Giving is getting very taxing

November 21, 1997

Just as students, parents and institutions received over $40 billion in tax aid, American colleges and universities are again facing major challenges as they confront significant demands to restructure and simplify the tax code.

This is precisely the wrong time to reduce the traditional tax support for colleges and universities. As Congress once again ponders replacing existing income tax, it must consider that variations on the flat tax, VAT and a national sales tax would eliminate incentives for charitable giving and tax-exempt financing. Enacting any of these proposals would have a grave impact on higher education.

The success of the American model in marshalling private generosity to foster public programmes is nowhere more evident than in our colleges and universities. They are a key resource for ensuring long-term economic growth and international competitiveness. Equally important, higher education broadens the base of individuals who benefit from the economic prosperity it helps create.

In recognition of the benefits they provide, colleges and universities have long enjoyed favourable tax status. This treatment is deeply rooted in our common law tradition and has played a critical role in developing higher education. Exemption from tax is the central element in the treatment of charitable and educational organisations. Taxpayers who itemise deductions are permitted, within broad limits, to deduct charitable contributions. Similar deductions are provided for corporations and estates.

In contrast, several of the tax restructuring proposals being discussed would remove these incentives. The most widely discussed flat-tax proposals would eliminate the charitable deduction in the interest of broadening the tax base to achieve the lowest possible tax rate. Even if Congress enacted a flat tax that retained a deduction for charitable giving, the value of the deduction for charities would be greatly reduced. Similarly, a shift to a national sales tax or VAT would necessarily eliminate the deduction, since under both systems tax is imposed on transactions rather than on aggregate annual consumption expenditures.

In 1996, voluntary contributions to higher education reached over $14 billion. For some people, the decision to give may grow out of a conscious recognition that an institution played a critical role in setting the course of his or her life; others give because they believe that support for education is an investment in the future; still others may give because they have fond college memories.

The current deduction lowers the after-tax price of giving for a top-bracket taxpayer by roughly 40 per cent. Taxpayers in lower brackets benefit from a smaller reduction. Eliminating the deduction would substantially increase the real cost of charitable giving for taxpayers who itemise their deductions.

Some proponents of structural tax reform suggest that the negative price effect of eliminating the charitable deduction would be largely, or even entirely, offset by a countervailing "income effect". Empirical studies reveal that donors increase the amount they give when they have more income. Some proponents of reform argue that structural tax reform will trigger economic growth and increase incomes to a point where the income effect will prevent the level of charitable giving from dropping.

A large share of gifts is made by taxpayers in higher brackets who receive the largest incentives to give under the current system. Colleges and universities would be disproportionately hard hit by eliminating the deduction.

Congress also needs to understand the direct impact that a reduction in giving to higher education would have on students struggling to pay for their education. America's colleges and universities share a commitment to subsidising the costs of education for those who cannot afford to pay regular tuition fees. Largely because of that commitment, higher educational institutions are able to serve students of widely varying economic means. Universities are under considerable financial stress as costs continue to rise. It is obvious that any drop in private giving would translate into fewer funds for scholarship aid and reduced access to higher education for America's young people.

The third important tax benefit is access to tax-exempt financing. By allowing purchasers of bonds issued on behalf of nonprofit educational organisations to exclude the interest they receive from their taxable income, the tax system enables colleges to borrow at rates between 1.5 and 2.0 percentage points lower than taxable rate. This has a significant impact on borrowing costs. For example a university that issued a 30-year tax-exempt bond for $10 million would pay $4.9 million more in interest if the bond were taxable.

Tax-exempt bonds to finance major capital expenditures are particularly important because of the large and costly physical plant required for education and research activities. A recent study estimates the capital needs of American colleges and universities for new construction and essential maintenance of existing facilities at $60 billion. Lack of capital funding means many face a major deferred maintenance problem. This is exacerbated by continuing reductions in direct support from the federal government.

Most flat-tax proposals explicitly exempt interest income from tax, and thus would eliminate the preferred status of college and university bonds, forcing them to pay the same interest rate as regular corporate bonds. Some proponents of tax restructuring argue that shifting to a consumption-based tax will increase savings and cause interest rates to drop, so that charities and local governments will not see a rise in their borrowing costs. But the impact of tax restructuring on general interest rates is far too uncertain to support the conclusion that elimination of tax exemption financing will not have a major adverse impact on colleges' and universities' ability to finance essential physical plans. A VAT or a sales tax would also erase the distinction between taxable and tax-exempt bonds.

If Congress chooses to enact a flat tax or a business transaction tax, serious thought needs to be given to how higher education - as well as other charities and state and local governments - will be given access to affordable credit.

With acknowledged dependence of American higher education on deductibility of contributions and tax-exempt financing to provide a quality education, it is imperative that the future administration and Congress make appropriately conservative assumptions about increased economic growth when assessing the implications of tax restructuring proposals on colleges and universities.

Sheldon Steinbach is vice president of the American Council on Education.

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