“IT MUST be borne in mind,” Britain's chancellor of the exchequer told the House of Commons in his budget speech, “that in every case exemption means a relief to A at the charge of B.” This was, indeed, the heart of his case for taking away a tax break that benefited charities. “It is not fair”, he went on, to impose the cost of the exemption, in the form of higher taxes, on “the fathers of families, men labouring to support their wives and children.” This was all the more important because the gifts encouraged by the exemption were largely designed to bring a wealthy donor “credit and notoriety” which “otherwise he might not have enjoyed.”

William Gladstone failed in this attempt to end the exemption of charities from income tax in 1863. He would not have been surprised when his successor, George Osborne, last week backed down on a more modest attempt towards the same ends. In his March budget Mr Osborne proposed a cap on the sum that rich people can deduct from their taxes thanks to their charitable donations, framing it as part of a strategy to crack down on wealthy tax dodgers. Britain's charities took up their cudgels, arguing that reducing the tax break would diminish donations and thus their ability to do good works. Charities are, by and large, more popular than chancellors. On this occasion, they protected their privileges, as they did in the 1860s (when, though the Times thundered at Gladstone for his “perverse boldness”, The Economist approved of his plan: see footnote).

But the British government is not the only one that charities have to worry about. In America historically generous tax incentives to donation are being questioned in a way not seen before. “I'm expecting a big fight in Congress over charitable deductions and over the definition of charity. I'm very concerned,” says Diana Aviv, the head of Independent Sector, an American trade association for charities. President Barack Obama has made a number of attempts to limit the amount of giving that the rich can deduct from their taxable income. And Ms Aviv says state and local governments are going further than that in attacking charitable tax breaks. There has been a sharp rise in demands from charities for so-called PILOTS (payments in lieu of taxes), which involve local governments threatening to withhold certain services from charities unless they “volunteer” to pay something into the government coffers (as they do, increasingly). According to the Lincoln Institute, a think-tank, such schemes have been introduced by municipal or other governments in at least 18 states. In Europe some countries in which generous state provision of services has been the norm, such as Sweden, have recently begun to experiment with tax incentives to boost the charitable sector. But this change, and established tax incentives elsewhere, may be under threat, according to Luc Tayart de Borms, who runs the King Baudouin Foundation in Belgium. “There is a danger that populist politicians across Europe will look at what is happening in Britain and say, if even the British are going after charitable tax breaks for the rich, why don't we?” In France there has been discussion of confining tax breaks, which can be quite generous, to charities that spend the money they receive inside the country. In hard times, it is not surprising that exchequers take an interest in such things. In Britain the Treasury estimates the total cost to the state of the various tax breaks to donors and charities will be £3.64 billion ($5.5 billion) this tax year; in America the Treasury estimates that the total cost to the federal government in 2012 of charitable tax breaks will be $39.6 billion, rising to $51.6 billion in 2014. But that is not the only reason reform should be up for debate. The basic question posed by Gladstone remains: why should taxpayer B face a bigger tax bill because taxpayer A chooses to give to charity?

Feel-good philanthropy

There was little debate over exempting charities from income tax when it was first introduced in Britain, supposedly as a temporary measure to finance war with France, in 1798. This seemed fitting, as charities had already been largely exempt from earlier taxes on property since the Elizabethan age. Likewise, there was little opposition in America when in 1917, four years after the federal government gained the constitutional right to levy an income tax, American taxpayers were allowed to deduct charitable donations from their taxable income (again, extending precedent established in the 19th century). A year later, Americans were granted, at death, unlimited deductions for their charitable bequests from the new estate tax.

Some economists say this can be justified on the basis that taxable income should include only personal consumption and wealth creation, and money given to charity is arguably neither. This was the implicit logic behind the development of deductible donations in Britain in the 1920s, when donors began to covenant part of their income to charities, and thereby avoid paying tax on it.

Rob Reich of Stanford University offers a robust counter to this view. “If a person has legitimate ownership of resources and can rightfully decide how to dispose of those resources, then whatever a person decides to do with those resources—spend it on luxury goods or give it to charity—is, by definition, tautologically, consumption.” It is demonstrably true that people derive pleasure from their donations. They may also earn benefits that are hard to come by through other means and peculiarly prized—social esteem and status, for example. Far from being non-consumption, giving is a particularly high-quality form of personal consumption.

The great exemption

A more promising line of defence for the charities is to view the tax break as a form of public expenditure that can be justified on the basis that it secures benefits for society that are worth more than the money which the state forgoes in taxes. For this argument to work, one needs to be convinced that tax breaks actually increase charitable giving. The headline giving numbers provide some support for this.

America has the most generous tax incentives for charity, and has the highest giving as a proportion of GDP, at 1.67%, according to a rare comparative study by Britain's Charities Aid Foundation. Britain's tax breaks for charity are the next-most-generous, and it had the second-highest share of charity to GDP, 0.73%, followed by Australia, 0.69%, which also has significant tax breaks. By contrast, the relatively weakly incentivised Germans give only 0.22% of GDP. The correlation is not perfect, though; despite their generous tax breaks, the French give just 0.14% of GDP.

