of the mutuals have been small because their taxable income has been small, and we know that their taxable income has been small because of the deductions they have been allowed under the 1951 revenue act. What remains to be determined is whether Congress has permitted these corporations to exclude from their respective tax bases any income which might properly have been taxed under the kind of a corporation income tax that we now have. If the answer to this question is "no," it must be presumed that the mutual and the nonmutual corporations are being taxed equally. If, on the other hand, the answer to the above question is "yes," we must conclude that the mutual companies have been granted certain tax favors.

In examining the 1951 law for evidence of any such tax favors, there are two provisions which would appear to require attention. The first is the provision which allows the mutual associations to deduct interest and dividends paid to depositors or shareholders. The second is the provision which permits these companies to exclude from income otherwise taxable certain amounts set aside as general reserves or as surplus and undivided profits. Since these associations ordinarily distribute between 70 and 80 percent of their net operating income to their depositors and shareholders, the first of these provisions is the more important from a quantitative standpoint, although it is with respect to the second that there appears to be the sharpest difference of opinion.

The first question which has to be raised concerning the dividend and interest deductions of the savings banks and savings associations relates to the character of these payments. Some of those persons who find evidence of tax favoritsm in these deductions argue that the "earnings" distributed to the depositors of these associations are similar in character to the "profits" which the commercial banks and other ordinary corporations distributed to their stockholders. As stated, this would seem to be a very questionable proposition which contains at most a modicum of truth. As intermediary financial institutions, the principal business of the savings banks and savings associations is to pool and invest the savings of their depositors. The funds that these institutions receive from savers are not "profit seeking" funds, but funds which are expected to be invested in high-grade bonds and well secured mortgage loans; and the "earnings" which they pay out to their depositors are clearly not "profits" in the ordinary sense of that word. All of this seems to be beyond dispute in the case of a stock savings bank or a guarantee stock savings and loan association, where the interests of the depositors and those of the stockholders are clearly demarcated; but it is sometimes lost sight of in the case of mutual companies where the two interests are combined. Although mutuality may be said to merge the ownership interest into the creditor interest, it does not destroy the substance of the latter. Depositors remain depositors and as such receive the same income from the same sources. This much should be clear. What is, perhaps, not so clear is whether they receive any income as the "owners" of a mutual corporation. To the extent that they do, it might be argued that the present tax law gives the mutuals a small tax favor with respect to this ownership interest. But it is presumed to be small, and what is even more important, there would seem to be no really satisfactory way of eliminating it.

The provisions which permit the mutuals to avoid taxes on income allocated to surplus and general reserve accounts would appear to be somewhat more vulnerable to the charge of tax favoritism. Although all of these reserve accounts are sometimes referred to as bad-debt reserves, the true surplus or general reserve account has to be distinguished from so-called valuation reserves which are usually earmarked to absorb losses on specific groups of assets that involve material risk. It is assumed that the allocations that are made to these restricted baddebt reserves will roughly equal the losses actually realized over time, and that therefore it makes little difference whether the loss deduction is taken at the time the loss occurs, or at the time the reserve against it is set up. Commercial banks are permitted to use a special formula in computing the amounts which they can add to their bad-debt reserves each year, and there is no reason to believe that the mutual savings banks and the savings and loan associations would not be allowed to use a similar formula if they needed to. Actually, the provisions that were written into the 1951 act covered a good deal more than the needs of these institutions for valuation reserves, so there was no need to provide a special formula for them.

The rationale of the general reserve or surplus account for mutual savings banks and savings and loan associations is somewhat different from the rationale of the valuation reserve. Because they have no capital stock and cannot go outside for guarantee funds to protect their depositors, these organizations have to build up such funds out of earnings; and this is something which they have always been encouraged, and have sometimes been required, to do by the State banking authorities, as well as by the Federal Home Loan Bank Board and the Federal deposit insurance agencies. While the most important function on the surplus or general reserve account is to absorb losses that may be incurred on assets, these accounts may also serve other functions such as (1) to pay for bank buildings, equipment and other nonearning assets, or (2) to help defray operating expenses with earnings on the portion of the surplus that is invested in earning assets, or (3) to assure the safety of new deposits, pending the time when surplus can be accumulated for such deposits out of earnings on assets acquired with them."

