After IRS impacts tax-credit scholarships, a chance for altruism (and better program design)

For most people, Internal Revenue Service recommendations induce snoozing. For school choice advocates, guidance released late August by the U.S. Department of Treasury (which houses the IRS) caused a swell of concern.

Some quick background: For decades, taxpayers have been able to deduct (up to a point) their charitable contributions from what they owe on federal taxes. Likewise, those who pay state income taxes, county and municipal taxes, and even property taxes that fund school districts, could also deduct these taxes on their bill from Uncle Sam. These later taxes—acronymized “SALT” for “State and Local Taxes”—previously were uncapped.

But, as you may have heard, a huge federal tax reform bill took effect this year. Amidst all the talk of lower corporate rates and higher standard deductions, the bill capped SALT deductions at $10,000. In a low-income tax state like Mississippi, this is a high bar to clear. Heck, most Americans hadn’t been itemizing their deductions while doing their taxes, meaning SALT wasn’t even part of their federal tax bill equation. But in higher-tax states like New York and California, there is more incentive to itemize in order to claim SALT deductions.

What does all of this have to do with school choice? Potentially a lot, and seemingly as an unintended consequence. Non-school choice states’ actions triggered broad intervention from the IRS for all charities, including those that distribute private school scholarships. A handful of high-tax states with significant numbers of citizens claiming SALT deductions greater than $10,000 tried to implement workarounds to the cap by setting up government-organized charities. The thinking here was that the states would offer tax credits for contributions to these non-profits, and that these contributions would then be deducted under the federal charitable deduction to “restore” the unlimited SALT provision.

It seemed like a win-win for high-tax states and their taxpayers…until it wasn’t. The Treasury Department rule requires taxpayers to subtract the amount of state credits received for a donation from their federal charitable deductions, which greatly disincentivizes the state-run non-profit system. This also will likely disincentivize donations to tax-credit scholarship organizations and thousands of other organizations that have operated with actual charitable intent years before the 2017 tax law.

The Treasury saw a perceived problem—high-tax states trying to work around the SALT cap—and identified a way to fix it. That’s exactly what Marty Lueken and I wrote the government could do in a report released last year when media attention to and misunderstanding of tax-credit scholarship programs was high.

A lot has changed since that report published, both regarding the tax code and within the national education discussion. There have been and will continue to be debates surrounding these changes. But the underlying ideal of altruism, inherent in making donations to provide children educational opportunities, need not be affected. (It’s worth noting that the Treasury estimates only 1 percent of scholarship-granting organizations will be affected by the IRS change.)

People donate to causes for a variety of reasons, and it’s true that states that offer tax credits for donations to scholarship granting organizations incentivize such donations. But there are plenty of other tax credits available for charitable contributions. It logically follows that donors to scholarship-granting organizations willingly contribute to these organizations because they want to help low- and middle-income families make their educational preferences a reality. You’d be hard-pressed to find a donor to an SGO who doesn’t still believe in that mission.

Various opponents and supporters of school choice have applauded the rule proposal for policy reasons. But it’s important to separate the gratification of policy victories from the real risk of students’ scholarships—no matter how many or few—going by the wayside. This risk was present prior to the IRS proposal, due to the raised standard deduction and estimates of fewer Americans applying the charitable deduction this year. The rule certainly heightens the risk to scholarship recipients, though. These students need to be the focus going forward, and the continued goodwill of donors is their best chance at educational opportunity in the short term.

But should school choice—a movement that promises all families the kind of opportunity traditionally available only to the rich—require altruism, at least on the part of individuals? There is no easy answer to this question. By funding school choice via tax credits, however, states shift the burden of meeting all students’ needs to private actors using a mechanism that depends on another system that’s often in flux—the tax code.

Other school choice models don’t take this path. Whether it be allocations to charter schools, vouchers for private ones, or Education Savings Accounts directly to parents, some state governments have taken on the responsibility of directly empowering families with options using the state funds that are set aside to educate each child. It’s true that state revenue might ebb and flow over the years, but those ups and downs affect all students, not just the ones who depend on the financial kindness of strangers.

And that’s the original ideal of school choice, that the public funding of education enables the private choosing of schools. Perhaps in the not-too-distant future, this ideal will be actualized. But in the meantime, school choice supporters would be wise to reflect on the shortfalls of the tax-credit scholarship model and work toward policy designs that won’t be affected by second-order effects of the federal tax code.

Just as they have before, students who receive tax-credit scholarships must rely on the altruistic actions of donors who want what’s best for children—regardless of which schools their families choose. In light of the IRS’s decision, it’s now more important than ever for governments to do the same.