.

Document D2 is designed to help taxpayers determine the correct amount of their charitable deductions. This document also illustrates the complexity of the tool. Several pages are required to summarize the special rules related to donating property instead of cash (pp. 9-11). Other pages explain the limits on how much can be given (pp. 9-11), the records that must be kept (pp. 12-13), and the rules for carryover (pp. 10- 12).

If the IRS challenges a taxpayer's return, document D3 spells out the process of appeal and protest. The less common but more demanding examination (i.e. audit) process is detailed in document D4.

E. Proposed Changes

1. H. R. 824, 107th Congress, 1st session
http://thomas.loc.gov/

2. Testimony of Dr. Kenneth Gladish, National Executive Director, YMCA of the USA on behalf of Independent Sector, before the House Ways and Means Committee
http://waysandmeans.house.gov/fullcomm/107cong/3-21-01/ 3-21glad.htm

Near the end of his administration, President Bill Clinton proposed several changes to the tax deduction for charitable contributions. President George W. Bush has echoed some of these recommendations and made some of his own. Document E1 provides an example of legislation introduced in Congress to translate some of these proposals into law. Document E2 sheds some light on what charitable organizations think about some of the major changes being proposed. Note: the Independent Sector is an umbrella organization representing hundreds of charities around the country.

F. Program Evaluation

1. U.S. Office of Management and Budget, "Performance Measures and the Economic Effects of Tax Expenditures"
http://www.whitehouse.gov/omb/budget/fy2002/spec.pdf

2. Joseph Cordes, "The Cost of Giving: How Do Changes in Tax Deductions Affect Charitable Contributions?"
http://www.urban.org/pdfs/philanthropy2.pdf

Historically, tax expenditures have seldom been evaluated. Although lack of oversight may serve the interests of beneficiaries, performing a competent evaluation of tax expenditures can be difficult. For instance, tax data may be hard to access given privacy concerns, and program objectives may be hard to determine given the lack of clear intent by legislators. Document (F1) presents some of the key issues in evaluating tax expenditures, according to the U.S. Office of Management and Budget. Document F2 summarizes some recent research concerning the impact of the tax deduction for charitable contributions on charitable giving.

Discussion Questions

Section A

1. Imagine that you are Martha Hoban, fictional president of the fictional National Coalition of Charities. You want legislation to expand the tax deduction for charitable contributions, and a sympathetic member of Congress asks what a ten percent increase might cost. Go to Table 1 in A1 and make the calculations for 2001-05. In doing so, be sure to count the three different places in which charitable deductions are listed (health, education, and social services).

You worry that the increase may seem too large. Consequently, try to put the dollar amount in some perspective. Even if the charitable deduction is ten percent larger than currently forecast, how will it compare to what other tax expenditures cost in the year 2005?

You worry as well than the charitable deduction is viewed in some quarters as simply a tax break for the rich. Using Table 3 in A1, how would you assess the relative "fairness" of the charitable tax deduction? How does it compare to other tax expenditures?

Section B

In making the case for an increase, you remind legislators about the vital role that charities play in addressing many of our nation's most pressing social problems. Originally, however, the charitable tax deduction was linked to winning World War I. At the time, the U.S. government was trying to raise a significant amount of new revenue to fight the war. Major options included increasing income taxes on individuals, levying excess profits taxes on corporations, and issuing war bonds. How, then, were charitable deductions looped into decisions about the nation's war- making ability (B1 and B2)?

You may not want legislators to probe too closely into the program's original objectives, because the record is hazy at best. The selection from the Congressional Record (B2) represents the only explicit discussion of the charitable tax deduction prior to its enactment.

a) What can we learn about the program's original objectives from this document?

b) Which members of Congress were for and against the program?

c) What reasons did they give?

This tax expenditure was enacted as part of the War Revenue Act of 1917 (B3). Title I of that Act specifies the basic tax rates, which rise with income. Title XII helps define taxable income, and includes the deductions for charitable contributions (Section 1201). As you can see, the original language applied to more than just charities. What other kinds of organizations qualified?

