Why aren't endowments taxed?

The curious case of John and Jane Smith

(Editor’s note: large endowments are actually taxed at 1.4%. But I like simple titles. So I am adding this note so those of you in the weeds don’t “well, actually” me.)

“Mr. and Mrs. Smith, your generosity is inspiring,” said Dr. Henderson, President of of Ivywood University, a (fictional) Ivy League institution in New England, beaming with gratitude. “Your $100 million endowment will create a legacy that lasts forever.”

John and Jane Smith smiled, then Jane jumped in. “We’re thrilled to help,” she said. “But we want to make sure the money is used exactly as we intend—giving all first-generation college students free tuition. We want to see 1,000 first generation students attend Ivywood in our lifetime.”

“Mrs. Smith, of course I admire your intentions,” Dr. Henderson replied from behind his big oak table. “But let me explain how the process works. Here at Ivywood, we treat endowments as perpetual funds. We invest the $100 million and use the returns—typically 5% per year—for scholarships. That ensures your gift benefits students forever, and creates a perpetual legacy for you.”

John, a hedge fund manager, knew his math. “So, if you’re using 5% per year, that’s $5 million annually, right?”

“Correct,” Dr. Henderson nodded.

“And how much does tuition cost these days?” Jane asked.

“The average cost of tuition, room, and board at Ivywood in 2024 is $85,000 per year,” Dr. Henderson replied. “With your $5 million annual spend, we estimate the Smith Scholarship will support about 59 students every year—forever. Your names will become synonymous with opportunity.”

Jane tilted his head. “Fifty-nine students? That’s it?”

“But forever, Mr. Smith,” Dr. Henderson turned to John and reiterated. “Your legacy will live on.”

The headquarters of one of the world’s largest hedge funds.

Jane’s tone turned sharper. “But we don’t want to wait forever. We’re not interested in funding 59 students a year indefinitely. We want to make a real difference in our lifetime—while we’re alive to see it. Imagine the ripple effect in the next generation of 1,000 first-generation Smith Scholars that get to work today.”

Dr. Henderson was caught off guard. “Well, Mrs. Smith, I’m not sure I understand. What do you mean?”

“We’re saying,” John politely interrupted, “what if we spend the full $100 million over, say, ten years? That’s $10 million a year. At $85,000 per student, that would support about 118 students per year. Over a decade, that’s 1,180 first-generation students whose lives we could change. We’re 75 and we don’t know how much longer we have left. We’ve got a goal to see 1,000 first-generation students in our lifetime.”

Dr. Henderson cleared his throat. “While I understand the desire to see immediate results, that’s not how we manage endowments. Our policy is to ensure the fund lasts in perpetuity. Spending the principal would go against the university’s financial principles.”

John raised an eyebrow. “So what you’re telling us is, even though this is our money and our vision, we can’t choose to use it to maximize impact over the next ten years?”

“I’m afraid that’s correct,” Dr. Henderson said, shifting uncomfortably. “It’s simply not how we work.”

John said “Wait a second. I run a hedge fund. That’s where the $100M came from. You’re telling me that 95% of my gift is essentially going to be invested in people like me? Or my competitors?”

Journalist Scott Galloway famously called Harvard “a hedge fund offering classes.”

The Math of the Smiths’ Proposal

To understand how Ivywood could be seen as a “hedge fund offering classes,” let’s break this down:

1. University's 5% Model:

   • $100 million * 5% = $5 million annual spending.

   • $85,000 average annual cost per student.

   • $5,000,000 ÷ $85,000 = 59 students supported annually.

   • Over 10 years, 59 students × 10 years = 590 students supported.

2. Smiths’ 10-Year Vision:

   • $100 million spent evenly over 10 years = $10 million annual spending.

   • $10,000,000 ÷ $85,000 = 118 students supported annually.

   • Over 10 years, 118 students × 10 years = 1,180 students supported.

A Clash of Philosophies

The Smiths’ plan would effectively double the number of first-generation students supported over a decade. But the endowment model of universities, private foundations, and nonprofits prioritize long-term financial stability over short-term impact.

The Smiths and Dr. Henderson are fictional, but this conversation is drawn from real examples of conversations I’ve seen first hand dozens of times. (Ivywood’s cost is drawn from the average cost of an Ivy League institution today)

For donors like the Smiths, who want to see transformative results within their lifetime, this approach can feel stifling. Their $100 million could tangibly impact 1,180 students in just ten years. But under the university’s model, their money would support fewer students annually, albeit indefinitely.

