PREFERENTIAL TAXATION AND PORTFOLIO CHOICE: SOME 

EMPIRICAL EVIDENCE 

Harvey Galper and Dennis Zimmerman 

U.S. Treasury Department 

OTA Paper 29 August 1977 

OTA Papers are circulated so that the preliminary findings of tax research conducted by 

Staff members and others associated with the Office of Tax Analysis may reach a wider 

audience. The views expressed are those of the author, and do not reflect Treasury 

Policy. Comments are invited, but OTA Papers should not be quoted without permission 

from the author. 
PREFERENTIAL TAXATION AND PORTFOLIO CHOICE: 

SOME EMPIRICAL EVIDENCE 

Harvey-__.._ Galper*

and 

Dennis Zimmerman** 

I. Introduction 

The Internal Revenue Code contains many provisions which 

confer special tax treatment on particular types or classes of 

investment activity. Economic theory suggests this preferential 

taxation of assets will alter individuals' portfolio choices 

such that the distribution of these tax benefits should be 

heavily skewed toward higher marginal tax brackets and higher 

incme investors. The consequence is a lower effective degree 

-1/ 'of progressivity in the tax structure. However, the extent 

to which this preferential taxation actually affects asset choice 

and the distribution of income is unknown because up to now no 

data set had been available for deriving separate distributions 

of holdings of various classes of assets h-7 -3y-in-I. tax rate. 

The Projector-Weiss survey conducted for the Board of 

Governors of the Federal Reserve System comes closest to 

-2/

meeting these requircL.ents. However, their survey ranks 

individuals by income class rather than marginal tax rate. 

Feldstein has analyzed these data, with the general conclusion 

that high income investors (and thus, on the average, high 

marginal tax rate investors) tend to hold larger proportions 
-2-

of more preferentially taxed financial assets in their portfolios than do low income investors. -3/ 

No similar data set exists for comparing the distribution 

of a variety of asset holdings by marginal tax bracket. The 

preferentially taxed asset most thoroughly investigated in 

isolation is tax-exempt state and local bonds. Ott and Meltzer 

suggest the average marginal tax rate of the non-institutional -4/

investors in such bonds is 60 percent. Galper and Peterson 

present an estimate of the cumulative percentage of tax-exempt 

bond holdings by marginal tax rate. -5/ 

Neither of these sources 

is particularly useful for our purposes without comparable data 

on other assets whose tax treatment differs from tax-exempt 

'bonds. Furthermore, for empirical work, the appropriate marginal tax rate according to which an individual evaluates the 

tax benefits to be gained from investment in preferentially 

taxed assets is his pre-investment marginal tax rate. His 

n-f': -investmentmarginal tax rate is the marcrinal +a% rate he 

would incur in the absence of the income flow generated by the 

-6/

investment. Data for calculating these pre-investment marginal tax rates have not prev-eausly been available. 

The purpose of this paper is to use a special Treasury 

tabulation of unincorporated business data by income and preinvestment marginal tax rate to demonstrate that the distribution of these tax benefits does tend to conform to -a priori 
-- 

-3-

expectations. Section I1 discusses how preferential taxation 

enters the investment decision. It illustrates, using a threeasset model, the expected impact of preferential taxation on 

portfolio choice and the income distribution. Section I11 

discusses the applicability of the special tabulation data on 

income flows for testing whether actual investment choices tend 

to conform to the pattern suggested in Section IS, and suggests 

using gross losses for this task. The major preferential tax 

provisions are described by industry. Preferentially taxed 

industries are then selected for comparison based upon analysis 

of industry gross losses and gross profits. Section IV presents 

and analyzes empirical distributions of individuals' unincorporated business gross losses from these industries. The main 

finding is that gross losses from those industries which are 

most preferentially taxed accrue disproportionately to the highest marginal tax bracket investors. Some qualifications of 

the resu'+* are discussed in SectifonV, and the conclusion= 

are summarized in Section VI. 

