Generally speaking, a charitable donation by a business enables it a deduction from taxable income equal to the fair value of the donated item less whatever ordinary income would have been gained on the item. In other words, the general rule is that donations of inventory only permit a deduction equal to their cost. However, some provisions have been enacted that provide “enhanced” deductions for certain donations. Under IRC section 170(e)(3), a business that donates items that are put to use by a charity or operating foundation to help the needy (e.g., food, clothing, medicines) is eligible for deduction not equal to cost but instead the lesser of (i) twice cost or (ii) the midpoint between cost and market value. Over the years, this provision has been expanded (and contracted) to include different types of business entities, different types of donations, and different types of donees. These enhanced deduction provisions have some notable effects:
- They can increase corporate donations. As an example, if a company has excess clothing inventory, there is a clear incentive to give it away. Say shirts priced at $10 that only cost $4 to produce go unsold. If they are donated to charity, the decrease in taxable income is $7, rather than the $4 if the item was disposed. The Wall Street Journal (12/10/05) reported that donations of merchandise are an estimated $3.5 billion annually; tax incentives have no doubt played a role.
- They can crowd out corporate cash giving. After all, giving $4 in cash yields a decrease in taxable income of $4, but if the $4 were instead used to make an extra shirt priced at $10 and it were donated, the decrease in taxable income is $7 despite no change in cash flow. For this reason, it should not be a surprise that The Wall Street Journal (12/10/05) reported that over half of corporate giving takes the form of merchandise donations.
Each of these effects clearly impacts charities and their operations. However, the impact of these tax provisions can be more far reaching. An Ohio State colleague and I recently conducted research to consider how enhanced deductions affect corporate behavior. In addition to confirming that they can promote more giving of merchandise, we also demonstrate two unintended consequences:
- With enhanced deductions, companies are incentivized to increase retail prices. Since the size of the deduction is itself tied to the price of the good in the market, maximizing tax benefits of donations entails increasing that price. From the previous example, consider the effect if a company raised the price of its shirts to $12. While this action may reduce consumer demand, it also increases tax benefits. With a $12 retail price, the tax deduction for each donated shirt rises from $7 to $8.
- With enhanced deductions, input suppliers are incentivized to decrease prices. Since many of the inputs being bought are being used to make donated items (not just items sold for profit), the average margins of retail buyers are lower than they otherwise would be. The input seller, in turn, has incentives to cut its prices to boost buyer margins and purchases. Of course, such price cuts can trickle down to the retail level and offset effect (1). We find that the net effect on retail prices depends on the particulars of the demand and competition of markets in which firms operate.
For those interested in more details, the full text of the research is available here.