and society will have suffered a loss in its institutional expression of ideals. But there is no need further to draw out long speculation on this matter of the effects of taxation of credit unions upon economic growth.

REVENUE POTENTIALITIES IN CREDIT UNION TAXATION

"Every tax ought to be so contrived as both to take out and to keep out of the pockets of the people as little as possible, over and above what it brings into the public treasury of the State." Adam Smith's canon of taxation has applicability to the revenue aspects of credit union taxation. First consider credit union incomes, reserves, and dividends in 1958. This is shown in table 15. In this table the income and the dividend figures are reported figures, and the reserv● deduction is estimated. Total income amounted to $177.7 million, less reserves of $35.5 million, left $142.2 million available for dividends. Actual dividends amounted to $127 million, leaving around $15 million for unallocated reserves, or "undivided profits." The dividend rate was 3.6 percent on average shareholdings, a rate fairly comparable with that paid by other financial institutions. Assuming that reserves and dividends would be tax exempt, there would be a very small base upon which to levy a tax. Almost any tax on this surplus would bring little "into the public treasury of the State" and would violate the canon of economy in taxation.

Net income:

TABLE 15.-Credit union income and its disposition, 1958

Source: Federal credit unions, "1958 Report of Operations," pp. 14, 18; State-chartered credit unions statistics furnished by the Bureau of Federal Credit Unions.

The distribution of the incomes of Federal credit unions in 1958 is shown in table 16. In this table, it should be noted, net income represents income before transfer to reserves or the payment of any dividends on 1958 shareholdings. Interest refunds in some, but not all, credit unions that made such payments are also included in the net income figures. Table 16 shows that 91 percent of the Federal credit unions in operation at the end of 1958 reported either a loss or net income less than $25,000. Only 1.2 percent of the credit unions reported income in excess of $100,000. It can be assumed that Statechartered credit unions follow a similar distribution.

TABLE 16.-Percentage distribution of net income, Federal credit unions, 1958

To take an extreme example-and one which is unrealistic-let us suppose that credit unions were taxed at the regular corporation rates and that all earnings before deduction of reserves were subject to tax. Projecting the earnings distribution of table 16 to all of the credit unions in the country, of the net earnings of $178 million, around $80 million would be taxed at a rate of 30 percent which would yield $24 million, and around $98 million at a rate of 52 percent would yield about $51 million, or a total tax yield of about $75 million. This would absorb the entire unallocated surplus of $15 million and would cut the dividends in half. Obviously it would mark the end of the credit union as it now exists in America. No revenue would be gained from such a destructive tax, and while the competitors of the credit union might benefit slightly, the consumers, 10 million credit union members in particular, forced to pay higher interest rates on consumer loans, would be the chief sufferers.

The figures in tables 15 and 16 show that almost any tax would cut into the amounts available for dividends. The average rate of 3.6 percent paid in 1958 seems to be moderate. And if the dividends themselves are taxed in full as regular income to the individual taxpayer as they are under present regulations-there would be little incentive for saving in credit unions. At any rate, the earnings figures of credit unions show that the revenue possibilities in credit union taxation are ridiculously small.

Credit union reserves

The question of credit union reserves is an interesting one in that legal regulations have largely removed this important matter from the province of management. Section 12 of the Federal Credit Union Act states:

All entrance fees and fines provided by the bylaws and 20 per centum of the new earnings of each year, before the declaration of any dividends, shall be set aside as a regular reserve against losses on bad loans and such other losses as may be specified in the bylaws **

This section goes on to set a maximum of reserves to be equal to 10 percent of the members' shareholdings, and it also provides for other reserves as conditions may require. State laws contain very similar provisions. How the original 20 percent and the 10 percent maximum were arrived at is unknown; they were not derived from experience, since credit union legislation was passed prior to the organization of these institutions.

