Yesterday, as Marc pointed out, Elder Oaks testified in front of the Senate Finance Committee in favor of the deduction for charitable giving. He argued that the charitable deduction is vital to the nation’s welfare.
Why, though, these hearings on the charitable deduction? Is it under attack? In case you haven’t been following the politics of tax and budgeting recently (of course, who hasn’t?), I thought I’d provide a little background to the hearing.
The Deduction for Charitable Donations
The charitable deduction is an itemized deduction (more on that later). It’s one of the older deductions in the tax law, though its run is not coterminous with the tax law. The modern federal income tax was enacted in 1913, but the charitable deduction didn’t manage to get enacted until 1917.
And what is the relevance of a deduction? Basically, a deduction reduces your tax liability by the amount of your deduction times your marginal tax rate. So, for example, if you pay taxes at a marginal rate of 35%, and you get a charitable (or any other) deduction for $100, you will pay $35 less in taxes than you would have without the deduction. If, on the other hand, you pay taxes at a 20% marginal rate, your tax bill would be reduced by $20.
And what is an “itemized” deduction? In calculating your tax liability, there are some deductions you can basically always take (these are called above-the-line deductions[fn1]). Itemized deductions are basically any other deductions. When you calculate your taxable income, you choose between taking your itemized deductions or taking the “standard deduction.” The standard deduction is a set deduction adjusted for inflation; in 2011, the standard deduction for a married couple filing jointly is $11,600.[fn2]
What this effectively means is that, if you and your spouse have less than $11,600 in itemized deductions in 2011, you’ll take the standard deduction. That is, let’s assume that you make charitable contributions of $5,000 and pay mortgage interest of $4,000 in 2011.[fn3] That gives you $9,000 of itemized deductions; in that case, you’re going to forget about your itemized deductions and, instead, take the standard deduction. If, on the other hand, you make charitable contributions of $10,000 and pay mortgage interest of $4,000, you will itemize your deductions and ignore the standard deduction.
In 2006, only about 36% of taxpayers itemized their deductions (meaning that the incentives that flow from the provision of deductions only incentivized 36% of taxpayers), a percentage that seems relatively steady. Poorer taxpayers are generally less likely to itemize; they are also more likely to donate to churches than richer taxpayers (who are presumably itemizing); richer taxpayers, on the other hand, are more likely to universities, hospitals, and cultural organizations.[fn4]
We All Like Charitable Deductions, So What’s the Problem?
The President’s proposed American Jobs Act[fn5] would limit the size of itemized deduction available to married taxpayers earning more than $250,000.[fn6] (Basically, that’s everybody with a marginal tax rate of 35%, and some portion of those who have a marginal tax rate of 33%.) Such taxpayers would still be able to take a deduction for, e.g., the mortgage interest they pay and the charitable donations they make, but the percentage of deduction would be limited to 28%. As a result, a high-income taxpayer who donated $100 to charity would reduce her tax bill by $28, not $35.
The question is, how will that affect charitable giving in America? The answer is, nobody knows exactly. It will probably reduce charitable giving by some amount, while it will almost undoubtedly not eliminate it entirely. So the Senate Finance Committee appears to have been trying to determine the scope of the reduction, presumably (one hopes) to evaluate whether the increased revenue is worth the decrease in charitable giving. And there’s probably not an easy answer.
(Note, of course, that, while the focus of the hearing was on charitable giving, the limitation does apply to all itemized deductions.)
[fn1] As a rough guide, your above-the-line deductions are any of the deductions listed in lines 23-35 of the 2011 IRS Form 1040.
[fn2] Unmarried individuals get a standard deduction of $5,800.
[fn3] For most individuals, getting about the standard deduction threshold only happens if they have a mortgage. Even if you tithe 10% of your income, you would have to earn more than $116,000 in 2011 to meet that threshold. In 2008, having $113,799 adjusted gross income (which is something less than gross income, but something more than after-tax income) put you in the top 10% of the U.S., income-wise. I use 2008 because it’s the most recent year for which the IRS has released a comprehensive analysis of tax data.
[fn4] I try, generally, not to flog my academic work here, but if you’re interested in some numbers, you can look at my paper “Reigning in Charities“; the relevant numbers are on pages 9 and 10, and especially in footnote 37.
[fn5] Yes, I know it’s been rejected by Congress; now the President is moving on to getting it passed piecemeal; while nobody things that every part will pass, many parts seem likely to pass.
[fn6] Note that that doesn’t get you unmarried taxpayers off the hook: your itemized deduction would be limited if you earned more than $200,000.