As a guarantee fund, the surplus or general reserve of a mutual finance company is intended to offer protection against such general risks as the possibility of another prolonged major depression. It is, of course, important that the public's savings should be protected against such a contingency, even though we shall presumably do everything in our power to prevent its occurrence. But the fact that a reserve of this type may not actually be used to fulfill its primary purpose makes all the more important for us to consider the other purposes which a fund of this type can serve. In one sense, these purposes too are social purposes since they may be expected to encourage and promote saving; but it is clear that they also strengthen the competitive position of the mutuals. So, while it is understandable that Congress should have seen fit to write into the 1951 Revenue Act a provision that would encourage the savings banks and savings associations to build up their guarantee funds out of earnings, it is also understand

"Economic Study of Savings Banking in the State of New York," New York, 1956, p. 184.

able why the taxpaying competitors of these associations should have regarded this action with disfavor. The earnings that have gone into these guarantee funds are no less income than the earnings which ordinary corporations have plowed into their own surplus accounts, and as income they could clearly have been taxed if Congress had wished to tax them. In this case, then, the mutuals would appear to have been given a tax concession which their competitors did not share. But to say that the mutual savings banks and the savings and loan associations could have been taxed on their undistributed earnings which they have used to build up their surplus and general reserve accounts, is not to say that they necessarily should be so taxed. This is a question of policy in the determination of which a good many different factors have to be considered. There is much to be said for broadening the tax base whenever this can be done by bringing into the fold, as it were, untaxed income that can properly be taxed. There is also a good deal to be said for tailoring our income tax law in such a way that competing firms are taxed equally. Finally, we should avoid as much as possible the use of tax provisions which in effect subsidize institutions or individuals which do not need to be assisted in this way. Considerations such as these suggest the desirability of taxing the retained earnings of the savings banks and savings associations.

On the other hand, we cannot overlook the fact that the impact of such a change in the law would be most severe on the newer and smaller savings associations which have not yet built their general reserves up to the desired levels. Growing institutions would feel the effects of the change more than stable ones, since the former would be under more pressure to increase their surplus accounts. Heavier taxes on the retained earnings of these corporations would almost certainly force them to lower interest rates, since there would appear to be virtually no possibility of passing the tax forward to borrowers. This might have the effect of retarding somewhat the rate of growth of many institutions by reducing the size of the rate differential that has up to the present given the mutuals some advantage over their competitors. The taxation of undistributed profits would not, of course, result in any double taxation of depositors income; but it might result in a considerable amount of overtaxation by the standards of the conduit theory. Whereas corporate stockholdings are assumed to be heavily concentrated in the middle and upper income classes, the depositors of savings banks and savings associations are more likely to be found in the lower middle income classes. Although these persons undoubtedly have the ability to pay taxes on the income that is put into the reserve accounts of savings associations for their benefit, it might be questioned whether a rate as high as the present corporate rate is an appropriate one to impose in this case.

V. CONCLUSIONS

The case for imposing heavier income taxes on mutual savings banks and savings and loan associations appears to have been considerably overstated by the competitors of these institutions. While it is true that these institutions have paid very low Federal income taxes in relation to their operating income, since they became taxable in 1952, they can be said to have been undertaxed only with respect to the

retained earnings which they have used to build up surplus and general reserves. A fairly strong case can be made for taxing these undistributed earnings although it would seem more appropriate to apply a rate closer to the first bracket individual income tax rate, than to apply the top corporate rate to these earnings. A tax on the distributed earnings of the savings banks and savings associations would be very inequitable and would seriously impair their ability to function as they now do.

FEDERAL INCOME TAXATION OF MUTUAL SAVINGS BANKS AND SAVINGS AND LOAN ASSOCIATIONS

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John G. Gurley and Yvette E. Gurley, The Brookings Institution 1 Our purpose in this paper is to appraise the present Federal income tax on mutual savings banks and savings and loan associations. An appraisal cannot be fairly presented, however, without first reviewing briefly the background of Federal income taxation of these financial institutions, including the Revenue Act of 1951, the main problems connected with such taxation, the effect of the taxation on economic activity, and the current proposals for reform.

THE PROCESS OF FINANCIAL INTERMEDIATION

Mutual savings banks and savings and loan associations are part of a large group of financial institutions generally classified as financial intermediaries. The term "financial intermediaries" also includes such institutions as commercial banks, Federal Reserve banks, Federal land banks, life insurance companies, and credit unions. Some financial intermediaries are incorporated for stockholders' profit, and some are mutuals. All of them, however, perform the same basic function of intermediating between ultimate borrowers and lenders. In performing this function, financial intermediaries purchase debts and equities of ultimate borrowers and create deposits, shares and other claims on themselves that are held by ultimate lenders. Each intermediary differs in some degree from the others in the types of financial assets it purchases and in the types of financial liabilities it creates.

The net income before income taxes of financial intermediaries is the difference between their operating earnings and operating expenses, after adjustment for capital gains and losses on fiancial asset portfolios. Their operating earnings come predominantly from interest and dividends received on their holdings of financial assets. Their operating expenses are chiefly interest and dividend payments to holders of their liabilities, wages and salaries, and other costs of managing portfolios. Their net income is allocated to income taxes (if any), dividends to stockholders (if any), and growth in capital or surplus accounts.

THE REVENUE ACT OF 1951 AND BEFORE

The four largest private financial intermediaries are commercial banks, life insurance companies, mutual savings banks, and savings and loan associations. Commercial banks have been subject to Federal income taxation since 1913, on the same basis as ordinary corpo

1 The views expressed in this paper are those of the authors. They do not necessarily reflect the views of other members of the Brookings staff, the administrative officers of the institution, or the board of trustees.