|SECTION VI TAX EXEMPT SECURITIES
VI Tax Exempt Securities
Should the tax exemption of Government securities by abolished? If so, what differentiations should be made with respect to future issues and outstanding issues authorized and sold under various terms and conditions? The problem is: first, what is fiscally and socially desirable; secondly, what is constitutionally and politically feasible.
Constitutional Question. -- With respect to the constitutional question, if a layman might venture an opinion it would be that the Supreme Court, with a different personnel or under other conditions than those which it has actually confronted, might have built up a very different line of decisions, but in fact it has established precedents that make invalid Federal and State taxation of each other's outstanding securities, at least, without the consent of the authorizing Government, and except in extreme emergencies, for example, such as might justify such extreme action as nullification of the gold clause in Government issues. Of course, the personnel of the Court and the pressure of events and of public opinion upon the Court change from time to time; there have been important reversals in the past, there may be others in the future.
But with the constitutional lawyers in hopeless disagreement and with no desire to make hazardous forecasts, we shall leave the question of constitutionality to the Supreme Court, which will not pass on it unless a law is enacted and a real case is brought before it.
Fiscal And Social Questions. -- The fiscal and social aspects of this problem of exemption are in almost as much of a snarl as are the legal aspects. Opponents of exemption have been most vocal in recent years, and they claim that it causes substantial loss of revenue, the nullification of the progressive or ability-to-pay principle of taxation, and the consequent maintenance of a privileged class. Examination of available evidence indicates that there is some truth in these claims but not so much as is usually believed, though it must be admitted that there are many gaps in the evidence and most of the analyses are not conclusive with respect to certain important points. Inasmuch as the present writer has had insufficient time and assistance to carry this analysis appreciably further this summer, the best that is practicable at this time is to summarize the data that are available, including the few additional that have been secured; to indicate the gaps that need to be filled; and to suggest the conclusions that are indicated, even though a number of them are insufficiently substantiated.
Outline Of Problems. -- The main issues, other than legal, may be suggested in outline form, somewhat as follows:
What would be the effects of abolition of the tax exemption of Government securities If the Federal and Sate Government reciprocate With respect to income taxes only? With respect to property and certain other taxes possibly? If Federal and State Governments do not reciprocate, or do so only partially? Important effects to consider are Fiscal effects On tax yields ) ) On Government interest payments ) of Federal, ) State, Because of additional tax ) and ) local Because of uncertainty of ) Governments ) future taxes ) ) On extent of public expenditures ) ) (extravagance) ) Effects on private capital market and business Social effects Because of graduated rates Because of privileged classes, etc.
Amounts Of Securities Outstanding. -- On June 30, 1934 there were outstanding Federal interest-bearing securities in excess of $26,000,000,000, besides nearly $3,000,000,000 in Federal Farm and Home Owners' Loans, or a total of about $29,000,000,000. The gross State and local debt on December 31, 1933 is estimated at over $19,000,000,000, (net debt at $17,000,000,000). Thus, the grand total of interest-bearing Federal, State, and local issues amounts to from $46,000,000,000 to $49,000,000,000. Of the Federal issues nearly half are wholly tax exempt, but interest on the remainder is subject to the surtax. Of the State authorized issues all are exempt from Federal income taxes. Most State issues are exempt from their own State and local taxes but not from taxation by other States when in the hands of owners subject to the jurisdiction of the State levying the tax. Inheritance and estate taxes are commonly considered taxes on transfers or privilege and are not subject to the usual limitations on property taxes and on some income taxes.
The annual interest on Federal issues amount to about $950,000,000 (about 3 1/3 per cent) on State and local issues probably to about $1,000,000,000 (about 5 1/2 per cent).
Government Securities Outstanding on June 30, 1934.
United States Government $26,084,249,000 United States Possessions 160,000,000 State and Local 19,429,000,000 /1/ Federal Farm and Home Owners' Loan 2,811,108,975 Total $48,484,447,975
A large part of the Federal and other Government bonds are held by banks and other corporations not subject to Federal surtaxes, hence the Government fails to collect taxes on interest from most of its bonds that are supposed to be taxable, though ultimately some of this is reached in the hands of dividend receivers. There are many gaps in the information respecting the amounts of Government bonds held by various income and other classes of owners, hence it is impossible to determine with accuracy how much extra in taxes the Government would get if none were tax exempt. /12/
Revenue Losses. -- The August 30, 1934 Treasury estimate /13/ of additional revenue that would be gained by subjecting the interest from Federal, State and local Government issues to Federal income taxes is as follows:
Corporation income tax $34 million Individual income tax 148.5 million Total $182.5 million
The corresponding estimate of Mr. L. H. Parker, Chief of Staff of the Joint Committee on Internal Revenue Taxation, nearly a year ago, before the 1934 Act was passed and when passed and when the public debt was smaller than now, was that extra revenue "would not exceed $160,000,000 annually". Various estimates have been made by others.
