,,UNFAIR" COMPETITION BY NONPROFITS AND TAX POLICY**

RICHARD STEINBERG*

NONPROFIT organizations can and do F? firms complain loudly about the lackearn "profits" whenever the revenues of a "level playing field," and urge that

from their commercial activities exceed the NP tax advantages for commercial activ-associated costs. There is no contradiction ities be eliminated. Legislators are re-with the concept of "nonprofit," for the le- sponding. For example, Blue Cross, Bluegal definition of this institutional form Shield, and TL4LA/CREF lost their fed-prohibits the distribution of surplus to eral corporate income tax exemptions

'in

those in control (the "non-distribution 1986 for the sale of commercial-type'in-constraint") rather than the generation of surance, even though insurance is theirsurplus [Hansmann, 19801. "Profits" at tax-exerapt purpose.' Congress held sev-nonprofit organizations often result from eral hearings to consider elimination oftwo sorts of commercial activities. "Re- the many "loopholes" in the current UBITlated" activities further the purpose for and mechanisms to tighten enforcementwhich the organization was granted tax- (Dale, 1990). Many localities have re-exempt status and include the sale of ed- pealed property tax exemptions for YMCAsucation (tuition) by nonprofit universi- when they compete with local health andties, health care by nonprofit hospitals, and racquet clubs, and states have withdrawnday care and nursing-home services by tax exemptions for nonprofit hospitalsnonprofit facilities. "Unrelate&' activities (Hansmann, 1988). Academics propose thatdo not directly foster the organization's a tax on "commercial business" should re-exempt purpose, although profits from place the tax on "unrelated business"unrelated activities may cross-subsidize (Bennett and Rudney, 1987). House leg-provision of charity care or other mission- islators propose that nonprofit hospitalsrelated services. Sales of computers by which fail to provide charity care at leastuniversity book stores, posters by art mu- equal to the value of their tax exemptionseums, or advertising in mission-related should lose that exemption (Suhrke, 1990).journals are regarded as unrelated. For- Although it is dffricult to measure ac-profit (FP) firms compete with nonprofit tual and potential competition, it is clear(NP) organizations in most of these areas. that billions of dollars worth of resourcesFP hospitals, day care centers, and nurs- are involved. The current operating ex-ing homes compete with NPs in the re- penditures of nonprofit hospitals were $134lated activities, and FP computer stores, billion in 1987. The corresponding figuresposter shops, and racquet clubs compete for other industries where nonprofitswith NPs in unrelated activities. compete with for-profits in related busi-

Profits from either sort of NP commer- ness are nursing and personal care facil-cial activity are wholly exempt from the ities-$7 billion, outpatient care and al-federal corporate income tax, but, subject lied services-$12.9 billion, and child dayto many exceptions, income from unre- care centers-$3 billion [Hodgkinson andlated activities is taxed under "unrelated

Weitzman, 19891. Reliable statistics onbusiness income tax" (UBIT), which is unrelated business income are harder tostructured similarly (but not identically)come by for three reasons. First, the UBITto the corporate income tax. State and lo-

cal governments often follow the federal exempts many commercial activities (such

example and exempt NP9 from local prop- as sales by school book stores to students

erty taxes, sales taxes on purchases of and faculty). Second, compliance with the

supplies, sales taxes on sales to the pub- UBIT, although improving, is believed to

lic, and state corporate income taxes. be poor. Third, unrelated activities maybe segregated into a variety of hybrid

*Formerly Virginia Polytechnic institute, now Pur- forms such as for-profit subsidiaries orjointdue University at Indianapolis. ventures, which are not separately tabu-

351

352 NATIONAL TAX JOURNAL [Vol. XLIV

lated by tax authorities. One quite con- veloping testable predictions about be-servative indicator of the magnitude of havior. Ultimately, such models mayunrelated business income is given by provide guidance towards the design ofUBIT tax collections, which increased from truly persuasive empirical studies.$39 million in 1985 to $128 million in 1990 In the first section of this paper, I con-[Schiff and Weisbrod, 19911. sider the appropriate setting in which to

Much of the legislative impetus has been embed economic models. Next I considerbased upon anecdotes about poor perfor- quantity, price, and quality decisions. Imance of competing FPs, but these anec- conclude with a summary.dotes provide insufficient guidance to pol- Many of the ideas presented in this pa-icy for many reasons. If a FP firm per come from unpublished drafts by var-complains that its business is suffering due ious authors, and a good deal of cross-fer-to unfair competition by NPs, we would tilization has occurred. In light of thelike to know: preliminary and interdependent nature of

1) Is the FP producing in an efficient these discoveries, I will make few at-maruier? If not, NP success could be due tempts to sort out and attribute the orig-to FP failures rather than differential tax inator of each idea. Instead, the reader istreatment. invited to explore all the articles listed in

2) Does the NP have an inherent cost the bibliography, and their "forthcoming"advantage (perhaps due to economies of revisions.scope), so, that FPs would suffer even iftax differentials were eliminated? T" What Sort of World Should We3) Do NP successes and correspond' ng Enibed Our Model In?FP failures represent systematic re-sponses to differential tax treatment, or is It makes little sense to theorize aboutthere an important random component? the behavior of individual organizationsTo the extent that success and failure oc- before considering and carefully specify-cur for random reasons, FPs are just as ing the world in which they live. One mustlikely to succeed and NPs to fail as vice understand the competitive environmentversa. However, only the former would be in order to predict which sorts of behaviorreported anecdotally, leaving a biased can survive and which will die out natu-picture. rally. One must also understand the other

