If the federal government is precluded by the very nature of the constitutional pact, as we are told in Collector vs. Day,1 from imposing any tax on state agencies, power to do this will not be conferred upon it by an amendment which simply changes the method of levying a particular kind of tax. What is now non-taxable will remain non-taxable. A change in the method of taxation does not constitute a change in the subject of taxation.

Any other interpretation of the amendment, moreover, would result, in the event of its adoption, in a situation which may well be characterized as absurd. The existing inability of the federal government to tax the property of a state or the instrumentalities of its government will of course continue, for the amendment clearly does not empower Congress to tax property as such. If it were to be held that the amendment gave the federal government power to tax the income of state bonds, we should then have the awkward result that the federal government could not tax the bonds themselves but could tax the income from the bonds. Or, to take a still more absurd case, if a state or municipality possessed some revenue-yielding property, like a piece of real estate, it would be competent for the federal government to tax that real estate if it assessed the tax eo nomine on the income, while it would be incompetent for the federal government to tax the real estate if the tax were levied on the property as such. In view of the fact that the market value of any piece of property is due only to its present and prospective income, it will readily be perceived in what a maze of contradictions we should be involved by the acceptance of so strained an interpretation of the amendment. When two interpretations of a clause are possible, of which the one is not only, as the supreme court has asserted, in direct opposition to the spirit of the constitution, but is also calculated to bring about the most awkward practical situation, while the other is in complete harmony with the trend of judicial decisions and at the same time is likely to obviate all fear of fiscal 1 II Wallace, 113.

contradictions or complications, is it not reasonable to assume that the court will prefer the second and more natural interpretation? Such an interpretation is the one which puts the emphasis on the words "without apportionment," and regards the amendment as legalizing a change simply in the method of levying the tax-a change from apportionment to direct

assessment.

We are therefore justified in concluding that the essential character of the implied restrictions in the constitution will not be altered one whit by the amendment. State and municipal bonds will henceforth, as before, be exempt from federal taxation, whether the tax be imposed on the property, or whether it be imposed on the income from the property.

§ 3. The Effect on the Borrowing Power of the States

If now, for the sake of argument, it be assumed that the contrary view is legally correct, and that the effect of the proposed constitutional amendment would be to legalize the taxation of state and municipal bonds, it may still be shown that the consequences mentioned in the message of Governor Hughes would not follow. We are told that the amendment might "place the borrowing capacity of the state and of its governmental agencies at the mercy of the federal taxing power," and that it might "place such limitations upon the borrowing power of the state as to make the performance of the functions of local government a matter of federal grace."

This opinion, as I hope to show, is erroneous, and the error is traceable to the lack of an adequate economic analysis on the part of the governor-an analysis, indeed, which is equally absent from the legal decisions which have misled him. In other words, even if the governer's law be sound, his economic reasoning is unsound, and his final position is still untenable. Let us leave for a time the whole domain of legal contention and discuss the question of the economic effect of the amendment.

The objection to a tax on governmental securities rests on

the presumption that their market value will be affected by the tax. As the supreme court said in 1829, in Weston vs. Charleston: "The tax on government stock is a tax on the contract, a tax on the power to borrow money, on the credit of the government. . . . The right to tax the contract to any extent, when made, must operate upon the power to borrow before it is exercised, and have a sensible influence on the contract." Of course this sensible influence on the contract can register itself only in the lower market price of the securities. This is the result of the familiar economic principle known as the capitalization or amortization of taxation.

The theory of the capitalization of taxation is, in effect, that when a recurring tax of virtually the same amount is imposed upon the capital or selling value of some durable or permanent property, the selling value of that property will be reduced by a sum equal to the capitalization of the tax.2 If, for instance, the normal rate of interest on securities is five per cent, and a five per cent bond has been selling at par, and if a new tax of one per cent per annum be imposed upon that particular class of securities, the price of the bond will fall from 100 to about 80.3 The new purchaser of the bond will

1 2 Peters, 449.

2 The whole subject of the capitalization of taxation is fully treated in Seligman, The Shifting and Incidence of Taxation, 3d. ed., 1910.

