A Better Way for Governments to Support Charities: Quadratic Charitable Deductions

Summary:

• I describe a method for governments to distribute charitable tax subsidies so that they favour smaller charities.
• Instead of government tax breaks being proportional to the donations a charity receives, they would be proportional to the square root of what they receive.
• This system means a charity that receives $1,000,000 in annual donations will get 10 times the tax subsidy of a charity that receives $10,000, instead of 100 times.
• Said differently, with quadratic charitable deductions, government provide a disproportionate boost to small charities (and donors).
• Mathematically, the approach encourages people to donate proportionally to how much they care about a cause.
• Practically, the approach will make it a lot more attractive to start a new charity.

How US and Irish tax systems currently work for donations

In the US, you don’t pay federal taxes on income that you directly donate to a charity. In Ireland, you pay taxes on income that you donate, but the charity is allowed to claim back that tax. Mathematically, both approaches are the same.

As an example: In a country with a 50% income tax rate and a tax deduction for charitable contributions (whether US style or Irish style), half of the money received by charities is a subsidy from the government:

• Charity A, receiving E1,000,000 of (after-tax) donations, gets a government subsidy of E1,000,000.
• Charity B, receiving E10,000 of (after-tax) donations, gets a government subsidy of E10,000.
• In total, the government subsidy to these two charities is E1,010,000.

This is roughly how charitable deductions work in the US and Ireland today.

An example of Quadratic Charitable Deductions

Here is an improved way to split the total government subsidy of E1,010,000 given to charity A and charity B:

• Split the subsidy according to the square root of after-tax donations received by each charity.
• Charity A: The square root of 1,000,000 is 1,000.
• Charity B: The square root of 10,000 is 100.
• So, the total subsidy of E1,010,000 gets split in the ratio of 1,000 to 100 (or 10:1), not $1,000,000 to $10,000 (or 100:1).

Specifically:

• Charity A (with E1,000,000 of donations] gets a tax subsidy of E918,182.
• Charity B (with E10,000 of donations] gets a tax subsidy of E91,818.

This is a small percentage reduction in income for charity A, but a large percentage increase in income for charity B. The whole system massively favours smaller charities and greatly increases the incentives to start new small charities.

A caveat on the Quadratic Charitable Deduction

With the above approach, there is an incentive for large charities to reorganise as a group of smaller charities. I think this issue is real, and worthy of consideration. However, I suggest the two following mitigating factors:

1. There is an administrative burden to running one charity as two (or more) separate charities. This provides a natural (albeit limited) deterrent to charities splitting up.
2. Governments can take a compromised policy approach and – instead of making subsidies proportional to the square root of after-tax donations – subsidies could be proportional to a 0.6 or 0.7 or 0.8 power of donations received.

Implementing this in practise

I don’t think a government like the US or Ireland would adopt this approach overnight, or even over years, although I am optimistic governments may move this way on the scale of decades. It’s worth noting that, in the software world, these kinds of funds already exist to support the development of open source software. Gitcoin is a significant, and growing example. You can read about Gitcoin grants involving millions of dollars of funding on Vitalik’s website.

In the meantime, there is a way to implement this system privately that I am thinking about. Quite simply, I could set up a charity that donates funds – using a quadratic method – to all registered Irish charities based on the prior year’s reported donations. It would be a little bit like an index fund for charitable giving, but incentivising smaller charities.

Over time, I think it would be possible to move away from a fund that is bounded by national borders, but the list of Irish registered charities provides clear information for a starting point.

Let me know if you would be interested in collaborating on a preliminary analysis of how a quadratic fund for Irish registered charities might work. A first step would be to figure out how to import a list of Irish charities and the total after-tax they each received in 2020. Further reading on Gitcoin’s experience with the approach would also be smart.

Notes:

1. Irish charitable tax breaks work a little differently than how I have described above because a flat tax rate is assumed in calculating the charity’s tax back (not the specific tax rate that the donor paid).
2. In the US, there is a charitable deduction at the federal level, but not always at the state level.
3. For a theoretical dive into quadratic voting and payments, I highly recommend reading Vitalik’s primer on quadratic payments, and the advantages of that approach over “one dollar one vote” and “one person one vote” as a way to fund public goods.