Tax-Exempt Entities Under a Wealth Tax

Wealth taxes are popular in some circles these days. Senator Elizabeth Warren has a new wealth tax proposal out, as do a couple of think tanks. I thought it would be interesting to work through how a wealth tax should approach entities that historically have been mostly exempt from income taxes: charities, governmental entities, pension funds, and non-U.S. taxpayers. For each of these, there are potentially competing goals from the perspective of the wealth tax and the policy rationales that motivate current income tax treatment. Any outcome probably has to end up being a compromise between them. This post got pretty long, so for now I’ll just focus on 501(c) exempt organizations.

Charities

Should charities pay a wealth tax? It depends, of course, on what the wealth tax is supposed to accomplish. If it’s just about raising revenue, then deciding rules for the charitable sector don’t matter that much, because nonprofits currently only hold about $1.5 trillion in investment assets. That’s just two or three billion a year in revenue at the rates Sen. Warren proposes.

Of course, a wealth tax could also incentivize wealthy families to move money to charitable vehicles, though theory and evidence on that are unclear. There are competing income and substitution effects. On the one hand, money given to a charity buys more if it’s untaxed (that’s the substitution effect). On the other, someone who wants to spend a particular target amount might actually up their giving to hold the after-tax amount constant (the income effect). There’s some evidence that endowment returns modestly crowd out (i.e., reduce) donations, which is consistent with income effects dominating over substitution effects. Would that also be true of a wealth tax?

Charity would be an especially appealing alternative if it would be possible not just to do good works with charity dollars, but also to continue to personally benefit the donor families. Unfortunately, current law does allow private foundations to employ family members and pay for their travel and other foundation-related expenses. Planners routinely choose private foundations over other alternatives such as donor advised funds for this reason.

Moving beyond revenue, another key goal of a wealth tax is likely to break up the concentrated power and influence that money brings. At first glance, that seems to imply an exemption for charities. The estate tax, after all, has the same goal, and it has a charitable contribution deduction. There, the theory is that charities aren’t a vehicle for the family to continue to exert its influence over society.

Modern charity law has in large measure failed to deliver on this theory. Private foundation rules aim to limit self-dealing, as well as to make it hard for a family to give up formal ownership of a corporation while still retaining practical control. But these rules can be gamed. One easy gaming route is to give money to an organization that manages to get itself categorized as a public charity, where the safeguards are much looser.

Lastly, a wealth tax could have some unintended side effects on charities. Among other things, a wealth exemption would likely encourage donors to accumulate more wealth inside their charitable organization, rather than waiting to donate later. This puts greater strain on the tension between donors and their agents over issues like how quickly to spend the money. The enforceability of the terms of restricted gifts agreement will get more important.

So my bottom line is that, at a minimum, a new wealth tax should likely be an occasion to revisit existing tax and other rules constraining charitable behavior. With the wealth tax will come new pressures to use charity to conceal direct dynastic control and to build up assets inside the firm. This might be a good chance to rethink rules, such as the treatment of private foundations, that have developed a lot of holes over time.

Other 501(c) entities

A bunch of other private entities are exempt from income taxes under current law, including labor unions, business leagues, community organizations and 501(c)(4) “social welfare” organizations. These groups share the feature that they are relatively unlimited in their ability to spend money on lobbying, and can spend a significant fraction of their assets on elections. In many cases, the sources of these funds need not be publicly disclosed.

My view is that for democracies to function, political expenditures should be transparent and any subsidies should be sharply capped. Certainly the opposite combination — unlimited subsidies for opaque expenditures — should be avoided at all costs.

We therefore cannot exempt these entities from a wealth tax. The possibility that the wealth tax exemption would act as a subsidy, in combination with the likelihood that this subsidy would benefit the wealthy and powerful vastly more than it would anyone else, makes this is a nonstarter for me. We already tax investment income of these entities to the extent that they make “qualifying expenditues” under section 527, and at a minimum a wealth tax should mimic this approach.

Here again, one could say that this position is contrary to some policy decisions we’ve already made in the income and estate tax systems. For instance, IRS has decided that gifts to c(4) organizations are not subject to the gift tax. I find that ruling mystifying. If the point of the estate tax is to diffuse and minimize influence, it surely should not allow a deduction for expenditures intended to exert influence! Once more, the wealth tax might be a good occasion to make existing law more coherent.