Mr. Kershner says:

AKRON

"Akron tax-free 4-percent bonds, due in 1942, were offered on a 3-percent basis, while Akron taxable 4-percent bonds, due in 1944, were offered at 4.40 percent, and 41⁄2-percent bonds, due in 1940, were offered at 4.35 percent."

The tax-exempt Akron 4's of 1942 are water bonds. According to the Bank and Quotation Record, Akron water bonds (protected by the revenues from waterworks as well as by their status as general obligations) sell at substantially lower yields than do the other Akron obligations. This probably explains most of the spread between the bonds cited by Mr. Kershner. This belief is substantiated by the differential indicated between taxable water bonds and taxable general obligations of Akron. On December 31, 1938, Akron 5-percent taxable water bonds, running serially from 1939 to 1953, yielded from 2 percent to 3.80 percent, whereas other taxable Akron bonds ranging from 44's to 51⁄2's, and running from 1939 to as late as 1956, yielded from 4 percent to 4.60 percent.

Mr. Kershner says:

CINCINNATI

"Cincinnati tax-free 4-percent bonds, due in 1942, were offered on a 1.25-percent basis, while Cincinnati taxable bonds were selling around 2 percent-a spread of 0.75 percent

* *

It is very difficult to understand the meaning of Mr. Kershner's statement that "Cincinnati taxable bonds were selling around 2 percent." Obviously, bondsparticularly short-term bonds-must be compared with securities of about the same maturity, for interest rates at the present time are very much lower for short-term than for long-term securities. In this connection it is interesting to note the wide variance in yield between Treasury bonds of different maturities, as shown in the following table. The yield quotations are as of December 31, 1938.

We have, therefore, endeavored to make a comparison of a Cincinnati taxable bond of somewhat comparable maturity with the tax-exempt 4's of 1942, but we are not able to even approximate Mr. Kershner's quotation. The closest maturities to 1942 which we have located in the Bank and Quotation Record, are taxable Cincinnati 54's of 1941 which yielded 1.25 percent and taxable 41⁄2's of 1943 which yielded 1.30 percent on December 31, 1938. These yields may be compared with the 2-percent yield for taxable bonds cited by Mr. Kershner.

Mr. Kershner continues:

66* * * Cincinnati tax-free 31⁄2-percent bonds, due in 1965, were offered at 1.50 percent, while Cincinnati taxable 5-percent bonds, due in 1965, were offered at 2.35 percent-a spread of 0.85 percent.'

The tax-free 32's of 1965, however, are callable, perhaps as early as 1942, and certainly as early as 1946, depending upon which of several possible issues Mr. Kershner may have had in mind. The taxable 5's, on the other hand, are not callable prior to their final maturity in 1965. Hence the maturities of the two

securities are not comparable.

The prices corresponding to the yields quoted by Mr. Kershner are from about 107 to about 113 for the tax-free 31⁄2's, depending upon earliest call date, and about 152 for the taxable 5's. If, by chance, the tax-free bonds should not be called and should run to their final maturity in 1965, they would give the relatively high yield of from about 2.85 percent to about 3.10 percent, or at least 0.50 percent more than that on the taxable bonds. The yield on the taxable 5's, on the other hand, is prevented from declining further than it has by the somewhat astronomic premium of about 52 points.

Mr. Kershner says:

CLEVELAND

"Cleveland tax-free 4-percent bonds, due in 1952, were offered at 2.15 percent, while Cleveland taxable 41⁄2-percent bonds, due in 1952, were offered at 3.10 percent a spread of 0.95 percent."

Mr. Kershner's Cleveland example is the only one in which there is not apparent upon the face of the example, as soon as the bonds are identified, adequate reason based on other causes to account for all or the major portion of the differential ascribed by him to tax exemption. We have, however, made an effort to verify Mr. Kershner's quotations, as they seem to be greatly at variance with the results elsewhere. An examination of all of the quotations for October, November, and December 1938, as published in the Bank and Quotation Record of the Commercial and Financial Chronicle, the most comprehensive generally published source of municipal-bond quotations, fails to show any Cleveland bonds maturing in the 1950's yielding less than 3 percent in October and November and 2.80 percent in December. It is, therefore, not possible to comment further on the Cleveland example.

Mr. Kershner says:

COLUMBUS

"Columbus tax-free 4-percent bonds, due in 1947, were offered at 2 percent, while Columbus taxable 4-percent bonds, due in 1956 and 1957, were offered at 2.75 percent-a spread of 0.75 percent."

The unfairness of comparing the yields of 9-year tax-exempt bonds with the yields of 19-year taxable bonds may be clearly seen by referring to the table on Treasury-bond yields for various maturities presented in connection with the discussion of Mr. Kershner's Cincinnati examples. Using exactly the same method of analysis, Mr. Kershner could have taken a long-term tax-exempt bond and a short-term taxable bond and wound up with exactly the opposite conclusion that is, that taxable bonds sell on a lower yield basis than tax-exempt bonds.

