The IRS 501(c)(4) Exposes Broader Flaws at the Heart of the U.S. Tax System

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.