8 As a matter of fact, whether the price of the security upon which the new tax is imposed will fall exactly to 80 depends very largely upon the amount of these securities, compared with the total amount of capital in the country. If the amount of these newly taxable securities is comparatively large, the price will not fall quite to 80, but perhaps only to 81; for the imposition of a tax on so large a part of the outstanding capital of the country will probably have an influence, even though slight, on the general rate of interest, and may reduce that general rate from five per cent to perhaps four and seven-eighths or four and fifteensixteenths. If a large amount of capital is transferred from these newly taxed bonds to other securities, the increasing demand for these other securities, previously selling at par, will enhance their price to a little above par. As, however, the net return on these other securities remains at five dollars, this is equivalent to saying that the rate of interest on the investment will now be a little below five per cent. If the general rate of interest falls to a little below five per cent, the market value of the taxed securities will now be a little over 80. If, as is usually

net only four dollars on the hundred, since he has to pay one dollar in taxes. If, however, he can look forward to a net return of only four dollars, and if the general rate of interest still remains at five per cent, he will naturally pay only eighty dollars for that bond. There is no reason why he should pay more, since he can continue to invest his money in enterprises which are not taxed and which will still net him five per cent. In other words, the annually recurring tax of one per cent will be capitalized into a sum which is automatically deducted from the market value of the securities, thus bringing about an amortization of these securities. At any given time the discrepancy between the taxed and the untaxed securities will be precisely such as to make the net income from each equal the normal rate of interest, and the difference in the market value of the two classes of securities will always be exactly equal to the capitalization of the tax.

The influence of tax exemption is the very reverse of that exercised by taxation. If all securities have hitherto been subject to taxation, and if one particular class of securities be suddenly exempted, the value of these tax-exempt securities will rise by an amount equivalent to the capitalization of tax. If five per cent bonds, like all other forms of capital that are subject to a tax of one per cent, should sell at par, it means that the normal rate of interest is four per cent, since investors net four dollars on every hundred dollars. If this particular class of bonds be now exempted from taxation, the price of the bonds will appreciate to 125, since five dollars bear the same relation to $125 as four dollars do to $100. Thus, whatever way we look at it, taxation will diminish the market value of bonds just as exemption will increase their market value.

Where an annual tax is actually enforced, and where other conditions remain the same, the difference between taxable and non-taxable securities is indeed precisely in accord with

the case, the taxed security forms only an insignificant part of the whole amount of capital, the influence on the general rate of interest will be inappreciable, and the price of the security will fall to 80.

the capitalization theory. In the United States, however, the influence of taxation is sensibly modified by prevailing conditions, and the discrepancy between taxable and non-taxable bonds is far less than might be expected. The rate of the local property tax varies in the United States from one and one-half per cent to over two per cent. Let us take two per cent as the normal figure. Let us also assume that the current rate of interest is four per cent, so that four per cent bonds will sell at about par. If there were no property tax, and if these bonds were now subjected to the two per cent tax, they would manifestly fall to 50, since one-half of their yield would be eaten up by the tax. If, on the other hand, we take the actual law under which all property is taxable at the rate of two per cent, then if the four per cent bonds were exempted from taxation their price on the market ought to rise from par to 200; for instead of the holder netting two dollars on each one hundred dollars (four dollars interest minus two dollars tax), he would now net four dollars, or double the amount. A doubling of the income, however, would involve a doubling of the market value.

As a matter of fact, the disparity between taxable and taxexempt securities in our American states falls far short of reaching this point. This is true not only of exemption from a special tax, but and in still larger measure, of exemption from a general tax. A good example of the influence of a special exemption is afforded by the New York State canal bonds. When these bonds were authorized, to provide for

1 An excellent illustration is found in the mortgage bonds of the Northern Railway in France, part of which are issued on its French line and part on the Belgian stretch, although the security is the same in both. In the case of the bonds on the French stretch, however, a special tax is imposed and levied up to the hilt by the French government. In the case of the securities of the Belgian stretch there is no such tax. The difference in the market price of the bonds, on the Paris stock exchange, is exactly equivalent to a capitalization of the French tax. Cf. Edgar Milhaud, L'Imposition de la Rente. Paris, 1908, pp. 29, 30.

2 For many of the facts in this section I am indebted to the courtesy of Mr. McKee, of Messrs. N. W. Harris and Company, of New York City, one of the largest American houses dealing in state municipal securities.