AN ANALYSIS OF THE FEDERAL INCOME TAX LAW AND ITS APPLICATION TO MUTUAL FINANCIAL INSTITUTIONS

Kurt F. Flexner, American Bankers Association

INTRODUCTION

The subject of taxation of mutual financial institutions falls naturally into two separate categories-equity and economic soundness. Equity is of great importance in a society in which the success or failure of an enterprise depends in no small measure on the application of equitable laws. The concept of equity is, of course, not a static one, and changing conditions make a periodic reevaluation of our laws, some of which are made obsolete by time, necessary.

So far as the economic soundness of our tax structure is concerned, it is desirable in this connection to ask the following questions: (1) Is it in the public interest? (2) Does it produce the desired results in accordance with overall economic policy?

It is an accepted principle in modern political doctrine for a State to grant special privileges to an organization or an entity which is performing a highly necessary service in the public interest and whose existence depends upon such privileges. Since, however, a just goyernment must have equal regard for all its citizens and entities subject to its laws, it is extremely important that special privileges be granted only when withholding them would deny the public a necessary service.

The broad purpose of Federal taxation in this country is to help raise funds for the domestic and international operations of our Government and to raise these funds in a manner conducive to economic stability. Taxation is, in a sense, always a burden to those subjected to it, but apart from the obvious fact that it is a necessary part of government, if it is properly conceived and soundly executed it will not, within reason, prove destructive to those who are capable of adjustment in a competitive society. If it were otherwise we could not have made as much progress in the last few decades.

It is the purpose of this paper to evaluate the principles of equity and economic soundness in respect to the Federal income tax laws as they apply to mutual savings banks and savings and loan associations. In regard to the equity principle, two questions stand out: (1) Does the present Federal income tax law, which in effect results in a negligible payment of taxes by the savings banks and savings and loan associations, constitute a privilege which, if withheld, would deny the public a useful and necessary service? (2) Does the existence of this special privilege enjoyed by the mutual savings banks and savings and loan associations give them an unfair advantage over their competitors?

In regard to the principle of economic soundness the questions to be answered are: (1) Will an effective tax collection from mutual financial institutions cause them hardships to which others, similarly taxed, are not subjected? (2) Is the tax law pertaining to the mutual financial institutions consistent with this Nation's general objective of economic stability?

THE PRINCIPLE OF EQUITY EXAMINED

The American financial community was not designed according to a master plan for if it had been it would undoubtedly be less complex. Instead, the system developed democratically in response to local and national needs. The American economy, however, consistent with the progress that has been made in economic development, has undergone major changes. In the early days it took nearly all our effort to produce the bare essentials with a modest surplus for new plant and equipment. Until a few decades ago, therefore, the commercial banks were mainly concerned with their commercial and industrial relations because the average person had little savings and was not a very good credit risk for long-term mortgage investments. Nevertheless, in a country in which property ownership was always popular the encouragement of saving and homeownership soon led to a demand for institutions which could facilitate both. This demand inaugurated the mutual savings bank and the savings and loan association. One was the little man's bank for savings, the other his promise of homeownership. This factor and their mutual structure has at times led to special treatment for savings banks and savings and loan associations.

It is not necessary at this point to question or to examine the validity of the preferential treatment which they have received. The only question is, Should they continue to receive it? It is undoubtedly true historically that the mutual savings banks and the savings and loan associations have in fact encouraged savings and homeownership among people of moderate incomes to a greater extent than would have been the case without their existence.

Many changes have taken place, however, which seriously question the validity of continuing the practice of preferential treatment and special privileges granted to savings banks and to savings and loan associations. Today the average man has grown so important in economic stature that in addition to the savings banks and the savings and loan associations, many other institutions including the commercial banks are not only willing but anxious to cater to him. In fact, the time and savings accounts of the commercial banks far exceed the savings accounts of either the savings banks or the savings and loan associations, and many of the commercial banks, especially the numerous smaller ones, depend for their existence on time and savings deposits.

