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fund liabilities for pension and other benefits to be paid under the plan. Since benefit payments to beneficiaries are certain to be much smaller than the contributions received for a long period of years, if not indefinitely, and since the amount of contributions can be raised when actuarially determined to be necessary, there is no need to build up reserves to absorb possible future losses on investments.

Credit unions, which are in a relatively early stage of development, are exempt from the Federal income tax at this time.

As compared with participations in common trust funds, pension funds, and regulated investment companies, deposits and withdrawable accounts of mutual savings institutions are virtual demand claims upon these entities, repayable in practice whenever the owner requests. Ideally, each depositor and shareholder in a mutual savings institution would receive, by periodic additions to his account, his ratable portion of all income currently earned by the institution. This would be possible, however, only in a Utopian economy where no borrower would ever fail to pay interest or principal of his debt when due and where interest rates would remain stable indefinitely so that bonds could be sold without loss when cash must be raised to meet withdrawals. But in our dynamic economy losses on assets due to defaults and to declines in bond prices caused by higher interest rates occur as inevitable accompaniments to economic growth and change.

Therefore, a small portion of the income of a mutual savings institution must be withheld from current distribution to participants and added to reserve accounts in order to assure that losses on assets will be absorbed without impairing the funds due depositors or owners of withdrawable accounts. Mutual savings banks retained 10 percent of their gross earnings for this purpose in the 5 years ended 1958. There is no other source available for additions to reserves of mutual savings institutions.

The question may be asked: Why must income be withheld currently and continuously by mutual savings institutions for additions to these necessary reserves for absorbing future losses?

There are several reasons. First, although savings entrusted to mutual savings institutions are invested prudently, all investments are subject to risk. Moreover, since the savings are invested promptly as received, they become subject to risk immediately.

Secondly, continuous investment of new savings as well as reinvestment of the proceeds of maturing loans and investments are made under changing circumstances and consequently under changing risk potentials.

Thirdly, investments are generally long term. In mutual savings institutions more than 90 percent of total assets are of long-term character at all times. Actuarial determination of potential losses on long-term investments is not feasible. Losses arise not only from failure of a debtor to pay his obligation in full but from other causes as well. Mutual savings institutions may and do realize losses on investments that are sold to raise cash. Such losses are unavoidable. A savings institution that would seek to invest only in risk-free investments, if there were such, would not be performing its function of mobilizing savings for the long-term capital needs of the economy.

In determining the amount of reserves required by a mutual savings institution, particularly a mutual savings bank, due regard must be

given to the fact that the institution cannot judge precisely, at the time of making an investment, how long it will be held and the loss, if any, that may be incurred when it is liquidated. Also, since the true yield of an investment reflects the contractual interest rate it bears plus or minus profit or loss on its sale before maturity, management cannot predetermine the effective yield it will realize on this investment during the time it is held.

What are adequate reserves?

What are adequate reserves for a mutual savings institution? A dilemma develops when this question is viewed from the standpoint of taxation. Tax laws seek to define adequacy, but banking laws and supervisory authorities have the last word on what are adequate

reserves.

State banking laws and the policies and regulations of State supervisory authorities bear heavily on the problem of adequate reserves for mutual savings banks. They seek to assure both that imprudently large amounts of income will not be distributed by a mutual savings bank to its participants and that undue amounts will not be withheld from them.

In the principal savings bank States distribution of amounts available for interest in excess of a maximum defined by law is required by law or may be required by the supervisory authorities. At the other extreme, the supervisory authorities can limit distribution from funds available for interest where additions to reserves are required in its judgment. Taxation of the income of mutual savings banks required to be retained to provide adequate reserves against losses would either thwart the aim of providing needed protection for depositors or curtail the serviceability of the mutual savings banks as an institution for promoting and fostering thrift.

The Federal Deposit Insurance Corporation, in its annual report for the year ended December 31, 1958, states again, as it has on previous occasions, that growth of bank capital accounts over the long term has not kept pace with the rise in bank assets. The FDIC points out further that while the rise in total capital accounts was about enough to keep pace with the rise in bank assets during 1958, the capital accounts of commercial banks increased relatively more than the surplus accounts of mutual savings banks have increased by less than 5 percent per annum.

