There has been much discussion about the fiscal cliff, which in a nutshell is a combination of spending cuts and tax increases that are set to take effect when the calendar clicks over to 2013. The tax increases come about from the expiration of tax measures such as the 2001/2003 Bush tax cuts and provisions under the 2009 stimulus. The spending cuts largely will come about as a result of the debt ceiling compromise, which mandates a 7.6 to 9.6 percent across-the-board cut in all discretionary spending (except programs for low-income Americans) and is divided between defense and non-defense spending. The spending cuts and tax increases collectively comprise about 4 percent of GDP, which could throw the U.S. economy into a tailspin. (Note: check out this article for more information on these facts as well as additional information on the fiscal cliff.)
In order to avoid this result, the Obama administration and Congress have been looking for alternatives in terms of taxes and spending—and several approaches would raise revenue by limiting deductions or other benefits that the tax code currently gives certain taxpayers. One such deduction is the charitable deduction, which allows taxpayers to reduce their taxable income (and resulting tax bill) when they make contributions to charitable organizations. Currently, that deduction gives a tax benefit at a taxpayer’s marginal rate—meaning that a taxpayer in the 35 percent tax bracket will save 35 cents for every dollar given to charity, a taxpayer in the 28 percent bracket will save 28 cents, and so on (subject to any other restrictions, such as the alternative minimum tax and adjusted gross income limitations).
One approach floated by some Republications is to cap total itemized deductions at a certain amount ($25,000 and $50,000 are two such amounts that have been discussed). Itemized deductions include the charitable deduction as well as other well-known deductions such as mortgage interest, medical expenses, casualty/theft losses, and state and local taxes. This approach contemplates that taxpayers would have a “bucket” of deductions that they can choose to take, up to a certain point—regardless of the taxpayers’ overall income. However, critics of this approach point out that it could reduce charitable giving, because many taxpayers will use up their allotted deduction amount on non-discretionary items like state and local taxes.
The approach presented by President Obama is to limit deductions to a certain percentage. In other words, deductions would be “decoupled” from the top tax rate, and higher-income individuals would no longer get a tax benefit at their marginal rate if they are in higher income brackets. Obama first presented a 28 percent limitation for all itemized deductions, but has since changed that to 35 percent (the highest bracket under the current tax code) for charitable deductions, with the 28 percent limitation in place for other itemized deductions like mortgage interest. However, he also has proposed raising the top income tax rate to 39.6 percent, so this would mean that taxpayers in that bracket would save 35 cents for every dollar given to charity (as opposed to 39.6 cents).
Of course, there is a tremendous difference of opinion on the effect such changes would have to charitable contributions, and the charitable sector overall. For an interesting point-counterpoint on the topic, check out this recent Wall Street Journal article. In advocating for a percentage limitation (as opposed to a dollar-cap proposal), the White House cited a National Economic Council report estimating that a $50,000 cap would reduce charitable giving by about $150 billion over 10 years. Yet all arguments that charitable giving will drastically drop due to limitations on the deduction assume that such giving is largely dependent on the associated tax benefit, but not everyone agrees that is the case. Donors can give for a variety of reasons, and many may continue to do so regardless of the availability of related tax benefits.
The bottom line is that the charitable deduction is very much in play as budget talks continue, and nonprofits need to stay in front of the issue, whether that is by advocating for the continued existence of the deduction, informing their donors on the status of current proposals or legislative changes, or just making sure they themselves understand the potential implications of changes in this area.