The not-for-profit sector is facing the loss of a privileged exemption that allows charities to avoid paying tax on profit-making activities.
Announced in May’s Budget, the changes will see not-for-profit organisations pay tax on surpluses generated from what the government describes as “unrelated commercial activities”, unless those profits are used to fund the charity’s altruistic activities.
On the face of it, this is being done in the name of providing a level playing field for tax-paying businesses and economic efficiency.
But there are strong arguments to maintain the status-quo for charities.
In late 2008, the High Court of Australia confirmed that charities’ tax exemption extends to commercial activities that charities operate, not just funds raised to pay for their charitable activities directly.
Under the proposed changes though, a church that operates a bakery and sells bread at market prices to the general public would pay tax on the surpluses from the bakery.
However, any of the bakery’s surpluses used to fund the church’s homeless shelter would fall within the church’s income tax exemption.
This is the same as the situation where for-profit entities may claim a deduction for donations made to a charity.
Surpluses that are reinvested in the business will be subjected to tax. In our example, if the bakery was to use some of the surplus to purchase new equipment or fund the opening of a new bakery, the surpluses so used would be taxed the same as ordinary business profits.
The reason for the change is that businesses operated by charities frequently compete with other for-profit businesses which have to pay tax on their profits.
The exemption provides charity-run businesses with an apparently unfair advantage since they are not faced with this additional expense.
Such advantages are the ability of the charity-run business to offer lower customer prices (thereby gaining greater market share at the expense of for-profit competitors) or having additional funds to reinvest in the business, to enable faster growth.
Supporters of free markets are likely to agree with this sentiment. However, allowing charities to retain their full exemption is actually more in keeping with a free market philosophy.
Exempting charities from tax ultimately allows market forces to identify worthwhile charitable causes, rather than a bureaucratic central authority.
This result comes about since most, if not all, of the work performed by charities would otherwise be expected to be done by governments. Consequently, charities relieve pressure on the public purse.
Every dollar that a charity spends on providing shelter or food and clothing to the poor is another dollar that the government now has to spend on roads, hospitals and schools.
This justifies allowing charities their income tax exemption. The exemption acknowledges the financial relief charities provide to the government. Assuming a tax rate of 30%, the government foregoes 30 cents in revenue and saves a dollar for every dollar’s worth of service that the charity provides.
It is here that market forces exert their influence over what services charities provide. To attract donations, charities need to provide services that the donating public regards as worthy.
Using compulsorily levied taxes to fund public services raises the usual concerns about vested interests capturing the bureaucracies administering those services and deciding which services get funded, with the very real prospect of inappropriate allocations being made.
Where a charity seeks to raise its funding through operating a business instead of direct donations, the same analysis applies.
A charity can raise funds in this way only by providing goods or services that the public demands. The charity may seek to attract additional custom by advertising that the business profits are used to fund charitable activities. But this will work only if the public approve of those activities.
Returning to the church-run bakery example, under the proposed changes, the bakery will need to pay tax on any surpluses that it decides to reinvest the surpluses in its business rather than pass on to the charity.
However, this is short-sighted. All income from the bakery must ultimately be funding the charity. Any reinvestment necessarily is designed to increase the income-producing capacity of the business.
As the charity’s work relieves the government of spending pressures, the government should be willing to see charities be as well funded as possible.
Allowing retained surpluses to remain tax-free improves the income-producing capacity of the business, increases the long-term funding source for the charity and provides increased relief on the government’s spending programs.
The current tax treatment, which has been approved of by the High Court, should be retained.
Charities should be allowed to continue doing their good works without additional costs being imposed on them and, ultimately, on the government itself, all in a misguided attempt to improve competition in sectors that are presently functioning fine.