MAINTAINS FAVORABLE POSITION

Former Secretary Mellon was also on record in various other parts of this same report on the hearings before the Ways and Means Committee on this same legislation.

In a previous report submitted on April 30, 1921, and reported in the hearings, he suggested for the consideration of Congress that it might also be advisable to take action by statute, or by constitutional amendment, where necessary, to restrict further issues of tax-exempt securities. Quoting from this report, Mr. Mellon said:

"It is now the policy of the Federal Government not to issue its own obligations with exemptions from Federal surtaxes and profits taxes, but States and municipalities are issuing fully tax-exempt securities in great volume. It is estimated that there are outstanding perhaps $10,000,000,000 of fully tax-exempt securities. The existence of this mass of exempt securities constitutes an economic evil of the first magnitude. The continued issue of tax-exempt securities encourages the growth of public indebtedness and tends to divert capital from productive enterprise. Even though the exemptions of outstanding securities cannot be disturbed, it is important that future issues be controlled or prohibited by mutual consent of the State and Federal Governments."

Here is a man of great wealth and for many years the head of the Treasury, who would ordinarily be regarded as among the first to go on record against such a policy of taxation if it were true that vast discriminations would be imposed upon wealthy holders of such exempt securities, coming out in favor of such a plan, if reasonably and logically applied, at a time when it was known quite generally that such legislation had little chance of enactment. This same attitude of Mr. Mellon appears in subsequent reports of the Treasury on the tax-exempt question, which will be referred to later, and which will indicate a fairly consistent view on this subject up to the present time.

COOLIDGE ENDORSES PLAN

On December 6, 1923, the late President Calvin Coolidge, in his annual message to Congress, Sixty-eighth Congress, first session, Congressional Record, volume 65, part I, page 67, said:

"Another reform which is urgent in our fiscal system is the abolition of the right to issue tax-exempt securities. The existing system not only permits a large amount of the wealth of the Nation to escape its just burden but acts as a continual stimulant to municipal extravagance. This should be prohibited by constitutional amendment. All the wealth of the Nation ought to contribute its fair share to the expenses of the Nation.".

At about the same time the Treasury Department was again on record on the subject in the following report to Congress:

"One of the most difficult problems the income tax presents is the tax-exempt security question. There are two solutions: First, eliminate the tax-exemption privilege; second, adjust the income-tax rates so that the value of tax exemption as a means of tax avoidance shall be lessened. The first solution requires a constitutional amendment, and its adoption has met with serious political opposition. Also, in the last session of the Congress there was defeated a recommendation of the Secretary of the Treasury that a taxpayer should not be permitted to take as a deduction, in figuring his net income, interest paid by him except to the extent it exceeded the tax-exempt interest received by him and which he did not include in his gross income. While the Treasury renews the recommendation made heretofore that a constitutional amendment to reach tax exemption be proposed by the Congress, it feels that the recognition of the necessity for this action by Congress may be delayed and that an immediate remedy should be adopted.

"Fully tax-exempt securities outstanding in the hands of the public now amount to $13,284,000,000 and are increasing at the rate of about $1,000,000,000 a year. The value of a tax-exempt security to a man of large income lies wholly in the fact that the tax-exemption feature gives him more free income than another equally safe investment, part of the return from which the Government takes. Under the present law, if a man has an income of $100,000 and is asked to invest money in some constructive project, the new project must return to him $1.75 for every $1 he would receive from investing the same money in tax-exempt securities. To express this another way, it takes about an 8-percent return on a taxable investment to be equivalent to a 42-percent return on one that is tax exempt. With higher incomes, the disparity is even greater. If the Treasury's recommendation for a maximum aggregate tax of 31 percent should be adopted, the relative values would be $1.44 to $1, or 62 percent taxable as compared with

41⁄2 percent exempt. The difference between an investment in ordinary productive business returning 8 percent, the requirement under the present law, and 61⁄2 percent, the requirement under the Treasury rates, to equal a 41⁄2-percent taxexempt is the difference between a sound investment and a speculative investment. One will be accepted, the other not. If the income-tax rates are reduced to a reasonable figure, the lure of tax-exempt securities to the wealthy becomes less appealing, and many will put their money into business or new projects and be content with less return because it will give them as much free income as would a tax-exempt security. From such investments the Government gets revenue, from tax-exempt securities it gets none. By such investments capital is provided for industry at lower rates, and the appalling increase of State and municipal indebtedness, with its inevitable taxation of the people to pay this indebtedness, is not encouraged.

