Vf/-v . Ku£~ IS « ■I HI1M— Cornell University Library The original of this book is in the Cornell University Library. There are no known copyright restrictions in the United States on the use of the text. http://www.archive.org/details/cu31924014051472 Investment Securities and Tax Exemption By G. E. PUTNAM Reprinted from Washington University Studies Vol. VII, Humanistic Series, No. 1, pp. 3-30, 1919. Corn eUUn^sKy^ary HJ5905.P98 taxeX empti°n lnvest „.n, secures 472 3 1 92A 0U 051 Investment Securities and Tax Exemption By GEORGE E. PUTNAM Reprinted from Washington University Studies Vol. VII, Scientific Series No. 1, pp. 3-29, 1919 INVESTMENT SECURITIES AND TAX EXEMPTION GEORGE E. PUTNAM Professor of Banking and Finance One of the many conspicuous evidences of the backwardness of American fiscal policy is to be found in the careless application of the tax exemption principle. While there is abundant justi- fication for the practice of exempting a portion of all private in- comes from taxation — it is one of the most convenient ways of making the tax burden correspond to the individual's ability to pay — the special exemption of government and quasi-govern- ment bonds from the income tax is completely out of harmony with modern conceptions of just and equitable taxation. And notwithstanding the fact that up to the time of the European war practically all of the European countries, after some wavering, had found it inadvisable to exempt their government securities from income taxes, the tendency in the United States had been just the reverse. Instead of upholding rigidly the principle of uniformity and universality in taxation, the state and national legislatures seemed committed to the more lenient and inconsist- ent policy of extending indefinitely the list of tax exempt securi- ties. The European war greatly accelerated this tendency, so far as the national government was concerned, because it called forth a tremendous increase in government and quasi-govern- ment bonds. The important securities which are now tax exempt in whole or in part, together with the extent of the exemption accorded to each type, are as follows : bonds of the Second, Third, and Fourth Liberty Loans, the 4f Victory Notes, and bonds of the War Finance Corporation are exempt from the normal federal in- 3 4 WASHINGTON UNIVERSITY STUDIES ■come tax, and from all state and local taxation; an additional •exemption from surtaxes is granted to the holders of these securities (in some cases only for a period of two years after the termination of the war) if their individual holdings do not exceed a certain prescribed figure; obligations of the United States, or its possessions, issued before September 1, 1917, as well as state, territorial, municipal, and District of Columbia bonds are exempt from the federal income tax; bonds of the First Liberty Loan, the 3f Victory Notes, and federal farm loan bonds are exempt from all federal, state, and local taxation except inherit- ance taxes; finally, most of the states exempt their own bonds and the bonds of their municipalities from state and local taxes ; In a few states, mortgages on local real estate are exempt from the general property tax. In general, two factors have been mainly responsible for the development of the tax exemption habit so far as government securities are concerned. In the first place, it is contended that tax exemption enables a government to market its bonds to better advantage in competition with private borrowers, thereby insuring, especially in time of crisis, a supply of funds that might not otherwise be available; and furthermore, that tax exemption saves the expense of tax collection. Of what ad- vantage, so the argument runs, would it be to a government to issue taxable bonds at higher interest rates and then bear the expense of collecting in the form of taxes the excess above the normal rate of interest paid to the bondholders? In the second place, there is the fact of our dual form of gov- ernment, state and federal, a form that has stubbornly resisted the adoption of an equitable tax system. In the past the federal government has been dependent for the most part on revenue derived from customs and excise duties, while the chief source of revenue for the states lay in the tax on real and personal prop- erty. So long as the revenue needs of the state and federal governments were adequately supplied from these sources, state and municipal bonds were automatically exempt from federal INVESTMENT SECURITIES AND TAX EXEMPTION 5 taxation. They were not, however, entirely exempt from prop- erty taxes. If they were taxable in the state of their origin, it was difficult for resident holders to evade the tax; if held by a resident of another state, they were taxable by the latter juris- diction in accordance with the doctrine mobilia personam sequuntur. But once the bond got beyond the state of its origin it usually evaded all property taxes either because it was held by a financial institution whose assets were not subject to property taxes, or because it was held by an individual who refused to declare it for assessment, justifying his action on the ground that the tax was excessive. And whether or not the justification was good, the contention was sound. Normally, the property tax rate was around 2 per cent. If the holder of a 4 per cent bond gave a full declaration of his property, the tax on his bond would be equivalent to an income tax of 50 per cent. The logical result of this absurdity was that the bonds of states and municipalities, if taxable by the jurisdiction in which they were issued, enjoyed a better market outside the state's jurisdiction than within. Such taxation not only discriminated in favor of foreign bondholders, but it tended also to impair the borrowing power of states and municipalities. The complete exemption on the part of the states of their own bonds and the bonds of their municipalities from the general property tax tended to overcome this difficulty without working any injustice to tax payers. It is still true, however, that the bonds of one state and its municipalities are taxable by another state when found in the hands of its citizens. Of course, such bonds are seldom found by the tax assessors. Although one state may tax the obligations of another state, it cannot impose a tax upon the obligations or instrumentalities of the federal government. This point was not definitely settled until a quarter of a century after the formation of the Union. Under the federal constitution, Congress was given power "to lay and collect taxes, duties, imposts, and excises" with the limitation that ' ' all duties, imposts, and excises shall be uniform throughout the United States"; that "no capitation or other direct tax shall be laid unless in proportion to the census " ; O WASHINGTON UNIVERSITY STUDIES that "no state shall, without the consent of Congress, lay any imposts or duties on imports or exports." Inasmuch as the Constitution failed to define in positive language the tax power of the states, it was inevitable that conflicts of law and jurisdic- tion would arise. One of the earliest and most celebrated legal cases growing out of the indefinite language of the Constitution was that of McCulloch v. Maryland, 1 decided in 1819. The Second Bank of the United States had been chartered by Congress in 1815 with power to issue circulating notes and to establish branches in various states. This measure proved