Thinking beyond this case: While this tax deduction offers direct benefits to individual and corporate taxpayers, it also provides indirect benefits to charitable organizations. In effect, the tax code helps to lower the price of charitable giving. This is one reason why charities like the Red Cross were originally active in pushing for this tax expenditure to be created, and why they remain active in protecting the program and calling for more generous tax benefits. Indeed, these charities have been more active politically than any coalition of taxpayers making charitable contributions. Using a similar logic, think about the kinds of indirect benefits that result from the various tax expenditures aimed at home owners. What kinds of groups, besides home owners, might work hard to protect and expand those tax expenditures?

Section C

If taxpayers are able to reduce their tax obligation by giving to charity, it seems reasonable to expect them to be able to document their contributions. The government needs to guard against fraudulent claims. On the other hand, it is probably too great a burden on all parties to expect a signed receipt for every single dollar dropped in a Salvation Army kettle. In recent years, members of Congress and IRS officials have tried to set out clear rules concerning the kinds of documentation needed for various types of charitable contributions. The documents in this section chart that process.

a) When Congress amended the tax laws in 1993 (C1), they set a certain threshold of donation, below which a written acknowledgment from the charity was unnecessary. What was that threshold?

b) One scenario not discussed explicitly in the 1993 law involves taxpayers who make charitable contributions via regular payroll deductions. The temporary regulations issued in 1994 (C2) required such taxpayers to provide what two documents as evidence of their contribution? When did those regulations take effect?

c) According to the proposed regulations (C3), what information must appear on the written acknowledgment given to donors by the donee organization?

d) When and where did the IRS hold a public hearing concerning these proposed regulations (C3)? What did individuals who wanted to speak at the hearing have to do prior to the hearing?

e) The final regulations (C4) include answers to a number of questions raised during the public comment period. For example, summarize and critique the IRS response when asked to provide an example of a good faith estimate of the value of any donated goods or services. Review all of the comments submitted by the public and the IRS responses. Identify the response that made the strongest case for the IRS position on the issue raised by the commenter. Identify the response that made the weakest case for the IRS position. Briefly explain your choices.

f) If Public Law 103-66 took effect in August 1993, how long did it take tax officials to translate legislation into final regulations with respect to charitable deductions (C4)?

Section D

The tax benefits of charitable contributions are available only to individuals who itemize their tax deductions on Schedule A of Form 1040 (D1). Itemizing makes sense if the sum total of deductions exceeds the standard deduction.

a) Imagine that you are a single taxpayer who has given a total of $2000 to charities in the past year. If you take no other deductions, does it make more sense for you to itemize this deduction or take the standard deduction? If you gave nothing to charity, would your tax burden be higher?

b) Suppose that members of Congress proposed increasing the value of the standard deduction in order to provide tax relief for millions of Americans. If you worked for a major charity, would you endorse or oppose such a move? Explain.

Because the charitable deduction for individuals is itemized, its value depends on how many other deductions taxpayers can claim. For example, suppose that you are single, gave $2000 to charities last year, paid $1500 in state and local taxes, and rented an apartment. Your older brother, who is also single, gave $500 to charities last year, paid $1500 in state and local taxes, but owns a house and paid $8000 in home mortgage interest and another $1000 in real estate taxes.

a) Which of you will benefit from the tax deduction for charitable contributions? Is this outcome fair?

b) All else being equal, what likely happens to the charitable deduction if more people become homeowners or take out bigger mortgages for more expensive homes?

Note: companies who make charitable deductions do not have to decide between taking the standard deduction or itemizing their deductions. Any allowable charitable contribution can be deducted from their income tax obligation. Hence, a larger fraction of companies than individuals are potentially eligible to take advantage of this tax expenditure.