Effects Of Taxes On Interest Rates. -- There is even more uncertainty about how much extra interest the Federal Government and others would have to pay on their debts if tax exemption were eliminated. Mr. McLeod, Government Actuary, estimates 1/2 of 1 per cent for Treasury bonds and 5/8 -- 3/4 of 1 per cent for certificates of indebtedness as the probable differential effect of Federal taxes.
The accompanying graph (Graph 11) supplied by Mr. McLeod shown the differences in yields from Federal bonds subject to surtaxes only and from others wholly exempt.
Table 14 gives similar data in tabular form for the First Liberty Loan 3 1/2's (wholly tax exempt) and the First Converted 4 1/4's (subject to surtaxes). The average differences shown over a period of 14 years is .727 per cent. If the very abnormal figures for 1920 were eliminated, the average would be slightly lower.
On a Federal debt of $30,000,000,000, 1/2 of 1 per cent amounts to $150,000,000 annually; 7/10 of 1 per cent amounts to $210,000,000. If State securities were taxed, the effect upon them would have to be included also.
The estimates of revenue losses above include that from Federal taxes on State and local, as well as Federal, issues. If these estimates are correct, the elimination of tax exemption would appear to indicate little or no fiscal gain to the Federal Government and a substantial loss to the States and localities, assuming Federal taxes only. State taxation of State and Federal bonds might mean little or no gain to the States, but certainly much loss to the Federal Government.
In 1924 the Federal Trade Commission estimated the loss of Federal taxes due to tax exemption of securities to be between $181,000,000 and $100,000,000 in 1923, with the latter figure probably more nearly correct. /14/ It suggested that taxing such securities might raise the interest rate very little or not at all because very all because very large public debts might so saturate the market that buyers subject to surtaxes would have to pay no more than the marginal buyer. This is a common argument, which appears to overlook the fact that all buyers are marginal with respect to the last units purchased by each. The Commission did recognize, however, that the interest rate might be raised by taxation.
Table 14. -- Prices and Yields on First Liberty Loan 3 1/2 Per Cent Bonds and First Liberty Loan Converted to 4 1/4 Per Cent Bonds, June 30, 1920, to June 30, 1934 (a) (Yields calculated at maturity date)
Year First 3 1/2's (b) and Day Prices Yield Per Cent June 30, 1920 $91.00 -- $91.08 4.049 Dec. 31, 1920 89.90 -- 89.92 4.130 June 30, 1921 86.54 -- 86.60 4.369 Dec. 31, 1921 94.84 -- 94.94 3.816 June 30, 1922 100.04 -- 100.10 3.497 Dec. 31, 1922 100.96 -- 101.00 3.441 June 30, 1923 100 14/32 -- 100 17/32 3.470 Dec. 31, 1923 99 5/32 -- 99 6/32 3.553 June 30, 1924 101 17/32 -- 101 19/32 3.401 Dec. 31, 1924 100 30/32 -- 100 31/32 3.439 June 30, 1925 100 31/32 -- 101 1/32 3.435 Dec. 31, 1925 99 17/32 -- 99 20/32 3.528 June 30, 1926 101 11/32 -- 101 15/32 3.406 Dec. 31, 1926 101 5/32 -- 101 9/32 3.417 June 30, 1927 101 -- 101 2/32 3.428 Dec. 31, 1927 101 20/32 -- 101 26/32 3.379 June 30, 1928 100 2/32 -- 100 5/32 3.492 Dec. 31, 1928 99 22/32 -- 99 27/32 3.517 June 30, 1929 96 10/32 -- 96 13/32 3.781 Dec. 31, 1929 99 15/32 -- 99 16/32 3.540 June 30, 1930 100 31/32 -- 101 1/32 3.422 Dec. 31, 1930 101 26/32 -- 101 29/32 3.352 June 30, 1931 102 16/32 -- 102 19/32 3.294 Dec. 31, 1931 97 27/32 -- 97 28/32 3.683 June 30, 1932 101 4/32 -- 101 6/32 3.401 Dec. 31, 1932 102 9/32 -- 102 11/32 3.297 June 30, 1933 102 17/32 -- 102 19/32 3.270 Dec. 31, 1933 100.18 (Closing) 3.447 June 30, 1934 104.04 (Closing) 3.111 Year First 4 1/4's (c) and Day Prices Yield Difference Per Cent in Yields Per Cent June 30, 1920 $85.60 -- $85.70 