Editors’ Note: Nicolas Duquette highlights the history of the charitable contribution income tax deduction, in a preview of an upcoming article in Business History Review. 

The US charitable-contribution income-tax deduction marked its centennial in 2017. Relative to nearly every other aspect of the federal income tax, the workings of the deduction have changed little since its creation in 1917. Both major US political parties have at times called to reform the deduction’s structure, which disproportionately grants high-income taxpayers eligibility and the highest subsidy rates. Yet as I explain in an upcoming paper in Business History Review, this structure is no accident—high-income households have always been the main targets of the charitable-contribution deduction. It is a policy that is essentially, and not accidentally, elitist.

The deduction’s drafters intended the deduction to reach such results. The contribution deduction was created to preserve voluntary giving to public goods by rich industrialists who had made their fortunes in business. Postbellum United States philanthropy did not begin as a response to tax policy; indeed, the great foundations of Carnegie and Rockefeller predated the Sixteenth Amendment entirely. Lawmakers saw such philanthropists as a source of social capital that should be protected from high tax rates on high incomes, lest the government find itself having to pay for programs philanthropy had previously funded voluntarily.

In 1913, the same year Rockefeller chartered his foundation, the Congress initiated the first modern income tax. In the first years of the income tax, fewer than 1 percent of households were subject to it, and it had rates no higher than 15 percent. However, in 1917 the top rate was abruptly raised to 67 percent to pay for the First World War.

The 1917 tax act added a deduction for gifts to charitable organizations to go with these high rates, not to encourage the wealthy to give their fortunes away (which the most influential and richest men were already doing), but to not discourage their continued giving in light of a larger tax bill. Senator Henry F. Hollis of New Hampshire—who was also a regent of the nonprofit Smithsonian Institution—worried that reduced after-tax income of the very rich would end their philanthropy, shifting burdens the philanthropists had been carrying onto the backs of a wartime government. As Hollis explained,

Usually people contribute to charities and educational objects out of their surplus. After they have done everything else they want to do . . . if they have something left over, they will contribute it to a college or to the Red Cross or for some scientific purpose. Now, when war comes and we impose these very heavy taxes on incomes, that will be the first place where the wealthy men will be tempted to economize, namely, in donations to charity. They will say, “Charity begins at home.” . . .  Look at it this way: For every dollar that a man contributes for these specific charities . . . the public gets 100 percent. . . . If it were undertaken to support such institutions through the Federal Government or local governments and the taxes were imposed for the amount . . . [i]nstead of getting the full amount they would get a third or a quarter or a fifth.

Hollis’s amendment to make charitable contributions deductible was accepted unanimously and without controversy.

This justification—that the deduction saved the government money in avoided spending, rather than costing it money in foregone tax revenue—persisted for decades. Consistent with Hollis’s policy justification, a 1938 House report claimed that

the exemption from taxation of money or property devoted to charitable or other purposes is based upon the theory that the Government is compensated for the loss of revenue by its relief from financial burden which would otherwise have to be met by appropriations from public funds, and by the benefits resulting from the promotion of the general welfare.

After the Second World War, wealthy, high-income industrialists discovered that under steep postwar tax rates, they were better off giving away their wealth than consuming it directly. This incentive precipitated a surge in charitable giving and foundation establishment that transformed the civil society of the United States and eventually led to new regulation of the nonprofit sector.

The reason for this giving surge is relatively simple: gifts of corporate stock are deductible at the fair market value of the shares at the time of the donation. And because the shares are not sold by the donor, that donor avoids paying any capital-gains tax, in addition to deducting the full value of the shares from their taxable income. Because gifts of stock avoid two taxes, it is arithmetically possible for such gifts to leave the donor with more money in hand than would result if he or she sold the stock and paid the taxes.

When the US Congress raised income-tax rates in the mid-twentieth century, it created exactly this situation. The richest American families avoided more in taxation by giving their fortunes to a foundation than they would have received in proceeds for selling shares of stock. Foundations flourished.