"The adoption of the solution of the tax-exempt evil by taking from it the wholly artificial attraction of high income taxes on other investments is within the immediate power of the Congress. This would prove advantageous to constructive business and to all who use capital, would remove the incentive for the most notorious avoidance by the wealthy of income taxes, and would assist in accomplishing the purpose of taxation; that is, to raise revenue, A continuation of the high artificial value to this legal means of escape must end or the graduated income tax will cease to be productive." (Italics supplied.)

At about the same time (Nov. 2, 1923), former President Herbert Hoover, who at the time was Secretary of Commerce, filed a report with Hon. Reed Smoot, in the United States Senate, referring to Secretary Mellon's report that $11,000,000,000 of State and municipal securities were in circulation free of income tax and stated: "It is generally believed that these securities are sought after by persons subject to the higher percentage of income tax. Therefore, the very persons

best able to bear the burden of taxation are escaping it."

The full text of this report of Mr. Hoover's views at the time as found in a report of the Senate Finance Committee, Sixty-eighth Congress, first session under date of March 26, 1924, on the question of tax-exempt securities is set forth as follows: DEPARTMENT OF COMMERCE, OFFICE OF THE SECRETARY, Washington, November 2, 1923.

Hon. REED SMOOT,

United States Senate.

MY DEAR MR. SENATOR: In accordance with your request, I enclose herewith a memorandum opinion by Judge Stephen B. Davis on the power of Congress to impose a special or additional estate tax upon the succession to the portion of an estate which consists of Federal, State, or municipal bonds, the income from which is exempt from Federal income tax. You will see that Judge Davis believes Congress has constitutional power to levy such a tax, subject, perhaps, to the condition that the differentiation in rates of levy be not arbitrary but have some reasonable basis. By such a tax rates can be so adjusted as to effect, through the difference in the amounts which would be exacted from the corpus of the estate, an ultimate approximate equalization between the burdens currently borne by incomes subject to surtaxes and incomes which are not so subject because of investment in securities of a legally privileged nature. Such an ultimate equalization would tend to do away with a great amount of the present successful avoidance of the burdens of Federal taxation.

This plan might, on consideration, develop weaknesses that are not now apparent but I would like to make some comment on this whole question of tax-exempt securities from the point of view of industry and commerce in support of Secretary Mellon's recommendations.

Secretary Mellon has stated that eleven billions of State and municipal securities are in circulation free of income tax. It is generally believed that these securities are sought after by persons subject to the higher percentages of income tax. Therefore, the very persons best able to bear the burden of taxation are escaping it.

Nor is direct tax exemption of these securities the whole story, for they furnish a wide basis for further avoidance of taxation. For instance, a man may borrow 70 percent on his house (if his other credit is good); he may invest this borrowed sum in tax-exempt securities; under our present income-tax laws he may deduct the interest which he pays on his mortgage from his income and does not have to account for the sum he receives on tax-exempt securities. There appears to have definitely grown up not only this form of avoidance but other forms based on various kinds of interlocking transactions which carry avoidance a great deal further than the actual sum otherwise collectible on tax-exempt securities.

This question has many bearings on productive industry and commerce and many_economic as well as social implications.

1. It must be obvious that we are thus thrusting the burden of income taxes upon productive industry and personal effort.

2. Most other countries in the world give special relief in income taxes to business and professional incomes as distinguished from rent and interest as being necessary to maintain the initiative and enterprise of the people. We not only do not give this relief but even a much larger burden upon earned income from business and professions and to offer larger opportunity for avoidance of taxes on so-called "property incomes."

3. Aside from the uneconomic thrust of taxes onto productive activities, there is an inherent injustice in this distribution of the burden from the fact that holders of professional and business incomes must set aside a portion of these incomes to provide for their dependents, whereas persons possessed of rent or interest incomes have by the nature of things already made such provision. Other countries allow a large deduction of amounts paid for insurance premiums. We allow none. 4. Under the tax-exempt provisions States and municipalities are able to borrow money with even lower margins of interest over manufacture and business. The net effect is to increase interest rates in industry and commerce, and this misdirection in the flow of capital tends to increase the prices of every commodity.

5. The collection of estate taxes upon exempt securities does not present the difficulties in payment presented by such taxes upon going business, for these securities are readily marketable. Such a tax increase will also result in a better distribution of estates representing unduly large accumulation.

6. Even though the States be disposed to accept a constitutional amendment on tax-exempt securities, it will take time, and in the meantime further securities will be piling up.

7. What additional tax should be placed upon the portion of the estate composed of exempt securities in order to compensate for the loss of income tax upon them needs careful study. It will probably have to be an empirical figure in any event. It is an extraordinary thing for a commercial nation like ours to have developed a form of taxation which puts a premium on nonproductivity and a blight on productivity itself. (Italics supplied.)

Yours faithfully,

HERBERT HOOVER.

