1. The savings and loan industry over the next ten years will find it increasingly difficult to finance the level of home mortgage debt at rates which it has over the first half of this decade; and accordingly,

2. Under the existing tax and regulatory framework, it is unlikely, unless the savings and loan industry were able to enjoy an unbroken period of above-average earnings, that it will be able to finance at present share levels a rate of housing growth at a level that housing experts say is necessary in order to meet the Nation's basic needs for additional housing over the next decade. At best under these constraints, the savings and loan industry cannot be expected to provide housing finance much beyond these basic levels.

We now turn to the final question which was posed earlier; that is, given that there exists a capital adequacy problem facing the savings and loan industry, and given that net worth limitations on growth are likely to continue and perhaps grow worse in the future, what can be done to improve upon the capital needs of the industry? Outside of methods which associations themselves might use to increase capital, such as conversion, there are three possible approaches to the problem.

1. The most direct approach would be to change the regulatory restrictions on the capital requirements of savings and loan associations but such a solution first of all is not germane to this committee, which is basically a tax-writing committee; and, second, such considerations are tied into risk and depositorsafety issues which should be dealt with independently.

2. A second approach would be to admit to the growth-net worth constraints as they are and are likely to be on the savings and loan industry and attempt to fill the gap between residential mortgage debt demand and residential mortgage debt supply through increased public housing programs in lieu of private funding. The Budget for FY 1978 calls for some $30 billion in direct, indirect, and offbudget expenditures by the federal government in the housing area. There is considerable debate as to the efficiency of these programs and the desirability of increased intervention of the public sector in the housing area. Within the context of this debate, it is perhaps useful to point out that a $1.00 reduction in the tax burden of a savings and loan association will increase that association's net worth by a corresponding dollar, which under existing capital requirements can support $20.00 of mortgage debt financing. By comparison, that same tax dollar which goes into public coffers can only support $1.00 of direct government expenditure housing programs. In terms of funds directed toward mortgage finance, the former tax-expenditure approach is more efficient.

3. As indicated in Chart 2, and as supported in Table 4, a good portion of the problem of capital-related constraints on growth in the savings and loan industry have been brought on through changes in the federal tax treatment of thrift institutions. Correspondingly, one can look for relief from these problems in the same area, particularly if the results would be a relatively efficient achievement of socially desirable goals, which I submit would be the case.

CHART 2

Prior to the Revenue Act of 1951, savings and loan associations and mutual savings banks were exempt from federal income taxation under the premise that since these institutions play an important role in the high national priority of financing residential construction, they should be exempt from taxation. As predominantly mutual organizations, S&Ls more closely resembled non-profit operations, like credit unions, than profit-oriented stock associations, such as commercial banks, which further merited this preferential treatment in the eyes of the Congress. With the continued growth of the industry and associated cries of tax equity and "fair-share" payments by the commercial banking system, Congress terminated in the Revenue Act of 1951 the tax-exempt status of thrift institutions. The provisions of this initial tax bill, however, were so lenient that for all intents and purposes federal income taxation of savings institutions remained virtually non-existent until the Revenue Act of 1962.

With the passage of this Act, Congress legislated major changes in the tax treatment of savings and loan associations. The significance of these changes is apparent from the quantum leap between 1962 and 1963 in the federal income tax burden of the savings and loan industry, (Table 6), and the significant drop thereafter in the growth in net worth (Table 4). The Revenue Act of 1962 primarily impacted the savings and loan industry, leaving mutual savings banks virtually untouched. Nonetheless, S&Ls were permitted under this act to deduct up to 60% of their net income for additions to reserves against bad debts, a deduction which permitted net income to be reduced by 15% to 16% as a consequence of federal taxation.

TABLE 6. RATES OF FEDERAL INCOME TAX AS PERCENT OF ECONOMIC INCOME, UNADJUSTED: 1 MUTUAL SAVINGS BANKS, SAVINGS AND LOAN ASSOCIATIONS, AND COMMERCIAL BANKS, 1975-76 2

2 Internal Revenue Service, Statistics of Income (Source Book); Federal Home Loan Bank Board, Combined Financial Statements; FDIC, Annual Reports.

The second major change in the federal taxation of savings and loan associations occurred in the Tax Reform Act of 1969. This Act reduced the deduction permitted for addition to reserves for bad debts from a 60% level in 1969 to a 40% level in 1979. The current deduction (1977) is 42% of taxable income.

In addition to legislated increases and added restrictions built into corporate tax treatment of thrift institutions by the Tax Reform Act of 1969, a sort of "piggyback" tax on the regular tax was also introduced-the minimum tax. Up until the Tax Act of 1976, this tax was a flat 10% rate applied to the sum of certain tax preference items excluded from the regular income tax, less a $30,000 exemption per taxpayer plus regular income taxes paid net of all

credits. The bad debt deduction permitted thrift institutions is among the preference items subject to the minimum tax although not all tax-exempt and deferred-income items are so included. Under the provisions of the Tax Act of 1976, the minimum tax for corporate taxpayers is increased from 10% to 15%, with reductions in the $30,000 exemption. For financial institutions, these provisions become effective in 1978 and for many associations, this again will represent a sizable increase in their federal tax burdens.