to be unpopular in a num- ber of jurisdictions. The state of Maryland attempted to restrict the operations of the national bank by imposing a tax upon the notes and operations of the branch located within that state. The Maryland Court of Appeals, the highest court of law in the state, upheld the validity of the statute, whereupon the defendant, one McCulloch, the cashier of the branch bank, brought the case before the United States Supreme Court as involving an interpretation of the federal constitution. The court, by Chief-Justice Marshall, unanimously held that "the States have no power, by taxation or otherwise, to retard, impede, burden, or in any manner control the operation of the constitutional laws enacted by Congress to carry into execution the powers vested in the General Government ; and that the law passed by the Legislature of Maryland imposing a tax on the Bank of the United States is unconstitutional and void." "If we apply," said the Chief -Justice, "the principle for which the State of Maryland contends to the Constitution generally, we shall find it capable of changing totally the character of that instrument. We shall find it capable of arresting all the measures of the Government, and of prostrating it at the foot of the States. The American people have declared their Constitu- tion and the laws made in pursuance thereof to be supreme; but this principle would transfer the supremacy, in fact, to the States. If the States may tax one instrument employed by the Govern- ment in the execution of its powers, they may tax any and every 1 4 Wheaton, 316. INVESTMENT SECURITIES AND TAX EXEMPTION / other instrument. They may tax the mail; they may tax patent rights; they may tax the papers of the custom house; they may tax judicial processes; they may tax all the means employed by the Government, to an excess which would defeat all the ends of government. This was not intended by the American people. They did not design to make their Government dependent on the States." Again in Weston v. the City of Charleston, S. C., 2 decided in 1829, in which the question involved was the right of a state or local taxing authority to tax federal bonds, the Supreme Court of the United States, by Chief -Justice Marshall, declared "that a tax on stock of the United States, held by an individual citizen of a State, is a tax on the power to borrow money on the credit of the United States, and cannot be levied on the authority of a State consistently with the Constitution . . . that if the right to impose a tax exists, it is a right which in its nature acknowl- edges no limits. It may be carried to any extent within the jurisdiction of the State or corporation which imposes it, which the will of such State or corporation may prescribe." As a result of these and subsequent decisions, it is an unques- tionable law of the land that no state can impose a tax upon the agencies or instrumentalities by which the federal government performs its functions. This is precisely as it should be. If the states had been permitted to levy their property taxes — the equivalent of excessive income taxes — on the holders of federal bonds, and their tax laws had been enforced, not only would the price of the bonds have been materially reduced, but the market price would have varied widely from one state to another on account of the variations in local tax rates. In other words, the states would have seriously impaired the borrowing power of the federal government. II By a similar course of reasoning it would seem to follow that the federal government cannot tax the agencies or instrumentali- ties of the states. For without such reciprocal limitations, 2 2 Peters, 449. 8 WASHINGTON UNIVERSITY STUDIES might not the federal government impose taxes on the instru- mentalities of the states to an extent that would cripple if not entirely defeat the operations of the state governments? In the words of Chief- Justice Marshall, "the power to tax involves the power to destroy," and it was clearly unintended by the framers of the Constitution that either government should have the power to destroy the other. The doctrine that the federal government cannot tax the agencies of the state governments was brought over bodily from the earlier decisions with reference to the taxation of federal agencies by the states. In The Collector v. Day, 3 decided in 1870, it was held that the salary of a state official, in this particular instance a judge of probate, could not be legally subjected to assessment for a federal income tax, for the same reason that the states were prohibited, under a proper interpretation of the Constitution, from taxing the salary of an officer of the federal government. 4 In United States v. Baltimore and Ohio Railroad Company, 6 decided in 1872, it was held that the federal govern- ment could not tax the agencies and instrumentalities of the states. In Mercantile Bank v. New York, 6 decided in 1886, it was held that a state tax on the shareholders of national banks was valid, but it was stated incidentally that state bonds or bonds issued "under its authority by its public municipal bodies, are means for carrying on the work of government, and are not tax- able even by the United States." Finally, in Pollock v. Farmers' Loan and Trust Company, 7 decided in 1895, which involved the constitutionality of a federal income tax law, it was held that the tax was a direct tax so far as it applied to the income from real estate or personal property and must therefore be apportioned among the states according to their population. With regard to the taxation of income from municipal bonds, the court said: "It was long ago determined that the property and revenues of municipal cor- ' 11 Wallace, 113. * Dobbins v. The Commissioners of Erie, 16 Peters, 435. 6 17 Wallace, 322. 8 121 U. S., 138. 7 157 U. S., 429. INVESTMENT SECURITIES AND TAX EXEMPTION V porations are not subjects of federal taxation. The same want of power to tax the property or revenues of the states or their instrumentalities exists in relation to a tax on the income from their securities." The question as to whether a tax on the agen- cies and instrumentalities of a state was direct or indirect taxa- tion was immaterial because the federal government had no power to levy such taxes. While the decision of the court in the famous Pollock case did not literally prevent the federal government from imposing a tax on incomes, except on incomes derived from agencies and in- strumentalities of the states, it rendered such taxation impracti- cable. If imposed, the tax would be direct, so far as it applied to incomes from real or personal property, and must be apportioned. This means that if state A with twice the wealth of state B had the same population, the income tax payable by a citizen of state B would be twice that of an equally wealthy citizen of state A. In view of the gross inequality that would result from such a scheme of taxation, Congress was virtually denied the right of imposing a tax on incomes. The purpose of the Sixteenth Amendment to the Constitution was to overcome this difficulty. The amendment states that Congress "shall have power to lay and collect taxes on income, from whatever source derived, without apportionment among the several states, and without regard to any census or enumera- tion. " To the layman this amendment would seem clearly to empower Congress to impose a tax on the income from state and municipal