11. Preferential Taxation and Portfolio Choice 

Following Bailey, we may show thdt preferential taxation 

of assets affects the before-tax rates of return on those assets 

and that the value of this preferential taxation is directly 

-7/

related to an investor's marginal tax rate (MTR). We may 

represent preferential taxation as excess deductions such 
-4-

as accelerated depreciation, percentage depletion allowances, 

etc. -- with the result that only a proportion 4, (a((1), of 

the before-tax rate of return is taxable. In general, an asset 

that has part of its income exempt from taxes (oC< 1) will command a premium which will tend to reduce its before-tax rate of 

return. The more of the income that is tax exempt, the greater 

the premium, and therefore, the lower is the before-tax rate 

of return. 

The tax law contains a variety of tax provisions which 

provide investors with considerable choice among j differentially 

taxed real and financial assets (j = 1 . . .m). The choices 

range from tax-exempt bonds (bc1 = 0) to fully taxed corporate 

bonds or physical assets employed in retail trade (4,= l), 

with innumerable partially taxed assets in between such as those 

in real estate (accelerated depreciation), in oil and gas extraction (percentage depletion and expensing of drilling costs) or 

those receiving capital gains tax treatment -- all character-

-8/

ized as OC j investments, 0<dj (1. As noted above, the 

greater the degree of excess deductions (the lower is d j) the 

greater the premium on the asset and, other ttdngs equal such as 

risk and transactions costs, the lower is its before-tax rate 

of return, r;. In other words, j <oLj+l implies rli, Crb.91 
-5-

To investigate the relationship between an individual investor with marginal tax rate equal to t and his marginal portfolio decision, we define the before-tax rate of return rb for 

three preferentially taxed assets: tax-exempt bonds (rk with 

4 = 0), a partially taxed investment (r2 with O<q2 .( I), b 

3 and fully taxable bonds (rb with d3 = 1). For the fully taxable asset (& = l), the after-tax yield is 

For the partially taxed asset (0 <5 4 11, the after-tax 

return is 

2 2 2 

(2) ra = rb - W2trb = rb (1 - dZt) 

Finally, for the tax-exempt investment ( oL1 = o), the 

after-tax yield is 

1 1 1 1 (3) ra = rb - O*trb = rb 

In making marginal investment decisions, an individual 

investor may be expected to choose that asset which yields the 

highest after-tax rate of return. This does not mean that tax 

preferred investments are necessarily the best investment for 

-all investors in all tax brackets. In fact, we can define 

rules according to which individuals choose their income maximizing investments. First, it is necessary to determine the 

particular MTRs along the entire structure of MTRs which 

represent the break-even point between any pair of investments. 
-6-

Take first a tax-exempt investment (e1 = 0) and a partially 

taxed investment (0LM, 1). In this case, finding the break2

even MTR, call it t*, which equates ri = ra involves solving 

the following equation for t*: 

(4) rb(l 1 - OL p*) = rb(l 2 - d2t*) 

This yields 

Thus, the marginal investment decision of all investors 

with marginal tax rates above t* should be to hold investments 

with higher excess deductions (OC 1), sacrificing before-tax 

return for non-taxable income and higher after-tax return. Investors with marginal tax rates below t* should make marginal 

investments with lower excess deductions (e2f if not even 

-9/

higher investments) to realize higher after-tax returns. 

In the same manner one can determine the break-even MTR 

between partially taxed investments and fully taxed invest­

' ments (& 3 = 1): 

3 2 2 (9) t** = (rb - rb)/(rb3 - d2rb) 

Those taxpayers with marginal tax rates above t** but 

below t* prefer non-taxable income to before-tax return, 

while those with matginal tax rates below t** prefer before3 tax return rb to non-taxable income, each in order to maximize 

after-tax return. 
-- 

-7-

Thus, investors above t* should prefer the most preferentially taxed asset as a marginal investment; investors below 

t** should prefer the least preferentially taxed asset; and 

investors between t* and t** should prefer the partially taxed 

-lo/

asset. These results suggest that, other things equal, distributions of holdings of assets by MTR should become more 

skewed toward higher MTRs as the degree of preferential taxation of the income from those assets increases. 

