Hellerstein, Jerome R.

English

Indiana University Bloomington Maurer School of Law

Indiana Law JournalVolume 29 | Issue 4 Article 11Summer 1954Effects of Taxation: Investments by Individuals, by J.Keith Butters, Lawrence E. Thompson, and Lynn L.BollingerJerome R. HellersteinNew York UniversityFollow this and additional works at: http://www.repository.law.indiana.edu/iljPart of the Tax Law CommonsThis Book Review is brought to you for free and open access by the LawSchool Journals at Digital Repository @ Maurer Law. It has been acceptedfor inclusion in Indiana Law Journal by an authorized administrator ofDigital Repository @ Maurer Law. For more information, please contactwattn@indiana.edu.Recommended CitationHellerstein, Jerome R. (1954) "Effects of Taxation: Investments by Individuals, by J. Keith Butters, Lawrence E. Thompson, and LynnL. Bollinger," Indiana Law Journal: Vol. 29: Iss. 4, Article 11.Available at: http://www.repository.law.indiana.edu/ilj/vol29/iss4/11INDIANA LAW JOURNALSection 301 as an alternative method of enforcing rights under collectiveagreements or should employees resort to state court actions with greaterfrequency, the necessity of preserving a degree of coherence betweenarbitration practice and rules of judicial decision would be heightened.The successful reconciliation of the functions of the judiciary, NLRB,and private arbitrators requires not only further definition of their respec-tive jurisdictions but also the mutual understanding and respect which canbe achieved only through evolution of basic principles commanding com-mon acceptance.ARCHIBALD CoXtEFFECTS OF TAXATION: INVESTMENTS BY INDIVIDUALS. By J. KeithButters, Lawrence E. Thompson, and Lynn L. Bollinger. Boston: Har-vard Graduate School of Business Administration, Division of Research,1953. Pp. xxxiv, 533. $6.25.This work by Professor Butters and his Harvard associates, theseventh and final volume in their series of studies of the effects of taxa-tion on business, deals with questions which are at the very heart of thebattle raging in Congress at this writing in connection with the pendingtax revision bill. The bill, as passed by the House of Representatives,1would reduce taxes on dividend income by an estimated $240 million inthe fiscal year 1955 and by $814 million in each year thereafter.' Thisreduction is supported in part by the argument that a reduction in taxeson dividend income will encourage investment in equity capital and there-by contribute to the expansion of our economy. The Democratic op-position, on the other hand, is urging, in lieu of a reduction in taxes ondividends, increases in personal exemptions in order to offset the currentbusiness recession.In the great debate now going on, glib assumptions and facilerationalizations are being widely substituted for facts, partly because ofthe political character of the debate but also because of the lack ofempirical data as to many of the basic issues involved. The work byButters and his associates seeks to substitute factual data for conjectureas to the impact of taxation on investment by individuals. And a strikingfeature of the work is the extent to which the study negates postulatesaccepted as gospel in many financial and investment circles.t Professor of Law, Harvard University.1. H.R. 8300, 83d Cong., 2d Sess. (1954).2. H.R. REp. No. 1337, 83d Cong., 2d Sess. (1954).BOOK REVIEWSBefore turning to the authors' findings, the methods employed in thestudy should be noted. In seeking to make an empirical investigation ofthe influences of federal taxation on individual investments, a list of746 investors who did business with 53 investment banking houses orsecurities dealers over the country was selected, with a view to obtaininga representative sampling of varying income, wealth, and investmentpolicies. Personal interviews, based on an exhaustive questionnaire, werehad with the investors by staff members. Because a very large part of thepotential investment capacity is known to be concentrated in the higherincome levels, the authors used in their sampling 535 persons with incomesabove $7,500, an income group which represented in 1949 5 percent of thepopulation, of whom 353 had incomes of $12,500 or more. They alsoutilized as their source-data questions included in surveys of investorsmade by the Survey Research Center of the University of Michigan.'The authors have provided us with the most detailed study whichhas been made of the impact of taxes on investment decisions-particularlyin the higher income levels. The sampling was, of course, a small one,and the interviewing technique is open to some question as to how truth-fully individuals report their actual motivations; this problem is intensifiedby the antipathy of most high bracket taxpayers for tax collectors. Never-theless, the elaborate and carefully prepared questionnaire, coupled withthe critical sifting and analysis of the data by the authors, tends to offsetthese weaknesses of the method. Moreover, when one is dealing with theelusive task of ascertaining the reasons for investments and the extentto which taxes affect the judgment as to the investment to be made, men'sminds are being searched, and there appears to be no satisfactory alterna-tive to the method used, which is widely employed in psychological andsociological studies.The authors start with the proposition that business must look mainlyto a very small proportion of the population,4 the upper 10 percent incomebracket, for individual investment in equity securities.5 Indeed, theauthors conclude that the top 3 percent of the population, with incomes3. While the study was based on interviews had in 1949, the data were analyzed inthe light of developments taking place in 1950 and 1951. During that