bonds under a general income tax law; but in the opinion of constitutional lawyers of high standing the amend- ment confers no such power. It is claimed, for instance, that the words "from whatever source derived" were intended to remove all discrimination between the sources that could already be taxed without apportionment and the sources that could be taxed only through apportionment; in other words, to put all sources of income in the same category so far as apportionment is concerned. Such an interpretation would scarcely counte- nance the federal taxation of state and municipal bonds because, whether or not the tax was apportioned, these bonds have been 10 WASHINGTON UNIVERSITY STUDIES held to be beyond the taxing power of the federal government. However sound or unsound this contention may be, the argu- ment has had sufficient weight with Congress, loath to raise a constitutional question that might prove embarrassing, to cause that body to grant a specific exemption from the federal income tax to the holders of state and municipal bonds. On the other hand, there is good constitutional authority for interpreting the Sixteenth Amendment in its obvious sense. In the rehearing of the Pollock case, 8 Chief -Justice Fuller observed that "the words of the Constitution are to be taken in their obvious sense, and to have a reasonable construction." And in Gibbons v. Ogden, 9 Chief -Justice Marshall said: "As men, whose intentions require no concealment, generally employ the words which most directly and aptly express the ideas they intend to convey, the enlightened patriots who framed our Constitution, and the people who adopted it, must be understood to have employed words in their natural sense, and to have intended what they have said." It is likewise to be inferred that those who amended the Constitution, no less than those enlightened patriots who framed it, expressed concisely the ideas they intended to convey. If this argument fails to weaken the constitutional contention that the Sixteenth Amendment is not to be taken in its obvious sense, there remains an even stronger argument, supported by economic fact, to justify a reversal of the Supreme Court's decisions with reference to the taxation of state and municipal bonds. In the past these instruments have not been taxable by the federal government because "the power to tax involves the power to destroy," and it was not intended that Congress should have power to destroy the state governments. It has already been shown that in its original application this doctrine was sound. It served to prevent the states from impairing the credit of the federal government. But now the question arises, Is the doctrine valid in its new setting? Would the power to levy an income tax on the instrumentalities of a state involve the 8 158 U. S.. 601. » 9 Wheaton 1, 188. INVESTMENT SECURITIES AND TAX EXEMPTION 11 power to destroy? Would the imposition of a federal tax on in- come from all sources, including the bonds of states and munici- palities, impair the borrowing power of these governments? If these questions can be answered in the negative, the Supreme Court has been repeatedly misled by the "power to destroy" doctrine, and the obvious meaning of the Sixteenth Amendment should prevail. It should be noted in this connection that if the federal govern- ment had the power to impose a special tax upon the bonds of states and municipalities, it would have the power to destroy those governments. Suppose, by way of illustration, that a federal tax of 20 per cent were imposed on the income from all state and municipal bonds at a time when the prevailing rate of interest was 5 per cent. In that case 5 per cent municipal bonds that had previously sold at par would now sell at ap- proximately 80 10 because at that price investors would receive the current rate of return after paying the tax. It is assumed, of course, that the tax is a special tax, that the rate of interest re- mains the same, and that there are other securities, non-taxable, which investors can purchase. Under these conditions, a municipality would find it necessary to pay an interest rate of 6.25 per cent on all new issues, whereas before the imposition of the tax it could borrow at 5 per cent. Obviously, a special tax on state and municipal bonds would impair the borrowing power of the state and local governments. The Sixteenth Amendment does not give Congress power to levy a special tax on incomes, but instead a tax on income "from whatever source derived." Now the effect of a general tax, applicable to all income, is quite unlike that of a special tax. A general tax, if moderate in amount, could have no appreciable effect upon the borrowing power of the states and their munici- palities. All income-yielding securities would be taxable alike — there would be no taxless field to which the investor could repair for the purpose of tax evasion. If, before the imposition of the 10 The exact price would depend upon the maturity of the bond. If the bond still had twenty years to run, it would yield the current rate of interest plus the tax at 85.84. If it matured in fifty years the price would be around 80.92. 12 WASHINGTON UNIVERSITY STUDIES tax, 4 per cent municipal bonds and 6 per cent industrial bonds were selling at par, an income tax of 20 per cent would not affect the price of either security. It would merely reduce the net yield of the municipal bonds to 3.20 per cent and of the industrial bonds to 4.80 per cent. All net yields would be in the same rela- tion to one another as before, while the rates at which these yields were capitalized would be reduced by the amount of the tax itself. The price of bonds, therefore, would not fall unless the tax rate was so high that it discouraged the accumulation of capital or, what amounts to the same thing, caused investors to consume from their savings. In that event there might be a valid economic reason for declaring the tax unconstitutional under a new "rule of reason," i. e., only excessive taxes would be unconstitutional. But thus far the courts have not ventured to suggest that the test of constitutionality be the tax rate itself, and it now seems that any test of this character would be useless ; for, in a country with productive resources like those of the United States, the danger of permanently raising interest rates and materially reducing the level of bond prices through excess- ive taxation is too remote to be worth considering. It will doubtless be contended by some that inasmuch as the exemption of state and municipal bonds from the income tax has improved the credit of state and local governments, the repeal of the exemption clause would likewise impair their credit. This argument appears to be valid but it is wholly superficial. It is conceded, of course, that special tax exemption will raise the price of a bond. In the case of the Liberty Loan bonds, the tax- exempt 3|'s have been selling around 99, while the first 4|'s, exempt from the normal income tax, all state and local taxes, and enjoying certain exemptions from surtaxes, have been selling at approximately 95 — a yield to the investor of 4.56 per cent. If the 3|'s were subject to the same taxes as the 4|'s, their capi- talized value would be 83.33 instead of 99. In other words, the price of a $1,000 Liberty bond yielding 3| per cent is $156.70 higher than it would be if it were taxed on the same basis as the 4|'s. The premium enjoyed by the