Demand for Charities and Tax Deductibility: One of the ways in which government policy supports a variety of activities in the economy is to make contributions to those activities tax deductible. For instance, suppose you pay a marginal income tax rate t and that a fraction δ of your contributions to charity are tax deductible. Then if you give $1 to a charity, you do not have to pay income tax on $δ and thus you end up paying $δt less in taxes. Giving $1 to charity therefore does not cost you $1- it only costs you $(1−δt).
A: In the remainder of the problem, we will refer to δ = 0 as no deductibility and δ = 1 as full deductibility. Assume throughout that giving to charity is a normal good.
(a) How much does it cost you to give $1 to charity under no deductibility? How much does it cost under full deductibility?
(b) On a graph with "dollars given to charity" on the horizontal and "dollars spent on other consumption" on the vertical, illustrate a taxpayer's budget constraint (assuming the taxpayer pays a tax rate t on all income) under no deductibility and under full deductibility.
(c) On a separate graph, derive the relationship between δ (ranging from zero to 1 on the vertical) and charitable giving (on the horizontal).
(d) Next, suppose that charitable giving is fully deductible and illustrate how the consumer’s budget changes as t increases. Can you tell whether charitable giving increases or decreases as the tax rate rises?
(e) Suppose that an empirical economist reports the following finding: “Increasing tax deductibility raises charitable giving, and charitable giving under full deductibility remains unchanged as the tax rate changes.” Can such behavior emerge from a rationally optimizing individual?
(f) Shortly after assuming office, President Barack Obama proposed repealing the Bush tax cuts—thus raising the top income tax rate to 39.6%. At the same time, he made the controversial proposal to only allow deductions for charitable giving as if the marginal tax rate were 28%. For someone who pays the top marginal income tax under the Obama proposal, what does the proposal imply for δ? What about for someone paying a marginal tax rate of 33% or someone paying a marginal tax rate of 28%?
(g) Would you predict that the Obama proposal would reduce charitable giving?
(h) Defenders of the Obama proposal point out the following: After President Ronald Reagan’s 1986 Tax Reform, the top marginal income tax rate was 28% — implying that it would cost high earners 72 cents for every dollar they contribute to charity, just as it would under the Obama proposal. If that was good enough under Reagan, it should be good enough now. In what sense it the comparison right, and in what sense is it misleading?
B: Now suppose that a taxpayer has Cobb-Douglas tastes over charitable giving (x1) and other consumption (x2).
(a) Derive the taxpayer’s demand for charitable giving as a function of income I, the degree of tax deductibility δ and the tax rate t.
(b) Is this taxpayer’s behavior consistent with the empirical finding by the economist in part A(e) of the question?