How Nonprofits Can End Up Becoming a Drain on City Budgets

Municipal governments can't sit idly by while tax-exempt organizations get services for free.

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Nonprofits in America range from small community charities to large national and international organizations and universities, hospitals, art museums, religious institutions and more. One thing they all have in common, however, is that they do not pay property taxes on the real estate and the buildings they own. In some cities, they are even exempt from paying for water and other services. This is despite the fact that a nonprofit benefits from the same city services as the tax-paying organization down the street or across town, from police protection and roads to public education for the children of the organization's employees.

In other words, the buildings and offices which house the economic activity of nonprofits are for the most part 'off the tax rolls.' Because education and health services are organized under the 501-c-3 provisions of the IRS tax code, states grant them tax-exempt status. Why? Because they are contributing to the 'general welfare' and providing 'social goods.' In the case of nonprofit hospitals, for instance, it's expected that in return for being granted tax-exempt status on their property, hospitals will provide care to the indigent, thereby reducing costs to the public sector. A laudable and entirely defensible reason for being granted a privilege. But how much indigent care is enough to qualify?

What's adequate?

Cities seeking to recoup some of the taxes lost to property tax exemptions took heart in a 2010 Illinois Supreme Court [PDF] decision that connected the degree to which nonprofits deliver legitimate charitable services to the question of whether or not they should be exempt from paying property taxes. The court’s decision upheld a state government denial of a property tax exemption to Provena Hospitals, which owns and operates the Provena Covenant Medical Center in Urbana, Illinois, as well as other healthcare facilities in the state. After finding that the "charity care" provided by the Urbana hospital amounted to only 0.723 percent of its revenues in a given year, the Supreme Court said that Provena did not deserve the exemption it had been receiving. "With very limited exception, the property was devoted to the care and treatment of patients in exchange for compensation through private insurance, Medicare and Medicaid, or direct payment from the patient or the patient’s family," the court found.

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The extent to which the Provena case produces meaningful revenue changes for cities, particularly those where tax-exempt hospitals are a significant presence, remains to be seen. As a substitute for property taxes, many nonprofits already make voluntary payments to cities (called payments in lieu of taxes, or PILOTs for short). The emphasis on "voluntary" and how much a 501-c-3 really wants to pay for city services—as opposed to how much the 501-c-3 is actually receiving in government services—tends to be the sticking point in negotiations. A 2010 study [PDF] published by the Lincoln Institute of Land Policy found that PILOTs "are often haphazard, secretive, and calculated in an ad hoc manner that results in widely varying payments among similar nonprofits." 

More to the point, the researchers found that PILOTS, as currently structured and administered in most cities, simply do not deliver anything resembling the amount of revenue lost to nonprofits’ property tax exemptions. For example, the study cited "negligible revenue potential from PILOTs for vast majority of Minnesota cities and towns." What is the tax value of the properties that are exempt from local taxation? In Philadelphia, 12 percent of the property tax base is exempt, while in some other cities the percentage gets as high as 50-60 percent if state government properties are included. Other examples are Boston (where the estimate is that PILOTs contribute only 1.4 percent of the city budget), Pittsburgh (PILOTs contributed $4.4 million or 0.89 percent of the city budget), and Detroit (0.17 percent).

Certainly, cities must re-examine their tax-exempts and be assured that they are indeed performing in a manner that legally grants them tax-exempt status. But cities should not lose sight of the fact that nonprofits do indeed consume city services and, if they are not reimbursing the city for the costs of those services, the city – meaning, the taxpayers – are explicitly subsidizing those services. If this is a policy that citizens are aware of and endorse, then democracy has produced a salutary outcome. But if it has been hidden from view or if there is an implicit assumption that the nonprofits, such as hospitals, are providing a quid pro quo to the city or they are constitutionally protected (e.g., religious institutions), then city council and the citizens should be informed.

Of course, there are other fiscal tools that cities can rely on that are not considered a 'tax' and therefore must be paid by nonprofits. Vehicle registration fees, for example, are imposed on all owners and are often dedicated to streets and bridges; water, sewer, sanitation, garbage fees are paid by all users of such services; a linear-curb fee is a charge to owners of property that border streets and can be used to provide street cleaning, street repairing, and streetlamp replacement; building permit fees; inspection fees; and the list goes on and on.

Among the more creative and outside-the-box suggestions for ensuring that tax-exempt entities pay at least a portion of the service-delivery costs is a trial balloon that was floated three years ago by the young Mayor of Pittsburgh and shot down within six weeks. The "tuition tax," as it was called when Luke Ravenstahl proposed it three years ago, was to have been a 1 percent tax on college tuition to help support city services by generating $16.2 million annually. Students, many of whom are not Pittsburgh residents, receive services without paying for them; and certainly universities, as tax-exempt organizations, don’t pay property taxes. The Pittsburgh Post-Gazette quoted the mayor as saying: "There is a tremendous amount of service that we provide already to these college students -- police protection, fire protection, building inspectors," Mr. Ravenstahl said, and it's time they helped pay for it.

The students and administrators rebelled, the city capitulated, and the universities responded by pledging to increase their PILOTs…… to $5 million. Compared to $16.2 million, that’s quite a discount. More important, however, is that the principles of fairness and transparency are being pushed to the sidelines. On what philosophical basis do the good citizen-taxpayers of Pittsburgh, or any city, agree to subsidize the costs of service delivery (e.g., public safety, transportation) for some entities and not for others? Whether a tuition tax is a good or a bad idea, the broader issue is: Taxpayers should engage in a broad-based dialogue about which entities should be provided services without charging them for the cost of service delivery and which entities should pay the full freight. If tax-exempts are providing quasi-city services, such as indigent care at hospitals, the taxpayer-voters might conclude that an equitable trade-off has been agreed to. Wherever any one falls on the tax-exempt/taxable divide, the taxpayer-voter ought to at least know which entities are subsidized at what tax-price, so that a deliberative dialogue on "who benefits" can be honestly and openly debated.

Top image: larry1235/Shutterstock.com

About the Author

  • Michael A. Pagano is dean of the College of Urban Planning and Public Affairs at the University of Illinois at Chicago and co-editor of Urban Affairs Review.