4) Do FPs suffer from competition at all constraints upon behavior to be sure thattimes, or only under certain market cir- predictions are realistic options for thecumstances? For example, if FPs suffered agents involved. Finally, one must under-from competition only in circumstances ptand flaws present in the broader econ-where their profits would otherwise be omy. Behavior which hurts when the restexorbitant, public relief should probably of the economy is "optinud" may help whennot be granted. the rest of the economy suffers from other

5) If NPs enjoy greater success at the "failures." I therefore consider five issuesexpense of FPs, which of the many tax and of model setting: market structure, entryregulatory differences in treatment of the decisions, tax incidence, capital con-two sectors are responsible? Elimination straints, and "second-best" consider-of some differences might not help FPs ations.very much, and the different taxes havevarying impacts on the broader economy. A) Market StructureDespite the obvious shortcomings of an-ecdotal evidence, it is not apparent how Most theorizing so far has looked atone should design a more definitive em- perfectly competitive markets in whichpirical study. With little theory to guide each agent (NP and FP) regards the priceus, we cannot distinguish causal relations as outside her control and merely picks afrom chance correlations. In this paper, I quantity to offer for sale. Within this po-review the economic modelling tech- lar model, each agent must assume thatniques which show promise towards de- every item offered for sale will be pur-

No. 31 RICHARD STEINBERG 353

chased and that there will be no "waiting to explore the new industrial organiza-lists" at individual firm. If agents as- tion literature (see, e.g., Tirole, 1988)sumed otherwise, they would have con- which employs the mathematical tools oftrol over the price. game theory to analyze questions of pred-

Several authors considered models of atory pricing. Perhaps it would be usefuliniperfect competition. For example, Rose- to combine these more sophisticated equi-Ackerman (1982a] considered a duopoly librium concepts with a model such as(two-firm) model in which FP profits are those of Schiff (19881 or &hiff and Weis-exorbitant absent NP tax advantages, and brod [19911.Np tax exemptions serve to reduce these Government's role as an "unfair com-profits to more normal levels. She points petitor" has been often mentioned in po-out that other policies (antitrust and price litical debates, but has received no atten-regulation) are designed to reduce exor- tion in formal behavioral models. Thisbitant profits by FPs, so that perhaps this neglect is sometimes justified, but whensort of "unfair" competition is socially de- st.ate-ovmed colleges compete with pri-_sirable. Her point is well-taken, although vate nonprofit universities and with for-it depends upon a particular view of how profit firms in the provision of computerduopolistic competitors behave. In my sales, athletic facilities, software, and the1988a paper, I pointed out that under other like, a tripart model of competition isplausible models of behavior, profits need warranted.not be exorbitant, and '%mfair" competi-tion can convert exorbitant profits into B) Determinants of Entry and Exitundeserved bankruptcy. I did not exploreother models of imperfect competition, and To determine the ultimate impact ofthere is room for more work here. competition, we need to understand the

Schiff [19881 examines another form of determinants of entry and e2dt by both F?simperfect competition called monopolistic and NPs in particular markets. As thecompetition, in which each firm produces admittedly extreme models of Rose-Ack-a different version of the same product. erman [1982b] and &hiff [19861 makeHe begins by adapting James'[19831 model clear, unlimited entry of new NPs se-of cross-subsidization to the unrelated verely constrains both their behavior andbusiness income debate. Assuming that the behavior of competing FPs. Sheer sur-nonprofit managers engage in commer- vival dictates the quantity, pricing, pro-cial activities with reluctance in order to duction technique, and solicitation deci-cross-subsidize their exempt-purpose ac- sions in a fashion quite independent of thetivities, he demonstrates that NPs will organization's objectives.charge a higher price than FPs for those Free entry is the natural starting pointcommercial activities which are unre- in economic modelling, but it should notlated to the organization!s exempt pur- prove the ending point for this type ofpose. In contrast, he finds it possible analysis. &hiff and Weisbrod [19911, re-(though not guaranteed) that NPs will lying on &hiff [19861, have made somecharge a lower price for related activities. progress towards understanding the en-If tax or regulatory breaks lead to lower try decision. In both papers, the authorscosts of production at NP firms, then the assume that potential entrepreneurs de-price comparison is muddier, and it is rive positive utility from providing ex-possible that NPs will underprice FPs for empt-purpose services and negative util-both types of goods. ity from commercial activities. These

Clearly, perfect competition is a rather entrepreneurs compare the equilibriumspecial polar case of limited relevance in utility they would get from operating athe real world. Further progress in de- nonprofit with the utility available fromveloping testable behavioral predictions their next best alternative and found a newdepends upon the continued development NP whenever the latter is greater. In theof more realistic models of the competi- earlier paper, Schiff assumes, for simplic-tive setting. I think it would be valuable ity, that the utility available from the next

354 NATIONAL TAX JOURNAL [Vol. XLIV

best option depends upon the level of prof- does. There is substantial question as toits available in the for-profit sector. The whose pocketbook is hurt as a result of thelater paper simply assumes that the res- tax, and this is the subject of "incidence"ervation utility level is exogenous. theory. Three groups, to varying extents,