Furthermore, the tax-free Columbus 4's of 1947 are waterworks bonds, about which Moody's 1939 Governments has this to say: "It was reported that earnings from the water system are sufficient to cover interest charges and sinking-fund requirements on waterworks bonds, which in addition are a general obligation of the city."

Mr. Kershner has this to say:

TOLEDO

"Toledo tax-free 4-percent bonds, due in 1942, were offered at 2.00 percent, while Toledo taxable 41⁄2-percent bonds, due in 1948, were offered at 2.80 percent, and those due in 1951 were offered at 3.00 percent and 3.10 percent."

Here again, bonds which are in no way comparable with respect to maturity have been used. It is interesting to note what a similar comparison between United States obligations shows. As of December 31, 1938, United States Treasury 3%-percent bonds of June 15, 1943-47, yielded 1.06 percent to earliest call date and the 3-percent bonds of September 15, 1951-55, yielded 2.33 percent to earliest call date. This is a differential of 1.27 percent due entirely to the difference in length of term of the securities. How then, is Mr. Kershner able to find that the market places any value at all upon the Ohio tax-exemption privilege when his differential of only 1.10 percent seems scarcely adequate to account for the differences in maturity?

COMMENTS ON THE ESTIMATES PRESENTED BY PROFESSOR LUTZ Regarding tHE ADDITIONAL INTEREST COST WHICH WOULD RESULT FROM THE REMOVAL OF TAX EXEMPTION FROM FUTURE ISSUES OF PUBLIC SECURITIES

I. INCREASE IN INTEREST COST WHICH WOULD RESULT FROM THE IMPOSITION OF FEDERAL INCOME TAXES ON INCOME FROM STATE AND LOCAL SECURITIES

Professor Lutz first takes up the matter of increased interest cost on long-term State and local securities. For this purpose, he makes several approaches to estimate the interest differential resulting from tax exemption.

First, he presents the results of a questionnaire he submitted to 13 dealers and to 4 insurance companies requesting their opinions of the probable increase in interest cost which would result if tax exemption were removed on 27 specified State and local bonds. The variations in the replies which he received serve to indicate how tenuous the measurement of the differential actually is. Thus, the range of the dealers' estimates of the average differential on the group of issues was from slightly less than thirty one-hundredths of 1 percent to a full 1 percent, with the average at sixty-one one-hundredths of 1 percent. The estimates of the insurance companies ranged from just below forty-six one-hundredths of 1 percent to almost eighty-six one-hundredths of 1 percent, the average being sixty-eight one-hundredths of 1 percent.

With respect to these estimates Professor Lutz says that they "constitute opinion evidence only" and that "they may be criticized as inconclusive, notwithstanding the peculiar qualifications which may be possessed by those who responded to the questionnaire." He then says that "another and more objective test is supplied by the bond market itself," and he introduces certain series of yields on municipal bonds and high-grade corporate bonds. Unfortunately, neither his tables nor his charts present the amount of the differential existing in favor of municipal bonds, but that may be explained by the fact that this differential is never really used. That is, after saying that the market provides a "more objective test," Professor Lutz never actually mentions the differential as indicated by the market. This is interesting, because the figures in his tables show quite conclusively that the differential fluctuates far too violently to reflect the value of the tax-exemption privilege alone. These fluctuations are due almost entirely to changes in the credit ratings assigned by the market to the State and local bonds as compared with the corporate bonds. The implication, however, is that the tables support the estimate of Professor Lutz that the differential is sixty one-hundredths of 1 percent, and that no discussion of the data is called for. An examination of the differentials obtained by subtracting the municipal index from the corporate index shows how weak this inference really is.

For example, his comparison of Moody's Aaa corporate bonds and the Bond Buyer Index for 11 first-grade cities during the last 11 years shows a yield differential ranging from negative twenty-seven one hundredths of 1 percent in May 1933, to positive one and eleven one-hundredths of 1 percent in October 1931. The differential jumps up and down remarkably. From December 1931 to January 1932, for example, it drops from one and nine one-hundredths of 1 percent to fifty-four one hundredths of 1 percent, or about half. Then from March to April it more than doubles, going from thirty-seven one-hundredths to seventyseven one-hundredths of 1 percent; and increases almost as much again in May when the differential becomes one and six one-hundredths of 1 percent. Again, from October to November 1934, the differential almost doubles; while from September to October 1935, it decreases by almost half. In 4 months of the period the differential was negative-that is, corporate bonds sold on a lower yield basis than municipal bonds.

