THE NONPROFIT SECTORS 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 nonprof it literature. A fundamental question concerning this subsidy is its r ationale. The present analysis suggests that the theoretical basis for the rationale previously proposed by Hansmann, that the nonprofit sec tor's capital constraint justifies its tax exemption, relies heavily o n 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 p artial factor tax is used to show the effect of the constraint on the allocation of resources. If the tax exemption is targeted to the ratio ned factor it can have no effect on the misallocation of resources bec ause the rationed factor is immobile. If the tax exemption falls on mo bile capital, that capital can avoid the tax by moving to the nonprofi t sector This must worsen the production distortion but might improve allocative efficiency. For an overall improvement in welfare, the impr ovement in allocative efficiency must outweigh the additional producti on distortions. Thus the Hansmann rationale for exemption of the nonpr ofit sector is similar to the rationale for exempting a sector that pr oduces goods that are public in nature: the exemption provides a suppl y side subsidy to nonprofit output for both cases. In either case, the exemption is inherently a second-best method to achieve an increase i n nonprofit output.