The Distortionary Effects of Subsidies for Charity in a Federal System

Prevailing accounts of the efficiency of subsidies for the nonprofit sector presume that the only alternative source of public goods is a single sovereign, controlled by a single median voter. Tiebout sorting, however, also provides citizens with alternative bundles of public goods. When these two systems are in place simultaneously, they may interact. We present a model in which subsidies may affect not only the choice between nonprofit and government, but also the choice among governments. Because nonprofits allow citizens to obtain alternative bundles of public goods without relocation, subsidies for the nonprofit sector alter incentives to relocate. We show that this distortion in the market for local government may either increase or decrease welfare, depending on the nature and geographical scope of the good provided. As a result, for some goods it is ambiguous whether subsidies for charity on net increase social welfare. We also consider extensions involving simultaneous provision of similar goods of differing quality. JEL Codes: H11, H77, K29, K34, L33 Economic accounts of the nonprofit sector have to date largely neglected its relationship to sub-national governments. In the standard model developed by Burton Weisbrod (1975), and elaborated on by Hochman and Rodgers (1986), Hall and Colombo (1995), and Rose-Ackerman (1996), subsidies for charity allow for the production of public goods beyond those preferred by the median voter. This “supra-median demand” theory, as we will call it, assumes that voters have no alternative government to which they could turn for production of their preferred good. That assumption is obviously untrue in a federation, at least as to goods that could plausibly be produced by sub-national governments.1 Indeed, under perfect Tiebout sorting there is no gap between supply of and demand for public goods. Weisbrod acknowledges this counter-argument, but dismisses it in one sentence with the assertion that frictions on relocation will always leave some residual unmet demand. (1975:178) But the presence of frictions does not absolutely foreclose relocation as a means for satisfying demand for a public good that is unmet locally; frictions merely increase the cost of obtaining any given good. Thus, in a federated system relocation and charitable formation stand side by side as alternative, and potentially competing, mechanisms for satisfying supra-median demand in any given sub-national jurisdiction. Other commentators have observed that private associations may compete with local governments to provide public or club goods. For example, Ellickson (1982) identifies residential associations as potential substitutes for local government. There is also a substantial empirical literature devoted to measuring the extent to which expenditures in one sector may crowd out expenditures by the other, co-located, sector. (See, e.g., Becker & Lindsay (1994), Gruber & Hungerman (2007), Cheung (2008)). There has not yet been any examination, however, into whether the possibility of private substitutes affects agents’ choice of jurisdiction, nor into whether any such effects are normatively desirable. In particular, in the United States many forms of charitable enterprise are tax-favored through the deduction for contributions to eligible entities. (I.R.C. §§ 170, 501(c)(3)). If subsidies create significant inefficiencies in the market for providers of public goods, that might offer reasons to reevaluate, or at a minimum to consider redesign of, the legal regime providing subsidies for charitable formation. The model developed here suggests that, in fact, subsidies for charity distort the market for local government. As noted, there is substantial evidence that a subsidy for charity affects a consumer’s choice between charity and government. More surprising is the possibility that subsidies for charity may alter a consumer’s choice between two rival governments. Because charitable production can substitute for government production, a consumer who is unhappy with the level or quality of public goods in jurisdiction one need not move, as Tiebout predicts; she can instead remain and supplement the inadequate government production with private charity. Subsidies exaggerate this effect by increasing the likelihood that charitable production will be cheaper than relocation.2 Whether these distortions reduce welfare depends on the nature of the particular public good to be produced by a given charity. Welfare is most likely to be reduced in the case in which production of the public good also produces some negative externality, and that externality could be mitigated if the site for production of the good were moved elsewhere. The predictions of the model are also sensitive to how the purposes of the subsidy for charity are specified. Weisbrod assumes that subsidies are intended to satisfy unmet demand for quantity: to open an opera house where none stands. Others assume that a subsidy intended to spur increased quality operates identically. (E.g., Gruber 2010). But competition over quality implies that there is some possibility for crowd-out in either direction. Once crowd-out is taken into account, the model predicts a lower likelihood that subsidies will reduce welfare. These predictions have potential implications for the design and implementation of any nonprofit-sector subsidies. First, the crowd-out result implies that encouraging competition over quality between private associations and government might be a more desirable goal for the subsidy than the more expansive traditional view.3 Also, given that some but not all organizations will face crowd-out, the model provides an additional reason to provide for multiple tiers of subsidy, rather than simply tying the subsidy to the donor’s marginal tax rate, as is the case under present law. (I.R.C. § 170). Several other implications are developed at length elsewhere. (Galle 2010, 2011).