APPENDIX 7

Economic Impacts of Particular State and Local Taxes on Banks With Special Reference to Neutrality

CARL S. SHOUP

Professor of Economics, Columbia University

1. SUBJECT AND SCOPE OF THE PRESENT STUDY

(a) Tax Impact: Neutral or Unneutral, for Banks?

The present study examines the economic impact on banks of each major tax imposed by state and local governments in the United States. The impact is analyzed to answer two questions.

First, is the tax neutral or unneutral (and if unneutral, in which direction), with respect to (a) banks as compared with other businesses, (b) interstate as compared with intrastate flows of funds, especially from banks, (c) techniques of producing banking services, for example, mechanization, and ratio of equity capital to loan capital?

Second, if unneutrality is found, how important in practice does it appear to be at the present time, and how important may it become if states are given the powers to tax national banks that are found in the "permanent" part, the post-1971 part, of Public Law 91-156? As just suggested, three aspects of economic neutrality are of particular importance for bank taxation. The first is labeled here, industrial neutrality: does the tax induce a flow of labor and capital from or to the banking industry, to or from other industries? The second aspect is geographical neutrality, especially as between interstate and intrastate banking activities: does the tax impede the flow of banking capital and services across state lines, or possibly, stimulate such flows, relative to what would occur without the tax? The third aspect is technical neutrality: does the tax tend to affect the financial structure and operating methods of a bank? For example, the tax may affect the proportion of profits retained in the firm, the bank's method of obtaining capital, or the degree of mechanization of banking operations.

A tax is economically neutral if the taxpayer does not change his conduct in order to reduce his tax bill. Thus a retail sales tax would be neutral as between banking and other lines of business if it induced no migration of capital or labor from the banking industry into other industries, or, conversely, from other industries into banking in order to save tax. This would be industrial neutrality. A bank tax is geographically neutral if it does not induce a bank to expand or contract its geographic sphere of activity in order thereby to save tax. An analogous test defines technical neutrality: A bank tax is technically neutral if the bank's capital structure and its mechanics of operation are the same as they would be if the bank had to pay a lump-sum tax of the same amount, i.e., a kind of tax that could not be reduced by

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changing the capital structure or mode of operation of the bank. Here, "same" means the same tax liability, under the tax being studied—say, a sales tax-as that liability would have been if the bank had not made those tax-induced changes. Of course no tax is completely neutral, either industrially, geographically, or technically. But some taxes are much more unneutral than others in one or more of these aspects.1 (b) How to Distinguish the Effects of a Tax from the Effects of the Use Made of Its Revenue

The effects of a tax must be distinguished from the effects of government services made possible by the tax revenue, and, similarly, from the effects of debt retirement, increase in the government's cash balance, or reduction in some other tax. To separate out the effects of the use of its revenue requires that we concentrate on the pressures exerted by the tax itself. We shall not thereby obtain a complete answer to a question like "What will happen to banks if we repeal (say) the retail sales tax?" for then some other tax would be raised, or introduced, or other changes would be forced in the public finance sector, and the banks would feel the impact of the combination of these measures. But it is still useful to ask, what pressure to do this or to do that does the tax itself put on the taxpayer, i.e., to change his conduct in an endeavor to reduce his tax bill? 2'

(c) The Three Aspects of Unneutrality Important to Banks

Industrial unneutrality is usually less if a certain bank tax is imposed by only one or a few states. Capital and labor can then flow to other states without leaving the banking industry. But of course this flow is an instance of geographical unneutrality.

The outflow will never be complete. As banking capital and labor in the taxing state are reduced, the capital and labor remaining will be able to obtain a somewhat higher price for their services in that state; supply will have been restricted, and demand is presumably unchanged. Moreover, some of the capital and labor hitherto in banking will accept a somewhat lower reward than before, rather than move to another state. To be sure, some capital and labor will move out of the banking industry into other industries, perhaps in that same state.

At some point the supply of banking service in the state will have become so restricted that the remaining banks can raise their charges by enough to give them what they need to remain in the banking industry there. This new level of charges may not be enough to recoup the tax (see section (d) below). If a tax were unneutral in favor of banking, the same arguments would apply, in reverse, as capital and labor would flow from other industries into banking, until a new equilibrium was reached. "Banking service" may include certain operations that can be conducted by a separate legal entity, owned by the bank, yet not subject to a tax on banks as such: e.g., a bank might separately incorporate its real estate loan department. In this event the "migration" is, in one sense, only nominal.

1 There are additional aspects of economic neutrality. A tax may be unneutral as between work and leisure, and so affect the supply of labor. It may be unneutral as between consumption and saving, and so affect the supply of capital. But the three aspects of unneutrality described in this paragraph appear to be the ones of chief concern to banking.