It is interesting to compare the size of the differential before and after the passage of the Revenue Act of 1932, which increased the maximum individual income tax rate from 25 to 63 percent. It might be expected that the differential would show an increase as a result of this increase in tax rate. In the year 1931 the differential had averaged about seventy one hundredths of 1 percent; but in the year 1933 it averaged only twenty one-hundredths of 1 percent. There is certainly no indication here that the higher rates of the Revenue Act of 1932 influenced the differential; but the indication is rather that changes in credit ratings overshadow the tax exemption in importance.

In the other table of market data which Professor Lutz introduces, we find a very interesting comparison of the yields on 15 first-grade municipal bonds and high-grade public-utility (A 1+) bonds as computed by Standard Statistics Co. Comparing these two series for the first 8 months of 1938, which is as far as the figures are given, we find that the municipal bonds average three onehundredths of 1 percent higher in yield than the public-utility bonds. In other words, the differential was negative three one-hundredths of 1 percent. Professor Lutz also presents the Standard Statistics series on A 1+ industrial bonds, on A 1+ railroad bonds and an average of all A 1+ corporation bonds, but the public utility bond series has been cited here because such bonds are higher grade than the other private securities.

There are attached hereto copies of the two tables on yields presented by Professor Lutz, to which have been added the differentials between municipal and corporate bonds.

* * all of

After this interlude on market data, Professor Lutz says: the above estimates represent the opinions of the various groups as to just how much shifting can be accomplished. A measure of this shifting can be sought in the tax rates themselves." He then refers to the fact that his estimates show that 35 percent is "approximately the average or effective tax rate which Iwould have been levied on all State interest deemed * * * to have been received in 1937 by individuals with net incomes of $5,000 and over." In other words, in estimating the revenue which would be derived from the removal of tax exemption from State and local governmental securities, Professor Lutz says that individuals with incomes of $5,000 and over would pay an average rate of about 35 percent. This rate of 35 percent, however, seems to have been in

correctly computed, for Professor Lutz, in connection with his revenue estimates, says: "Then the tax to be collected on the $337,400,000 of State and local interest imputed to individuals with net income of $5,000 and over would be $77,055,000." This is an average rate of 23 percent, not 35 percent.

In any event, Professor Lutz says that 35 percent of the average municipal bond yield of 2.60 percent would be ninety-one one-hundredths of 1 percent, which would be the amount of the tax which individuals would attempt to shift by demanding higher interest rates. Similarly, with the corporation income tax at 161⁄2 percent, he finds that corporations would endeavor to shift a tax of about forty-one one-hundredths of 1 percent. Then he says: "An average of these extremes would be 66 points, which almost coincides with the average of the insurance company estimates of the effect of the Federal tax."

It should be noted that this estimate of a differential of 66 points is not an attempted measurement of what the market now accords to the privilege of tax exemption, but is an estimate of the tax which would be paid if State and local securities were not tax exempt. The two concepts are quite different, for it is entirely possible for the tax-exemption privilege to be valued at zero in the market, for the reason that those purchasers who derive no benefit from tax exemption would logically refuse to pay a higher price because of the tax-exemption privilege, while investors who did derive some benefit from tax exemption would then be paying no extra price because of the tax exemption. Consequently, the revenue loss might be large, while the interest saving to governments would be nil. It is obvious, therefore, that this method can throw absolutely no light on the additional interest cost to State and local governments which would result from the subjection to the Federal income tax of interest from State and local securities.

On the basis of these various data, Professor Lutz suggests that "a fair measure of the difference in interest cost for the States and their subdivisions, after the subjection of the interest on their bonds to Federal income taxation, would be an increase of 60 points in the interest rate." He then applies sixty one-hundredths of 1 percent to the long-term debt of State and local governments to obtain an estimated increase of interest cost of $111,000,000.

The accuracy of this estimate depends entirely on whether the sixty onehundredths of 1 percent differential Professor Lutz uses is reasonable. Certainly he has not demonstrated that it is; and his explanation of the derivation of the differential is quite unsatisfying.

On the short-term debt of State and local governments, Professor Lutz guesses that the interest rate would be boosted twenty one-hundredths of 1 percent if tax exemption were removed. Applied to the $890,500,000 of such debt outstanding in 1937, an estimate of $1,800,000 of added interest cost is provided.

II. INCREASE IN INTEREST COST WHICH WOULD RESULT FROM THE IMPOSITION OF STATE INCOME TAXES ON INCOME FROM FEDERAL SECURITIES

Turning now to the estimated increase in interest cost on the securities of the United States Government and its instrumentalities, which would result from the subjection of interest on such securities to State income taxes, we find Professor Lutz doing some interesting reasoning. He cites no statistics as to the market valuation of the present exemption, and relies entirely on deductive reasoning in making the estimate of the increased interest cost. His reasoning in this connection is interesting because if he had applied it to the present situation, Professor Lutz would have found that no differential in favor of Federal securities can exist today as a result of the exemption of interest thereon from State income taxes.