The tax-free status of credit unions probably accounts for the uncritical acceptance by credit union people of these reserve requirements. The matter simply was settled. The income tax is of the essence of valuation reserves as found in banks and in finance companies. Where a tax is involved, a valuation reserve must reflect the loss experience of the company. But in a tax-free credit union, as far as the law is concerned, the loss experience is beside the point; a credit union may have experienced large losses or small losses, but nevertheless it must set aside the statutory reserves.

In the past also the agencies which administer credit-union laws have tended to exert pressure toward high reserves. By limiting the distribution of the earnings in the form of dividends, the credit union has a margin from which it may absorb the consequences of faulty management decisions or of economic reverses. From the point of view of a supervisory agency this makes some sense. However, the agency negotiates from a position of strength and it may conceivably require the accumulation of reserves far beyond the point indicated by the financial facts-past, present, or future. So much for the law and its administration.

Classifications of reserves which have been developed for banks or for other types of financial institutions hardly apply to credit unions. Credit union reserves fall into two broad classifications:

1. Allowances. (a). Depreciation allowances. These are taken on buildings, furniture, and fixtures. In large credit unions the cost value is maintained in the asset accounts. In small organizations depreciation is charged directly against the asset accounts. Since fixed assets are such a small part of credit-union assets this type of allowance is not too important.

(b) Allowances for losses, or valuation allowances.-In strict usage a decline in the value of assets which has occurred is reflected in reserve accounts rather than in the assets themselves, Properly speaking, such reserves are offset against the related current asset, or loan accounts, in order to show the expected realizable value of the assets. In most businesses these accounts have a "tax allowance" treatment; this, of course, does not pertain to credit unions. In a credit union financial statement part of the "regular reserve," or the "guaranty fund," might be considered a valuation allowance. Part of this account, however, would fall under the second group, general capital reserves.

2. General capital reserves.-(a). Accumulated but undeclared dividends in "undivided earnings," or "undivided profits" account. At the end of the year part of these are declared as dividends and the remainder is left in the undivided earnings account. This is really an addition to capital, or an unallocated capital reserve. Where, as in the credit union, the capital stock is unlimited, there is no particular virtue in having capital unallocated since credit-union stock cannot be sold or redeemed at more than its par value, regardless of the amount held as undivided earnings.

(b). Reserves for contingencies. After all known accrued liabilities, a reasonable depreciation for physical property, losses on loans, etc. have been provided for, under certain conditions-such as a pending lawsuit-it may be prudent to create additional capital reserves. Such reserves, however, are properly a part of the capital and should

be transferred back to undivided earnings when the need for such reserves is no longer required.

In credit union financial statements, generally speaking, there are two main reserve accounts: (1) regular reserve, also called guaranty fund, or reserve for bad loans, and (2) undivided earnings. At the end of 1958 total reserves in Federal credit unions amounted to 6.1 percent of loans outstanding. In State-chartered credit unions reserves were slightly higher, 6.8 percent of loans outstanding. In Federal credit unions total reserves were 120.3 percent of delinquent loans and total reserves plus undivided earnings, less dividends paid in January 1959 amounted to 8.3 percent of loans. Comparable figures on the percentage reserves to delinquent loans and on undivided earnings are not available for State-chartered credit unions. In both Federal and State-chartered credit unions the proportion of reserves to total liabilities has gradually been increasing over the years.

Another odd feature of credit union law is that generally reserves are measured against shares, not loans or investments as one might expect. Thus section 12 of the Federal Credit Union Act states:

That when the regular reserves *** shall equal 10 per centum of the total amount of members' shareholdings, no further transfer of net earnings to such regular reserve shall be required except that such amounts not in excess of 20 per centum of the net earnings as may be needed to maintain this 10 per centum ratio shall be transferred.

The implication of such a provision is to require larger statutory reserves than if loans were used as a measurement. Loans average slightly over 75 percent of shares in Federal credit unions. Thus 10 percent of shares will equal 13.33 percent of loans. State laws vary somewhat, but generally speaking in these laws maximum reserves are measured against shares rather than against loans, and State laws generally require higher maximums than does the Federal act.

