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September 4, 1985

REAGANOS TAX REVOLUTION: MIXED BENEFITS FOR FINANCIAL INSTITUTIONS

David I. Fand and Bruce Bartlett John M. Olin Fellows

INTRODUCTION

Ronald Reagan's tax reform package has two broad goals. It is intended to simplify the system, ending complex and unrea- sonable tax devices that benefit accountants and special inter- ests rather than the average taxpayer. And it seeks to reduce the tax rates for individual taxpayers by removing certain deductions and by increasing the burden on corporations.

The generally increased business burden, of course, is a hidden tax on individuals because ultimately only people can pay corporate taxes--as stockholders or the purchasers of more expen- sive goods. In some cases the burden would be particularly onerous. Financial institutions, for example, would pay $2 billion extra, significantly cutting into this industry's nation- wide profit of just $10.6 billion last year.

Yet despite the damaging impact of the tax hike on financial institutions, the tax reform elements in the Reagan package merit serious consideration. The package, for instance, advances the general policy of deregulating financial institutions, letting firms compete on a more equal tax basis within the industry, and eliminating many complicated tax preferences that give certain sectors advantages over others. While all this should benefit the economy, the problem is that it comes at the price of higher taxes.

Advocates of the Reagan proposals claim that financial institutions can afford the higher taxes because the industry is generally undertaxed. This is untrue; the industry is not under- taxed. Yet it may be unwise, from the perspective of financial institutions, to reject the Reagan proposals because their struc- tural elements will help the industry. They will introduce technical changes that in effect will promote deregulation of the financial institution industry and allow that industry to, be treated similarly to other sectors of the economy.

ARE FINANCIAL INSTITUTIONS UNDERTAXED?

Yes, say critics of the industry, pointing to a Joint Tax Committee report of last year that found financial institutions paid an average 6.4 percent tax rate on income earned in the U.S. Yet such statistics are extremely misleading unless coupled with the findings that financial institutions paid a tax rate of 39.1 percent on foreign-source income. As'such, the financial insti- tutions' tax rate on their total earnings was 24.3 percent. By comparison, all U.S. corporations paid a worldwide tax rate of 29.2 percent.'

Even these broader measurements of taxation greatly under- estimate the tax paid by financial institutions in two important ways:

First, financial institutions are required by law to main- tain reserves, consisting of cash in their vaults or deposits at the Federal Reserve, neither of which earn income. Though some reserves are clearly necessary, the Federal Reserve generally requires reserves to be much higher than market conditions demand. The forgone income on such reserves constitutes a tax borne by financial institution stockholders in the form of lower dividends or by the depositors in the form of lower deposit rates, higher borrowing rates, or reduced services.2 This impli- cit tax can be calculated only roughly. In 1984, financial institutions held reserves of $38.71 billion (not counting vault cash). If they had earned a return on these reserves equal to the interest rate on three-month Treasury bills, financial insti- tutions' profits would have increased $3.7 billion, or about 25 percent. In effect, the reserve requirement imposed a 25 percent "profits tax."

Second, financial institutions tend to hold large amounts of their assets in the form of tax-free municipal bonds. It is misleading, however, to view such bonds as entirely free of tax because they pay interest rates significantly lower than those available on other instruments. In 1984, for example,-the average interest rate on municipal bonds was 10.15 percent, compared to 12.71 percent on high-grade corporate bonds. Hence, a municipal bond purchaser already pays an implicit tax of more than 20 percent before paying any direct taxes--a tax which, in effect, goes directly to state and local governments in the form of reduced borrowing costs. (Needless to say, elimination of a prime market for municipal bonds would probably raise yield on municipal bonds and therefore the cost of financing state and local capital expenditures.).

Financial institutions, moreover, are not among the nation's most profitable industries. Indeed, one of the most serious problems faced by the U.S. economy is the weakness of many finan- cial institutions, ranging from giant Continental Illinois to small country banks and savings and loans in Ohio and Maryland.3

Another point worth keeping in mind is that the profits of financial institutions included in the National Income and Product Accounts are largely those of the Federal Reserve System, which, for some unknown reason, is treated as a private entity, rather than a governmental entity. Therefore, one must net out the Federal Reserve's earnings (which are largely repatriated to the Treasury) in order to get an accu- rate picture of bank profits. In 1984, for example, the National Income and Product Accounts reported total corporate profits in the financial industry (which includes, in addition to banks and savings and loans, stock and commodity brokers, insurance companies and others) of $27.3 billion. Of this, $16.7 billion, or almost two thirds, were the Federal Reserve's profits.