Further progress could be made. Both may share in the burden of the corporatealternatives make the implicit assump- income tax-stockholders, suppliers oftion that potential entrepreneurs have a inputs (chiefly capital), and consumers.distaste for commercial activity when they The tax code is far too complicated toenter the nonprofit sector, but not when model in all its glory, and various sim.they enter the for-profit sector. One way plifications have been proposed for ana-to motivate this disparity would be to as- lytic purposes. The easiest alternative issume that potential entrepreneurs have to regard the corporate tax as a tax on purevarying distastes for commercial activity, (economic, as opposed to accounting) prof-with some having no distaste at all. This its. This implies that stockholders bear thelatter group would found new for-profits, entire burden of the tax and equilibriumand those with distaste would found new prices and quantities do not depend uponnonprofits. Equilibrium would then in- the tax treatment of NP income .3 Most

volve sorting by entrepreneurial type. economists regard this approximation asChanges in tax laws or the competitive unrealistic, as the cost of equity financingenvironment which forced NPs to in- cannot be deducted in computing corpo-crease their commercial activities would rate tax liabilities. They thus regard thethen change the character and objectives tax as a tax on capital. This would raiseof the NP firm as well as the number of the costs of production at FPs above thefirms. In particular, I surmise that a suf- corresponding costs at NPs, resulting inficiently large subsidy to the NP sector the much ballyhooed tilted playing field.could lead to entry of a marginal entre- Not all economists agree on the properpreneur with no distaste for the commer- model for many reasons (including thecial aCtiVity.2 possibility of 100 percent debt finance in

Finally, some attention should be de- the FP sector), and empirical studies ofvoted to the sunk costs of sectoral choice. incidence have obtained mixed results."In a changing world, entrepreneurs can Fortunately for those making a career outget "stuck" in the wrong sector, regret- of such analyses, the 1986 tax reformsting their initial choice but not enough to have altered the character of corporateovercome the costs of switching. taxes.

Economists need to structure altema- The incidence of the UBIT is also of im-tive testable models of the entry and exit portance for policy analysis. Even if thedecision and conduct empirical studies. The UBIT is identical to the corporate incomestatus of currently available data makes tax in structure, the differing objectives,this a diiticult (perhaps impossible) task, sources of fimds, and constraints (espe-though Schiff and Weisbrod's (19861 pa- cially the nondistribution constraint) mayper makes an interesting start. Case result in a different pattern of tax inci-studies and other techniques borrowed dence. Perhaps some portion of the taxfrom the other social sciences may also would fall on donors or grantmakers orprove useful. We gain some insight on the charitable-service recipients, not just onentry/exit decision from studies of orga- paying consumers, owners, or suppliers ofnizations that have converted from FP to capital and labor. This subject has, to myNP status or vice versa (L-egorreta and knowledge, received no attention in theYoung, 1986). Further such studies need literature.to be done. Schiff [19881 notes the effect of the

structure of the UBIT on tax incidenceC) Incidence of the Corporate across the activities of the firm. Cur-Inconw Tax rently, there are many loopholes exempt-

There is no question who nominally pays ing active commercial activities from thethe corporate income tax-clearly the firm UBIT and these are under legislative at-

No. 31 RICHARD STEINBERG 355

tack. However, passive income (income production by both sectors in a worldftom dividends, interest, royalties, and where NP access to capital is restricted.rents) is exempt and likely to remain so. They conclude that tax exemption is in-WMIE tax exemptions lower NP costs in deed a crude correction-it helps, but doesgeneral, they actually raise the relative not obtain full efficiency and alternativecosts of active commercial production. corrections may do better.When a NP invests in active production, In his more recent work, Hansmannit forgoes the opportunity to earn the pre- apparently concurs. histead of viewing tax-corporate-tax rate of return from alter- exemption as a corrective, he analyzes thenative passive investments. In contrast, accompanying distortions in his 1989 pa-when a FP invests in active commercial per. He argues that ff NPs were com-production, it forgoes the post-corporate- pletely exempt h7om the UBIT as cur-tax rate of retum.5 Thus, NPs face a higher rently structured, they would invest in aopportunity cost of active production, and less-diversified portfolio (reducing the ef-would prefer passive investment unless the ficiency of the subsidy provided through,active commercial output strongly and di- exemption), extend the current domain ofrectly helps them accomplish the exempt productive inefficiency to more activities,purpose. and save at a higher rate than is war-

ranted. In fact, he hints that loopholes in

D) The Market for Capitalthe taxation of unrelated business incomeare a far less important source of ineffi-

In his 1981 paper, Hansmann argues ciency than is the general exemption ofthat NP exemption from the corporate in- that NP commercial income related to thecome tax could be justified as a crude organizatioxes primary purpose. He sug-compensation for the difficulty NPs have gests that a general narrowing of tax ex-in obtaining capital. By their very na- emption ought to receive renewed scru-ture, NPs cannot issue meaningful shares tiny.of equity capital, for dividend paymentsare prohibited under nonprofit statutes of E) Second-Best Considerationsincorporation. But lenders may worryabout the risks inherent in 100 percent- It has long been known that full effi-debt finance structures and thus require ciency is obtained in a world where alla higher interest rate on such loans. This goods are traded in perfectly competitivehigher cost of capital "inefficiently" dis- markets. Further, any tax-@reated "dis-advantages NPs. Exemption from the cor- tortions" in such a world lead to ineffi-porate income tax allows the firm to more ciency (in the broad economic sense-anquickly accumulate internal capital, economy is inefficient if there is a feasiblecrudely compensating for the higher costs way to make everybody better off). Theof external finance. "general theory of the second-best" con-

