The Nonprofit Sector's Capital Constraint: Does It Provide a Rationale for the Tax Exemption Granted To Nonprofit Firms?

The exemption of the nonprofit sector from the corporate income tax is an implicit subsidy that has received little attention in the nonprofit literature A fundamental question concerning this subsidy is its rationale. The present analysis suggests that the theoretical basis for the rationale previously proposed by Hansmann, that the nonprofit sector's capital constraint justifies its tax exemption, relies heavily on the output effect of exemption. The article first suggests that the nonprofit sector's capital constraint might not be effective. Granting an effective capital constraint, the equivalence of the ration to a partial factor tax is used to show the effect of the constraint on the allocation of resources. If the tax exemption is targeted to the rationed factor, it can have no effect on the misallocation of resources because the rationed factor is immobile. If the tax exemption falls on mobile capital, that capital can avoid the tax by moving to the nonprofit sector. This must worsen the production distortion but might improve allocative efficiency. For an overall improvement in welfare, the improvement in allocative efficiency must outweigh the additional production distortions. Thus the Hansmann rationale for exemption of the nonprofit sector is similar to the rationale for exempting a sector that produces goods that are public in nature: the exemption provides a supply side subsidy to nonprofit output for both cases. In either case, the exemption is inherently a second-best method to achieve an increase in nonprofit output.