The reasoning in point can be summarized in one sentence. Professor Lutz says that if Federal bond interest were subjected to State income taxes, the price of Federal bonds would tend to be set by the purchasers in States levying income taxes, rather than by the purchasers in nonincome tax States. This is logical, for there can only be one price and it cannot be higher than those purchasers are willing to pay who stand to receive the least net return after allowing for taxes.

The application of this reasoning to the present situation is somewhat complex but it proves conclusively that no yield differential can now exist with respect to Federal securities because the interest thereon is exempt from State income taxes. At present, those purchasers who live in States leving income taxes on other income receive a greater benefit from interest on Federal securities than persons in States not levying any income taxes. The monetary return is the same in both cases, but the purchaser in an income-tax State at present derives a special benefit because if he invested in a private security, he would be taxed on his interest income, but his Federal bond interest is exempt from the State income tax. On

the other hand, the investor in a State which levies no income tax receives no State tax advantage on Federal bond interest as compared with interest from private securities. Hence, the purchasers in nonincome-tax States now derive the least benefit tax-wise from the State tax exemption on Federal securities-that is, no benefit at all—and they accordingly set the price for such securities, the price they are willing to pay making no allowance for the exemption from State income taxes.

An illustration will serve to clarify the reasoning. Assume that only the Eastern States levy an income tax and that it consists of a uniform 5-percent rate on all income, but that this tax does not apply to any Federal bonds which might be issued. Suppose that there are no Federal securities outstanding until the Federal Government issues a small amount of bonds at 4 percent which we shall suppose to be the standard rate of interest for riskless investments. The tendency will be for this bond to be purchased almost entirely by persons living in the Eastern States, because it will provide a yield equivalent to a private security with an interest rate of 4.21 percent. That is, a private security with an interest rate of 4.21 percent will yield 4 percent after taxes. Investors in the States which do not levy an income tax, however, will compare the 4-percent yield on the Federal security with a 4 percent yield on a private security, inasmuch as they do not have to consider income taxes. Investors in the Eastern States will compete against each other for the Federal security, and, since the supply is limited, will drive the price up, and the yield will consequently decrease. The yield will tend to go to 3.80 percent, the net return after taxes on a 4-percent taxable bond.

Under these conditions, the Federal Government could have issued the bond originally with a 3.80-percent interest rate. It should be noted, however, that the basic interest rate of 4 percent would not have changed-rather, the Federal Government would be borrowing at a rate lower than the basic rate because of the exemption of interest from income taxes levied by the States. Moreover, the purchasers would be in the same position as they would have been if the Federal interest had been subject to the State income tax, for the tax saving would be exactly offset by the lower interest rate. It should be noted, however, that the Federal Government would here be gaining at the expense of the States, since the States would lose the tax revenue, but the Federal Government would save a corresponding amount in interest.

Now assume that the Federal Government issues a much larger amount of the same bond, so that investors in the Eastern States are unable to absorb the full supply and some have to be sold to investors in the Western States. The latter investors will be unwilling to accept a yield of less than 4 percent, since that is the yield they can obtain on comparable private securities and the price will therefore have to be on a 4-percent basis. Inasmuch as there can be only one price, the holders in the Eastern States will now get the bond at a price which does not reflect the value of the tax exemption to them.

Under these conditions, the Federal Government will derive no saving, because interest on its bonds is exempt from the income taxes levied in the Eastern States. True, the States will continue to lose revenue, but the advantage will inure solely to the purchasers in the States levying income taxes.

Accordingly, following Professor Lutz's reasoning, there can be no saving in interest cost at present to the Federal Government, because the interest on its securities is exempt from State income taxes, for some of its bonds have to be held by persons in States which levy no income taxes. Consequently, Professor Lutz would have to conclude that there could be no increase in interest cost to the Federal Government if interest on its securities were made subject to State income taxes, and he should reduce his figure of $30,000,000 as the estimate of such cost to zero.

III. INCREASE IN INTEREST COST WHICH WOULD RESULT FROM THE IMPOSITION OF FEDERAL INCOME TAXES ON INCOME FROM FEDERAL SECURITIES

Having considered the estimates of the increased interest cost to the States resulting from Federal taxation of the interest on State and local securities, and the increased interest cost to the Federal Government resulting from the subjection of interest on Federal securities, to State income taxes, there remain for consideration the estimates which Professor Lutz made respecting the additional interest cost to the Federal Government resulting from the subjection of the interest on its securities to Federal income taxes. He makes no attempt to figure what the market differentials are at the present time because of the exemption from Federal income taxes. Instead, he estimates the additional interest cost on the basis of the percentage tax which corporations and individuals would pay on Federal interest.