Goodspeed and Kenyon [19881 note siders cases in which there are two or moreproblems with Hansmann's 1981 analy- distortions, and asks whether eliminationsis. Some NPs have minimal capital needs of one distortion will help when the other(such as day care centers). Further, un- distortion cannot be eliminated. In gen-like FPs, NPs can obtain capital through eral, such a policy has no guarantee ofdonations and foundation grants. Follow- success, and fixing one distortion coulding tax reform, it is easier for NPs than move the economy further away from eco-FPs to obtain capital by marketing tax- nomic efficiency.exempt bonds. These researchers note that It seems clear that NPs reside in a sec-empirical studies have provided only in- ond-best world. Many relevant marketsdirect evidence supporting capital con- fail to exist or are not perfectly competi-straints, and that one 'shouldn't expect tive, and governmental policies distort thesuch evidence to be persuasive. Nonethe- economy from its first-best optimum inless, they formally model the impact of tax- many ways. Perhaps the most importantexempt income on the efficiency of overall inherent distortion to consider is the cor-

356 NATIONAL TAX JOURNAL [VOI. XLXV

porate income tax itself. It is no easier to rect competition with NPs would be hurt-estimate the importance of this distortion all other FPs and NPs would be madethan to determine the incidence of the better off by NP exemption. On the othercorporate tax-indeed.- the two problems hand, there are substantial limits to in-are inextricably linked. One of the best tersectoral capital mobility (Schiff, 1988).studies (Ballard et al., 1982) concluded that Minor refinements in the drafts of sev-each dollar raised through the corporate eral cited papers should enable us to de-income tax reduces the value of aggregate termine the impact of the corporate in-output by one dollar and forty nine cents. come tax as a second-best constraint. ItThis forty nine cent "excess burden" is would be valuable to consider other dis.substantially higher than the estimated tortions inherent in the economy to de-excess burden from other forms of federal termine whether these conclusions are ro-taxation.6 bust.

Exempting commercial activities fromtaxation when they are undertaken by theNP but not the FP sector is clearly dis- 11) Price, Quantity, and Qualitytortionary. Less efficient NPs could un-dersell more efficient FTs simply becauseof artificial tax advantages. 7 The gain in A) Feasibility Constraints

productivity if these activities were Were it not for non-sales revenue (do-transferred to the more eiticient sector nations, dues, and grants), restrictions onwould provide the resources to more than entry of new firms (due to licensing, cer-compensate NPs for their loss of market tificates-of-need, or brand-name recogni-share, enabling everyone to be better off. tion), and differential tax and regulatory

Placing the two sectors on an equal advantages, NPs would be forced to be-footing by closing some of the loopholes in have the same way as FPs (i.e., Stein-UBff would, in these terms, appear to be berg, 1987). Cost-minimizing productionefficiency improving (Hansmann, 1989), techniques would be adopted by both sec-though it is clearly a second-best solution. tors as a prerequisite for survival. NPSPlacing both sectors on an equal footing could only sell the types of goods sold byby eliminating all taxation of commercial FPs, using the same price schedule. Anyoutput is first-best,' as this policy elimi- attempt by NPs to market those goodsnates both the distortion due to tax dif- which FPs avoid or to subsidize the pur-ferentials and the distortion due to the tax chases of the poor through sliding scalesitself. Such a policy appears to be a polit- would lead to bankruptcy. Some firmsical impossibility at this time. Indeed, the might offer higher quality goods at higherrecent tax reforms had the effect of greatly prices, but the sorting of quality levelsincreasing corporate income tax collec- between the sectors would be entirelytions. random.

There is thus no guarantee that ex- Restrictions on entry raise the price intending UBIT would enhance economic both sectors, hence increasing the poten-efficiency, and some chance that this pol- tial residual from sales (profit). This po@-icy would make things worse (Steinberg, tential profit provides a cushion which al-1988a). To the extent the incidence of the lows the behavior of NPa to depart fromcorporate income tax falls on capital, in- that of FPs. FPs are also provided with avestment (and hence economic growth) are cushion, but unless restrictions on entryreduced. Exemption of NP from this tax also restrict takeover bids, cannot depart(and the UBIT) in effect subsiclizes part of from cost-minimizing and profit maximiz-the capital stock. If capital is at all mo- ing behavior in their choice of productionbile across sectors, this subsidy would spill techniques, prices, quality, product vari-over (Schiff and Weisbrod, 1991; Good- ety, and quantities. Any deviation fromspeed and Kenyon, 1988), and the rate of profit-maximizing behavior would makereturn to capital would be higher in both them ripe for a takeover bid, and the newsectors. Only a fraction of those FPs in di- owners would fear the same threat

No. 3) RICHARD STEINBERG 357

(Steinberg 1988a; 1988b). percent), or to use higher-cost productionDonations and other non-sales reve- techniques.9 Each of these general tech-

Ilues also provide a cushion, allowing be- niques could be applied in a fashion thathavioral departures. In the long run, NP helped society (which I will refer to as aentry restrictions are crucial here as well "good deviation") or hurt society (a 'I)ad(at least if an extreme model of entry deviation!') (Steinberg, 1988a; 1988b).decisions is chosen), for each new NP Consider the first alternative. NPs couldreduces the net returns to fundrais- use the cushion to provide goods which areing at existing firms, in the limit, to zero simply not worth their opportunity cost.(Rose-Ackerman, 1982b). In any case, If they chose this option, they would havethe potential size of the donative cushion to use their cushion to subsidize the price,is limited and is often thought to be so- for consumers would not buy the good atcially inadequate (though this remains a price reflecting the costs of production.controversial, as goverronent grants and It is hard to imagine why NPs would con-tax incentives for giving may overcome sciously choose this bad deviation, but thethe tendency of donors to "free ride" off cushion provides protection against mis-the contributions of others). takes. A FP which misjudged the mar-