tremendous volume of out- INVESTMENT SECURITIES AND TAX EXEMPTION 13 standing municipal bonds by virtue of tax exemption cannot possibly be calculated owing to the multiplicity of the issues and the fact that there are no taxable bonds with which fair compari- sons may be made. But it is a matter of common knowledge that the position of state and municipal bonds in the investment market has been materially improved through the exemption clause of the federal income tax law. Just as a special tax on a bond will depress its price, so a special exemption will enhance its price and strengthen the credit of the debtor corporation. Congress, therefore, conferred a favor upon the state and local governments in exempting their bonds from the income tax, a favor which the Constitution did not expressly authorize. A future Congress might go even further and provide that govern- ment funds be loaned to the states and their municipal corpora- tions at an interest rate of 2 per cent. But if these favors were subsequently withdrawn, could anyone seriously contend that the borrowing power of the states and municipalities was thereby being impaired? The Supreme Court, then, has been misled by two false assumptions : first, that because the tax power in the hands of the states involved the power to destroy, it would be equally danger- ous to grant the power to the federal government ; secondly, that a general income tax, applicable to income from all sources, would lower the price of state and municipal bonds when only a special tax could actually impair the borrowing power of the state and local governments. In view of the failure of the court to distinguish between special and general taxes, it follows that the obvious import of the Sixteenth Amendment should prevail, not only because its import is obvious but also because the economic basis for the "power to destroy" doctrine is invalid. In time, no doubt, the federal courts must recognize that some precedents outlive their usefulness in a world where economic conditions are rapidly changing; and that a new doctrine is needed expressly for the purpose of preventing the federal government from conferring special favors upon the states. Inasmuch as the Constitution contains no clause either for- bidding the taxation of the instrumentalities of the states or 14 WASHINGTON UNIVERSITY STUDIES authorizing that they be granted special favors through tax exemption, it would support this new doctrine as logically as it supported the old one. But until Congress has the courage to face the constitutional issue by repealing the special exemption clauses of the federal income tax law, the Supreme Court will have no opportunity to reconsider its "power to destroy" doctrine or to harmonize it with the facts of economic life. Ill Quite a different case for tax exemption is presented by the quasi-government securities. Chief in importance among these are federal farm loan bonds — bonds that have been issued by the federal and joint stock land banks pursuant to the provisions of the Federal Farm Loan Act of 1916. Legally, these bonds are in no sense liabilities of the federal government. They are not secured by the tax power or by any property to which the federal government has title. But in other respects they so resemble direct government obligations as to warrant the belief that they have "the support of the good faith and credit of the United States." 11 The primary purpose of the federal farm loan system was to reduce to approximate equality throughout the United States the cost of borrowing on farm mortgage security. In conformity with the practice in vogue in European countries, the farm mortgage was to become a standardized form of investment. The twelve federal land banks established under the Act and the joint stock land banks that might be organized were em- powered to make loans on first mortgage security within specified districts and, on the collective security of the mortgages so held, to issue farm loan bonds. The principle of substituting collective for individual mortgage security in the field of agricultural finance was unquestionably sound. Just as investment trusts have been utilized by Euro- peans to standardize and promote their foreign investments, so the land banks were expected to facilitate the flow of capital from 11 Opinion of Hon. Charles E. Hughes as quoted in the Congressional Record, vol. 58, July 1, 1919, p. 2379. INVESTMENT SECURITIES AND TAX EXEMPTION 15 the investment centers of this country to the rural districts, es- pecially to the great farming sections of the West and South which, for want of capital, had been held back in their agricul- tural development. To make certain that the purpose of the Act would be ac- complished, the bonds were made unusually attractive to in- vestors. The bonds of every federal land bank, for instance, were to be secured by the capital, reserves, and earnings of all the federal land banks, and by mortgages previously indorsed by local associations of borrowers within the land bank district. Mortgage loans were limited to 50 per cent of the value of land and 20 per cent of the value of improvements, while borrowers were obliged to assume double liability on their stockholdings in the local associations. Furthermore, if any federal land bank should be unable for a time to meet all claims arising on account of the payment of interest coupons or the redemption of bonds, it might rely upon federal assistance, since the Act authorized the Secretary of the Treasury, in his discretion, to deposit gov- ernment funds with federal land banks and to charge a rate of interest not exceeding the rate current on other government deposits. The aggregate of all sums so deposited could not exceed $6,000,000 at any one time. Such security should have proved ample to insure the sale of the bonds in large amounts and on most favorable terms, but this was not enough. The Act further provided that all first mort- gages executed to federal or joint stock land banks and all farm loan bonds were to be regarded as "instrumentalities of the Government of the United States," and as such were to be ex- empt from federal, state, municipal, and local taxation. Pre- sumably this exemption does not apply in the case of inheritance taxation for the reason that such a tax has been held to be a tax upon the transfer of property rather than upon property itself. It should be observed, however, that the Act made no mention of this exception. In the more recent federal legislation author- izing the first issue of Liberty Bonds, the law stated specifically that these bonds were to be exempt from all taxation except estate and inheritance taxes. 