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The Actual Return Upon Taxable and Tax-Exempt Securities

March 7, 2014 | by

It’s late, and you’re still awake. Allow us to help with Sleep Aid, a series devoted to curing insomnia with the dullest, most soporific prose available in the public domain. Tonight’s prescription: “The Actual Return Upon Taxable and Tax-Exempt Securities,” first published in the War Taxation: Some Comments and Letters, in 1917.

1838_Schumann_Die_eingeschlafene_Strickerin_anagoria

Wilhelm Schumann, The Sleeping Embroiderer, 1838.

Dear Sir:

Your letter indicates that you do not sufficiently realize the enormous advantage in interest yield which under the income tax schedule as fixed in the House Bill is possessed by tax-exempt securities as compared to taxable securities, especially, of course, in respect of large incomes.

Permit me to call your attention to the following eloquent facts:

The yield of tax-exempt securities at prevailing prices ranges from 3-1/2% to nearly 4-1/2%. Under the rates fixed in the War Revenue Bill as it passed the House of Representatives, a taxable 6% investment would yield:

 

 

per annum

2.28%

 on incomes over

 $2,000,000

2.34%

“““

1,500,000

2.40%

“““

1,000,000

2.69%

“““

500,000

2.97%

“““

300,000

3.26%

“““

250,000

3.54%

“““

200,000

3.90%

“““

150,000

4.20%

“““

100,000

Or, to put it in another way, the investment in 3-1/2% “Liberty Bonds” is thus equivalent to investing in a taxable security yielding:

 

 

per annum

9.21%

 in respect of incomes over

 $2,000,000

8.97%

“““

1,500,000

8.75%

“““

1,000,000

7.82%

“““

500,000

7.07%

“““

300,000

6.45%

“““

250,000

5.93%

“““

200,000

5.38%

“““

150,000

5.02%

“““

100,000

The investment in, say, New York City Bonds, being tax-exempt, at their present yield of 4.20%, would represent the following rates of income as compared to investments in taxable securities:

 

 

per annum

11.05%

 in respect of incomes over

 $2,000,000

10.76%

“““

1,500,000

10.50%

“““

1,000,000

9.38%

“““

500,000

8.48%

“““

300,000

7.74%

“““

250,000

7.12%

“““

200,000

6.46%

“““

150,000

6.02%

“““

100,000

Of course, all these figures hold good only for the period during which the proposed rates of income taxation would prevail. As the income tax rate decreases, the yield from tax-exempt securities diminishes proportionately.

The volume of tax-exempt securities at present outstanding, including the new “Liberty Loan,” is estimated at not less than $8,000,000,000.

The ability of corporations to find a ready market for their securities is a prerequisite for the continuance of business prosperity or, indeed, of adequate business activity. I need not elaborate the effect which the comparison of the income yield from tax-exempt securities as against taxable securities under an excessively high income tax schedule—even if confined to larger incomes—must necessarily have upon the eligibility of corporate securities for investment purposes. The conclusion seems unescapable that the resulting degree of disinclination to invest in such securities coupled with the impulse to dispose of existing holdings would bring about liquidation, severe shrinkage of values and more or less pronounced demoralization in the investment market—a condition of things which could not fail in a measure to affect adversely the country’s business in general, and which could only partially be counteracted by Government expenditures, however large.

As to your observations concerning the principle of tax-exempt issues, I believe the Government acted wisely, considering all the elements of the situation, in making its first great war issue, the Liberty Loan, tax free. But in the face of the figures above quoted, the question naturally presents itself whether our traditional policy of making Government issues tax-exempt should not be discontinued, which, of course, would mean that a materially higher rate of interest than 3-1/2% would have to be paid for Government borrowing.

In theory, it seems to me, there can be little doubt that the balance of arguments is against the tax-exemption of Government loans. As an abstract proposition little can be said, I think, in favor of a policy the effect of which gives an advantage to the rich and well-to-do, militates against the widest possible distribution of Government issues amongst the people, tends to facilitate Governmental extravagance by concealing the true cost and establishes a fictitious basis of national credit.

Thus, for instance, on the $1,000,000,000, or thereabouts, which our Government has loaned to the Allies at 3-1/2% interest, it is losing money, because, whilst it nominally borrows this money through the Liberty Loan at 3-1/2%, the cost to it is actually considerably higher because it loses the revenue which would accrue to it from the income tax if the bonds were not tax-exempt.

Let me add that I do not wish to be understood as suggesting that our Government should charge to the Allied Nations more than the nominal rate at which it is borrowing. They have been fighting these three years and bringing unheard of sacrifices for a cause which we have recognized to be ours no less than theirs, and if we loan them money somewhat below its actual cost to us that item weighs but very lightly in the scale, especially also if we consider the immense monetary profits which our country has reaped from the sale to them of munitions, material and supplies.

However, as against the theoretical objections, some of which I have mentioned, to the tax-exemption of Government loans, there are certain “imponderabilia”—things which cannot be exactly weighed—in favor of a low rate of interest for Government borrowing, even if the lowness of the rate is to an extent fictitious. There are also certain practical reasons for the maintenance of our traditional policy, and various concrete facts which must be taken into account. For instance, there is the problem of how to deal with the situation that might result from the withdrawal of deposits from savings banks and similar institutions, which probably would be liable to occur in case the Government offered a bond issue at the higher rate it would have to fix if the inducement of tax-exemption were removed.

There is the problem of the existence of billions of municipal and state securities which offer to the holder the privilege of freedom from municipal, state and Federal taxes. I understand that it is the consensus of opinion of our leading lawyers that under the legal theory which treats such issues as “instrumentalities of government” that privilege cannot be abridged and that Congress has no constitutional power to tax state and municipal issues.

If state and municipal issues to be made during war time retain the feature of being free from taxation, can the Federal Government afford to make its war loans taxable, and thereby place itself in a position where it would have to borrow under conditions which would put it and its credit at a disadvantage as compared to state and municipal issues?

The problem is a complex one altogether and, like all economic questions, requires to be approached in a dispassionate spirit, giving due consideration to the reasons for and against. The temper of the stump speaker is not appropriate for dealing with taxation problems.

Let me add, in conclusion, that I fully agree that it is “sheer fiscal stupidity” and “socially inexpedient as well” to permit “mushroom fortunes” to be built out of war profits. I believe there ought to be imposed a large excess war profits tax on the English model upon a fair and well conceived average basis of earnings so calculated as to take account of the vast difference in the country’s industrial plant to-day and before the European war. Such a tax may not be entirely free from objections in theory, but from the social and moral point of view it is, I am convinced, thoroughly sound and proper and called for. Appropriate taxation of excess profits, together with an adequately though not exorbitantly heavy income tax would go a long way to prevent the enrichment of a class through the calamity of war, without at the same time affecting wages or laming the enterprise and business activities of the country.

Yours very truly,

(Signed) Otto H. Kahn

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