Tax and regulatory advantages (such as ketability of a particular product wouldthe exemption of RBI from the corporate be forced to rapidly withdraw or go out ofincome tax and the many exemptions of business-a cushioned NP can continueUBI from the UBIT) provide a third cush- its mistake for years. NPs might alsoion. Again, sufficient entry by NP firms choose this bad deviation in order to prac-could push the Wes price so low that the tice self-dealing-the purchase of over-cushion evaporates. Entry would fmt drive priced inputs from a FP firm owned by aall F?s out of business, then push the price director of the NP firm. That such self-even lower, forcing remaining NPs to act dealing is illegal does not rule out its oc-like profit maximizers. FPs are not driven casional occurrence.out of business by predatory NP behavior Most writers have focused on the po-in this case, but by the effect of numbers tential for good deviations here. NPs couldon the market price. apply thew cushion towards production and

Less extreme (and probably more real- distribution of goods which provide exter-istie) models of entry allow potential co- nal benefits. External benefits are bene-existence with NPs behaving in a distinct fits accruing to individuals who are notfashion. For example, Schiff and Weis- the direct purchasers of a.gobd, and arebrod's 1991 model allows entry only by often associated with the services of NPsnonprofit entrepreneurs who have a dis- in the fields of health, day care, research,taste for commercial activity, so that some education, and arts and culture. Becausemarket share remains for the FP firms FPs cannot capture the external benefitsdespite lower after-tax costs of production in the price of the goods they sell, theyat NPs. Conversely, free entry by tax-dis- will underprovide these goods. NP provi-advantaged FPs would not eliminate the sion is efficiency-improving, but it is notNP cushion, so that NPs would be free to the only available alternative. Govern-behave in a non profit-maximizing fash- ments could provide these goods directly,ion. or provide subsidies which induce FP firms

to provide them. But government provi-sion is also distortionary, so we are once

B) Behavioral Options again faced with a determination of thesecond-best. Some progress has been made

The differential tax-cushion can be ap- here (Andreoni, 1989; Roberts, 1987) butplied three ways: to provide goods (or much remains to be done.quality levels, or trustworthiness) which One 'good' providing external benefitsFPs cannot provide (if they wish to sur- is 'excess' capacity. When service demandvive), to undercut the FP price (hence in- fluctuates randomly, FPs tend to supplycreasing market share, perhaps, to 100 the average level of demand, leaving con-

358 NATIONAL TAX JOURNAL [Vol. XLIV

sumers locked out in peak periods (Holt- ing as "For-Profits in Disguise." @If con.man, 1983). For example, FP hospitals sumers could not be certain whether awould not want to leave some beds idle particular NP was trustworthy, theirmost of the time so that they could be pre- willingness to pay for the output of thatpared for an epidemic or a natural disas- firm would be reduced below that neces.ter. A suiticient cushion allows NP hos- sary to cover the firms' additional costs ofpitals to provide this capacity, if they "honesty." A cushion is therefore neces.choose to. sary if most NPs are to behave in a trust.

Rose-Ackerman [19871 developed a worthy fashion when there are a few badmodel in which NP quality varies in a apples in the bunch.systematic cushion-related way. She con- Although individual NPs could use theirsiders NPs governed by ideological pref- cushion to underprice competing FPS, it iserences that may differ from those of do- hard to imagine why they would want tonors and patrons. For example, the do so. Rose-Ackerman's [1982a) carefuldirectors of a symphony orchestra may analysis detailed the NP decision here. Sheprefer to present new and experimental showed that it might be worthwhile formusic, while patrons and donors prefer the individual NPs to purchase existing FPSclassics. These directors must compro- or to invest in bonds. Either alternativemise their preferences in order to survive. would have a higher rate of return thanIn her model, it is governmental grants the rate of return on a cushion applied tothat provide the cushion, but only minor underpricing, at least in a competitivemodffications would be necessary to adapt market. Put another way, since the NPthe model to consideration of differential firm believes it could sell any quantity ittax treatment. The size of the cushion de- wishes to at the going (FP) price, theytermines the extent to which directors would not need to underprice to expandmust compromise their preferences and sales. As in all perfectly competitivehence a dimension of the quality of the models, their production decision is lim-product. V&ether to call this a good de- ited only by the costs of incremental out-viation or a bad deviation is unclear. put, not by the size of the market (Stein-

NPs could also apply the cushion to- berg, 1988a). Again, the analysis needs towards distributional objectives, offering a be extended to models of imperfect com-Sliding payment scale to aid the poor. FPS petition, and the detailed assumptionscould not do the same in a competitive necessary to derive her conclusion de-market or in any market allowing take- serve renewed scrutiny following the ex-over bids." Finally, in markets charac- tensive tax reforms of 1986.12terized by asymmetric information (where The fact that individual NPs would havethe seller knows more about the quality no incentive to undercut the F? price doesof his product than the buyer), FPS must not imply that existence of the cushion hastake advantage of this information and no impact on the price. In a competitiveexploit the customer's ignorance if they model, prices are determined by the in-wish to survive." NPs can, if they wish, tersection of supply and demand. The lo-market "trust" and use their cushion to cation of the supply curve is determined,survive competition. in part, by the number of firms in the