16 WASHINGTON UNIVERSITY STUDIES The original argument for the exemption of federal farm loan bonds was based upon several considerations. In the first place, it was the avowed purpose of the Farm Loan Act to reduce materially the cost of borrowing on farm mortgage security; and there was no denying the fact that tax exemption would greatly enhance the investment qualities of the bonds, thereby reducing the farmer's rate. Moreover, since there was some doubt as to whether the land banks, equipped with entirely new machinery for making loans, could stand on their own merits in competition with the agencies that confined their operations to the older sections of the country, tax exemption appeared to be the only expedient that would definitely insure the success of the experiment. Finally, it is to be noted that it was necessary to reconcile in one measure three conflicting interests. One group of legislators had been strongly in favor of direct government loans, another of cooperation, and still another of private enter- prise as the basis of land credit reform. In spite of the declara- tion of President Wilson in his first annual message that "The farmers, of course, ask and should be given no special privilege, such as extending to them the credit, of the Government itself," the advocates of direct government loans, i. e., of special priv- ilege, gained a portion of their demands in the tax exemption clause; and their success in this respect is a reflection upon the spirit of the Act itself. The necessity of granting this special favor amounted to a public acknowledgment of the fact that private enterprise is more efficient than government enterprise when given the same opportunity. In the second place, there was the argument that anything that helps the farmer helps everybody else, that in these days of the high cost of living the production of foodstuffs is a matter involving the welfare of all, and therefore farm loan bonds should have as much right to tax exemption as the bonds of munici- palities. This latter point of view is clearly presented in a publi- cation 12 of the Farm Loan Bureau as follows : "Stock in the Federal Reserve Banks of the United States is exempt from all taxation, and the bankers owning these stocks 12 The Borrowers' Bulletin, May, 1919, p. 3. INVESTMENT SECURITIES AND TAX EXEMPTION 17 receive 6 per cent dividends on them, yet nobody questions the propriety of this arrangement. "Mutual building and loan associations all over the United States are free from taxation on their mortgages and the income from them. This gives to the city homebuilder a low rate of interest, but nobody complains that this is unjust. "Mutual savings banks are, by the provisions of the federal income-tax law, entirely exempted from the taxes which it imposes. "The cities and towns of the United States issue municipal bonds for the purpose of paving and improving streets, and other- wise making city life convenient, comfortable, and happy. These bonds and the income therefrom are exempt from all forms of federal taxation. This is a fine thing for the cities and towns, because it gives the people a low rate of interest and enables these necessary improvements to be made, and nobody objects to it." There is only one point in this argument that is worth con- sidering, namely, that farm loan bonds should have the same right to tax exemption as the bonds of municipalities. This argument overlooks the fact that, for taxing purposes, "munici- pal bonds" include all bonds issued by local taxing districts, such as road bonds, county bonds, drainage bonds, country school bonds, etc., bonds that are secured by the local tax power; and that no new favors are needed to put farmers on an equal footing with residents of the cities so far as tax exemption is concerned. But aside from considerations of this character, there is the fact that some one must pay taxes. If the bonds issued by the federal, state, and local governments, and by the federal and joint stock land banks are completely exempt from taxation, wage earners and the owners of real estate must assume a greater proportionate share of the tax burden. Sooner or later the benefit derived by the farmer by virtue of his lower rate of inter- est must be swallowed up in part by an increase in the federal tax rate on his income or by an increase in state taxes on his property. Fortunately, the single tax proposal, which would 18 WASHINGTON UNIVERSITY STUDIES carry to its logical conclusion, the present tax exemption policy, has never met with much favor among farm owners. A third argument for the exemption of farm loan bonds was based upon the belief that any taxes that might be imposed would ultimately be paid by the farmer, rather than by. the bondholder, in the form of a higher rate of interest. Inasmuch as the laws of most of the states require borrowers to pay taxes on their property without deduction for indebtedness, complete tax exemption of the bonds appeared to be the only remedy for the nightmare of double taxation. This argument, which is by far the most important, is based upon the time-honored doctrine of economists that it is worse than useless for a state to tax real estate and mortgages at the same rate. If such taxation succeeds in reaching the holders of farm mortgages it scales down an interest rate of, say, 6 per cent to a net yield of 4 or 4| per cent and diverts local capital to other forms of investment or, indeed, causes it to migrate to other states where it will be beyond the reach of the local tax assessors. To the extent that the law does not succeed — and this is the most likely case — it puts a premium on dishonesty and perjury and effectively reaches only the estates of widows and orphans. Mindful of the fact that the rigid enforcement of a high property tax on mortgages gives rise to double taxation, and that the tax may be shifted in part to borrowers in the form of a higher rate of interest, some state legislatures have entirely exempted mort- gages from taxation; others have attempted to solve the problem by imposing recording taxes ; in fact, a great variety of solutions, amounting practically to total exemption, have at one time or another been offered. But in most jurisdictions the double tax method is still in force. It has been a mistake, however, to assume that a property tax on mortgages would necessarily be shifted. 13 In many of the middle western states, for example, where mortgages have been taxable at the same rate as real property and where numerous attempts have been made with some degree of success to find and 13 Many economists, guided by plausible assumptions rather than by specific facts, have fallen into this error. Only a few really scientific investigations have been INVESTMENT SECURITIES AND TAX EXEMPTION 19 assess real estate mortgages, the interest rate has scarcely been affected by the drastic efforts of the tax gatherers. If the tax rate tended to raise the interest rate on mortgages, it tended also to divert, the capital of non-taxable institutions, i. e., those taxable under a different method, to the farm mortgage field and, in turn, to restore interest rates to their former level. Among these institutions, banks, mortgage companies, and insurance companies have been the most conspicuous. With the aid of their machinery for making loans, capital could easily migrate from one state to another to take advantage of remunerative in- terest rates or, indeed, could remain at home and evade the tax. It so happens that one of the most important elements af- fecting the local rate of interest throughout the Middle West has been the large supply of ' ' foreign ' ' capital. Individual investors residing in the East make a regular practice of buying mortgages on land located in the West. The great life insurance companies of the North and East have a carefully selected farm loan terri- tory extending into practically every state of the South and West. These companies, "foreign" to most of the states in which they lend, together with the farm mortgage brokers, have practically dominated the farm mortgage business in the newer agricultural states. And under the regime of state government it has been virtually impossible for one state to