In the March issue I examined the rationale for seeking charitable grants and donations. The argument for gifts and grants was based on the economic concepts of externalities and public goods. In short, I observed that if nonprofit organizations provided public goods and services which could not be produced at efficient levels in the unfettered private marketplace, then nonprofits could improve social welfare by seeking to support and expand those goods and services, at least in part, through charitable donations.

In this installment, I would like to further explore the issue of public goods and ask the question, where do government revenues fit into a nonprofit organization’s financial portfolio? Let’s start with another economic concept that points to the vulnerability of nonprofits’ dependence on voluntary contributions - free riders. As noted in the previous installment, free riding means that not everyone who benefits from public goods will support them through voluntary payments or contributions. Because individuals cannot be excluded from enjoying the benefits of public goods, some will choose to exploit th! e situation by benefiting without paying anything, or by paying an amount substantially less than the benefit they receive. As noted in the March column, nonprofits have some remedies for this but these are often inadequate. We probably cannot depend on nonprofits to produce a sufficient level of social services for the poor, or environmental improvements, through voluntary contributions alone. This leads us logically to depend on government to overcome free rider effects. Government enjoys police powers and can impose taxes to support public goods at more efficient levels.

However, government’s advantage in overcoming free riding does not necessarily extend to service delivery. Government may raise revenues to support public goods but nonprofits may be more effective in actually delivering those services. This is the essence of Lester Salamon’s “third party government” theory of nonprofits. A number of factors may contribute to the choice of nonprofits as more effective vehicles for delivering certain public goods. These include potentially lower expenditures, including the leveraging of volunteer effort and charitable support, ! greater ability to customize services to meet the preferences of local communities and particular client groups, and efficiency- and quality-related benefits of competition through the engagement of multiple providers. There are also costs to contracting out which government must take into account in making this “outsourcing” decision. However, suffice it to say that, especially since the 1960s, government in the U.S. has chosen to implement many of its public goods, through contracting and subsidy of private organizations rather than direct supply, and that much of this support has been directed to nonprofit organizations.

The question at issue here, however, focuses on the flip side of government’s financing of public goods - the circumstances under which it makes sense for a nonprofit organization to seek and accept government funding, and where that funding fits into its overall revenue portfolio. This is not an easy question. On the one hand, the social missions of many nonprofit organizations are consistent with those of government funding programs. Hence, it makes sense to tap into government funding streams to advance that mission. On the other hand, government funding ca! n be problematic for nonprofits if it threatens to distort that mission. NCNE Research Advisory Council member Steven R. Smith, Michael Lipsky, and other researchers have identified these risks in the social services and other fields. Other researchers have highlighted some of the practical issues facing nonprofits that engage government funding, including cash flow problems associated with delayed or after-the-fact government payments, the need to support a costly bureaucracy in order to respond to government reporting and regulatory requirements, and potentially chilling effects on advocacy activity. Another concer! n is with interactions with other sources of revenue, so-called “crowd ing out” wherein acceptance of government funding may reduce charitable contributions. As NCNE Research Advisory Network members Richard Steinberg and Susan Rose-Ackerman, and others have shown, such effects can work both ways - i.e., government funding can either stimulate or suppress private giving, depending on the circumstances and how the funding is structured. Another concern is the volatility of government funding over time. Research by Lester Salamon, Alan Abramson and others have demonstrated important impacts on nonprofits of periodic government retrenchments, although scholars such as NCNE Research Advisory Council member Kirsten Gronbjerg have also suggested that despite its problems, government funding can prove to be a more reliable, less volatile, source of funding for many nonprofits than other types of revenue.

So where does this all leave the nonprofit decision maker? As with most things that nonprofits do, the best place to start is with mission, and to ask under what circumstances government funding can advance that mission beyond what would be possible without it. This brings us back to theory - what are the kinds of missions that are likely to be best supported by government funding?

First, back to the notion of externalities and the concept of free riding. If government funding can help to expand a service that involves substantial external benefits, and if a nonprofit cannot raise sufficient private support to maximize those benefits, then engagement of government funding may make good sense. A nonprofit that provides parenting education financed by modest fees and some donations might be able to do much more with a government subsidy.

Next, there are some services that nonprofits provide which are essentially public goods, with little chance to sustain themselves in the marketplace and which are likely to encounter substantial free riding. Foster care of neglected and dependent children is such a service. Engagement of government funding to overcome free riding makes sense in this circumstance as well. Indeed, it can be noted that nonprofits engaged in services that are essentially “redistributional” in nature, whether involving health or social services to less fortunate groups, housing for the homeless, or food for the hungry, are l! ikely to benefit from government assistance. Researchers such as Julian Wolpert and NCNE Research Advisory Network member Charles Clotfelter have demonstrated that despite its charitable values, the nonprofit sector as a whole does not offer services that are strongly redistributional. Rather people tend to patronize and support institutions that provide services to groups and activities close to home - their own churches, cultural, educational and health care institutions, etc. While redistribution takes place in some areas, it is not sufficient to underwrite important social benefits needed by society as a whole. Nonprofits whose missions address these redistributional issues are therefore often well advised to seek government funding.

In summary, the inclusion of government funding in a nonprofit’s revenue portfolio is likely to make sense, according to available theory, in certain circumstances involving externalities, public goods and redistributional benefits, where markets fail and free rider effects are strong. Theory, research and practical experience also suggest certain provisos that a nonprofit must take into account in seeking or accepting government funding. These include the additional costs associated with participating in government funding and regulatory systems, possible losses of other kinds of revenues due to interaction effects or crowding-out, chilling effect! s on advocacy, and the ever present danger of mission-drift wherein the integrity of the organization is threatened by virtue of its responsiveness to pressures to conform to government priorities.

Clearly a few words here cannot hope to capture the full complexity of a nonprofit’s decision to seek or accept government funding. However, I hope this sketch is helpful in creating part of the bigger picture of nonprofit finance. Next time we’ll go back to the market place and ask where fee revenues and profits from commercial ventures fit into the picture.