From the inception of Federal income taxation in 1913 until 1951, mutual savings institutions were exempt from such taxation. This exemption was ended by the Revenue Act of 1951. In devising a method for taxation of mutual savings institutions Congress gave well-balanced consideration to the twin objectives of assuring that earnings not required by them as a reserve against losses would be paid into the taxable income stream and of preserving the Nation's existing strong systems of specialized savings and home financing agencies. Congress sought continued safety for the savings funds entrusted to these mutual savings account institutions by permitting them to build up reserves ample to keep them sound. Taxes were to be collected only on earnings that would exceed this requirement.

Congress set a 12-percent surplus and reserve ratio as a maximum beyond which retained earnings of mutual savings institutions would be taxed at the full income tax and surtax rate applicable to cor

porate income generally. The 12-percent ratio specified in the Revenue Act of 1951 was not a figure chosen at random. It was adopted by Congress in 1951 after considerable discussion and debate as a desirable yardstick for taxing retained earnings of mutual savings institutions under the conditions then prevailing. Changes in conditions since then, such as declines of 20 points and more during the 1950's in prices of long-term Government bonds of which mutual savings banks are large holders, and sizable declines in the values of FHA and VA mortgages which they hold, would argue strongly against any lowering of this ratio of surplus and reserves to deposits beyond which retained earnings become taxed.

Imposition of a tax on the small proportion of their earnings set aside by mutual savings institutions as a necessary reserve against future losses could produce at most only a very limited amount of tax revenue by comparison with that which the Treasury will derive over a period of years from the expansion of taxable interest and dividends paid out to individuals by these institutions because of the growth in the volume of savings entrusted to them. The tax that would be imposed on earnings set aside as a necessary reserve each year would be levied but once; that is in the year earned. On the other hand, the interest-dividend income generated by each annual increase that mutual savings institutions attract is taxed annually year after year. An illustration is given in appendix A of the difference between what the Treasury will receive by taxing annual additions to reserves in full and taxing the additional interest-dividends that will be paid out on savings if mutual savings institutions are permitted to continue to grow at the average rate of the past 5 years.

To pay a tax on earnings set aside as a necessary reserve against future losses mutual savings institutions would be compelled to reduce the rate of return paid on savings. This would check their growth. A slower rate of growth, in turn, would lead to a reduction in annual additions required for their surplus and reserves. Checking the rate of growth of these institutions would choke off large yearly additions to taxable personal income and produce smaller amounts of tax revenue from the taxation of dwindling annual amounts of retained earnings of the mutual savings institutions.

Taxation of additions to reserves by mutual savings institutions would result in a narrowing of the income tax base, therefore, rather than the broadening sought by the committee. At the same time, it would militate against economic growth and increase the threat of inflation by reducing the volume of savings available to finance longterm investment.

The present law, with its tax on retained earnings when surplus and reserves equal or exceed 12 percent of deposits, provides ample assurance against excessive retention of earnings by these institutions. At the same time, the soundness and effectiveness of the Nation's major savings agencies are not undermined.

Deductibility of interest payments

Proposals to limit the deductibility of interest payments made to savers by mutual savings banks would not only be unfair and inequitable but would also jeopardize the large and growing contribution made by these institutions to the taxable income stream.

These proposals are inequitable because such a limitation on the deductibility of interest payments does not apply to any other class of taxpayers.

It is a basic principle of tax law that interest payments are a deductible expense for the taxpayer, as are wage and salary payments and other business expenses. Since interest payments, like wages and salary payments, are taxable income to the recipient, the deduction allowed for interest paid avoids inequitable double taxation of the income used to pay interest. It is also obvious that failure to allow a deduction to the taxpayer for interest paid could jeopardize the ability of many taxpayers to meet interest payments as they fall due, and so could jeopardize their solvency.

Limiting the deductibility of interest paid by mutual savings banks would not achieve a sound fiscal purpose. Such limitation is designed to limit arbitrarily the rate of return paid on savings by mutual savings banks. It would force many mutual thrift institutions to pay lower rates of interest on savings by limiting the deductibility of such payments from their taxable income. This involves an element of regulation of interest rates by tax law rather than by the Federal and State agencies duly constituted to supervise and regulate the business of banking organizations.

