To Tax Or Not To Tax
It shouldn't be a question.
This is a follow up to my post on good versus bad nonprofits. In that post I mentioned in passing that taxation of nonprofits seems to be at the core of what it means to be a “nonprofit”. While it is from the standpoint of defining these types of entities for tax purposes, it is really orthogonal to their purpose. The purpose of a nonprofit is for an ownerless firm to achieve some goals using resources.
When it comes to taxing them, the reason this shouldn’t be a question is simply because we should not tax corporations in general. As Megan McArdle recently said on her podcast Reasonably Optimistic, taxing corporations is a particularly bad tax policy. In the episode she pithily explains how it fails on anyone’s terms.
Perhaps a better way to understand the argument is to realize that corporations cannot be taxed. The idea that a corporation is paying a tax bill is a fundamental mistake in tax incidence confusing accounting entries with economic reality. Corporations are collections of people, and those people pay the tax. Before you say, “Exactly! And that’s what we want,” understand that those people are owners, customers, and employees. Owners, the presumable target of those wanting to tax corporations, have the most control to pass off the tax incidence. To the degree they do endure it, be careful what you ask for. The end result is that the tax is hurting capital, the lifeblood of the economy upon which customers and employees depend.
In reality it is employees and customers who bear the brunt of the economic tax incidence. Customers face higher prices and reduced quantities including less quality as a result of corporate taxation. Employees face less employment than they would otherwise enjoy because the business is smaller than it would otherwise be.
Still, we do attempt to tax corporations. The result, like with any tax, is we get less of the thing being taxed—less corporation output. So if we were to tax nonprofits, we would get less nonprofit output. Shortly we will explore the implications.
Before we do that, though, we need to recognize there are two taxation issues facing nonprofits that they currently enjoy protection from. The first of these is the tax benefit donor’s enjoy when they donate to a qualifying nonprofit. If you give to a nonprofit, you can either deduct that donation (e.g., money to a 501(c)3) or you can fully avoid those funds being subject to taxation (e.g., setting up a private foundation or making a qualified charitable donation (QCD) out of a 401(k)). [NB: my apologies for all the jargon.]
Effectively these are negative taxes (subsidies), and they have reciprocal effects economically—just like taxing something gets less of it, subsidizing something gets more of it. Therefore, nonprofits benefit by getting more funds than they would otherwise get in a world where this tax benefit did not exist—subject to the economic caveat ceteris paribus (all else held equal).1
The second benefit is the impact at the entity level itself—the fact that it isn’t taxed on its profit/income.
So we have two elements to consider:
Donor benefit
Entity benefit
Nonprofit is a misnomer. Nonprofits do have profits. At least they should if they are actually providing benefit to society and wish to not simply immediately pay out all revenues (donated funds gained). Retaining these as investments for future beneficiaries is where these profits generally accrue. That introduces income (that would be taxed as income if they were a for-profit entity) as well as capital gain and more income from the investments themselves (that would be taxed as such, again, if they were a for-profit entity).
Since a nonprofit doesn’t have owners, it has to do something with its profits. Presuming we want the nonprofit to exist now almost always means we want it to exist in the future. That implies not paying out every dollar that comes in immediately.
What if all or much of the excess is paid to employees? Well, many of them are already doing this. Tax policy cannot prevent it other than having the IRS act as steward to monitor egregious behavior (e.g., private inurement). The IRS is ill-suited for this role to say the least. Much like FDIC insurance and FDIC/Federal Reserve bank regulation, this shifts the duty to a government body that itself has bad incentives and raises moral hazard generally in the process.
Might I suggest that caveat donoris is a more appropriate guidepost? Having donors monitor and decide what are appropriate practices from employee pay to marketing budgets and so forth is a much more effective method of getting desired behavior from nonprofits. We already have robust cottage industries designed to make such evaluations. And the effective altruism movement holds this objective as a central tenet. The more donors know they are the first and last defense against inappropriate behavior would only strengthen it.
Still, I don’t think corporations should be taxed. So why might I suggest that nonprofits should be? The reason goes beyond the simple idea of fairness and uniformity; although, that is the start of the reasoning.2
In an imperfect world where we insist on taxing for-profit entities, the economic distortions increase by excluding non-profit entities from this burden. Many would retort, “But that’s okay. Let’s err on the side of helping nonprofits.” Not so fast, my friends.
We must be careful what we ask for. Sheltering nonprofits from the tax burden as is now the case tips the balance in their favor. And the lesson from the prior post is that many of them are not doing a great job. And even when they are well run, the tax benefit encourages them to amass capital (endowments, etc.) rather than use these resources today.
To be certain there is a balancing act that is filled with assumptions and priors in the debate between spending now and spending in the future. While it is true, as I said above, that we almost always want non-profits to exist in the future when we want them to exist in the present, the devil is in the details about how to strike this balance. And also to be certain, we have greatly (not necessarily gravely) erred on the side of the future rather than the present.
Investment people like me are often pushing back against spending today with an eye to growth, which has two components. For one, we want purchasing power (spending impact in the case of nonprofits) to be preserved knowing the future needs and inflation risks are unknown. For another, we tend to favor the idea that the magnitude of impact can be larger when funds are compounded through investment.
Here is the very important other side of that debate: we do know what the spending needs are today, we don’t know if they will be needed in the future (many problems will actually be materially smaller if not solved), and we do know that if the future is even a little like the past, society will be vastly wealthier in the future.
And here is another, perhaps uncomfortable, truth: Let the future take care of itself. Don’t err on the side of saving so strongly that you (a world with current needs that is relatively poor) sacrifice for a future someone (a world with unknown but likely lesser needs that is relatively rich) who not only doesn’t need the help but who might be harmed in getting it. The concept I’m getting at is analogous to a stereotypical trust-fund grandchild who becomes a spendthrift never made to take care of themselves—skin in the game is a powerful, beneficial motivator.
Uniformity in the tax treatment of all these entities would better align incentives and give us a clearer picture on how resources are being used.
In short: Don’t tax corporations, period. But if you insist on doing so, tax all of them—for-profit and nonprofit—alike.
As with most things, the world is more complicated than that. The impact of a change of tax policy here shows less impact than might be assumed at first glance—supported both in theory and real-world experience. Many donors are very insensitive to the tax benefit (e.g., small donors cannot take advantage since they don’t itemize and large donors are insensitive to price). Ask AI for more if curious.
Another secondary reason I will avoid exploring is that it would bring uniformity and simplification to the accounting practices between for-profits and nonprofits.