5.251 1.202 Dec. 31, 1920 85.10 -- 85.20 5.300 1.270 June 30, 1921 87.23 -- 87.32 5.141 .772 Dec. 31, 1921 97.08 -- 97.18 4.440 .624 June 30, 1922 100.14 -- 100.18 4.240 .743 Dec. 31, 1922 99.06 -- 99.10 4.311 .870 June 30, 1923 98 -- 98 4/32 4.382 .912 Dec. 31, 1923 98 9/32 -- 98 11/32 4.366 .813 June 30, 1924 102 4/32 -- 102 7/32 4.103 .702 Dec. 31, 1924 101 16/32 -- 101 18/32 4.145 .706 June 30, 1925 102 21/32 -- 102 25/32 4.062 .627 Dec. 31, 1925 101 20/32 -- 101 24/32 4.131 .603 June 30, 1926 102 15/32 -- 102 16/32 4.073 .667 Dec. 31, 1926 102 30/32 -- 103 2/32 4.033 .616 June 30, 1927 102 29/32 -- 102 31/32 4.034 .606 Dec. 31, 1927 103 12/32 -- 103 16/32 3.994 .615 June 30, 1928 101 18/32 -- 101 22/32 4.126 .634 Dec. 31, 1928 100 6/32 -- 100 9/32 4.231 .714 June 30, 1929 99 1/32 -- 99 3/32 4.325 .544 Dec. 31, 1929 101 7/32 -- 101 10/32 4.147 .607 June 30, 1930 102 3/32 -- 102 8/32 4.071 .649 Dec. 31, 1930 102 28/32 -- 102 30/32 4.007 .655 June 30, 1931 103 11/32 -- 103 13/32 3.963 .669 Dec. 31, 1931 99 10/32 -- 99 24/32 4.292 .609 June 30, 1932 101 20/32 -- 101 22/32 4.105 .704 Dec. 31, 1932 102 8/32 -- 102 11/32 4.039 .742 June 30, 1933 102 5/32 -- 102 10/32 4.039 .769 Dec. 31, 1933 101.18 (Closing) 4.097 .650 June 30, 1934 103.13 (Closing) 3.912 .801 Average .727
Of course, if both Federal and State Governments tax each other's bonds, the difference in interest rates by virtue of this taxation might be less than if only Federal or only State bonds were exempt. On the other hand, if the bonds of either or both jurisdictions are made taxable, an extra element of uncertainty is introduced, no one can know what the tax rates will be a year hence, particularly 20 or 40 years hence, consequently the normal interest rate will have to take account of this uncertainty as well as of the tax itself. The uncertainty of the effect of a definite tax and the additional uncertainty of the effects of unpredictable taxes raise doubts of the desirability of abolition of exemption in the minds of those intimately connected with the Government bond market, especially now when large refundings and new flotations are being considered. But to make the change after all important issues are out would be like locking the barn door after the horse is stolen.
Dr. C. O. Hardy, who has made the latest published comprehensive study /15/ of this subject, comes to the conclusion that losses by virtue of tax exemption of Government bonds are commonly much overestimated; that with respect to wholly tax exempt Federal securities, the Treasury probably losses about the same in taxes as it gains in interest, but that it sustains a net loss with respect to Federal Farm Loan bonds; that the Federal Government loses because it cannot tax State and municipal securities, but that this loss is no greater than the issuing Governments gain; that most other arguments advanced in favor of the abolition of tax exemption are unsound or of insufficient importance to justify the proposed change, but, on the other hand, that most arguments generally advanced in defense of tax exemption are also of no weight. He found no evidence that high surtaxes interfered seriously with business activity or added to the cost of living. Moreover, he thought that the tax disparity caused by the very high surtaxes as compared with taxes on those with small incomes could be justified only as a means of equalizing incomes or of offsetting the regressivity of other taxes.
As stated earlier, the data bearing upon the various questions involved in this problem are so incomplete and elusive that the analyses based on them are inconclusive, so much so that those who have strong feelings against tax exemption certainly will hesitate to accept either the indications of the estimates given above or Dr. Hardy's conclusions.