What has experience shown as to the adequacy of credit union reserves? In Federal credit unions more than $12 billion has been lent in 25 years of operation. During this period $22.2 million, or 18 one-hundredths of 1 percent of this amount, has been charged off as uncollectable. Of course credit unions are extremely slow, in most cases, in charging off loans and this figure might be higher were more stringent chargeoff practices followed. Nevertheless, the loss ratio seems to show that the reserves have been entirely adequate, at least as far as the system as a whole is concerned.

A study of 129 credit unions with assets of more than $1 million and covering the years 1952-56, showed that for the 5 years this group charged off 0.21 percent of the volume of loans made and 0.26 percent of the loans outstanding at the end of the year. These figures are slightly higher than similar ratios found in bank instalment lending and lower than those of consumer finance companies. The comparisons between the different types of lenders are not exact, however. In this same study of large credit unions it was found that over the 5 years 4.84 percent of the net earnings were charged off as losses on loans; in only 1 year of the 5 did such loss exceed 5 percent. Some individual credit unions, of course, had higher loss ratios. For this small group the legal reserves were more than adequate. This is probably true for credit unions as a whole. Where failures occur they are due primarily to problems of management and not to inadequate legal reserve requirements.

But do not credit union reserves, perhaps excessive in view of loss experience, provide a tax loophole? Again perspective is required. Credit union reserves in recent years have been growing slightly more than $25 million a year. Part of this amount is a true valuation allowance and properly reflects losses on personal loans. The remainder is so picayune that it affords almost no revenue possibilities. The whole question of credit union reserves affords another example of the oddities found in credit union legislation. Possibly the question of the allocation of credit union earnings to reserves should be more within the discretion of credit union management. Equity, it would seem, should give to the credit union member more in dividends than to place the earnings of the organization in unallocated capital reserves. But such observations are beside the point. In view of the small size of the amounts involved and the adjustment to the present reserve requirements by credit union people the question of credit union reserves may be regarded as one of minor importance.

Conclusion

The intent of Congress in passing the Federal Credit Union Act in 1934 was to provide American consumers, through their group effort, with a means to accumulate their savings and to take care of their credit needs at moderate interest rates. Tax exemption was provided in the Federal Credit Union Act, and to 1954, when the Bureau of Federal Credit Unions was placed on a self-supporting status, Congress appropriated slightly more than $4.5 million for the administration of the act. The act, modeled on the rural Canadian credit society and similar State credit union legislation, stressed an idealistic conception of voluntary, unpaid service of officials and organization within closely defined occupational or associational groups. The detailed regulation contained in the act has imposed many difficulties on management and the credit union has had its greatest success in a rather restricted lower-middle income stratum of society where group morale exists or can be generated. A tax on this income group would be regressive in character.

The cost structure of the credit union, with a maximum interest rate to borrowers of 1 percent per month on the unpaid balance of the loan, has been particularly restraining and credit union earnings have been moderate. In 1958 the dividend rate on_average_shareholdings was 3.6 percent. Even this return was made possible only through a certain amount of "subsidy" to the organizations, and the chief element in this subsidy was the unpaid work of credit union officials. Since an income tax on credit union earnings cannot be shifted it would fall in full on the earnings of the members and would probably result in lowered dividends. If credit union dividends continue to be taxed in full as ordinary income to the member, as they now are, the result would be double taxation more severe than that imposed on the stockholders of other business corporations.

The whole credit union development is so small that it exercises almost no impact in the field of saving. Here a tax exemption would hardly violate the canon of neutrality. In the area of consumer credit, however, the influence of the credit union is probably greater, but in the direction of providing, through competition with high-rate lenders, lower interest rates to consumers. In this case a tax exemption might even contribute to an improved allocation of resources.

47060-59-pt. 822