period, bothindividual and corporate taxes increased; but at the same time the high level at which theeconomy operated, the increased tempo of business, and the high level of individual sav-ings (They increased from about $6 billion in 1949, to nearly $11 billion in 1950, and toover $17 billion in 1951.) lead the authors to conclude that their results are substantiallyapplicable to 1952.4. The authors note that American business obtained the bulk of its equity capitalfor expansion and growth not from new stock issues but from retained earnings. P. 2.This matter is considered at length in an earlier study in this series. See SMITH, EFFEcTSOF TAXATION: CoRPoRATE FINANCIAL POLICY (1952).5. Pp. 16-29, 122-143.INDIANA LAW JOURNALof $10,000 or over and holding about 75 percent of all marketable secur-ities owned by private investors, provide the major reservoir of individualinvestment funds.6The study does not substantiate the widely held belief in the businessand financial community that severe increases in tax rates have for allpractical purposes wiped out the capacity of individuals with large in-comes to accumulate new investable funds. Instead, the writers find thatwhile changes in the tax structure made in the past five or ten yearshave substantially reduced the capacity of the upper bracket taxpayersto accumulate new investable funds, their remaining capacity is still verylarge and, indeed, is much larger than is popularly supposed.The fact that individuals in the high income brackets are still able toaccumulate large amounts of investable funds under existing tax rates,makes it, in the authors' view, particularly important to determine the ex-tent to which this potential equity capital reservoir has been absorbedas a result of federal tax policies. In approaching this problem, the authorsdivide investors into several categories. First, income and security mindedinvestors in the higher income levels, who place major emphasis on anadequate income yield or on the preservation of their capital, tend to bedriven by income taxes from high yield common stocks into low yieldinvestments, such as government bonds. Such investors, particularlythose in the top wealth classes, are influenced by income and death taxesto increase their holdings of cash, government bonds, and life insuranceat the expense of corporate securities. When the authors turn, however,to the investors who are mainly interested in capital appreciation and aretypically prepared to take risks of capital loss, they find that the effectsof taxation are of an entirely different character. The single most im-portant feature of the tax structure for these investors is, they find, thepreferentially low capital gains tax rate, which has stimulated venturesomeindividuals to seek out investments offering prospects of capital gain.Significantly, because investors normally expect to make a profit and notsuffer a loss, the authors found few instances in which individuals weredeterred from making investments because of the limited deductibility ofcapital losses from ordinary income.Turning from the types of investments into which investors put theirmoney, the authors studied the influence of taxation on the timing of thebuying and selling of securities. They sought to test the belief that thecapital gains tax accentuates fluctuations in the securities market bydiscouraging the sale of securities on which there are large unrealizedcapital gains, thereby reducing the supply of securities offered for sale6. Pp. 25, 140; Cb. XVII.660BOOK REVIEWSand exaggerating market booms. The conclusion reached is that thetiming of investment transactions was definitely inflfienced by the capitalgains tax, but the authors were unable to find that these tax influenceshave in any sense been a dominant or major explanation of the swingsin securities markets. Moreover, the data conspicuously fail to providesupport for the charge that the capital gains tax impairs the transfer ofcapital from existing securities to new ventures on any significant scale.The combined estate, gift, and income tax structure creates, theauthors report, strong incentives for inter vivos and testamentary familygifts in trust. The setting up of a trust creates a new income tax entitybeginning at the lowest tax bracket, removes wealth from the highestestate tax bracket, and substitutes the lower gift tax rates (again startingat the lowest rate bracket). These have been powerful incentives to thewide use of gifts in trust, in which management and control of wealthlargely remain in the settlor. Moreover, with a life estate given to theprime beneficiary and remainders over to the secondary beneficiaries,ordinarily one generation of estate taxes is skipped.Over-all, the authors find that the wide use of gifts in trust tendsto create a greater conservatism in investments than if the property wereheld by the donor.' Corporate trustees in particular are traditionally andopenly conservative in their investments.' The magnitude of the effect oftrusts on investment policy may be indicated by the fact that in 1949corporate trustees managed $50 billion in assets for the benefit of privateindividuals-a sum approximately equal to the total policy reserves of alllife insurance companies in that year. Hence, the effects of trusteeshipsin preventing the flow of funds into the stocks of less well-establishedcompanies and new ventures is not inconsiderable. Curiously, therefore,a major impeding tax effect on the venture capital market found by theauthors is one for which the government itself is only indirectly respon-sible; but the conservatism of the one branch of the financial communityitself, the corporate trustee, bears the primary responsibility.What impact do these findings, the