Comprehensive Study Recommended. -- The completion of the study of tax exempt securities -- so well begun by the Couzens Committee, the Federal Trade Commission and Dr. Hardy -- is a very large task, but the importance of the issues involved appears to justify exploring further the possibilities in this connection. The task could probably be performed by the Treasury Section of Financial and Economic Research if it does not have too much other work, but the task is too large to be taken on incidentally as a small extra.
It would appear more appropriate for the Treasury than for almost any one else to make this very important study, but, if this is not feasible, one might consider making unofficial inquiries to see if Dr. Hardy and the Brookings Institution or the National Bureau of Economic Research would undertake the task. /16/ This should be done at once to avoid delay in legislation before too many more bonds are issued. Without some such extensive study, about all one can do now is to make the best estimates and guesses possible on the basis of studies and facts at hand. The issue is rather important, it is being pressed by business organizations and by Congressmen more and more each year. The Treasury and Congress are practically forced to take some position on it.
Tentative Conclusions. -- The writer's tentative and insufficiently supported opinion is that the Federal Government loses comparatively little fiscally through tax exemption of its own securities, that the States and local units of Government probably lose still less on the whole -- in fact, they may gain --; but that exemption may nullify graduation in part and foster certain privilege unduly, although it is popularly thought to foster even more privilege than it in fact does.
On the whole the writer is quite uncertain as to what is wise for the Government to do at this time about an elimination of tax exemption of Government securities, though he is inclined to favor it if the cost is not too great. He does not at present believe, however, that much, if any, net revenue is to be gained in this way. But if a more exhaustive study of the subject shows that the Governments concerned would lose no substantial amount of net revenue, if any, by the abolition, he would be in favor of it because of its effect upon progressive taxation, social justice, and class feeling.
Some argue that tax exemption never had the constitutional support commonly supposed, and that it has even less since the adoption of the sixteenth amendment. One way to test this would be for Congress to put the question up to the Supreme Court by the enactment of a law. It is very doubtful if the States will approve most of the proposals for a constitutional amendment permitting the taxation of these securities. It would be a breach of faith to tax all present outstanding Government securities under the guise of an occupational excise tax as is proposed by some governmental authorities, even if this method is technically constitutional as some proponents claim. It would not be so indefensible, however, to use such a method to reach future issues.
Recommendations. -- If the study suggested above could be started promptly with an adequate staff, recommendations could probably be made before the end of the next session of Congress, in time for that body to submit an amendment based on the finding. If there is no prospect that Congress will soon have any more information than is now available, the writer would make the following recommendations, though with much difference for reasons already indicated:
1. Submit a Constitutional Amendment (Oliver plan) to permit the Federal Government to levy non-discriminatory income taxes upon future issues of securities authorized by the states, with provision for returning proceeds ratably to the States. Or,
2. Submit Constitutional Amendment to permit both Federal and State Government to levy non-discriminatory income taxes upon each other's future issues of securities. (Government compensation might be included. Very doubtful if three-fourths of States would ratify this, and it is not urged strongly.)
3. If neither of the above is politically feasible, enact statute to permit non-discriminatory Federal and State levies of general excise taxes, measured by income, including income from tax-exempt Federal and State authorized Government securities, upon future issues of such securities, (Not urged.)
Any one of these plans, if adopted, would settle, or lead to settlement of, the most important constitutional questions now involved, though any plan involving a constitutional amendment would probably require several years for ratification.
The Oliver plan has much more chance of ratification by 36 States than the second plan. It would permit a trial of the effects of taxing Government securities and might result in additional revenue, possibly to both State and Federal Governments, unless borrowing rates were raised too much. It would enable the Federal Government to get a little more in taxes than it turned back to the States even though it distributed to the States the amounts of tax collected at average rates on State securities, because it would throw more income into surtax brackets where the rates are above the average. This extra amount is relatively insignificant, however. If it worked well, this plan would probably lead the States to tax their own securities, but it would not permit the taxation of Federal securities by 48 different States and their numerous local governmental units with all varieties of methods and rates. Even though such taxes were non-discriminatory, they might have serious effects, due to uncertainties as well as to terms of taxes per se, as noted a few pages above.
The second plan is not very attractive on account of the objections noted in preceding paragraphs; moreover, it has little change of ratification. If no better plan is evolved, however, it might be tried.
The third plan is a rather devious one; direct methods would be preferred if feasible. If applied to future issues only, however, as any plan should be, bond buyers would be put on notice and no breach of faith would be involved.
Note. -- In order to give a better idea of the problem summarized above and also of the gaps in data at hand, there is in the Appendix to this section an outline or brief statement of the study we planned to undertake but had to give up because of the difficulty in getting the desired data with the help and time available. (Pages 221-223a)