Americans are incredibly generous when it comes to private philanthropy. It is estimated that as a nation we contributed some $390 billion in 2016 (Giving USA, 2017). In an undergraduate course in the Department of Economics called “The Economics of Compassion” we use standard tools of economic analysis to discuss improving the forms of compassionate activity that Americans are so predisposed to endorse.

One section of the course talks about becoming “informed donors” in terms of private philanthropy. With all of the options out there for giving during the holiday season, choosing a charity can be a daunting task. If your time were not valuable, there are direct, legal ways to get detailed information on most charitable organizations. For example, many categories of charities are required to file IRS Form 990 and make them publicly available. These are long, detailed forms containing a great deal of information about the charity. But suppose you were looking for a charity defined even in terms of fairly narrow criteria such as “sustainable agriculture in the developing world,” or “children’s health charities in the Southeast United States.” It could still be a daunting task to identify the relevant charities, locate their legal addresses, and then download and dissect their 990s.

Not surprisingly, in the era of the Internet and social media, there are independent organizations who perform these identification and analysis tasks for potential donors. Charity Navigator, GiveWell, Guidestar, and Ministry Watch are just a few of the examples. But, drawing on the old question “Who is guarding the guardians?” it’s still important to ask, “Do these charity rating sites give us good information about where we can donate money to be effective for the activities that we wish to support?”

An unavoidable problem with charity rating agencies is that they, by necessity, have to find a way to make summary and comparative recommendations, often called “ratings.”  In some cases, the components of the ratings are non-controversial (for example, financial transparency and guards against self-dealing, or the practice of organizations acting in their own interests rather than the interest of beneficiaries). However, one frequently employed metric has proven to be very controversial, and that is the so-called “overhead ratio,” or the proportion of a charity’s expenses devoted to things like salaries, administrative costs, and fundraising.

So what’s the problem with using overhead in rating charities? There are three problems that are notable.

First of all, overhead is often distinguished from “program expenses.” But in many cases, that divide is not clear cut. Is the salary of the filing clerk who also serves as the intake-greeter for clients an administrative cost or a program cost? Secondly, there is evidence (Gneezy, et al. (2014) and Portillo and Stinn (forthcoming)) that Americans are naturally “overhead averse,” meaning that we are sensitive and negatively predisposed to charities with higher overhead. This suggests that errors in definition or measurement of administrative activities by rating agencies can have a disproportionate impact on charitable donations, perhaps on your own decision as to whether to support charity A or B.

Finally, the very concept of whether donors should be averse to overhead has been challenged by the so-called charitable “effectiveness” movement (popularly championed by Dan Pallotta in his book (Uncharitable). While it’s difficult to introduce that argument in an abbreviated form such as a blog-post, we can generally summarize it with the following exaggerated question: “Which would you rather see raising funds for research for a cure for an illness that affects you or your family? A charity that raises $50,000 with a 10 percent overhead ratio so that it distributes $45,000 to research or a charity that raises $200,000 with a 30 percent overhead ratio that donates $140,000 to research?” The “effectiveness” movement asks us to consider that a charity with a higher overhead ratio may be more effective in fulfilling their mission than a charity with fewer overhead expenses.  Skimping on overhead spending makes it difficult for a nonprofit to attract high-quality workers and support the infrastructure necessary to benefit their recipients.

Unfortunately, there’s no easy answer to the “overhead matters” versus “effectiveness matters” debate. Some charity rating agencies (e.g., GiveWell) have tried to incorporate effectiveness into their ratings. But “effectiveness” may turn out to be just as hard to pin down as a proper definition of overhead.

So, what do we recommend that an informed donor do in light of these problems?

There are some parts of the rating system that really are not controversial and can be of enormous benefit to potential donors. Charities that are systematically off the scale in areas of financial non-transparency or threats of (or actually documentation of) self-dealing should raise a red-flag. But, at the end of the day, if you’ve studied the charity and its mission (and better yet, have personal experience with its programs) and you are happy with what you see, the less important the overhead/effectiveness debate should be for you.

Dr. Robert Mark Isaac is the Quinn Eminent Scholar Professor and the Chair of the Department of Economics.

  Joe Stinn is a Ph.D. candidate in the Department of Economics. His  research focuses on nonprofit organizations.​

The featured image is from the website, The Balance.