impose its property tax on personalty held in another state, or for the latter state to find the made concerning the incidence of a property tax on mortgages, and the results of these are more or less conflicting. The facts merely show that generalization is dangerous so long as economic conditions and tax methods vary from one state to another. For instance, Professor Plehn has shown that during the period 1880 to 1899 the effect of the California method, which was sui generis, was to raise the rate on mort- gages in San Francisco by more than the amount of the annual tax, the excess repre- senting the "cost of shifting." (See C. C. Plehn, "The Taxation of Mortgages in California," The Yale Review, vol. VIII, 1899, pp. 31-67.) On the other hand the results of the investigations of the Wisconsin Tax Commission relative to the effect of mortgage taxation in that state during the years 1900 to 1906 inclusive completely upset the generally accepted doctrines as to the incidence of mortgage taxes. In spite of the law of 1903 which virtually exempted mortgages from taxation, interest rates remained in practically the same relation to the rates existing in certain ' ' foreign' ' counties where the double tax system prevailed. (See T. B. Adams, "Mortgage Taxation in Wisconsin," Quarterly Journal of Economics, Vol. XXII, 1907, pp. 1-27.) 20 WASHINGTON UNIVERSITY STUDIES personalty for assessment. For these reasons, the shifting of a property tax on mortgages to borrowers in the form of a higher rate of interest has not been so common as is generally supposed. But if one were to concede the main point of the argument, even though it is untrue, that a property tax on mortgages is invariably shifted to the borrower, it by no means follows that mortgages or farm loan bonds should be exempt from the income tax. Here is where the advocates of tax exemption have com- pletely failed in their attempt to find valid economic support for their claims. Accustomed only to the unjust operation of property tax laws, they have overlooked the fact that incomes are now taxable, and that there is a distinction between the double taxation of property and the double taxation of income. They have assumed that all double tax methods are bad, when in point of fact some forms of double taxation are most convenient and effective devices for making the tax burden conform to the individual's ability to pay. Suppose, by way of illustration, that A receives an income of $10,000 a year from property, while B receives the same income from services. How do the tax- paying abilities of these individuals compare? In spite of the fact that their incomes are exactly equal, A undoubtedly has the greater ability to contribute to the support of the government because his income is derived from property. The justice of this principle is now firmly established; only in the method of its application is there any ground for a difference of opinion. In some countries, income is classified according to its source and a higher tax rate imposed upon income from prop- erty than upon income from services. In the United States a simpler policy, from the point of view of tax administration, is now in vogue. Under the federal income tax law an income of, say, $10,000, whether derived from property or services, is tax- able at a uniform rate, while income-producing property is taxed by the several states. This means that income derived from personal services pays only the federal income tax, while the same income from property pays not only the federal income tax but also a property tax. If this is regarded as double taxation, it is double taxation of a most desirable form. It is merely a con- INVESTMENT SECUKITIES AND TAX EXEMPTION 21 venient device for making A's total tax bill — which he pays ultimately out of his private income — greater than B's even though their incomes are the same. IV Any merits that may still be claimed for the above arguments are relatively insignificant when account is taken of some of the results of the tax exemption policy. By far the most conspicuous evil of tax exemption is that it completely upsets the purpose of graduated taxes. In the first place, it enables those with prop- erty incomes to escape the burden of progressive rates, thereby causing the burden to be shifted to others less able to pay. Suppose, for example, that a married person without dependent children receives a yearly net income of $50,000 (after paying state taxes) from real estate valued at $1,000,000. Under the Revenue Act of 1918 his federal income tax would be $11,030. If he converted his real estate into 5 per cent federal farm loan bonds at par, his property and income taxes thereafter would be nothing, his net income would in no way be diminished, while the man who received the same income from personal services would continue to pay a tax of $11,030. The ability of the former would still be greater, but only the latter would be taxable. The injustice of tax exemption, however, does not stop here. It not only gives rise to unwarranted discrimination in favor of property owners, as opposed to wage earners, but it also confers a much greater favor upon the wealthy classes than upon the investor in moderate circumstances. Under the federal income tax law, for instance, a married person without dependent chil- dren is subject to a flat tax rate of 2 per cent if his annual income is $3,000; 22.06 per cent if his net income is $50,000; and 70.30 per cent if his income amounts to $1,000,000. The yearly saving in taxes that each of these three classes might make through the purchase of a $1,000 farm loan bond yielding 5 per cent amounts to $1.00, $11.30, and $35.15 respectively. If the same bond were subject to taxation, the net yield to these investors after paying income taxes would be 4.90 per cent, 3.90 per cent, and 1.48 per cent respectively. Or, to put it another way, a 5 per cent non- 22 WASHINGTON UNIVERSITY STUDIES taxable bond is the exact mathematical equivalent of a taxable bond yielding 5.10 per cent if the bondholder has an income of $3,000; 6.41 per cent if his income is $50,000; and 16.83 per cent if his income is $1,000,000! These and other significant facts relative to the unequal benefits conferred by tax exemption are shown in the following table: Net income Total tax Tax rate Net yield Net yield Rate of Annual Present of married on whole of of interest value of value of person income non-taxable taxable required on tax tax without 5 per cent 5 per cent taxable exemption exemption dependent bonds bonds securities on 81,000 5 on $1,000 5 children to yield 5 per cent per cent bond (Annual loss to federal government) per cent bond maturing in 20 years (Present value of total loss to federal government) dollars dollars per cent per cent per cent per cent dollars dollars 3,000 60 2.00 5 4.90 5.10 1.00 12.46 10,000 830 8.30 5 4.58 5.45 4.15 51.72 20,000 2,630 13.50 5 4.32 5.78 6.57 81.87 50,000 11,030 22.06 5 3.90 6.41 11.30 140.82 100,000 35,030 35.03 5 3.25 7.69 17.51 218.21 200,000 101,030 50.50 5 2.47 10.10 25.25 314.66 500,000 323,030 64.60 5 1.77 14.12 32.30 402.52 1,000,000 703,030 70.30 5 1.48 16.83 35.15 438.03 Obviously, the small investor has little to gain from the pur- chase of tax exempt securities. If his income is exactly $3,000, it is immaterial whether he buys a 5 per cent taxable bond at par or a 5 per cent non-taxable bond, maturing in twenty years, at 101.24. The annual value of the tax