In my last post about nonprofit structure, some interesting and important aspects of tax-exemption weren’t fully explored. Specifically, I glossed over why tax-exemption exists in the first place. Let’s rectify that.

The tax-exemption at the heart of nonprofit organizations—along with “nondistribution constraint” (i.e. one cannot profit from, or own equity in, a nonprofit; it may not inure to someone)—is the the key distinction between a nonprofit organization and any other incorporated entity. The reasons why a nonprofit organization should receive tax-exemption (and the government subsidy it implies) are varied and contested.

Norman Silber’s A Corporate Form of Freedom (p. 167-169) presents the following reason why nonprofit organizations—in aggregate—should receive the special privilege of tax-exemption:

  • The difficulty in measuring a nonprofit’s income and assessing an appropriate tax. (Boris Bittker and George Dahdert, 1967)

  • It rewards altruistic behavior in support of communities that might otherwise diminish or fail entirely without governmental subsidy. (Prof. William Ginsberg, 1980)

  • Tax-exempt services offset services the government would otherwise provide directly. But, to compensate taxpayers for the benefits conferred by government exemption, taxpayers must receive services(“quid pro quo”). This would also require tax authorities to seek direct evidence of need prior to conferring an exemption.

  • Tax-exemption contributes to pluralism “by providing the public goods and services that either are undersupplied by the private market or by the government or else not provided in the same socially desirable manner” (“Community Benefit” theorists)

  • The nondistribution constraint necessitates that nonprofits operate where the government or market have failed and this thus justifies their tax exemption. (Prof. Henry Hansman, 1980)

  • The justification for tax-exemption may be found in understanding nonprofits as part of a “sovereignty”: independent of the state rather than subservient to it. The weakness of this theory being how this quality—and by whom it is determined—is conferred upon these “sovereigns”. (Prof. Eveylyn Brody)

Of all of these theories, “none of them quantify, in the interests of equal treatment, the particular quality that would result in an exemption being granted or denied.”

Additionally, none of these theories provide rationale for why anyone would go to the trouble of forming a tax-exempt organization that inherently denies profit and ownership. The rise of the modern nonprofit sector can be traced back to the 1960s with an increase in government giving and the humanitarian, charitable and altruistic impulses that emerged in culture at that time. As to why those impulses should lead to the current expansive nonprofit field, the following reasons have been given:

  • Middle-class guilt about the disparities between the affluent and the poor

  • Wealth-transfer mechanisms for the rich

  • Dissatisfaction with the profit motive as an incentive to extract work and induce consumption

  • Greater abundance in society general

  • The inability for government agencies to provide services to meet growing needs as a result of the widening gap between rich and poor