The Property Tax Exemption for Charities is an Unfunded Mandate

News organizations are reporting that the Massachusetts legislature is considering a bill this week to tax property owned by the state’s many wealthy charities, including Harvard and MIT. A more accurate description would be that the bill would allow local governments to tax those properties. In nearly every state, it is local governments that tax property. But it is generally state law that determines whether charitable property is exempt (as it is basically everywhere in the United States) or not. Although I think there is a role for charity in a federated government, existing property-tax exemption laws are a poorly designed tool for promoting charity.

You can see, with a little reflection, why we probably wouldn’t leave the decision about whether to support charity or not up to local governments. Most charity spills across city and county borders. Since 1997, at least, it’s been unconstitutional for a government entity to subsidize only those charities that provide local benefits. In effect, if a city wants to underwrite soup kitchens, it must also offer breaks to groups that want to save the whales or liberate Ukraine.

Standard public finance economics tells us these kinds of public goods should be financed at higher levels of government, because local governments will, predictably, under-provide spillovers for their neighbors. A counter-argument one sometimes sees in favor of local financing is that it sometimes also brings local control, which can have experimental or accountability benefits (obviously, this is a common back-and-forth in education financing debates). But that counter doesn’t really make sense when it comes to financing charity, because no matter who cuts the checks, it will be the charity that makes decisions, not the government.

Property tax exemptions sort of follow the public-finance prescription, in the sense that the decision whether or not to finance charity is made at the state level, where more of the spillover benefits are internalized. But even if the decision is made in the right place, it’s still being paid for by local governments.

States should use carrots, not mandates, to encourage charity. In general state money is cheaper than local money: the easier taxes are to avoid, the more social waste they create when imposed. It’s easier to duck a county tax than a state’s — just ask the City of Philadelphia. So, if states really want to encourage localities to create positive externalities, a subsidy might be a better choice. Subsidies might also have good income effects: by making local voters better off, they could increase demand for public goods, including charity.

The reason states don’t do this, of course, is because it is far easier politically to shoulder off the responsibility to pay to other, inferior, officials. In effect, the property tax exemption is an unfunded mandate: state officials can claim the benefits of supporting charity, while the budget impact is someone else’s problem. I’ve shown evidence that a similar dynamic affects Congress when it legislates what states can tax.

One counter-argument might be that the property tax is an especially good base from which to pay for charity. Charities are perhaps most valuable during economic downturns, especially charities that focus on safety-net programs. But recessions tend to put pressure on budgets that lean heavily on income and sales taxes, since revenues from those sources are falling when folks are out of work and consuming less. Still, there are solutions to this dilemma that don’t require an unfunded mandate, such as a small, statewide property tax. Maybe Darien can tell us others?

Finally, it’s worth mentioning that I’m a bit skeptical that the property-tax exemption actually benefits charities, but I’ve gone long enough for now.