exemption privilege on his farm loan bond is only $1.00, and the capitalized value, $12.46. But with every material addition to his income, the incentive to buy tax exempt bonds becomes greater. In the case of those having annual incomes of $1,000,000, the annual value of tax exemption on a $1,000 farm loan bond bearing 5 per cent is $35.15, and the capitalized value of these exemptions $438.03. If the supply of tax exempt securities should be materially diminished so that the available number was insufficient to INVESTMENT SECURITIES AND TAX EXEMPTION 23 satisfy the needs of the very wealthiest classes, the price of 5 per cent farm loan bonds would tend to rise to 143.80, that is, to a premium representing the highest capitalized value of the tax exemption privilege. Under present conditions, however, no such premium is possible. Owing to the large volume of munic- ipal and federal bonds outstanding, bonds exempt in whole or in part from progressive income taxes, it is unnecessary for the recipients of large incomes to pay a price for tax exempt bonds that anywhere near covers the capitalized value of the tax exemp- tion privilege. Thus far, 5 per cent federal farm loan bonds have not sold above 108, although they have sold steadily above par. It is for this reason that the main argument in favor of exempt- ing government bonds from the income tax breaks down. Under a system of proportional taxation, it is probably true that tax exempt bonds of the federal government would sell at a premium corresponding roughly to the capitalized value of tax exemption, and thus yield a greater return to the government. But under a system of progressive taxes, the price of the bonds is not enhanced by the capitalized value of the. exemptions, and therefore the amount that the government can gain from a lower rate of interest will not be so great as the loss in revenue from the income tax. What the individual gains from tax exemption represents, of course, a loss to the national treasury. This loss cannot possibly be calculated because there is no way of ascertaining the exact distribution of tax exempt bonds among the various classes of taxpayers. But sooner or later the loss in tax revenue will be- come prodigious for the reason that the ownership of tax exempt securities tends to become concentrated in the hands of the wealthy classes. These are the classes who would normally pay the heaviest taxes and who, moreover, would be the most alert and proficient in ferreting out some means of shifting the tax burden. That their incomes are sufficiently large in the ag- gregate to enable them to absorb most of the tax exempt bonds outstanding, either through direct purchase out of current in- come or through the conversion of income-producing property, is shown by the Report of the Commissioner of Internal Revenue 24 WASHINGTON UNIVERSITY STUDIES for the fiscal year ending June 30, 1917, which gives the total number of income tax returns by class distribution as follows : 14 Income Class Number of Retttbns $100,000 to $150,000 2,900 150,000 200,000 1,284 200,000 250,000 726 250,000 300,000 427 300,000 400,000 469 400,000 .500,000 245 500,000 1,000,000 376 1,000,000 1,500,000 97 1,500,000 2,000,000 42 2,000,000 3,000,000 34 3,000,000 4,000,000 14 4,000,000 5,000,000 9 5,000,000 and over 10 Some inference as to the extent of the losses that are possible through tax exemption may be drawn from the extent of the loss to which the federal government is now liable on account of the exemption of state and municipal bonds. On June 30, 1913, there were at least $4,195,609,436" of these bonds outstanding. The present volume is certainly far in excess of that figure, if for no other reason than that tax exemption has greatly stimulated extravagant borrowing on the part of the local governments. But assuming that the total volume of bonds is only $4,000,000,- 000, that they bear an average interest rate of 4 per cent, and that they are all held by individuals receiving annual incomes of $50,000, the annual loss to the national treasury is $35,280,000. If the bonds have an average maturity of twenty years and the present rates of taxation are maintained, the capitalized loss to the government would be $479,455,200. If the bondholders had annual incomes amounting individually to $1,000,000, the an- nual loss to the government would be $112,480,000, and the capitalized loss, $1,528,603,200. 14 Annual Report of the Secretary of the Treasury on the State of the Finances, 1917, p. 788. 16 Wealth, Debt, and Taxation (Bureau of the Census), 1913, vol. 1, pp. 37, 236, and 238. These bonds were classified as follows: State $403,366,569 Counties 332,236,161 Cities, towns, villages, etc 3,460,006,706 INVESTMENT SECURITIES AND TAX EXEMPTION 25 These figures, of course, are merely suggestive of the losses that might be sustained at present on one group of securities. Con- cerning the possibility of loss on tax exempt federal bonds, it would be idle even to speculate. Not only does the tax exemp- tion privilege vary from one issue to another, but it is probable that these bonds are held by small investors to a much greater extent than is true in the case of municipals. Fortunately, the loss that is now being sustained on federal bonds will not continue indefinitely because the bonds themselves will eventually be retired. But in the meantime the steady growth in the volume of federal farm loan bonds 16 does not augur well for government revenues of the future. If the time should come when the $4,000,000,000 17 of farm mortgage indebtedness in the United States is held by investors in the form of 4 per cent federal farm loan bonds, and the present rates of taxation are maintained, the possibility of loss to the national treasury would be exactly equal in amount to the loss which the government is now liable to sustain on state and municipal bonds. And it should be noted that the above estimates take no account of the possible losses sustained by the state and local governments. Since most of the states derive the greater portion of their revenues from general property taxes under a system of proportional taxation, their loss would be fairly constant, whether farm loan bonds were held by recipients of large or small incomes. But the loss through tax exemption is not borne solely by the federal, state, and local governments. Some account must also be taken of the loss that has been sustained by the purchasers of Liberty bonds. With the exception of the First Liberty Loan and the 3| Victory Notes, the bonds issued by the federal gov- ernment during the war were not entirely exempt from taxation. 16 On July 1, 1919, only $286,000,000 of these bonds had been authorized by the federal land banks. Of this amount, the Secretary of the Treasury held $136,885,000 and the public $149,115,000. (The Borrowers' Bulletin, August-September, 1919, p. 2.) 17 This is only a rough estimate. In 1915 the federal Department of Agriculture estimated, on the basis of the Thirteenth Census figures, that the total farm mortgage debt of the United States was $3,598,985,000. (Hearings before the Subcommittee of the Joint Committee on Rural Credits, 64 Cong., 1 Sess., p. 107.) 