Dr. Henderson leaned back in his chair, and put his hands in the shape of a big steeple, staring at his own hands and not the Smiths. “Mr. and Mrs. Smith, I understand your desire to see immediate change, but I must emphasize the power of legacy. By supporting 50 first-generation students every decade, forever, your gift will impact thousands over time. This kind of enduring legacy ensures stability and opportunity for generations.”

John Smith disagreed politely but firmly. “Dr. Henderson, that sounds great in theory, but we’re living in a moment of acute crisis. Class divisions are tearing elite America apart. Access to institutions like Ivywood is no longer just about education—it’s about who gets a seat at the table in shaping our country’s future. Funding 1,000 students in the next decade would double the number of first-generation leaders entering the highest levels of influence. That’s the kind of impact we want to see.”

Jane Smith nodded in agreement. “Look, Dr. Henderson, we don’t need to reinvent the wheel here. Foundations like the Olin Foundation had a ‘spend down’ policy and reshaped entire sectors of American life. They focused their resources on initiatives like law school scholarships for conservative thinkers, and funding Federalist Society, which trained conservative legal scholars who now dominate the federal judiciary. We personally disagree with many of the outcomes—I personally am horrified at the rulings from today’s Supreme Court—but there’s no denying the incredible return on their capital. They transformed their vision into reality within a generation.”

The Olin Foundation fully spent down its endowment in 2005.

Dr. Henderson hesitated before responding. “I appreciate your perspective, and there’s no doubt there are some…how do we put it…unorthodox foundations. But their model is rare. Most people like you choose to build something enduring, something that lasts beyond immediate political or social tides. The Smith Scholarship, as a perpetual fund, would secure opportunity for countless students long after we’re gone.”

Jane sighed, leaning forward. “But what about right now? What about the next decade? America is at a crossroads, and Ivywood is part of that story. If we don’t make bold moves to bridge these divides now, perpetuity might not matter.”

Dr. Henderson offered a faint smile. “And if every donor took the spend-down approach, what happens to the institutions like Ivywood in 50 years? Legacies built on immediate action alone might not weather the storms of the future.”

A Larger Philosophical Question…

Both Dr. Henderson and the Smiths make reasonable arguments. Dr. Henderson’s focus on perpetuity offers stability and long-term benefits, ensuring that the Smiths’ gift continues to support first-generation students indefinitely. But the Smiths’ perspective, rooted in a sense of urgency and inspired by the transformative impact of spend-down philanthropy like the Olin Foundation, highlights a bold approach to addressing immediate crises.

Yet, it’s the Smiths’ perspective that is rarely, if ever, represented in mainstream philanthropy. Should donors prioritize perpetual legacies or immediate impact? And when institutions prioritize their financial structures over donor intent, are they truly serving the greater good? For John and Jane Smith, the dream of seeing over 1,000 first-generation students graduate during their lifetime may remain out of reach—not because it’s unachievable, but because the system isn’t designed to work that way.

The broader (unresolved) question-if we are going to provide tax incentives for the nonprofit sector, is it better to provide that incentive for dollars that are spent sooner, or later? (The Opportunity Zone investment incentive requires investors to invest funds 180 days after receiving cash for the policy purpose that the cash needs to immediately be put to work). And should all nonprofits over a certain size (not just endowments) be taxed, to ensure that nonprofits are spending tax exempt resources in a timely manner? Or is Dr. Henderson’s long-term legacy comment lasting?

…and a policy question that’s likely to come up in 2025

And it underscores a policy question—if Harvard ($50 billion under management), Yale ($40 billion under management), the Gates Foundation ($75 billion under management), and dozens of other institutions are sitting on billions, and are effectively, hedge funds offering classes (or programs), is something broken with the system?

I believe the question of taxing endowments could become a major issue in the coming years, as America grapples with balancing the budget and reevaluating the role of educational organizations and nonprofits in a society increasingly defined by inequality. With endowment assets concentrated in a handful of elite institutions, the discussion around their tax-exempt status is both timely and politically charged.

One of the most significant proposals in this space comes from Vice President-Elect JD Vance. During his Senate tenure, Vance introduced the College Endowment Accountability Act, which aimed to implement a 35% excise tax on the net investment income of endowments exceeding $10 billion. The rationale behind this proposal was straightforward: these institutions have amassed immense wealth while tuition costs and student debt continue to rise, leaving many Americans questioning whether such tax exemptions are still justified.