It seems reasonable that taxpayers cannot claim tax deductions for simply giving something to someone. If the family next door gives some clothes their 7-year-old daughter has outgrown to my 4-year-old daughter, the family next door should not receive tax benefits. Likewise, if I give my son a $5 a week allowance, I should not receive tax benefits. But where do you draw the line? Consult the instructions accompanying Schedule A (D1) and especially IRS Publication 526, "Charitable Contributions" (D2) to determine which of the following qualify as charitable contributions.

a) annual dues paid to a non-profit country club

b) used car given to a battered-women's shelter

c) painting donated to a museum

d) $25 worth of raffle tickets bought from a local volunteer fire department

e) money donated to church

f) $500 donation to a political candidate

g) $100 donation to reduce the national debt

h) value of time spent volunteering at a local soup kitchen

Do you think that the government has chosen to exclude and include the right kinds of behaviors? Explain.

Suppose that among your $2000 worth of charitable deductions was a used car given to a local shelter, which you valued at $750. Unfortunately, the IRS has determined that the fair market value of your used car should have been $300 and not $750. You disagree. What can you do to appeal (D3)?

It turns out that the IRS has started to become suspicious of large, non-cash charitable deductions and has used this factor to help identify taxpayers for a full examination (i.e., audit). As luck would have it, the threshold for such deductions is set at $750, and you are chosen (D3).

a) Can a paid tax professional accompany you to any meetings with the IRS, or even represent you in your absence?

b) In case you are unable to resolve your differences with the IRS, even after working through the Appeals Office, where do you go next?

Review pages 7-9 of (D2) regarding the valuation of donated property. Identify at least two validation rules with which you disagree or for which the rationale appears weak. Suggest alternative rules that you would recommend for consideration by the IRS. Review the limitations on the percent of income that can be contributed to certain types of charitable organizations (D2, pp. 9-12). Do you agree of disagree with the policy that limits the amount of income that can be contributed? Explain your answer. Suggest two ways to simplify this complex provision.

After reading the documents in Sections C and D of this workbook, do you believe that the rules governing this tax deduction are clear enough that individuals can complete the necessary forms without the help of paid tax professionals? If your answer is "no," identify which rules seem particularly complicated.

Section E

Legislators have been looking at ways to use the tax code to foster even more charitable giving. What concrete proposals are embodied in E1 and E2?

Document E2 offers testimony from the National Executive Director of the Young Men's Christian Association (YMCA), a leading national charity. What evidence does he offer to support the kinds of proposals discussed in the previous two documents? How might extending charitable tax breaks to non-itemizers affect the distribution of tax benefits?

Thinking beyond this case: The tax deduction for charitable donations is not the only way that the tax code encourages charitable giving. As of May 2001, policy makers were debating cuts in the estate tax (aka the "death tax"), which affects the size of inheritances. While some charities oppose this proposal, fearing that it would diminish the incentive to make charitable donations, other analysts argue that such fears were unfounded. For a summary of these arguments, see Eugene R. Tempel and Patrick M. Rooney, "Repeal of the Estate Tax: Its Impact on Philanthropy" (November 2000), available on-line at http://www.philanthropy.iupui.edu/EstateTax.html.

Section F

Members of Congress who oppose expansion of this tax expenditure may ask for proof that the current program is working well. As F1 suggests, evaluating individual tax expenditures is a technically difficult challenge. Instead, policy makers typically refer to the general strengths and weaknesses of tax expenditures as a policy tool. What does OMB see as the defining characteristics of this tool?

The OMB argues that a performance measure must identify the relevant inputs, outputs, and outcomes of a given policy. For the tax deduction for charitable contributions, the primary input is the tax revenue lost. What would be the relevant outputs and outcomes? Which of these would be easy or difficult to quantify?

The final document (F2) summarizes some recent research concerning the impact that the tax code has had on charitable giving. After you read the article, be able to answer the following:

a) What is the price elasticity of giving?

b) What level of price elasticity is needed for the tax deduction for charitable contributions to be "treasury efficient"? Is this deduction treasury efficient?

c) What other criteria might be used to evaluate the tax deduction for charitable contributions?

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