RECENT TREASURY RECOMMENDATIONS

We find the Secretary of the Treasury again on record on tax-exempt securities in his annual report to the Sixty-ninth Congress, first session, for the fiscal year ending June 30, 1925, with the following statement:

A con

"Looking at the proposition logically, there is no reason for the existence of taxexempt securities. There ought to be no refuge to which the wealthy man can go and avoid income taxes at times when the Federal Government needs the money. stitutional amendment to make these securities taxable should be passed. The Treasury has consistently been the advocate of such reform. The delay, however, has been so long and the amount of securities now outstanding, which would not be affected by the amendment, has become so great--it is over $14,000,000,000 now-that the practical way of reaching the present situation seems to be by taking away the artificial advantage of these securities through the reduction of the surtax to as reasonable figure. If you place your surtax at a point where productive business and investments can compete with tax-exempt securities in neet return to a wealthy investor, you have solved the present difficulty. It is interesting to note that the First Liberty 32's, which alone of the Liberty bonds are wholly tax-exempt, have gone below par for the first time since June 1922, reflecting the view that the expected reduction of surtaxes to a normal figure justifies the wealthy owners of these bonds in selling them to put their money into productive investment. We already are getting results on the mere belief in ultimate tax reform."

Again in 1928, in the annual report of the Treasury for the fiscal year ending June 30, 1928, Secretary Mellon reported as follows:

"I recommend that the Congress consider an amendment of the Second Liberty Loan Act, as amended, authorizing the Secretary of the Treasury to exempt further issues of securities from the surtax as well as the normal tax.

"The enactment of such an amendment would not interfere with the subsequent adoption of a constitutional amendment permitting the Federal and the State Governments to tax so-called 'tax-exempt securities', should the Congress and the States deem such an amendment desirable. But pending the adoption of such an amendment there is no reason why the Treasury Department in marketing

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securities should be at a disadvantage as compared with States and their subdivisions, or why there should be discrimination against individual investors who desire to acquire United States Government securities.

"If States and their political subdivisions continue to issue securities which are wholly tax exempt at the rate of a billion dollars a year, the Federal Government should not be limited to the issuance of securities exempt only from the normal income tax. Although the United States securities for individual investors, therefore, do not compare favorably with the yield on State and municipal securities which are issued free from all taxation."

TREASURY. POSITION IN 1930

A later and more vigorous recommendation was made by Treasury Secretary Mellon in his annual report for the fiscal year ending June 30, 1930, where he says: "In this connection I renew the recommendation contained in my annual report for the fiscal year ended June 30, 1928, that the Congress consider a further amendment to the Second Liberty Bond Act, as amended, authorizing the Secretary of the Treasury to exempt further issues of securities from the surtax as well as the normal tax. In the act of June 17, 1929, Congress modified the Second Liberty Bond Act, as amended, by providing that all certificates of indebtedness and Treasury bills issued thereafter should be exempt both as to principal and interest from all taxes, except estate and inheritance taxes. I renew my recommendation that this exemption be extednded to bonds. Special legislation is not required in the case of notes, since the Secretary of the Treasury is authorized by existing law to make this exemption applicable to notes.

"Some time ago the Treasury Department earnestly recommended the adoption of a constitutional amendment permitting the Federal and State Governments, respectively, to tax securities to be issued in the future, which under present constitutional provision are not taxable. There appears, however, to be no immediate prospect of such an amendment being adopted. Pending its adoption, there is no reason why the Treasury Department, in marketing securities, should be at a disadvantage as compared with States and their subdivisions, or why there should be discrimination against individual investors who desire to acquire United States Government securities. It is idle to argue that the issuance of United States tax-exempt securities would furnish convenient means of income-tax avoidance. As long as the States and their political subdivisions continue to issue securities which are wholly tax exempt at the rate of $1,000,000,000 a year there is at all times an ample supply of gilt-edge securities available to those desiring to escape income-tax payment through investment in tax-exempt securities. Limiting the Federal Government to the issuance of securities exempt only from the normal income tax does not result in increased income-tax collections but simply in a higher interest cost to the Government.

"Insofar as individual investors are concerned, the present situation gives rise to discrimination as between them and corporations. Corporations being only subject to the normal tax, United States securities in their hands are completely tax exempt, whereas practically all such securities in the hands of individuals are subject to surtaxes. The yield on United States securities for many individual investors does not, therefore, compare favorably with the yield on State and municipal securities, which are usually wholly free from taxation." (Italics supplied.)

A VIEW ON CONGRESS

From the CONGRESSIONAL RECORD in 1922, and at other times, we also find excerpts from leading arguments in favor of eliminating tax-exempts securities: "There is no other country that issues tax-exempt bonds in the same way that we do." (E. D. Chassell, Senate, hearings, p. 78; the Reference Shelf, vol. III, no. 1, p. 112.)