2 The point of view of the present writer on this issue is presented in Carl S. Shoup, Public Finance (Chicago: Aldine, 1969), pp. 7-15. The results of the pressure may be thought of, in the language of the calculus, as the instantaneous rate of change, plus or minus, in the amount of assets that the taxpayer keeps in the banking industry-or the instantaneous rate of change in some other relevant economic quantity.

Migration of bank capital and labor to another state is somewhat hampered by the fact that commercial banks are restricted to their state of domicile, and sometimes even to their city of domicile. On the other hand, banking capital is relatively liquid and therefore relatively mobile, at least over the years. Moreover, the question is not usually one of existing capital's moving or not moving. In a growing country capital is continually being accumulated, and the total labor force is increasing, so that the tax usually influences simply the directions taken by these increments of capital and labor. Under a tax unneutral against banking, less of the new flow of capital and labor will go into the banking industry than would otherwise.

.

Geographical tax neutrality has not been as important for banks as in some other industries, in view of the governmental restrictions on the geographical expansion of any one bank, noted above. But these restrictions are not as severe as they were formerly. Charles Conlon, executive secretary of the National Association of Tax Administrators, notes that "More recently, national banks have been accorded a greater scope of operations outside the domiciliary state by virtue of the loan production office rulings. This extension of national bank operations geographically has been accompanied by an even greater expansion in the kinds of activities conducted by national banks. These include data processing services; leasing of personal property; ownership of subsidiary corporations performing mortgage servicing, factoring, warehousing and similar functions; credit cards; collective investment accounts; the sale of insurance and travel agency functions." The geographical issues to which these activities, as well as traditional lending, give rise are considered under the several taxes below; some of the most perplexing of them involve allocation of income among states for purposes of the income

tax.

Technical unneutrality has not been the subject of so much discussion as industrial unneutrality or geographical unneutrality. To the economist it is equally serious, since it implies, prima facie, a waste of resources. For example, if a business firm uses more labor and less machinery because in that way it can reduce its tax bill, there is a presumption that this new pattern of inputs is less efficient than the initial one, else the firm would have been using it in the first place. Total product could be increased if a technically neutral tax were substituted so that firms would be free to use the most efficient techniques of production, without tax penalty. This question is particularly important under a retail sales tax that taxes purchases of capital equipment.

Moreover, technical unneutrality always causes a certain amount of industrial unneutrality. Some industries necessarily use capitalintensive methods of production, and a sales tax that taxes machinery will be unneutral against such industries.

(d) Relation Between Tax Shifting and Tax Neutrality

Complete shifting of a tax sometimes does not, and sometimes does, imply industrial neutrality of the tax. Let us consider a clearly dis

& Letter from Charles F. Conlon to Hon. Wright Patman, reproduced in Testimony Received in Consideration of H.R. 7491 and Related Bills, Hearing before the Committee on Banking and Currency, House of Representatives, Ninety-First Congress, May 26, 1969 (Washington: U.S. Government Printing Office,) p. 31. These remarks apply, to a somewhat similar degree, to state banks.

4 If the initial pattern of inputs were socially inefficient, perhaps because it was imposing costs on others for which the firm did not have to pay ("negative externalities"), a tax might be devised especially for the purpose of inducing the firm to change that pattern. None of the taxes this paper is concerned with are of that type, and it would be pure coincidence if any of them reduced negative externalities.

criminatory tax, one imposed only on the industry in question. It might be thought at first that this discriminatory tax could escape the charge of unneutrality if it were shown to be fully shifted to buyers of the industry's products. If the industry can recoup the entire tax, how can the tax be labelled unneutral with respect to that industry? Yet it will be unneutral, by the definition given in section (a) above for that term, if the shifting is accomplished only by driving some capital and labor out of the industry. Such emigration reduces the industry's output. Customers, bidding against one another for the reduced supply, push the price up. If the supply in this taxed industry is so reduced that the price rises by the full amount of the tax, complete forward shifting has occurred. Capital and labor remain in the industry in this extreme case, only because the price does rise by enough to recoup the tax. This case is a combination of a perfectly elastic supply with a demand that is neither perfectly elastic nor perfectly inelastic.

On the other hand, it is theoretically possible for complete shifting to denote industrial neutrality. Let us consider the same discriminatory tax as above, but let us suppose that the taxed industry's customers can find no substitute whatever for the product of that industry. They are willing to take a fixed amount of that product at any price within a range that covers the old price plus the tax. The price rises by the full amount of the tax, but now no capital or labor leaves the industry. This combination is one of a perfectly inelastic demand coupled with a supply that is not perfectly inelastic.