2) Deduction for Interest that Carries Tax-Exempt Securities

Current law allows depository institutions to deduct most of the interest cost of deposits that financial institutions use to purchase tax-exempt securities. Advocates of the Reagan changes complain that the current law permits depository institutions to shelter income from taxes and thus encourages depository institutions to make financial investments that are not optimal from the viewpoint of economic efficiency. It is also argued that commercial banks and thrift institutions have a competitive advantage over other lenders which cannot deduct any portion of interest on loans used to purchase tax-exempt securities. Reagan tax plan backers further maintain that income should be matched with its cost of production. As such, they say, deductions should not be allowed for interest paid on deposits that are used to purchase tax-exempt securities.

These arguments warrant consideration. It is difficult to justify why financial institutions should enjoy a special tax break to purchase assets (such as municipal bonds) that already provide tax relief. Such specialized relief, moreover, encour- ages a misallocation of resources. To be sure, eliminating the deduction for interest to carry tax-exempt securities would make it more difficult for state and local governments to market their securities at rates below those paid by the U.S. Treasury and blue chip corporations. This could put pressure on cities and states to raise revenues by other means, such as tax hikes. But this is a choice that local governments should face. Providing special federal tax relief to encourage expenditures by state and local government violates a key element of the Reagan tax reform--elimination of the income tax deduction for state and local taxes.

3) Repeal of the Tax Exemption for Large Credit Unions

Credit unions are now exempt from federal, state, and local taxes on all income--whether it is retained or distributed to depositors. Tax-free retained earnings of credit unions can also accrue tax-free interest. The Reagan tax proposals would elimi- nate this because it is viewed as giving credit unions a competitive advantage over other depository institutions.

A case can be made for the change. Broad deregulation of all types of depository institutions requires that they all be treated equally. Credit unions, moreover, already have benefit- ted from deregulation which permits them to offer more consumer services. As such, it would seem fair to impose the same kind of tax treatment on credit unions as on other financial institutions.

Credit unions disagree. They assert that they differ from other depository institutions since they are "member driven" rather than "profit driven"--that is, more like associations than businesses. This argument, however, indicates that credit unions want it both ways. Either they are unique nonprofit institu- tions, in which case they should not be allowed to engage in tax-free competition with commercial institutions, or they should be free to compete on the same tax basis as other institutions.

4) Repeal of Special Rules for Net Operating Losses of Depository Institutions

Depository institutions now enjoy special tax treatment of net operating losses. Example: the losses can be carried back ten taxable years preceding the current year or carried forward five taxable years after the current year. Other taxpayers, however, generally can carry net operating losses back just three years or forward fifteen years. Businesses typically prefer carrying a loss backward to carrying it forward, since carrying it backward can provide an immediate tax refund; carrying it forward merely reduces future tax liabilities. The Reagan propo- sal would repeal the depository institutions' special tax treat- ment of net operating losses.

This is probably sound policy. There seems little reason why financial institutions should be treated differently from other businesses. The Reagan proposal thus is in line with the principle of tax equity and simplification.

5) Repeal of Reorganization-Rules for Financially Troubled Thrift Institutions

Acquisition of stocks or assets of one corporation by another now generally qualifies as a tax-free reorganization only if "continuity of interest" exists, that is, the shareholders of the acquired corporation receive a significant continuing equity interest in the acquiring corporation. Special rules enacted in 1981 allow acquisition of financially troubled thrifts to take place on a tax-free basis even if they do not satisfy the conti- nuing interest requirement. Backers of the Reagan tax proposal maintain that these special tax rules hide and probably increase federal subsidies, because some thrift losses are, in effect, shifted to the government in the form of lower taxes for the acquiring institution. The tax proposal seeks to repeal these special rules.

Since a central purpose of the tax reform is to simplify the code and remove special tax advantages for favored interests, the elimination of these rules seems justified.

CONCLUSION

The financial industry, as corporations in general, will bear an increased burden of taxation under the Reagan proposal. This would not seem advisable, in view of the current plight of so many financial institutions. Nevertheless, the Reagan tax proposal does "level the playing-field," by eliminating some of the disparities in the taxation of different types of finan- cial institutions. It would be be far better, however, were this accomplished in a way that did not require an increase in taxa- tion.

Although the tax increase on the financial industry is relatively small, it must be seen in the context of the overall low profitability and the continuing problems of many-firms in this industry, as manifested by record numbers of bank and thrift institution failures. Since the amount of revenue potentially raised is quite small in the aggregate--about $2 billion per year--this tax increase should be reconsidered.

Nevertheless, the tax proposals relating to financial insti- tutions do satisfy one important goal of tax reform: achieving tax neutrality, by reducing the tax differential among financial institutions. Whether this justifies the overall increase in taxation must be judged in the context of overall tax reform.