The savings account has become so important that those institutions which have been able to attract it have grown the most. Between 1945 and 1957 assets of the savings and loan associations increased by 455 percent, the assets of mutual savings banks by 107 percent, and the assets of commercial banks by 39 percent. With the national income rising as it has and as it will, the importance of savings will

become even greater, and the institutions able to attract them will make the biggest progress. Commercial banks will not be able to grow as fast as the economy as a whole unless they are able to share in the growth of savings. This will be especially true for the many thousands of relatively small commercial banks which are closely linked to their communities.

Today the average person has many outlets for his savings. He can put them into savings banks, commercial banks, savings and loan associations, insurance companies, mutual funds, he can purchase stocks and bonds directly, and he can do many other things. In a free society, however, the choice among alternative institutions accepting savings must be left to the people who save. Otherwise, such funds will be channeled arbitrarily and the results may, or more often may not, be in the best interest of the saver and the financial community as a whole.

So long as the savings banks and the savings and loan associations were unique in their important functions as the little man's savings depositary and home financer, their special treatment could be defended. Today it cannot be defended any longer. This does not mean that savings banks and savings and loan associations are no longer necessary. On the contrary, their existence is indeed in the best public interest. They have, however, become very sizable industries with their combined assets around $100 billion. If in the face of existing alternatives available to the saver, the savings banks and the savings and loan associations continue to receive preferential treatment, not only will this be inequitable so far as their competitors are concerned, but such protection from competition generally is the surest road to inefficiency. The longer preferential treatment is granted to an industry the more difficult adjustment becomes when the special privileges are removed. If the savings banks and savings and loan associations have a solid foundation, and I believe that they do after their long history of growth and service, they will be able to adjust to equitable treatment under competitive conditions.

It can be said of all our industries that, although they operate successfully under the American system of taxation, if they all had received special tax protection they might well all believe that a cessation of such protection would lead to their ruin. Indeed, if an industry must receive permanently special treatment to operate successfully, it is built on a sandy foundation, and where other industries performing similar services do not require special treatment, the sooner the special treatments are removed the better. Whatever reason, therefore, which justly warranted special treatment of the savings banks and the savings and loan association, this reason no longer exists. To prolong the existence of such privileges is to subject capitalism, which in order to succeed as an economic system must be built on dynamic competition, to inefficiencies that can only weaken it.

It is undoubtedly true that some commercial banks do not have very large time and savings accounts in proportion to their total deposits, but for the commercial banks as a whole, this is not true. For a great many commercial banks, time and savings accounts are the source of growth and even existence. The popular but erroneous belief that commercial banks as a whole cater to business and savings banks and savings and loan associations to the family and the home should be

corrected. The great majority of commercial banks are community banks dependent upon the family and the home. In the future this relationship will become even stronger and more essential to the growth and survival of many commercial banks.

It is true that all too many commercial banks have not yet fully accepted the change that has taken place in our economy-the supremacy of the consumer and homeowner in our credit structure. Total residential mortgage credit and consumer credit far outweigh any other type of debt or equity in our financial system, with the exception of the public debt. Many commercial banks have already accepted this fact, and have grown and prospered as a result. Others are still slow in adjusting to the great change that has taken place in our economy. The fact remains, however, that for most commercial banks the development of successful community and family relationships will make the difference between growth and decline. To serve the community, however, commercial banks must be able to attract savings and to help finance the construction and ownership of homes. It is unthinkable that the tax laws should under these circumstances discriminate against the commercial banks and give them less than an equal opportunity to serve their community and to grow.

In 1958, commercial banks with assets of over $235 billion had a net income of $2.95 billion after the deduction of operating expenses and interest paid on time and savings deposits. On this net income they paid a tax of $1.19 billion, or 40 percent. In 1958, the savings banks with assets of $37.8 billion earned a net income of $962 million after payment of operating expenses. They paid interest on deposits to the extent of $812 million, retaining a final net income of $150 million on which they paid a tax of a little over $500,000, or about one-third of 1 percent.