By reducing the total amount of interest payments, and by discouraging the flow of savings into mutual savings institutions, the effect would be to narrow rather than broaden the tax base, and so to contravene the expressed objectives of the committee. Such proposals are open to the very serious further objections that they would contribute to inflation pressures by discouraging savings and so increasing reliance upon commercial bank credit expansion to finance economic growth. Finally, they would set a dangerous precedent for limiting the deductibility of interest payments to taxpayers for ulterior objectives. A tax law to limit interest payments on savings by mutual savings institutions would thus involve misuse of the taxing power.

2. PROGRESSION

The personal income tax assures progression in the distribution of the tax burden upon the interest income received from savings accounts. Such interest constitutes an increment to taxable personal income that is taxed, in effect, at the highest rate applicable to the taxpayer.

The rise in average family income during the past decade has tended to step up the effective tax rate applicable to the interest received on savings accounts. The larger the rise in income the greater the increase in the tax rate applicable to interest earned on savings.

Families with dollar incomes of over $4,000 more than doubled between 1947 and 1957, according to the Office of Business Economics of the U.S. Department of Commerce. (See U.S. Income and Output, a supplement to the Survey of Current Business, November 1958, p. 43.)

In 1947 about 161⁄2 million families earned more than $4,000; their number increased to 34 million last year. On the other hand, the number with incomes below $4,000 declined from 28 million in 1947 to 192 million in 1957. Table 1 in appendix B shows these shifts in greater detail.

The Federal Reserve Board's 1959 Survey of Consumer Finances indicates that ownership of savings accounts becomes more widespread as personal incomes increase, adding to the element of progression in the taxation of such income. Table 2 in appendix B shows the percentage ownership of savings accounts by income levels for each year 1953-59.

Interest income, including interest-dividends paid by mutual savings banks and savings and loan associations, has been rising more rapidly than other types of personal income and also more rapidly than other types of taxable income, as shown in tables 3 and 4 in appendix B.

Between 1947-49 and 1958 interest-dividends paid by mutual savings banks and savings and loan associations have risen by more than 350 percent while personal interest income has risen by 133 percent, and total personal income by 76 percent. Between 1947-49 and 1956, the latest year for which data have been published, reported taxable interest income rose by 115 percent as compared with 230 percent for interest-dividends paid by mutual savings banks and savings and loan associations. Interest-dividends on savings accounts have become an expanding segment of the taxable interest reported to the Bureau of Internal Revenue.

Because mutual savings institutions distribute all but a very small portion of their current income exclusively to their beneficiaries as taxable income to them, they contribute progression of the income tax rates applicable to such income as well as to a broadening of the tax base. Their effectiveness in furthering these objectives can be hampered, however, by tinkering with present methods of taxation of mutual savings institutions.

3. FREE PLAY OF THE MARKET IN ALLOCATING RESOURCES

Mutual savings banks, in particular, are free to direct the flow of savings into the channels of long-term investment where they are most needed, as indicated by the relative rate of return offered by those who seek to attract such savings.

In the decade of the 1950's, when the most urgent demands for savings have come from homebuilding and corporate expansion, savings banks have channeled the savings received by them into these two vital uses. Investments of mutual savings banks in these two categories now aggregate $28.8 billion. When the Treasury's need for funds was most urgent during the World War II period, savings banks invested the new savings they received in U.S. Government obligations. The investment of mutual savings banks in U.S. Government securities rose to almost $12 billion during that period.

Mutual savings banks also purchase State and municipal obligations when the yield offered makes them relatively attractive as media for the investment of funds received from depositors. Mutual savings banks hold only $758 million of tax-exempt securities at this tme. Under the present system of taxation of mutual savings institutions, there is thus no distortion in the allocation of savings into productive long-term investment despite the great and growing volume of taxexempt security offerings, except to the extent that funds are being diverted by individual savers from savings accounts into tax-exempt issues solely to escape taxation of investment income.

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