As can be seen from Table 6, the upshot of all this tax activity since 1951 is that the federal taxes for savings and loan associations have increased from 1% of their economic income in 1962 and earlier, to 16% in 1969, to an effective rate which for many associations is approaching 30% in the current year. In a matter of some 15 years, the savings and loan industry as a whole has experienced a 25 to 30 fold increase in its effective federal tax burden. The importance of this phenomenon from the standpoint of capital sufficiency in the savings and loan industry is brought out in Chart 2 and Tables 6 and 7 which evidence the relation of rising tax burdens and a falling net worth position.

TABLE 7.-NET WORTH HISTORY OF ALL SAVINGS AND LOAN ASSOCIATIONS FROM 1950 THROUGH 1975 ASSUMING 3 ALTERNATIVE LEVELS OF FEDERAL AND STATE INCOME TAXES—(1) NO TAXES, (2) ACTUAL TAXES, AND (3) FULL CORPORATE TAXES !

1 Robert R. Dockson, "Comments on Capital Needs of S&L Associations," Second Annual Conference: Change in the savings and loan industry, San Francisco Federal Home Loan Bank, December 1976 (forthcoming).

It is noteworthy that at no time during the debate and the presentation by the Treasury in the aforementioned Tax Acts that any serious consideration was ever given to questions of net worth induced constraints on growth and its potential impact on mortgage debt financing. The issue in 1962 was simply-"Thrifts pay no federal tax-it's time they do, particularly given the relatively heavy burden of taxation borne by commercial banks (at that time)."

In ensuing tax legislation, the issues centered around rate comparisons with non-financial corporations and by attempts to submit "all forms of income to some tax". The links between tax-saving additions to reserves, capital requirements, and industry growth were never made or developed in the debate.

We believe that a major overhaul of the federal tax treatment of thrift institutions is long overdue and would like at this time to endorse the concept of the

mortgage interest tax credit (MITC) as proposed in Title VII of the Financial Institutions Acts of both 1973 and 1975. Under this concept, the percentage-oftaxable income method of calculating loss reserves for thrift institutions would be eliminated with further reserve additions on qualifying loans computed under either the percentage of eligible loan or the experience methods presently available to commercial banks. In lieu of this bad debt reserve allowance, we propose a tax credit be granted equal to a specified percentage of gross interest income from qualifying residential mortgages. Essentially, the credit would be a function of interest income on qualifying residential mortgage loans, and the size of the credit would be a function of the percent of such assets which a financial institution or individual has in its portfolio. An incentive effect is built-in since the greater the amount of qualifying residential mortgages which a financial intermediary has, the greater the size of the credit and thereby the greater the amount of the tax benefit. Under this provision, any taxpayer which holds less than 10% of its portfolio in such qualified assets would not be eligible for the MITC.

As to the cost of this proposal, Table 8 provides revenue estimates on the MITC as was reported out of the Senate Committee on Banking, Housing and Urban Affairs in the Financial Institutions Act of 1975. These estimates are net of any revenue gains resulting from the elimination of the bad debt allowance provisions and are similar to the revenue losses under our proposal. They reflect the first order total revenue losses to all taxpayers qualifying under this provision and as such do not account for the increased private and public benefits which would accrue. These benefits are extremely difficult to quantify, which is probably why the Treasury has not done so. Nonetheless, benefits do accrue, they are significant, and they should be recognized.

1 Source: U.S. Treasury Department, Office of Tax Analysis; mortgage tax credit of 3% percent of interest on qualified assets at 80 percent of qualified assets phasing down to 11⁄2 percent at 10 percent of qualified assets. Revenue losses are net.

As to the benefits associated with this proposal, we submit the following: 1. The MITC would increase the availability of funds for financing residential mortgage debt. Given an average net tax expenditure of $800 million per year, it is estimated that approximately three-fourths of that would accrue to savings and loan associations, or $600 million per year. Over a ten-year period, the MITC would increase the net worth of savings and loan associations by approximately $6 billion relative to the present tax law. Under the FIR (net worth) requirement of 5%, these savings would permit an added growth in assets of $120 billion over this period. Under the assumption that 80% of such funds would go into residential mortgages, an additional $96 billion funds would become available for residential mortgages relative to what would be the case under existing tax law.

2. The mortgage interest tax credit would reduce the net worth constraints which are now and will continue to impinge upon the growth of savings and loan associations. With the mortgage interest tax credit in lieu of the current tax treatment of savings and loan associations, the net worth of S&Ls would only have to grow $19 billion net of the tax benefit accruing from the mortgage interest tax credit in order to provide mortgage debt commensurate with the basic housing needs as described previously. This translates into an annual growth rate in net worth of about 7% net of the tax subsidy compared to an 82% growth rate under existing tax law. Even if one were to add the financing requirements related to the inadequate housing considerations spelled out earlier, net worth of savings and loan associations, net of tax benefit, would need to increase on an average annual rate of 82%-high, but reasonable. 3. Third, the MITC would be a move toward reestablishing federal tax equity among competing financial intermediaries. As evidenced in Table 6, the federal