The savings and loan associations in 1957, with assets of $46.4 billion, had a net income of $1.66 billion after the payment of operating expenses. They paid a dividend of $1.24 billion leaving a final net income of $412 million. On this they paid a Federal income tax of $4 million, or 1 percent.

It is my conclusion, therefore, that the special tax treatment granted savings banks and savings and loan associations at present is neither desirable from the public interest point of view nor from the standpoint of fair competition.

THE PRINCIPLE OF ECONOMIC SOUNDNESS EXAMINED

If the savings banks and savings and loan associations have no claim to special tax treatment, the question still remains, How will Federal income taxes affect them, their customers, and the economy as a whole?

Starting with the economy as a whole, the suggestion has been made that to tax the savings banks and savings and loan associations would in effect constitute a tax on savings which would be per se inflationary. This argument on the surface seems logical, but deeper probing exposes its weaknesses. Savings may be increased either at the expense of taxation or of consumption. Not to tax the savings banks and savings and loan associations is, however, no help in the fight against inflation if the Government's expenditures are taken as fixed. The taxes lost by not taxing the savings banks and the savings and loan associations either have to be made up by increased taxes elsewhere or the Govern

ment has to increase its demand for loanable funds, neither of which is, under the circumstances, anti-inflationary. Indeed, the loss of potential taxes from savings banks and savings and loan associations may well be inflationary if it is assumed, as it should be, that Government expenditures, business expenditures, and consumption expenditures will not decline. This is so, because by not paying taxes the savings banks and savings and loan associations possess a greater ability to meet the demand for loanable funds.

The fact that savings banks and savings and loan associations, by not being taxed, are able to attract more savings is, therefore, of no help in the fight against inflation. Because if Government spending and total taxes remain the same, total savings will not increase as a result of not taxing the savings banks and savings and loan associations. All that happens is that their ability to attract more savings occurs at the expense of the taxed institutions. An industrial corporation, for example, planning an expansion could, if it were not taxed, use the funds thus saved to help finance this expansion. This would cause it to borrow less. On the other hand, if total expenditures in the economy remain unchanged or do not decline, the hypothetical corporation which is not being taxed would either merely shift the tax burden to others or it would compel some sector in the economy to borrow more.

By the same token, if savings banks and savings and loan associations were taxed in an equitable manner total savings would not decline if the Government did not increase its expenditures and consequently its total tax receipts. If the savings banks and the savings and loan associations looked upon equitable taxation as a challenge they could through an attack on high costs and inefficiencies, where they might exist, prevent a loss of relative position. If they do not meet the challenge of taxation successfully, savings would be reallocated in accordance with the principles embodied in a free market mechanism. It is by the first method, however-increased efficiencythat a competitive society proves its merits and not by special protection.

So far as the interests of the saver are concerned, equitable tax treatment of all financial institutions would not hurt him at all. The ability of a financial institution to pay taxes depends, of course, on its profitability. Savings banks and savings and loan associations do not have profits in the ordinary sense, but they do earn net income. This net income is distributed partly to savings depositors or shareholders, and partly retained as surplus and reserves. It is out of this net income that taxes must be paid if they are paid at all. The size of such net income depends, of course, on earnings, operating expenses and other expenses. There is a close relationship between growth, expenses, dividend and interest payments, reserves, and the ability to pay taxes. If growth is too rapid and operating expenses, therefore, relatively high, or if operating efficiency is too low, net income may be too small to pay competitive or higher than competitive dividend or interest rates on savings, too small to accumulate proper bad debt reserves, or too small to pay taxes unless dividends on interest payments are reduced.

If, however, the rate of growth of the savings banks and the savings and loan associations is determined by competition under equita