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People are Drawing the Wrong Lesson from the IRS 501(c)(4) Scandal: We Need to Rethink the Whole Concept of Tax-Exempt Organizations

President Obama is shocked and angered that the IRS targeted certain conservative organizations for special scrutiny when they applied for 501(c)(4) tax exemptions as “social welfare” organizations. Republicans are just as shocked. The whole Washington political establishment is shocked, just shocked, that anyone, let alone the IRS, would try to stem the flow of political money that pours through this gaping loophole in the federal tax system.

The campaign finance reform organization Democracy 21 has tirelessly documented abuse of the 504(c)(4) loophole by political organizations. Its president, Fred Wertheimer, is quick to agree that the IRS was wrong to single out Tea Party affiliated organizations for scrutiny. However, Wertheimer does not suggest that the IRS should evenhandedly rubber stamp all 501(c)(4) applications. Instead, he argues that it should aggressively clamp down on loophole abusers of the right, left, and center. His list of targets includes Carl Rove’s Crossroads GPS, the pro-Obama group Priorities USA, and Americans Elect, an organization that sought to run an independent candidate for president in 2012.

There seems to be an informal premise, supported by past practice of the IRS, that a self-proclaimed social welfare organization is abusing its tax status if it spends more than half of its budget on overtly political activities. As Wertheimer points out, the IRS does not enforce even this generous limit. Many 501(c)(4)s cross the 50 percent line with impunity, and some have even registered as political parties. However, as he recently told the Washington Post’s Dylan Mathews,  the 50 percent limit, even if strictly enforced, is already too generous. According to the relevant statute, it should be zero.

Although I applaud Wertheimer’s efforts to get the IRS to obey the law, I think his focus is far too narrow. The 501(c)(4) “social welfare” designation is only one of many tax exemptions that needs a rethink. The IRS code includes more than two dozen types of 501(c) organizations,  ranging from credit unions to insurance companies, that qualify for various kinds of tax privileges.

The 501(c)(4) social welfare groups that are at the center of the current IRS scandal are sometimes lumped together with their close cousins, 501(c)(3) charitable organizations. They share some tax privileges such as not having to pay tax on income they earn and exemption from gift taxes. In other ways they differ. The big draw of 501(c)(3) status is the right of donors to deduct contributions from their federal income taxes.  The main attraction of 501(c)(4) groups, instead, seems to be their right not to reveal the identity of their donors. For some donors, anonymity is apparently even more valuable than a tax deduction.

In a two part series last year [1] [2], I argued that we should eliminate the tax deductibility of contributions to 501(c)(3)s. These are the main points I made, many of which apply to 501(c)s of all varieties:

  • The ostensible justifications for 501(c) tax exemptions are “social welfare” and “charity.” However, these organizations are not exclusively devoted to such goals. Even for 501(c)(3)s, no more than a third of tax-advantaged spending goes to real charity, if we use that term according to its dictionary meaning of “generous actions or donations to aid the poor, ill, or helpless.” For other 501(c)s, charity and social welfare is often even more incidental to their main activities.
  • Even the full tax deductiblity of 501(c)(3) contributions does little to increase overall giving. That conclusion finds support both in statistical evidence and in the effects of past tax law changes that have sharply cut the economic value of the deduction with little if any impact on total giving. The idea that we would get insufficient political giving without tax privileges for 501(c)(4)s is even less credible.
  • All tax exempions are costly to the federal budget. That is why economists refer to them as “tax expenditures.” Just for 501(c)(3) organizations, each $1 of truly charitable spending induced by the tax exemption costs the budget from $3 to $4.5o, depending on the estimate. If we included tax losses from exemptions for all the 501(c)s, the ratio would look even worse.
  • In any event, tax-deductible giving is only a small part of what makes Americans the most generous people in the world. Much of that distinction comes from our willingness to help both neighbors and strangers on a one-to-one basis and to volunteer our time, not our money, to charitable organizations. The same goes for politics. It is unlikely that an end to the tax privileges and anonymity provided by 501(c)(4)s would fatally damage the democratic process or the willingness of people to give time and money to political causes they believe in.

Progressives and conservatives should be able to agree, although for different reasons, that we should eliminate 501(c)s of all kinds.

Progressives tend to have faith in the ability of government to promote social welfare and help the less fortunate. Accordingly, they should be willing to support a reform package that closed tax loopholes, left tax rates unchanged, and spent the resulting increase in revenue on expansion of social welfare programs.

Conservatives tend to think that reducing tax rates is an important policy goal in itself, and to think that the private initiatives do a better job than government in helping the poor and undertaking other civic initiatives. Accordingly, they should be willing to support a package that eliminated tax preferences, used the resulting gain in revenue to reduce marginal tax rates, and left social welfare to the private sector.

In a rational world, progressives, conservatives, and centrists would be able to craft a tax reform compromise that did a little of each of the above and left us all better off.

The bottom line: The scandal over the apparent political bias in the IRS treatment of 501(c)(4) groups is nothing compared to the broader scandal of a tax system that is corrupt and inefficient at every turn. We need to attack the code with an axe. In doing so, we should not to flinch at chopping off the 501(c)s with all their rotten branches.