JD Vance and other political actors like Vivek Ramaswamy take a politically charged angle to this: universities are “woke,” bloated, and spending tax exempt resources on administrators who are saying things politically that they disagree with. I don’t think this line of thinking is productive, as there are *many* reasons for taxing endowments that do not have to do with “Wokeness” (though I could see a coalition thinking about tax reform having different motivations, which is normal in politics).

The budget case for taxing endowments

It’s likely in 2025 there is going to be a tax extension bill that holistically looks at different ways to raise revenue (and cut taxes) with the threat of large budget deficits moving. Let’s look at how taxing endowments and nonprofits may play into that.

To estimate the potential impact, consider the largest endowments in the U.S., such as Harvard University ($50.7 billion), Yale University ($42.3 billion), and Stanford University ($36.2 billion). Combined, these institutions manage well over $150 billion in assets, with annual returns often exceeding 8%. Based on these figures:

1.     Net Investment Income: If these institutions collectively generate a conservative 7% return, that’s approximately $10.5 billion annually in net investment income for the three largest endowments alone.

2.     Excise Tax Revenue: A 35% excise tax on $10.5 billion would yield approximately $3.675 billion annually from just these three institutions.

Expanding this calculation to include the dozens of other endowments exceeding $10 billion could significantly increase revenue. For example, if the total taxable endowment income across all affected institutions reached $25 billion, the annual revenue from the excise tax could exceed $8.75 billion.

Alternatively, a broader proposal to impose a 5% excise tax on endowment incomes over $500 million would capture a much larger pool of institutions, potentially generating up to $100B annually, depending on the exact size and distribution of returns.

As America wrestles with growing deficits and urgent social needs, proposals like taxing endowments reflect a shift in how policymakers view the role of wealth in nonprofit and educational sectors. Whether such measures gain traction will depend not just on their revenue potential but also on whether they resonate with a public increasingly skeptical of concentrated financial power.

Appendix: What other ways could you think about nonprofit taxation?

This piece was meant to be a discussion of a hypothetical $100 million gift and look under the curtain on what actually happens with large nonprofits, foundations, and universities. For some final feedback I called my close friend, professor Daniel Hemel (who specializes in tax law at NYU). Daniel’s take:

·      We already have a 1.4% tax on endowments, it feels like the most politically viable thing is just to increase that amount. The case for and against is worth arguing, however, it’s unclear how Harvard paying 10% vs 1.4% would change behavior.

·      Another large issue is this: if what you’re really worried about is how can what is effectively taxpayer subsidy of $100M contributions better serve the public good, there are other tools. Contributions are *not* treated as a realization event; that is, an event that provides a taxable reporting to the government. if John Smith had $1M of stock that had appreciated to $100M, then he gives that $100M to Harvard, he actually does not pay tax on that $99M. You will see this all the time.

·      One proposal could be to treat contributions as a realization event, as well as shift tax deductions from offsetting to a credit. So let’s say every charitable contribution gets a 25 cents on the dollar offset. A family that makes $100,000 a year and tithes $10,000 a year to their church would get (if they itemized their tax returns) a $2,500 credit. The Smiths would pay tax on the $99 million stock gain, and get in return a $25 million credit. That would generate far more revenue for the taxpayer.

What does this mean for topophilia?

The bottom line from Professor Hemel is that nonprofit taxation is fraught with externalities, but as we go into a year where there’s likely to be a tax extension bill, there are generally holistic reasons to take a look at this billion-dollar topic.

Alexis de Tocqueville, in Democracy in America, extolled the virtues of small, local civic associations as the bedrock of American democracy. He observed that these organizations not only addressed immediate community needs but also cultivated active citizenship, fostering a sense of collective responsibility and engagement. Tocqueville wrote, "The health of a democratic society may be measured by the quality of functions performed by private citizens." By contrast, the concentration of wealth and power in billion-dollar institutions, such as large university endowments, risks undermining the localized, participatory ethos Tocqueville admired.

Policies that redirect resources toward smaller, community-based associations could help restore this balance, encouraging grassroots solutions while addressing the inequities perpetuated by centralized, tax-exempt wealth. This perspective raises a profound question: Are we better served by incentivizing the growth of massive, institutional endowments, or by empowering smaller, more agile organizations to meet the needs of their communities directly?

And going back to the theme of this newsletter—diminishing the incentive to have huge institutions that can be described as “hedge funds offering programs” could help. It would probably disproportionately benefit the small contributions to the local nonprofits (churches, schools, soup kitchens, sports leagues) and significantly diminish the value of nine-figure contributions to huge foundations and endowments, which may not be a bad thing.