Historical Price of Giving

The graph linked to above plots the tax price of donating stock for various high-income tax brackets and capital-gains ratios over the period 1917–2016. During the First World War and for several years following the Second World War, wealthy industrialists with large unrealized capital gains facing the very highest tax rates were better off donating shares than selling them, even if they had no interest in philanthropy. Taxpayers with higher cost basis in their stock wealth or with taxable incomes not quite in the highest tax bracket may not have been literally better off making a donation in each of these years, but they nevertheless surrendered very little after-tax income by making a donation relative to selling their stock. As one philanthropist later told anthropologist Teresa Odendahl,

[Taxes] were extremely important because I could give away securities and end up with the same amount of money, after tax, as if I sold them. And if I gave them away, they went where I wanted. If I sold them, they went to the U.S. Government.

Beyond tax benefits, the wealthy also discovered that with a bit of advance planning, they could give their corporate shares away while continuing to receive important benefits from their companies. Before 1969, there were few checks on the governance of family foundations or their handling of shareholder power. Foundations presented an appealing way to have the benefit of selling shares without losing control of the business. A family foundation holding shares of stock, which voted those shares as a bloc, could maintain family control of a firm, however much the heirs to the dynasty may have squabbled at the foundation’s board meetings. Even better, family foundations could pay family members generous salaries to direct and manage the foundation, allowing them to continue to benefit from the profits redounding to the foundation’s stockholding.

There is significant evidence that business founders chose the foundation vehicle over this period for these reasons of tax reduction and corporate control. A 1982 survey found that half of the largest foundations established in 1940–1969 were begun with a gift of stock large enough to control a firm, and that founders rated tax motivations as an important factor. This was true for few foundations established before 1939, when the wealthy would not have been better off giving than selling their shareholdings.

Ultimately, the incentives in the federal tax code attracted the attention and then the outrage of the US Congress. Individual lawmakers began to question whether donations really saved the government spending on social services, or whether abuse of the foundation vehicle was instead eroding the tax base, costing the Treasury money, and undermining the public interest. Large charitable foundations were investigated by Congressional committees.

The controversy culminated in the passage of the Tax Reform Act of 1969, which increased oversight of nonprofits in general and foundations in particular. The law increased the public’s access to charities’ IRS filings, required more detailed disclosure and documentation of charitable contributions on individual returns, and imposed payout requirements and conflict-of-interest rules on foundations. The 1969 law also came close to eliminating the favorable treatment for the entrepreneurially wealthy’s gifts of appreciated stock. Several drafts of the bill taxed the capital gain on any appreciated property donated, though the final version left this rule intact.

Despite these reforms, the 1969 act did not fundamentally change the workings of the contribution deduction. Nevertheless, the act marked a shift from the long-standing perspective that the deduction saved the Treasury money by protecting philanthropic contributions to social goods, to a more skeptical perspective that the deduction was an implicit cost that must be justified by its benefits.

This shift would not be fully realized until the Reagan era radically reoriented fiscal politics. Ronald Reagan assumed office in 1981 with a message that synthesized calls for renewed charitable and voluntary activity with a high priority on reduced marginal tax rates and a simplified tax code. The dramatic 1981 and 1986 tax rate reductions eliminated the supercharged incentives for giving by the entrepreneurially wealthy. The same philanthropist who told Teresa Odendahl that “I could give away securities and end up with the same amount of money, after tax, as if I sold them” remarked after 1986 that “the laws have changed so it is not so advantageous to give away securities rather than selling them.” Households in the top 0.1 percent of the income distribution reduced the share of income they donated by half from 1980 to 1990, concurrent with the reduced value of the deduction over that period.

Although Rockefeller, Carnegie, and other industrialists-turned-philanthropists invented the modern conception of philanthropy, they were not motivated by taxation. Instead, their giving inspired the contribution tax deduction, which in turn shaped the growth and transformation of giving behavior in subsequent decades. This pattern continues: though Tax Policy Center predicts the 2017 tax reform will reduce the share of US households who can take advantage of the itemized deduction from about one-third of all households to about one-tenth, within that tenth virtually all high-income households will, as they have since 1917, continue to receive a subsidy for giving.

-Nicolas J. Duquette

Nicolas J. Duquette is assistant professor at the USC Sol Price School of Public Policy in Los Angeles, California. He received a bachelor’s degree in economics from Dartmouth College, and a doctorate in economics from the University of Michigan. His research explores the connections between public policy and the nonprofit sector in historical perspective.