Within countries one can look at changes in the “tax price”—the cost of a donation to the donor—for an indication of the effects of tax policies. If a taxpayer faces a marginal tax rate of, say, 28%, an extra dollar given to charity reduces the tax bill by 28 cents: the tax price is thus 72 cents. For a higher-rate taxpayer, say one paying a marginal tax rate of 50%, the tax price falls to 50 cents.

At first glance it would appear that the tax price is irrelevant. Dropping marginal tax rates on the wealthy in America has meant that the tax-price of donation there has soared over the past decades (see chart). But the rate of charitable giving, too, has increased. This seems to be because wealth matters too. As America's rich have become much wealthier, they have given more to charity even though the cost of doing so has risen. Surveys suggest that tax rules affect the size and timing of gifts, but not the initial decision to give, which depends largely on being moved by the cause or being asked directly to support it. The idea that growing wealth offsets high tax prices fits with evidence from a biannual survey of charitable donors by Bank of America and the Center on Philanthropy at Indiana University. In the 2007 survey 7% of high-net-worth families said they would “dramatically decrease” their giving, and a further 39.6% would “somewhat decrease” their giving, if changes in rules on exemption put up the tax price of their donations. Feeling less flush after the financial crisis, in 2009 the numbers had risen to 18.7% and 48.3% (the 2011 figures are due shortly). Economists have been trying to work out how, other things being equal, changes in the tax price will affect behaviour. In the 1970s, early econometric studies by Martin Feldstein of Harvard, among others, suggested that the “tax-price elasticity” was more than one—that is, if the tax price were cut by 10%, giving would increase by more than 10%. If you assume that the public benefits more or less equally from charitable spending and taxable spending, that sounds like a good deal. However, as these studies have become more sophisticated, the consensus estimate of the tax-price elasticity has diminished to significantly less than one. This shift matters: at less than one, an additional dollar in incentives for giving generates less than a dollar's worth of donation. In such a situation charities need to produce more bang for the buck than state spending to justify their perks.

That said, the elasticity need not be stable from country to country, or the same for all types of donor. Sarah Smith of the University of Bristol and Kimberley Scharf of Warwick University recently carried out a series of experiments for the Treasury to gauge how sensitive higher-rate taxpayers are to changes in tax incentives. She found that for donors who had previously made relatively large gifts of between £25,000 and £50,000, the tax-price elasticity was 1.19, well up into the everyone-wins realm. But for higher-rate taxpayers as a whole the elasticity was just 0.33.

Especially if elasticity is low, policymakers should be seeking assurance that charities spend money in a particularly wise, effective way. There is a growing effort around the world to develop better performance measures for charities that might help. But it has a long way to go before it can provide answers to whether the tax breaks for charity pay. A more practical measure is that many governments use charities as contractors to provide various social services, paying them to help the homeless, care for the elderly and so on. Around a third of the money going to charities in America and more than half the money they get in Britain is in the form of direct payment from government for services. That governments are choosing to do this more and more suggests they think these services represent value for money. That said, there is a risk that subsidised charitable service-providers may be squeezing out innovative for-profit alternatives.

Cost alone may not be the whole story. One of the arguments for subsidising charities through the tax system is that bringing in donors adds something to the mix. Spending decisions by government are often bureaucratic and risk-averse, not to mention captured by the vested interests of public-sector unions and the lobbying process. Proponents say the charitable tax deduction opens up new avenues, paying for itself by providing a pluralism that would otherwise be unavailable.

Governments might spend money through charities not just, or even mainly, because they are better value for money, but because they work in ways that governments themselves cannot. In the most famous case, America's tax breaks allow it in effect to hire the world's most successful businessman, Bill Gates, as its agent for good works, buying the public the benefit of his acumen.

Faith and hope, too

The Gates Foundation spends on causes widely agreed to be good, and supported by the public purse through other means. In general, though, giving never matches very closely the spending choices of democratically elected governments. Overall, American donors give more than half of their charitable donations to religious organisations, according to a study by Mr Reich of Stanford University. Only a small part of total American giving was in any sense redistributive from rich to poorer people, the study concluded. The churches, synagogues and so on that received most of the money were typically attended by the donor, and thus could be interpreted more as a membership fee than an act of charity (the study did not include religiously linked charities engaged in good works under the heading of religious organisations).

Different types of donors favour different things. Rich American donors give a lot less to religions than less-well-off ones do. Instead, “Taxpayers with incomes over $1m tend to favour higher education, health, and the arts,” notes Charles Clotfelter, an economist at Duke University, in a recent paper.