10 Responses to “People are Drawing the Wrong Lesson from the IRS 501(c)(4) Scandal: We Need to Rethink the Whole Concept of Tax-Exempt Organizations”

Cam PayneMay 20th, 2013 at 4:10 pm

Abuse of non-profits is rampant, egregious and should be stopped for all the reasons you mention in your excellent article !

Ideas: A whistle-blower website with real security to protect the whistle-blower. After vetting by the CBO, these would be posted online as non-profits suspected of committing fraud or other illegal activities (including tax evasion). The potential charge (complaint) would be posted as well.

Jardinero1May 20th, 2013 at 11:26 pm

Every corporation whether profit seeking or charitable in nature spends, invests or distributes every dime that flows through it. Thus, I have always thought that taxing corporations was a waste of administrative resources on the part of the taxing authority. Furthermore, corporate taxation generates comparatively little revenue whilst creating enormous cost of compliance expense for corporations. It would be far better to abandon corporate taxation, altogether; and tax personal income and consumption more. The money is more easily taxed where it earned by individuals or spent spent by individuals.

Part time CFOMay 21st, 2013 at 4:38 am

Said this, you only mean to increase the burden of taxation on the public and salaried individuals along with the businessmen and High Class People, rather government should take steps to strict the rules and close the loop holes from where the organizations tend to save tax that is to be paid by them.

MikeMay 21st, 2013 at 8:47 am

This entire scandal is not about changing the law but rather an abuse of power by the Obama Administration. Your comments merely fall in line with those who choose to abuse that power. Picking sides in this situation or coming up with other "committee" recommendations will not even tough this issue. Most Americans know what happened here.

EdDolanMay 21st, 2013 at 10:06 am

I agree with Jardinero1 in this exchange. Corporations as corporations cannot bear any of the economic burden of a tax; only their stakeholders can do so. It is true, there is a long controversy in economics as to how the burden of the corporate tax is split among workers, customers, shareholders, suppliers, executives, and so on, but the corporation as such bears no burden. It would be better to scrap the corporate tax and replace it with more transparent and targeted taxes.

However, PT CFO is right that as long as we are stuck with the corporate tax, it would be better to close the loopholes and lower the marginal rate, so that all corporations paid closer to the same tax.

evodevoMay 21st, 2013 at 10:08 am

Oh, really? Where were you and your protestations when the Bushies were doing the same thing, only to black and Democratic organizations? Hmmmm ??

llisa2u2May 21st, 2013 at 10:59 am

Unfortunately the political interference is confusing the basic issue of a probing process by the IRS. The IRS probing process may have been initiated because of political influences also. HOWEVER, the basic issue of intent of organizations to form as a 501c is the real issue. If the intent is to disguise and hide funds etc. then the IRS needs to probe the organization. Otherwise, the IRS staff is not doing their job. Political interference issues aside, another basic issue is the whole concept of philanthropy and charity. With a superficial read of the percentage of real funds that are actually distributed to anybody in real need, it is easy to determine and to conclude that very few funds are finally distributed to needy folks. Most of the funds are paid in salaries, expenses, and administrative activities, especially fundraisers for the promoted "cause". So really a lot of funds are really going to all the partygoers. But bottomline, that's what both the leadership of the Democratic Party, Republican Party, and all the other parties really want. They really don't want any funds going to anyone who isn't drinking from the same teapot. Well, when the teapot is really empty, then maybe those partiers will start to remember why there was a party. Of course, by then, it's gonna be too late. Hey, it's too late already. Right now it's just a free falling scenario. So all the partiers that seem to have an issue about the issues they keep using to divert every one else's time, focus and money, should just start DONATING and VOLUNTEERING. Then, there might be more money for everyone else to start using effectively for real causes, oh! and real community policies, community development and real community/state issue problem solving……

o2generateMay 22nd, 2013 at 2:27 am

I hold the notion that all businesses (small, one-person, to General Electric-sizes) should be taxed as a percentage of gross revenues, and the amount of gross revenues only. Tax tables would be somewhat complicated (similar to the arcane tables the ICC used for shipping rates in the old days). High volume, thin margin businesses such as grocery stores would get a much lower rate (according to the tables) because it is recognized that margins are small for such business, while hedge funds and derivative-traders would have a much higher tax rate on their gross revenues, in the same sense that taxes do some "social engineering" and steer people toward behavior that benefits the country as a whole. Arguing with the IRS over which classification your business fell into, rather than searching through dozens of feet of shelved taxation code for a business such as GE, would certainly reduce valuable manpower now employed in the tax "game".
The age of the enterprise (new businesses getting a reduced rate) would also figure into the equation. But let the economic facts of facility depreciation, cost of equipment, aircraft purchases for the movement of executives, remain outside of tax considerations.

ThomasGrennesMay 22nd, 2013 at 12:18 pm

It is the 100th anniversary of the Federal Income Tax, and it is time to rethink rules for tax-exempt organizations and to make fundamental reforms of the Corporate Income Tax and the Individual Income Tax. They would all be improved by drastically reducing exemptions (loopholes) and lowering marginal tax rates. Over the last century,
Congress has created a fiscal monster that is one more example of the decline in the quality of fiscal policy in the United States.

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