If the public were fully informed of the market. To the extent that a cushion in-difference in trustworthiness between the duces entry of new NPs, the market pricesectors, no cushion would be necessary. FP will be depressed. Thus, in extreme modelsprices would be lower than NP prices, so of entry, the entire FP sector is driven outthat NPs could cover the higher costs as- of business, while more moderate modelssociated with honesty, and consumers with imply that the size of the tax-based cush-relatively high demand for honesty (say, ion determines the relative market sharesbecause they believed they had less abil- of the two sectors.ity to detect cheating) would pay the ex- The third category of cushion expendi-tra and patronize NPs. The problem arises ture is-higher-cost production techniques.when some NPs do not provide trust, act- These may represent sheer waste due to

No.33 RICHARD STEINBERG 359

caanagerial inattentiveness or lack of ex- The second factor is donor sensitivities.pertise, or production of managerial and Preston [19881 considers the case of do-employee benefits such as perqs, higher nors whose willingness to donate dependssaaries, and employment of incompetent upon the external benefits of the servicefriends. When the impact of high-cost provided. This resource dependence in-production is combined with moderate en- duces managers to provide extemal-ben-try of new NPs, we face, perhaps, the worst efit goods regardless of their preferences.deviation, for eiticient FPs are replaced She demonstrates that the resulting prod-by inefficient NPs solely because of tax uct spectrum enhances economic effi-considerations. Again, high-cost produc- ciency relative to a FP-only world. In her6on could not survive in extreme models model, entry is not so extreme as to driveof entry. the net proceeds from fundraising to zero,

so donations can provide a cushion. It doesnot appear that tax and regulatory cush-

C) Factors Governing Nonprofit ions would provide further efficiency gams,Behavioral Choice but Preston does not Weifically address

the matter.Three general factors appear important Donors may also be sensitive to unre-

in determining how NPs choose to exer- lated commercial activities. Schiff andcise the discretion permitted by tax cush- Weisbrod [1988) assume that donors eitherions-managerial preferences, donor sen- dozet react or react negatively to com-sitivities, and the fine structure of the tax mercial activities. They justif3r this choice

A and regulatory subsidies, two ways. First, donors may regard theManagerial preferences obviously de- fact that an organization engages in com-

termine choice from the set of feasible al- mercial activity as a signal that the qual-ternatives-tbis is no more than a tau- ity of their output is low. Second, they maytology. To make this explanation useful, take this as a signal that the NP is losingwe need a theory of the determinants of sight of its charitable mission. While bothmanagerial preferences. The beginnings justtications are plausible, several fac-of such a theory were explored in Young tors cut the other way. Foundations are[1983; 19861, who develops a typology of reluctant to provide seed money to NPspure entrepreneurial types and specu- that they expect will never outgrow theirlates about the factors governing entre- dependence on grants. They

'may view

preneurs' career selections, both among commercial activity as a sign that theindustries and among sectors. Schlesin- seeds they plant will grow on their own.ger (19851 considered a much narrower Further, the commercial activity may en-

3 range of entrepreneurial types and devel- hance the visibility of the related activ-9 oped some conclusions using a formal ity, increasing donor awareness of needs.L, model. It would be useful to gather empirical

Clearly, a lot more needs to be done here. evidence, for existing theory provides lit-In particular, we need to know how the tle guidance on the magnitude and direc-

1, type of manager likely to be in control tion of the interaction between donationse would change when tax and regulatory and commercial activity. In conductingI- advantages are altered. Earlier in this such studies, one should consider dona-e paper, I suggested one dimension of this tions of time (volunteering) as well as thoseIs approach (the sorting of managers by dis- of money. Finally, one should recognizeit taste for commercial activity), but the is- that some employees implicitly provideIs sue is much broader. Further, we would donations by accepting lower salaries or

like to know more about the evolution of not putting in for overtime. Perhaps com-each manager's preferences. Does in- mercial activity by NP firms would re-volvement in commercial activity slowly duce employee willingness to do so, rais-

i- alter the preferences of those in control ing salaries in the related business.s. until the NP loses sight of its original The loyalty of employees is also of greatto mission? importance, for turnover results in higher

360 NATIONAL TAX JOURNAL [Vol. XLrv

costs of recruitment and training and lower In contrast, Chang and Tuckman [1990]average productivity. In some circum- find no evidence that property tax ratesstances, commercial activity may demor- affect the market share of nonprofit hos.alize the workforce and reduce loyalty to pitals in their analysis of Tennessee data.the NP. Thus, one should also study the It would be useful to extend this typeimpact of commercial activity on em- of analysis to a determination of absoluteployee turnover rates. (as opposed to relative) output levels, for

Finally, the fine details of the tax and one would like to know whether the re-regulatory structure will affect NP be- duced share of NPs in total output is ac-havioral choices. Most analysis so far has companied by a reduction in total serviceconcentrated on exemption from the cor- provision or a corresponding increase inporate income tax, or on general NP ad- FP provision. Hansmann and Chang andvantages. Little work has been done to Tuckman are unable to estimate the im-determine if the cushion provided by, say, pact of federal tax differentials becauseproperty tax exemption is inherently ac- they employ a single cross-section of state-,companied by incentives that affect NP county-, or city-level data. Federal taxchoices differently than those accompa- differentials simply don't vary across thesenying corporate tax exemption, though the samples, so their impact is not estimata-issue has often been raised (Schiff, 1988; ble. This gap could be filled by a similarHansmann, 1989; Clotfelter, 1988-1989). study utilizing nationwide time-series

