Published on March 20th, 2014 | by Kimberley Scharf0
Do Tax Reliefs Encourage Charitable Giving?
Late last year, the National Audit Office criticised the lack of evidence on whether tax reliefs encourage giving. I would like to discuss how policymakers and the charitable sector can answer this important question.
One of the key functions of tax reliefs is to encourage certain behaviours that are deemed desirable – such as charitable giving. Indeed, most developed countries offer tax relief for charitable contributions. The US has a tax deduction system, while a tax credit system is in place in Canada. Here in the UK there is Gift Aid, a two-part tax relief consisting of a match and rebate.
Tax reliefs are however costly for governments, since every £1 offered in the form of a relief is £1 less in the Treasury’s purse. Due to this, there is public interest in understanding whether or not reliefs are effective. When economists assess the effectiveness of tax reliefs, they focus on answering two key questions:
- First, are these tax reliefs successful at encouraging giving?
- Second, are they effective in comparison with alternative instruments – subsidies, for example – that could be used to accomplish the same objectives?
The answers to these questions depend crucially upon how donors respond to tax incentives – do they increase their donations? Decrease them? Leave them unaltered?
For an economist, the process of evaluating responses begins by understanding donor behaviour. Economists think of donors as people buying something, and these purchase decisions are based on two factors:
- Prices – ‘how much does it cost’; and
- Availability – ‘how much of it do I already have’.
People’s choices about where to spend their money can alter when these factors change. Government policies can affect both sides of a donor’s calculation, by affecting the ‘price of giving’ as well as the availability of public goods and services. So how donors respond to these changes on both sides will enable us to evaluate the effectiveness of tax reliefs on giving.
The ‘price of giving’ is the private opportunity cost to a donor of inducing a £1 increase in a charity’s budget. For example, in the case of Gift Aid, a basic rate taxpayer who makes a £1 donation to charity out of after-tax income delivers £1.25 to a charity; this means that Gift Aid reduces the price of giving from 1 to 1/1.25, or, 80p to the pound.
Once the effect on the price of giving of a particular tax relief has been calculated in this way, empirical evidence can be gathered and used to obtain an estimate of the ‘price elasticity of giving’, which measures how private donations actually change in response to changes in the price of giving. As an example, a price elasticity of giving equal to –1 means that a 1% decline in the price of giving leads to a 1% increase in contributions.
Armed with some estimates of the price elasticity of giving, we can then tackle the questions we set out above using what is known as the ‘unit elasticity rule’. This says that tax incentives for giving are budget-efficient if the price elasticity of giving is equal to or larger than one in absolute value, ie if £1 of foregone revenue spent on tax incentives generates at least £1 in additional contributions.
As I mentioned before, however, donors’ responses need to be assessed not only in relation to price, but also to availability. Availability is relevant because if those revenues foregone through tax incentives are instead spent directly by government or given directly to charities, they might ‘crowd-out’ private giving by reducing the perceived need for donations. In other words, the ‘crowd-out’ effect of direct spending can make tax incentives worthwhile even when its effect on donations is comparatively modest.
There are a number of other considerations that might come into play in assessing the desirability of tax reliefs for giving, including donors’ responses. Unfortunately in the case of the UK, donors’ responses have not been extensively studied – there are hardly any available estimates of donors’ responses, and some of those are considerably out-of-date. UK charities and policymakers should make gathering such evidence a priority.
An extended version of this article first appeared in the February 2014 edition of Finance Focus, the monthly members’ magazine of the Charity Finance Group (CFG)