Similarly, a discriminatory tax that is not shifted may nevertheless be neutral as among industries. It will be so if inability to shift the tax is explained by an extreme specialization of labor and capital to the taxed industry. In this case, labor and capital in the taxed industry have nowhere else to go; they are able to produce nothing but the taxed product. They must therefore accept whatever is left to them after tax. Here we have perfectly inelastic supply, while demand is not perfectly inelastic. The result, no shifting at all, may well be deemed inequitable, but it does represent complete industrial neutrality; there is no flow of labor or capital out of the industry.

But if inability to shift the tax is explained by an unwillingness of all customers to pay a cent more for the product than they were paying before the tax was imposed, industrial unneutrality exists. The customers can turn to some untaxed good or service that they consider to be a perfect substitute for the taxed one. In this rare case, there must occur some migration of capital and labor from the industry. Migration continues until only very low cost producers are left. This is the combination of a perfectly elastic demand with a supply that is neither perfectly elastic nor perfectly inelastic.

(e) Supply and Demand in the Banking Industry

Commercial banking does not exemplify any of the four extreme cases just discussed. Commercial banking services form a heterogeneous group of products. Let the main products be considered the lending function and the demand deposit and time deposit handling functions. As to the demand for these products, although the commercial banks' customers may have no good substitute for the handling of their demand deposits, they can turn elsewhere for the handling of time and savings deposits and for loans.

On the supply side, neither labor nor capital in banking is so ir

revocably specialized to that industry that they will not move out of it under substantial tax pressure. Indeed, as suggested in section 1(c) above, banking capital, and presumably banking labor, are more likely than most other capital and labor to move into other industries, if their earnings in the banking industry become relatively depressed.

Neither banking demand nor banking supply, therefore, is likely to correspond with any of the extremes given in section (d) above, except that the supply of banking services may be not far from perfectly elastic over the long run, chiefly because the ratio of fixed assets to total assets is fairly low in the banking industry. A tax discriminating against banking is therefore likely to prove substantially unneutral against banking over the long run, and perceptibly so in the short run.

Again, in a growing economy, the long run may not be very long. Actual emigration of capital and labor from the banking industry may not occur; perhaps all that will be needed to shift some of the unneutral tax is a slowing down of the rate of entry of capital and labor into the banking industry, relative to their rates of entry into other industries.

Accordingly, if complete shifting of a discriminatory tax on banking does occur, it will reflect, not a rigid (perfectly inelastic) demand for banking services but, rather, an almost perfectly elastic supply of capital and labor to the banking industry over the long run. Complete shifting in this fashion implies, we have seen, industrial unneutrality on the part of the tax, since it can be achieved only by tax-induced migration of capital and labor from the industry or, in a growing economy, by a tax-induced relative decline in the rate of growth of the banking industry.

The same reasoning applies of course to a tax that is unneutral in favor of banking. Banking then grows faster, relative to other industries, than it would under a neutral tax, and consumers' choices among the various goods and services of the economy as a whole are correspondingly distorted.

(f) Taxes Included in the Present Study 5

The sections to follow, Numbers 2 to 9, consider each major state and local tax as it would affect banks if imposed under the "permanent" (post-1971) section of Public Law 91-156, which requires only that national banks be treated for tax purposes the same as state banks.

Sections 2, 3, and 4 deal with taxes directly affecting equity capital or the return from equity capital: the corporation income tax, the tax treatment of dividends, and the franchise taxes on capital employed in the taxing state. Section 5 covers retail sales taxes and gross receipts taxes. Section 6 analyzes taxes on bank assets, and Sections 7 and 8 deal with the other side of the balance sheet by considering taxes on bank shares and on bank deposits. Unemployment compensation taxes are noted briefly in Section 9.

5 The classic study of bank taxation in the United States is that by Ronald B. Welch, State and Local Taxation of Banks, Special Report of the [New York State] Tax Commission, No. 7 (Albany: New York State Tax Commission, 1934). Other studies include: John B. Woosley, State Taxation of Banks (Chapel Hill, N.C.: University of North Carolina Press, 1935); Lewis H. Kimmel, The Taxation of Banks (New York: National Industrial Conference Board, 1934); John D. Helmberger, State and Local Taxation of Banks (Minneapolis: University of Wisconsin, unpublished doctoral dissertation, 1960). See also Si: Leland, The Classified Property Tax in the United States (Boston: Houghton Mifflin, 1928), pp and 277-78, and Dick Netzer, The Economics of Property Taxation (Washington, D.C.: Brooki pp. 140-43.