In my .1988b paper, I suggested two re- data.finements of curtent tax and regulatory There is a truly voluminous literaturePOlicY-increasing the contingency Of such which attempts to determine whether NPadvantages on a "public support tese' and costs are higher than F? costs, which I willon refinements of "non-inurement" crite- only briefly summarize." Many studiesria. The recent proposals to condition NP examine administrative costs in the healthhospital tax-exemptions on provision of insurance industry. Blue Cross and Bluesuticient charity care are in the same Shield are nonprofit health insurers whichspirit. The basic idea common to these compete with commercial FP insurers. Noproposals is, I believe, sound-we should donations flow to the "Blues," so their en-provide the types of cushions which in- tire cushion is provided by tax differen-herently provide incentives for good de- gals, which vary across states. Most cross-viations-but the application of this idea sectional statistical analyses find that NPto policy remains woefully underdevel- administrative costs were higher in thoseoped. states which provide bigger tax differen-

tials. This is the exact pattern one wouldD) Empirical Evidence predict if one believed the cushion were

Hansmann [19871 estimates the impact primarily devoted to waste. Two studies

of state tax differentials of three sorts examine nursing homes. One finds that(sales, property, and corporate income salaries are no higher in NP than FPtaxes) on measures of the nonprofit mar- homes, so that if the cushion is devoted toket share in four industries (nursing waste, this waste does not take the formhomes, hospitals, primary and secondary of excessive salaries. Another finds thatschools, and vocational schools). The es- overall costs per patient were higher intimated individual effects of each tax NPs, but this study provided few controlsusually were as predicted, and the collec- for the quality of care. A study of the nu-tive effects of tax exemption were jointly clear medicine industry (a distinct diag-significant in both a statistical and an ab- nostic center at many hospitals) findssolute sense. For example, he finds that higher costs at NPs.elimination of these three tax differen- By far, the majority of efficiency stud-tials would reduce the NP share in the ies were conducted on the hospital indus-nursing home industry from its sample try. Summarizing the evidence, Paulyaverage of 24 percent down to 5 percent. concluded:

140.31 RICHARD STEINBERG 361

the overall impression is that of data is now accessible, so some thought"@rship-re]aW difference in hospittahlerceosit3giiitvteine ought to go into design of the ideal survey;slity, or in quality given bed size, teaching status,

instrument.,ii,d other proides for type of output . . . The one areain which there may be differences . . . is in price lev-

- My own impression is that (this differential)ale' * cularly strong evidence for important con- HI) summau

u is notoquences arismg from ownership structure. . The

for osin niesnp may mmply be that (FP) firms are more We do not yet know the impact of taxrEl. aely to be found in mwkets in which any fim,,for- and regulatory differentials on the behav-

c- profit or not-for-prefit, would charge high prices,' (P. ior and performance of competing FP andice

262). NP fims. This uncertainty extends to bothi@4 I would add that it is quite difficult to the theoretical And empirical levels. The-

md conduct an empirical study properly for ory construction has been hampered byna- niany reasons. First, firms are often jointly unresolved issues of environmental set-Ise providing multiple outputs, only some of ting involving market structure, entry and

*1 which are measured and incorporated in exit rules, tax incidence, capital market-;ax elupirical studies. Failure to include out- imperfections, and second-best consider-@8e puts which are provided to a greater ex- ations. Nonetheldss, several promisingta. tent in one sector than the other would analyses are in the draft stage.lar tend to bias cost comparisons. Second, Tax and regulatory differentials areies there may be subtle quality differences necessary (in many cases) if NPs are to

between the two sectors. An apparently play a distinctively different role in theLre homogenous product can be provided more economy. These differentials provide aqp conveniently (in terms of hours, location, cushion which could be devoted to both

necessity to backorder, etc.) in one sector, good and bad deviations: provision of thoseor with more courtesy, or with greater re- goods which FPs cannot supply, price-es

th liability. Third, those studies that hold breaks for the needy, increases in NP

ue quality constant may be over-controlling. market share, higher cost production

ch The fact that FPs provide a given quality techniques, or some combination of the

40 level more efficiently than NPs is of little four. We do not yet know how to design

n- relevance if NPs systematically provide a tax and regulatory breaks which foster

n- different quality level. Finally, there may only good deviations, nor do we know

0-be cream-skimming, as FPs concentrate whether the beneficial effects of good de-

TPon easy sales or treatments. Thus, the viations outweigh the harm from bad de-

setypical NP customer may differ from the viations under the current tax and regu-

a-typical FP customer, confounding simple latory structure. Future progress in the

Idcost comparisons. design of public policy towards the com-

reAs far as behavioral studies, we have petition will depend upon a better under-

Dsalmost nothing. Data limitations have standing of the incentives provided by al-

itprecluded careful industry-by-industry temative approaches toward subsidization.