The American tax system, he points out, “gives the wealthiest taxpayers a disproportionate role in allocating public resources.” In 2008, individual Americans with incomes over $500,000 (who make up less than 1% of taxpayers) accounted for 18% of all income and made almost a quarter of all charitable donations. By contrast, the two-thirds of taxpayers with incomes under $50,000 earned about 20% of total income and made about 20% of all donations. In 2006 taxpayers with incomes over $100,000 received 76% of the total $40.9 billion tax subsidy due to the charitable deduction, although they made only 57% of all donations; those with incomes of less than $50,000 received a mere 5% of the subsidy, despite making one-fifth of all charitable donations.

This unfairness costs a lot of money and in some cases, at least, makes little difference. Warren Buffett recently told The Economist that tax concerns were largely irrelevant to his giving, and that he thinks the same is true of many of his super-rich peers. “I gave $2 billion last year and saved almost $2m in tax.” The “plutocratic bias” also tends to argue against the pluralism case for tax incentives, in that it overpopulates civil society with organisations friendly to, and aligned with, the interests of the wealthy.

Moves to restrict the marginal rate of deductions to the base rate of tax, as proposed both by Mr Obama and Mr Osborne, would make the situation more equitable by giving all taxpayers the same incentive to give. Switching to a tax credit, whereby all donors get the same amount of tax credit for giving, would be another way to achieve greater equity between higher- and lower-rate taxpayers, and could be easier to understand and simpler to administer than the current system. Mr Osborne also wanted to move from unlimited deductibility to an annual cap of 25% of income, up to a maximum of £50,000. America has a cap of 50% of income deducted in any one year—30% if given to a private foundation—but unused allowances can be carried forward to later years.

Whatever you want

Making things fairer by favouring the rich less would probably reduce overall giving. It would also shift its character, with proportionately more going to religion.

One does not have to be rabid on issues of church and state to see that tax subsidies for people's charitable urges might be easier to justify if the range of organisations and purposes that count as charitable were better aligned with broadly upheld conceptions of the common good. In most countries the definition of charity is incredibly broad, a breadth that can be traced back to the Charitable Uses Act passed under the first Queen Elizabeth in 1601. This identified four categories of charity: relief of poverty; advancement of education; the advancement of religion; and a somewhat catch-all “other purposes beneficial to the community”. In the late 19th century Britain's tax authorities tried unilaterally to narrow the definition to something closer to almsgiving. Had the courts not overruled the move, reaffirming the broad Elizabethan definition of charity, the sector might look quite different today, with a greater focus on unambiguously good works that would make giving it favourable tax treatment far easier to defend.

Britain updated its definition in the 2006 Charities Act, but beyond demanding somewhat clearer evidence of public benefit it barely changed. This now looks like a missed opportunity. However, at least there is a public-benefit test in Britain. America places remarkably few limitations on becoming a tax-exempt 501c3 charity, beyond a requirement not to engage in party politics.

Most experts on charity reckon the status quo to be the least-bad option. They argue that, however well-intentioned, sharpening the definition would be a mistake, paving the way for government to weigh the sector down with bureaucracy, discouraging entrepreneurs from Messrs Gates and Buffett on down from engaging with society's problems, and killing the vitality that makes the best charity so valuable. It may offend some that people are as keen to give to donkey sanctuaries as to shelters for victims of domestic abuse. But, as Patrick Rooney of Indiana University asks: “Who has the wisdom to decide what is a good charity?” Mr Reich, however, argues that the tax breaks would have greater credibility if they were designed to incentivise only the more useful sorts of charity, especially those focused on reducing poverty. In a similar spirit, the attorney-general of Minnesota is suing non-profit hospitals which she believes do not do enough for the poor. Even the modestly increased demand for evidence of public benefit from Britain's Charities Commission has prompted private schools with charitable status such as Eton, where such needy cases as Prince William and the prime minister, David Cameron, were educated, to introduce new scholarship funds to recruit students from poor families. In Australia significant reform of the charity and non-profit sector is under way, including the creation of the equivalent of Britain's Charities Commission, and a review of the definition of charity. Other countries should follow suit. Mr Osborne's embarrassing U-turn may prompt better-prepared attempts at reform. Trying to justify the advantages of giving only to “real” charities will never be an easy task when well-loved charities fear they will lose out. But assuring Mr B that he isn't paying more tax simply so that well-off Mr A can feel better about himself would in itself benefit the community.

From our response to Gladstone's proposal to make charities pay income tax:

A good State aid would help the poor charities more than it helped the rich. But an exemption from the income tax helps the rich as such, and in proportion as they are rich. The poor charities have no income derived from the property which could be exempted—they possess none, and therefore are taxed upon none. You give them, therefore, nothing. But the rich charities, which have large estates, gain much: their income tax is returned to them. The principle of the present law is to aid the wealthy because they are so, and to aid them in proportion as they are so.

The truth is even worse. The income of poor charities is derived from voluntary contributions of the taxpaying classes. If you exempt any of the rich charities, you must proportionally burden those classes, for the actual expenditure must be defrayed; and if A is let off, B must pay more. The result therefore is, that the voluntary contributors to poor charities are taxed more, and the income of poor charities perhaps therefore diminished, in order that an increase of income may be given to rich charities, and most of it to the very richest.