Do Tax Incentives for Nonprofits Provide an Unfair Advantage?

In recent years, a debate has emerged about whether nonprofits, by virtue of their tax exemption, have an unfair advantage when competing with for-profit organizations for the same customers.

The debate has focused on industries like health care, but in a new paper, Wharton business and public policy professor Katja Seim brings the question to health clubs and recreation centers. Both strip-mall chains like Curves and the old-standby YMCA offer exercise machines and personal trainers, nutrition counseling and yoga classes.

But one pays taxes, and the other, generally, does not.

So does that put them on an uneven playing field? Not exactly, write Seim and co-author Teresa D. Harrison, a professor at Drexel University, in “Nonprofit Tax Exemptions and Market Structure: The Case of Fitness Centers.”

For-profit organizations, they note, tend to view their tax-exempt peers with suspicion, claiming they have an advantage with no clear public benefit. The authors say this criticism is based on two assumptions: that both kinds of health clubs serve the same audience, and that the tax exemption allows nonprofits to enter the market to the exclusion of the for-profit clubs. There is a good deal of overlap in the customers for which the two businesses compete, but organizations like the YMCA also tend to attract people who value child care and youth programs, as well as people who embrace the organization’s Christian values-based mission, the authors point out.

Concerns that nonprofit tax exemptions put for-profits at a competitive disadvantage are largely unfounded, Seim says, noting that the Y “brands itself very clearly around family values and programming, even in its fitness offerings.” Seim and Harrison add in the paper that the two kinds of health clubs “do not seem to have a significant impact on each other’s entry decision.”

Concerns that nonprofit tax exemptions put for-profits at a competitive disadvantage are largely unfounded, Seim says, noting that the Y “brands itself very clearly around family values and programming, even in its fitness offerings.”

To put a finer point on it, the authors note that the tax exemption is an important element in the nonprofits’ business model, and that if they suddenly lost it, entry of these centers into the market would decrease by 25%. Some communities would see lower levels of physical fitness, since for-profits would be unlikely to fill that hole left by the lack of nonprofits, they write.

Market and Mission

Nonprofits account for a 20% share of the fitness and recreation club market by membership, the researchers say. YMCAs, which dominate this sector, rely heavily on membership dues and program service revenues, they add. The YMCA — Young Men’s Christian Association — started out in 1844 in England with more of an evangelical objective, but by the turn of the century had evolved to a health-and-fitness focus. Today, YMCAs provide fitness facilities, sports and aquatic programs, and after school programs, including child care. There are 4,519 locations nationwide in the U.S. YMCAs tend to have staying power — Seim and Harrison note that the median location has been around since 1984, as opposed to the generally newer for-profit clubs.

Groups that benefit from 501(c)(3) status are exempt from federal income taxes, and are usually also exempt from state income, sales and property taxes, the researchers write. In an attempt to quantify the tax benefit, the authors found that businesses roughly the size of a fitness center tended to pay about $43,000 in taxes in 2009.

The authors looked at fitness centers in 442 medium-sized markets of between 10,000 and 200,000 residents. They found YMCAs in 179, or 40%, of those markets. For-profit facilities are in 407 of the 442 markets, they write, adding that the largest of the for-profit chains is Curves, with 62% of chain affiliations, they note.

To test their questions, the researchers created an empirical model that takes into account factors including profitability, fixed costs and taxes paid by for-profits. They used demographic data such as population size, education levels, income, age and marital status, as well as regional health factors. The researchers also took into account other places to exercise, like higher education institutions, publicly owned community centers and outdoor parks.

They found that in markets where there were four or fewer for-profits, there was a YMCA in the area 34% of the time. In markets with five or more for-profits, a YMCA was there 66.3% of the time. Both types of fitness center appear to benefit from the same demographic profile: “We find that both non- and for-profit firms have a higher likelihood of entry in higher income markets … suggesting that the nonprofit does not seek to enter primarily low-income, underserved markets.”

However, there is some differentiation, the researchers add: The YMCAs were more likely to locate in larger markets and markets with a population that is more educated, wealthy and slightly older. The population also tends to include more single people and more African Americans.

The researchers also measured the population of children ages nine and younger who may need child care and after-school services — a service offered at the Y, but generally not at the for-profits. In addition, they looked at religious affiliation, noting that Christian adherents are more likely to sign up with a YMCA — “The core mission of promoting Christian values suggests that the overall religious affiliation of the populations may play a role,” Seim and Harrison write.

The authors add that since nonprofits do not need to, and in fact cannot, return profits to their funders, they could have an incentive to offer higher-cost, and higher-quality, services.

“This type of service is thus likely to appeal to a different customer segment from a normal fitness center, even though the two probably do compete on proximity to the customer and price,” Seim notes, adding that even if a consumer desires the family programming generally offered by the YMCA, if the Y is too far away, he or she might opt for the local for-profit club.

Taxes and Cross-Subsidization

There is also a funding difference between the two businesses. YMCAs can cross-subsidize, using fitness center revenue to help pay for youth programs.

The researchers used the model to see what would happen if for-profits paid $3,400 more in taxes than they currently do. They saw for-profit entry into the markets decrease by 7% while nonprofit response did not change. “We predict virtually no change in the nonprofit response to this lower propensity of for-profit entry, in line with the results that for-profits do not have an economically meaningful effect on nonprofit value,” Harrison and Seim write.

The authors add that since nonprofits do not need to, and in fact cannot, return profits to their funders, they could have an incentive to offer higher-cost, and higher-quality, services. Nonprofits, they say, place a value on attracting large numbers of customers, which results in lower costs.

Studies show nonprofits in general have a higher market share in places where taxes are higher, although it’s unclear whether this is because more nonprofits are trying to break into those areas, or because nonprofits tend to have greater longevity than for-profits, they write. The nonprofits, Harrison and Seim note, tended to have more employees than for-profit clubs. Of course, Seim acknowledged that not all for-profit health clubs are made equal.

“The Y,” she says, “may not compete as much with, say, a Bally’s, as an LA Fitness might.”

According to Seim, the findings show that, in this case, offering nonprofits preferential treatment via the tax code is “an effective way to achieve the stated goals of incentivizing nonprofits to provide services that otherwise do not get provided, but that from a social perspective we would like to be provided.” The tax exemptions drove nonprofit entry into the primary gym business, she notes, “but also into other services such as child care provision, which might be under-provided [in those communities] otherwise, while at the same time not overly affecting the presence of for-profit gyms.”

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