RESEARCH CORNER

Economic principles and the not-for-profit sector - Part 2 Last month, I posed the question: "How does one go about promoting the charitable sector and contribute to the development of a civil society?" Using china as my context, I proposed that governments could address this issue by following three economic principles: 1) allowing people to choose which NPOs to organize and to which organizations to contribute time and money; 2) using information conveyed by these choices to identify NPOs worthy of government support; and 3) using grants and tax relief to reward the organizations that help achieve a fair distribution of resources among members of society.

These three principles led to specific recommendations, including the following:

* NPOs are a natural outcome of markets, and governments should not try to inhibit their formation.

NPOs co-exist with for-profit businesses because NPOs tend to spring up in response to market failure (for example, a for-profit athletic association can not easily assure its membership that their dues are used for operating costs and not to pay dividends to an owner).

From this reasoning, two questions arise: Should NPOs be given preferential tax status, and which organizations should be considered NPOs?

* NPOs should be exempt from income tax for the simple reason that governments can only effectively tax whatever people try to maximize.

Income and consumption taxes work because people desire income and consumption. Taxing NPOs does not make sense because these organizations have no profit motive, and because doing so could result in unwanted behaviour (such as spending all residual hinds each year).

For-profit businesses would like to qualify as NPOs to gain this preferential tax treatment; thus, I define NPOs as having several ownership and governance characteristics, including the prohibitions against residual ownership interests and indefinite terms lor directors. Such rules would have prevented the well-publicized case of IKEA attaining tax-exempt status, as described in The Economist (May 13, 2006, pp. 69-70).

* The distinction between charitable organizations and non-charitable NPOs must be based on the idea of fairness.

In other words: Does an organization help to promote a fair distribution of resources among members of society by serving the community at large? Thus defined, "charities" would include hospitals, food banks, and educational institutions, but exclude community athletic and social groups (for example). In comparison, Canadian rules specifically list three categories of charitable purpose entities: for relief of poverty, for advancing education, and for advancing religion; and also include those determined to be charitable by the courts; still, these rules are generally consistent with the idea of fairness.

Given the distinction between charities and non-charitable NPOs, what additional benefits should be conferred on the former and not on the latter? Before answering this question, it's important to recognize the considerable difference between the fairness achieved by charities and the fairness achieved by government programs and taxation: Because voluntary sharing through donations results from rational choice, it improves the well being of society (in terms of Pareto efficiency), while government-imposed taxes and programs do not. With this desirable outcome in mind...

* Governments should help support charities by exempting them from consumption taxes and by providing tax benefits for charitable donations.

As I mentioned last mouth, conferring subsidies via tax benefits for donations is more efficient than awarding direct grants because it incorporates the first-hand knowledge of a community's citizens.

Despite minor differences, these recommendations are in line with Canada's status quo. It's reassuring that our tax laws relating to charities and other non-for-profits are consistent with economic principles.

[Author Affiliation]

BY KIN LO, CA, PH.D.

[Author Affiliation]

Kin Lo, CA, Ph.D., holds the CA Professorship in Accounting in the Sauder School of Business at UBC. The CA Professorship is funded by the CA Education Foundation of BC. Send your questions on accounting research to Kin at kin. lo@sauder.ubc.ca.