"The owners of great estates are gradually transferring all of their property into tax-exempt securities. It is easy to find men with incomes of over $100,000 who pay not a single cent to the National Treasury, nor to the State, county, or township, while farmers, businessmen, and others are suffering under the burdensome and oppressive taxes that necessarily prevail today." (William R. Green CONGRESSIONAL RECORD, 64:700, Dec. 19. 1922.)

"Tax exemption is a very grave peril, for it undermines the very basis of public revenue and it is a social evil of the first magnitude. It places the greater part of the tax burden upon earned incomes and gives more or less immunity to earned incomes. It diverts capital from productive enterprises and housing into wasteful or deferable governmental enterprises. The present is an emergency of the

utmost importance, demanding imperatively a constitutional amendment of the character proposed." (R. C. Leffingwell, House hearings, p. 137; the Reference Shelf, vol. III, no. 1, p. 115.)

“When a man so wealthy, so experienced, and so conservative as Secretary of the Treasury Mellon declares the combination of tax investments and high surtaxes is drying up the sources of industrial capital, placing a premium on Government extravagance, and forcing the less able part of the population to pay double taxes it is time to sit up and pay attention. The situation develops in two ways. Tax-exempt securities offer the wealthy man a field of investment from which he obtains full personal use of his income. At the same time investment in commercial securities is penalized by high income taxes. Two adjacent advertisements in yesterday's financial pages provide an illustration. One offers South

Dakota school bonds to pay 5 percent, 'exempt from all Federal income taxes.' Another offers 7-percent bonds to finance a paper mill. If a man with an income of $100,000 or more invests in the paper mill half his 7 percent goes to the Government, leaving him a profit of 32 percent. Out of the $1,000,000 invested in the mill he would net $35,000. Out of the $1,000,000 invested in school bonds at 5 percent he would net $50,000. Naturally he buys the school bonds. Not only do they pay him more but they face none of the risks of business. That makes it difficult for all commercial enterprises to obtain capital. A Texas country-school district has better credit than the United States Steel Corporation. And at the same time those able to pay the most taxes are tending more and more to escape taxation. Thus the Government's revenue is falling off while local and State governmental debts are increasing and raising taxes for all who pay them." (Chicago Tribune editorial, Feb. 15, 1923.)

THE PRESENT SITUATION

The logic and wisdom of levying a tax on exempt securities has continued with such force down to the present time that the present session of Congress is faced with the necessity of taking some definite affirmative action. There is no escape from this conclusion. The question now is simply one of which course we shall adopt.

In approaching the procedural difficulties I have done so with a full realization and understanding of the present economic situation, as well as numerous decisions of the United States Supreme Court and our Federal courts relating to the constitutionality of imposing a tax on income from certain types of exempt securities. These facts, which will hereafter be discussed in some detail, have led me to the conclusion that Congress will adopt the following course: (1) Enact legislation to amend the revenue laws so that future issues of Federal securities can be taxed; or (2) propose a constitutional amendment granting power to the Federal Government and to the States to tax future issues of all States or subdivisions thereof. The first step would be easier because it would not require a constitutional amendment, but the benefits would be relatively small, being derived only from future issues of Federal securities and in no way affecting the income from State and local issues. On the other hand, there is some strong opinion that a constitutional amendment in no event is absolutely necessary, and that liberal interpretation by the courts would enable the Government to levy a tax on all types of Federal and local securities as an excise within the prevailing constitutional provisions. Decisions supporting this view will be referred to later:

With these problems in mind I have introduced two bills, the first of which, S. 1892 (73d Cong., 1st sess.), makes incomes from United States securities subject to the income-tax laws of the United States. This measure is set forth as follows: "Be it enacted, etc., That notwithstanding any other provisions of law, all income derived from securities issued after the date of enactment of this act, by or under the authority of the United States, shall be included in gross income within the meaning of section 22 (a) of the Revenue Act of 1932 for the purposes of taxation under title I of such act, and shall also be subject to taxation under all income-tax laws of the United States hereafter enacted.'

The second measure is Senate Joint Resolution No. 61, which proposes an amendment to the Constitution giving power to the Federal Government and to the States to levy and collect taxes on income derived by States or subdivisions thereof. This resolution is set out as follows:

"Resolved by the Senate and House of Representatives of the United States of America in Congress assembled (two thirds) of each House concurring therein), That the following article is proposed as an amendment to the Constitution, which shall be valid to all intents and purposes as a part of the Constitution when ratified by conventions in three fourths of the several States, which conventions