26 WASHINGTON UNIVERSITY STUDIES By far the greater portion of these issues were subject to sur- taxes if individual holdings exceeded a certain figure. Fortu- nately, the government was able to avoid the competition that would normally have existed between its own securities and tax exempt municipal bonds by denying to the local governments the unrestricted right to use their credit. But in view of the neces- sity of stimulating the production of foodstuffs, it could not consistently deny to the federal land banks the right to issue their tax exempt bonds. This situation was ominous. It meant that tax exempt farm loan bonds would sell regularly above par, while Liberty Loan bonds sold regularly below. On grounds of patriotic service the public was asked to subscribe to government securities which in the investment market would be unable to hold their own with federal farm loan bonds. And that is not all. During the more recent Liberty Bond campaigns, the Secretary of the Treasury purchased the bonds of federal land banks with public funds in order to prevent temporarily all competition between the two classes of investments — competi- tion that might have interfered seriously with the sale of Liberty bonds. This means that the one who patriotically subscribed to the 4j Liberty issues was unconsciously lending a portion of his funds to farmers at a low rate of interest ; and that the bonds so purchased by the Secretary of the Treasury would eventually find their way into private hands to be used for the purpose of shifting the tax burden. In other words, the patriotic subscriber who accepted a low rate of interest on his government loan was contributing not only to the private profit of farmers but also to the tax-dodging propensities of the well-to-do slackers. Something might be said in favor of exempting farm loan bonds from taxation if the proceeds were employed to advance the economic welfare of the less fortunate members of society; but at present the proceeds are not used for this purpose. The Federal Farm Loan Act was not designed to assist the farm tenant to become a landowner. By far the greater portion of the loans made by the joint stock and federal land banks have been used for the purpose pf refunding other mortgages or of expand- INVESTMENT SECTJBITIES AND TAX EXEMPTION 27 ing the operations of prosperous landowners; 18 and compared with the total number of American farmers, the number of those who have received direct benefit from the Farm Loan Act has been exceedingly small. 19 More than that, those who have been benefited the most are those who needed it least. Finally, when the bars have once been let down to permit tax exemption on the bonds of quasi-public institutions, there is no telling how far the privilege may be extended. One class of security holders demands the right because another class has it ; or one group of borrowers insists on receiving the same benefit that is freely accorded to others. And the logic of these de- mands can not be ignored indefinitely. Already, indeed, there are a number of proposals current having for their purpose the accomplishment of certain economic reforms through the magic of tax exemption. One of these proposals 20 would provide for the establishment of twelve national farm credit banks which would mobilize capital for the personal credit needs of farmers — ■ just as the federal land banks provide capital for their long-time needs — by issuing tax exempt bonds on the security of their personal notes. Another scheme, 21 intended to promote home building and home ownership on the part of the wage earning classes, would provide for the division of the United States into eleven districts, and for the establishment in each district of a federal building loan bank. Each bank would have a capital stock of not less than $100,000 to be subscribed by building and loan associations within the district. On the security of first mortgages turned over by the local associations, the loan banks would issue bonds bearing an interest rate of 4| per cent or less, the proceeds of which would be used to purchase additional mort- gages from building and loan associations. Through the pur- chase of mortgages and the issuance of bonds, the loan banks 18 For an analysis of the purpose for which $44,580,035 of the loans have been made, see "The Federal Farm Loan System," American Economic Review, vol. IX, March, 1919, p. 76. 19 On July 1, 1919, the number of loans closed by the federal land banks since their establishment amounted to 91,472. (The Borrowers' Bulletin, August-September, 1919, p. 4.) 20 H. R. 8827, 65 Cong., 2 Sess. » S. 2492, 66 Cong., 1 Sess. 28 WASHINGTON UNIVERSITY STUDIES would direct a continuous flow of capital into building and home ownership channels at a very minimum of cost to bor- rowers. The bonds of these institutions, like the bonds of federal land banks and national farm credit banks, would be deemed to be "instrumentalities of the Government of the United States" and as such would be exempt from federal, state, municipal, and local taxation. It goes without saying that the purpose of this latter proposal is commendable. Home ownership, rather than tenancy, is the form of tenure that should be encouraged in a democracy. Op- portunity to acquire and the right to possess hold for the young man a certain magic which makes for initiative, independence, and citizenship. Unlike the wandering Bolshivik tenant, the man who owns his own home is interested in the welfare of his community and the maintenance of property rights. The contrast was tersely expressed by Mark Twain in the familiar sentiment: "Any man would die for a home, but who would die for a boarding house?" Yet in spite of the overwhelming ad- vantages of home ownership from a social point of view, and the need of a nationwide program to deal with the perplexing prob- lem of tenancy, especially in these days of labor unrest, no reform measure which relies upon tax exemption should be contem- plated. From a fiscal point of view such proposals lead nowhere. And in the last analysis it makes no difference whether the ultimate object of these proposals is desirable or undesirable. Just as there is no known method whereby a man may lift him- self over a fence by his bootstraps, so there is no magic in tax exemption. It not only fails to benefit permanently the class that needs it, but in any case it tends to nullify the purpose of progressive income taxes. In addition to the loss that it has already imposed upon the various taxing jurisdictions, it has inflicted a flagrant injustice upon wage earners, small investors, and the holders of Liberty bonds. Manifestly, our public policy has been badly at fault either in the matter of tax exemption or in the application of progressive rates to incomes. The two policies are antagonistic and in- consistent. One or the other should be speedily abandoned. INVESTMENT SECURITIES AND TAX EXEMPTION 29 It is idle, however, to think of the abandonment of progressive taxation. That institution is now firmly established in all the important European nations; it is universally recognized as the only means whereby the tax burden may be made to conform ap- proximately to the individual's ability; in short, it is a product of the forces that have made for democratic government, while tax exemption is a remnant of absolute monarchism. If, therefore, the tax system is to be equitable, if the ideals of democratic government are to be maintained, it is time to call a halt to the present policy of tax exemption. The weakest stronghold of that policy lies in the tax exemption clauses of the Federal Farm Loan Act, and it is there that the attacking forces should first be concentrated.