Governmental “Crowding Out” in Philanthropy

In economics, “crowding out” describes the way that increases in government spending may lead to a reduction in private spending. The theory suggests that government spending does not have as large an effect on the economy as might be expected because the impact is offset due to the crowding out of private spending.

It turns out that a similar dynamic appears to be at work in philanthropy. But while the crowding out theory in macroeconomics is controversial and the magnitude may not be large, a new report suggests that government grants to nonprofits end up crowding out a stunningly large amount of private philanthropy.

In a paper by James Andreoni and Abigail Payne of the National Bureau of Economic Research (hat tip: John MacIntosh of SeaChange Capital Partners), the authors find that for every $1,000 of government grants given to a nonprofit, private donations fall by $757. This means that while the government is trying to supply the nonprofit with $1,000 in additional financial resources, in practice the nonprofit only receives an additional $243 due to the drop in private donations.

But fascinatingly, it appears that the drop in private donations is mostly self-inflicted. For every $1,000 in government grants, nonprofits reduce fundraising expenditures by $141, causing private donations to fall. Netting together the reduced fundraising expenses and the additional revenue, the nonprofit ends up about $385 better off financially for every $1,000 in government grants.

There are a lot of interesting ways to think about the implications of this data. The authors of the report reflect to some extent on the lack of a revenue maximizing approach to fundraising – bringing to mind some of Dan Pallotta’s critiques – and seem to suggest that nonprofits should just choose to not slow fundraising when they receive a grant.

But the report reminds me of a story my friend George Overholser tells about the ramifications of the nonprofit sector booking all grants as revenue without any accounting for equity (growth capital). George used to be a venture capitalist and work with a venture philanthropy organization. He relates a story about how in the morning he presided over a meeting where the venture philanthropy group made a large grant to a nonprofit. Everyone was very excited and it was high fives all around with the nonprofit executives leading the cheers. The excited executive director happily pointed out that the grant met their entire fundraising budget for the year and so now they could focus on their programs.

That afternoon, George presided over a meeting where the venture capital group made a large investment in a for-profit. Again it was high fives and excitement, except this time only the venture capitalists were cheering. Looking over at the for-profit executive team, George noticed they all seemed nervous. When he asked what was wrong, the CEO said, “well, now that we have the growth capital, the pressure is on to generate revenue!”

To the nonprofit executive director, it didn’t matter if the venture philanthropy donors called their grant an “investment”. The only accounting treatment for money coming into a nonprofit is revenue. But for the for-profit, the venture capital money really was an investment. It would be booked as equity, not as revenue, and from here on out their success in generating revenue would be measured against the amount of equity they had deployed to build their business.

I’ve written before about the importance of philanthropic equity, a concept that George pioneered, in the past. But I’ve never really thought about the way that the lack of appropriate nonprofit accounting actually creates a vicious crowding out effect.

I’ve always thought that the catchphrase “accounting is destiny!” that Clara Miller and George would throw around when they ran the Nonprofit Finance Fund was a little… nerdy. But it sure seems to me that our simplistic nonprofit accounting standards, paired with our moralistic views around spending money on fundraising, is a major culprit of our undercapitalized nonprofit sector.

If accounting is destiny, the nonprofit sector will not see the emergence of a significant number of high growth organizations until growth capital is officially recognized in nonprofit accounting.