Hodge Doubles Down on Taxing Exempt Organizations

Did you get a chance to read the Tax Foundation Report asserting that we should tax more exempt entities? In fact, the report concludes we should tax most exempt entities. Lloyd blogged about it last week.  I did not bother reading the report until I noticed the author, Scott Hodge, doubling down in a WSJ opinion last Thursday:  

America’s largest tax-exempt nonprofit, Kaiser Permanente, generated more than $110 billion in revenue and $5.6 billion in net income in 2019 between its hospital, insurance and state health plans. Of the $2.5 trillion in revenue generated by 501(c)(3) organizations in 2019, nearly $1.4 trillion, or 55%, went to hospitals and health insurers. They netted more than $60 billion in profit that went untaxed.

The second-largest tax-exempt sector is higher education, with more than $294 billion in revenue and $22 billion in net income in 2019. There were 51 private universities that reported more than $1 billion in revenue in 2019. Only 19% of university income comes from charitable donations.

Should an organization be considered “nonprofit” when most of its income comes from sources that resemble business transactions? Should investment income accrue largely tax-free for the 800 university-related endowments, foundations, real-estate holding companies and fundraising entities that collected nearly $27 billion in 2019 and held almost $210 billion in assets? Is the $1.1 billion per year in tax-free income the National College Athletic Association generates from broadcast rights and corporate sponsorships justified while college athletes pay income tax on their earnings?

Subjecting tax-exempt organizations’ business-like profits to the 21% corporate rate could generate nearly $40 billion each year. Washington should reform nonprofit tax laws by imposing principled distinctions between charities and commercial enterprises.

I tell you, I was really ready to give that guy a piece of my mind after I saw that piece.  Until I pretty much lost all the arguments I was having with him in my head as I read the report.  His basic point is that donations to exempt organizations should be tax exempt but all trade or business revenue, related or not, should be taxed.  Plain and simple.  He gives too justifications, one plausible one not.  The first is increasing tax revenues and lessening the tax burden on the rest of us.  Presumably he doesn't include the increased cost of public welfare, defined broadly, in the calculus.  But $40 billion ain't chump change. The second is "unfair competition," an accusation that most economists don't even buy anymore.  That exemption provides a competitive advantage.  Whatever advantage tax exemption provides is most certainly outweighed by charitable fiduciaries' lack of profit motive, it seems to me. Cutting off the hope of profit severely disadvantages charities if what they are really doing is competing in the market place.  The premise underlying the unfair competition fear that underlies UBIT is faulty because charities aren't really competing.  

Anyway, the full report doesn't limit the proposal to hospitals or universities.  Hodge means to tax bake sales and team car washes. Its almost un-American but there was something familiar about the basic theory.  And then I remembered Mark Hall and John Colombo's article on the "Donative Theory of Tax Exemption."  They wrote the article way back in 1991 and I have always thought of it as one of the best ever on why we [should] exempt charities from tax.  Their article is a sophisticated and much more thorough prequel to the Tax Foundation report.  My recollection is that Hall and Colombo support the conclusion that tax exemption should be reserved solely for "donative organizations," and that organizations engaging in a trade or business, even to an insubstantial extent, should be taxed regardless of whether the business is related. I don't remember them explicitly asserting the latter point but it flows from their donative theory.  Limiting tax exemption solely for donations is not a bad idea if the market effectively provides public goods.

Hansmann might have something to say about this. But first, Hodge might assert that the presence of such a vibrant market generating so much revenue means that there is no market failure to justify tax exemption. The presence of so much supply and demand indicates the market is working, not failing. In tax exemption, according to Hansmann, market failure results from free-riding and the donor/consumer's inability to verify that she got what she paid for.  If I donate to NPR to support a favorite program, non-contributors share in the outcome. The public good cannot be dispensed on an individual basis because I can listen to NPR even if I didn't contribute. If I donate to the International Red Cross for disaster relief somewhere overseas, I don't know if my donation is even used for that purpose.  In either case, "consumers" might not patronize nonprofits providing those pubic goods; its rational to let somebody else pay for the public good.  But Hodge might assert that in today's technologically based economy consumers can always know whether they are getting what they pay for and that hospitals and universities are not impacted by free-ridership or the unverifiability of outcomes.  

So I am not sure market failure exists for students or patients. They can know, especially with the help of all sorts of state and federal laws, whether they are getting what they pay for. But those are not the only "consumers," Hansmann might retort.  Others include donors who are funding a new academic program or think tank within the university.  Those "consumers" are unable to know whether they get what they pay for or to ensure that what they pay for is not shared with others who contribute nothing.  Tax exemption conditioned on compliance with the "non-distribution constraint," eliminates one source of possible diversion, according to Hansmann.  For that reason tax exemption is efficient. Hansmann might also point to the chicken and egg problem.  He could assert that the presence of the market results from tax exemption, it doesn't prove tax exemption is unnecessary or inefficient. In other words, tax exemption conditioned on the non-distribution constraint is the necessary precursor of the market that Hodge now asserts is proof that tax exemption is unnecessary.  Without tax exemption the market would not exist because consumers would fear free-riding and unverifiable results. 

Thus the counter-point is that the vibrant "program service revenue" market that Hodge points to as evidence that exemption is unwarranted might not have existed but for tax exemption. I am not sure I buy the argument, but it cannot be as easily dismissed as Hodge's report suggests.

darryll k. jones