pcomparisons of the effect of tax and reg- In light of our current ignorance and the

to ulatory changes on the behavior and en- potential distortions inherent in differ-

mtry of competing NP and FP firms. Per- ential treatment, some legislators wouldhaps a data set could be designed which have us deny tax exemption to those NPB

it matched IRS forms 990 and 990T (filed by which cannot prove that they provide so-n nonprofits) in a particular industry with cial benefits in excess of the governmenvsIs the corporate and partnership tax returns "tax expenditure" on them. Why subsi-

of FPs in the same industry and city, dize NPs, the thinking goes, for the pro-Cross-city and -industry comparisons vision of public goods when only a portion

s might enable us to learn something here. of the subsidy will be devoted to inere-Alternatively, the Urban Institute's sur- mental public good provision? WouldWtvey of NPs in 16 areas might contain use- direct public expenditures be superior?fal data that could somehow be raatched I cannot agree with this thinking. The

y against FP data from other sources. I re- burden of proof should not fall upon eachmain fairly skeptical that the right kind individual NP to justify its exemption. NPS

362 NATIONAL TAX JOURNAL [Vol. XLIV

innovate and experiment, and not every contrast, both dividends and capital gains are exemptexperiment is a success. Successful inno- from the UBrr. Thus, although the situation is more

complicated then portrayed in the text, the generalvations (such as day care, hospitals, drug- thmet of the argument holds. See Rose-Ackermanaddiction therapy,- and universities) have (1982a], Schiff (19881, and Hausmann [1989) for fur.often been picked up by government or for- ther discussion,

6See any recent public finance textbook, such as Ro-profits after NPs have demonstrated their sen 119881 for a discussion of alternative methods ofviability; "inefficienv' subsidies may be the estimating excess burdens and the attendant contro-price we have to pay for the next break- versies.through. 'I do not me= to suggest that competitive Nl% would

The burden of proof should also not fallindividually choose to underprice FPs, an argumentcorrectly rejected by both Rose-Ackennan (1982] and

on the NP sector more generally. NPs Hausmann [19891. Rather, the potential for high prof.constitute a pluralistic alternative to cen- its at NPB would induce eutxy of now NPs, drivingtral government, allowing a heterogenous down the market price until it was below the average

total coats at FP firms. Sea the discussion in the textsociety to better express diverse demands below.for public goods. Further, NPs serve as a al know "fint-besc is a ctreaffw redundancy in thecompetitive check on governments, pro- English laugmage, but it is a traditional designationviding a benchmark and a spur against in the language of economists.

inefficiency by government bureaucra- 9if the cushion is devoted to managerial perqs, andthese are counted as a cost of the good sold, then it

cies. Thus, we should be very cautious would seem that production costs are higher. This isabout removing those tax and regulatory not really productive inefficiency (in the technicalbreaks that allow NTs to function in a economic sense) because we are really jointly produc.

If pro f ing two outputs in this case-one which is sold anddistinctive fashion; the burden c 0 one which is provided as compensation to the man-should be placed upon the reformers. ager. The process could be productively efficient (if

there were no cheaper technique for producing thiscombination of outputs) but allocatively inefficient,

ENDNOTES as a change in the output mix could make everybodybetter off (see Schlesinger, 1985). Sacrificing preci-

**I appreciate the helpful advice of Thomas Bart-sion for clarity, I will simply refer to this as "ineffi.

hold and Jane Gravelle. ciency" or "higher oosv in the text.

'I.R.C. section 501(m). lothere are certain technical exceptions. For ex-

'This approach is similar to that taken by Gravelle -ple, a price-&wiminating monopoly would gen-

and Kotlikoff [19891, who faced an analytically sim-erally charge lower prices

to poor people in order to

ilar program in a different setting. They considered maximize their own profits, but the pattern of eqo-librium prices would not result in any particular def-

the incidence and efficiency costs of taxing corporate, inition of equity except by coincidence. Another ex-but not noncorpomte firms when both produce the samegood. In this setting, the modeler also has to work to

ceptaon oomus when there is publicity value in helping

explain co-existence, for tax laws would seem to favor the poor (for example, limited giveaways of expensive

UOUCorporate producers to the complete exclusion Of new drugs by pharmaceutical companies) which im-

corporations. Their solution, to assume scmvity of on-munnes altruistic and greedy managers alike fromtakeover bids.trep-neurial talent for founding and managing non- "Obviously, my treatment here is too brief to becorporate

equifibriura'rms end analyze the resulting sorting convincing. Gwa-antees, a desire for repeat business,, may serve as a model for future work onlicensing requirement&, court suits, and a variety ofthe.unfaw competition issues involving nonprofit or- other mechanisms must be considered before we canions, Their work suggests an additional com-

ication in the present setting, for if for-profit cor- conclude that FPs have the incentive and ability to

p,,I,, ould reorg,-ui,,, lor-pfit ,nrPo't"'cheat the customer. Weisbrod and Schlesinger [19861

(or hybrid S-corporations), the tax-exemption issuesand Weiabrod (19881 discuss all these complications

would be quite'different [Barrett, 19881.and several others, and conclude that the basic con-clusion of this text holds under some conunon cirem-

'In Schiff and Weisbio&s models, equilibrium stances.quantities are affected by a pure profits tax since the 12Barrett [19881 considers this point in considerableNP maximizes a utility function rather than mone- detail and begins such an analysis.tary profits. A pure profits tax then affects equilib-rium via the "income efTecC on managerial utility, 13@eent critical surveys of raucli of this evidence

'For a nice introduction to the controversy, see At- can be found in Marmor et al. 119861, Steinberg (19871,

kinson and Stiglitz L19801, although much has been Selden and Weisbrod (19881, and Weisbrod [19881.written since then.

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