principal factual conclusions ofthe authors, have on the current revenue revision? Perhaps the moststriking conclusion suggested is that the continued favorable treatmentof gains on sales of securities-i.e., taxation of net capital gains at thespecial 25 percent rate as contrasted with treatment as ordinary income-is a significant factor in inducing investments in equity securities andthat the substantial disallowance of capital losses as deductions fromordinary income is not a serious deterring factor. However, as the7. Pp. 370-371.8. Ibid.INDIANA LAW JOURNALauthors carefully point out, granting of preferential tax treatment ofcapital gains poses d serious problem in tax equity in view of the taxationat ordinary income rates of wages and salaries, authors' royalties, doctors'and lawyers' fees, and the individual merchant's profits.' In weighingthe impact of the existing capital gains tax on the investment marketalongside considerations of equality in taxation, two of the authors favor"heavier taxation of capital gains," while the third believes that "both onequity and on economic grounds" the capital gains tax should be reduced."The study sheds light on several facets of the current dividend taxreduction controversy. One may fairly infer from the authors' findingsthat a cut in the effective tax rate applicable to dividends will tend toinfluence the more conservative and the income-minded investor to turnmore readily to equity securities than he now does-although such incen-tives are not required to provide the equity capital needed by establishedbusinesses during periods of over-all prosperity and optimism (whichare the only types of businesses in which this class investor will put hismoney in any event). In times of depression, the authors point out thatthe investment risks-not those concerning taxes but the risks of loss ofcapital-would constitute the major factor which" would deter the readyflow of funds into equity securities. Moreover, as they point out, the exist-ence of tax-free havens for investments, such as tax exempt state andlocal governmental securities and life insurance, appears to be a majorfactor in diverting the funds of income and security-minded investorsaway from corporate securities. The conclusion implicit in their study isthat the closing-up of those avenues of investor income tax escape couldexercise a highly important influence on the flow of funds into thecorporate securities market. And finally, one may infer from the studythat elimination of the tax advantage to the settlor of the family trustwould go far towards freeing large amounts of potential investmentcapital for the equity securities market.These are controversial conclusions not drawn by the authors but, inthis reviewer's judgment, implicit in the study. It does not follow that a9. The justification for special treatment of capital gains provided by earlier statutesunder which the broad objective of the capital gains tax was to approximate the liabilitywhich would have been incurred had the profit been realized ratably over the holdingperiod no longer exists under the current law. Thus, under the Revenue Act of 1934, 100percent of the profit was taxed at ordinary income rates if the security or other capitalasset had been held for one year or less, 80 percent if the asset had been held for morethan one but not more than two years, 60 percent if the asset had been held for more thantwo but not more than five years, 40 percent if the asset had been held for more thanfive but not more than ten years, and 30 percent if the asset had been held for more thanten years. INT. REv. CODE §117. Obviously, the rationale supporting the earlier statutehas no application to the present law under which there is a maximum 25 percent tax forall capital assets held for more than six months. INT. REV. CODE §117(c).10. P. 68.BOOK REVIEWSwise over-all tax policy would embody these conclusions in a taxingstatute. There may be strong countervailing considerations such as theeffects of taxation of income from state and local governmental securitieson the ability of hard pressed state and local governmental units to raisemoney and the consequent impacts on the entire local governmental taxand fiscal structure, which might make taxation of the income fromsuch securities unwise. Likewise, taxation to the settlor of the incomeof family trusts would produce a whole host of other problems. In orderto prevent tax avoidance and to produce equity among taxpayers, such astep might require taxation to the donor of all family income or at least ofincome from property which has been the subject of gift whether or notin trust. In short, the effects of a change in tax policy on the flow ofcapital into the equity investment market is only one of many consider-ations which must be weighed in shaping tax reform.Facts have a way of being troublesome and disturbing to acceptednotions. The tax investment facts produced by this valuable study, whichconstitutes an important contribution to the literature of the field, notonly serve to undermine a good deal of wishful assuming but in additionsuggest fresh and provocative lines of re-examination of tax policiesaffecting individual investments.JEROME R. HELLERSTEINtt Assistant Professor of Law, New York University.

Effects of Taxation: Investments by Individuals, by J. Keith Butters, Lawrence E. Thompson, and Lynn L. Bollinger

bepress Legal Repository

https://www.repository.law.indiana.edu/cgi/viewcontent.cgi?article=2565&context=ilj

Effects of Taxation: Investments by Individuals, by J. Keith Butters, Lawrence E. Thompson, and Lynn L. Bollinger

Abstract

Similar works

Full text

Available Versions

Indiana University Bloomington Maurer School of Law

bepress Legal Repository