Chapter II: The Actual Return Upon Taxable and Tax-Exempt Securities

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