111. The Data and Preferential Tax Provisions 

To examine the relationship between preferential taxation 

and portfolio choice, this analysis uses data from a special 

Treasury Department project undertaken by the Statistics 

.Division of IRS. This project, which collected data from a 

sample of individual 1040 tax returns and their associated 

schedules C and E for the year 1972, indicates the taxable 

income from each unincorporated business along with its in811,c+.rv fiesignation. These data provide two improvements 

essential to our purpose over currently available tax information the capacity to disaggregate an individual's unincorporated business income by industry and by individual 

-1I/

business entity generating the income. The industry disaggregation is essential if one wishes to analyze the portfolio 

choices of individuals as a function of differential tax treatment of industries. Entity disaggregation is essential in 
-8-

order to construct, for each individual, gross income prior to 

loss offsets as a step in the computation of the pre-investment 

MTR, that is the MTR in the absence of the income flowing from 

the investment. 

Unfortunately, we cannot test directly the hypothesis that 

asset holdings of preferentially taxed assets are skewed to 

higher MTR investors because our data do not include asset 

holdings or investments, but rather the flows of taxable income or losses earned in various industries. However, an 

important aspect of preferential tax provisions is the allowance of excess deductions which generate tax losses in situations where positive economic income is being earned. These 

.tax losses can then be used to reduce taxes on other income. 

Since tax preferences are often reflected in gross losses, it 

seems reasonable to use the distribution of gross losses to 

represent investment in tax-preferred industries. 

This use of data on losses is consistent with the observation that those tax losses which are also true economic 

losses do not reduce and thus are not of particular benefit 

to high MTR taxpayers. We would, therefore, not expect to find 

disproportionate shares of economic losses-that is, losses from 

non-preferentially taxed industries--in high MTR taxpayers' 

portfolios. 
-- 

-9-

An additional consideration is that not all investors in 

any industry are tax-motivated some invest because of knowledge of the industry or various non-economic considerations. 

Since losses themselves tend to be part of tax preferences, 

restricting the analysis to investors with gross losses may 

come closer to identifying the set of tax-motivated investors. 

Finally, it should be noted that we are not primarily 

concerned with the actual level of investment as it may be 

represented by gross losses, but rather with the distribution 

of investment. There is no reason to believe that the distribution of those tax preferences which appear as tax losses 

would not be distributed according to igvestment holdings. 

Preferential taxation may take several forms. The devices 

most commonly used in 1972, the year for which our data are 

-12/

applicable, are by industry: 

A. Oil and Gas Extraction 

1. Intanqible drilling costs -- The investor may x. 

expense intangible drilling and development costs 

which, in the absence of the statutory provision, 

would have to be capitalized and deducted over the 

life of a successful well or at the time the well 

is abandoned. 

2. Percentage depletion allowance -- The investor may 

claim a deduction for a fixed percentage of the 
-10-

value of the resource being extracted as compensation for the "depletion" of the resource, regardless of the amount actually extracted. 

B. Real Estate 

1. Accelerated depreciation -- The investors may use 

a method of depreciation which results in allowable depreciation deductions in excess of economic 

depreciation during the early years of the investment. 

2. Construction period taxes and interest -- The 

investors may expense taxes, interest and other 

carrying charges attributable to the construction 

period, rather than add such expenses to the cost 

of the property and depreciate them over the useful 

life of the building. 

3. Conversion of ordinary income into capital gain --

To the extent that depreciation allowances exceed 

economic depreciation, the "basis" of the asset is 

artificially reduced and upon the sale of the asset 

ordinary income may be converted into more favorable 

capital gains. The existing depreciation recapture 

provisions do not completely eliminate the advantage of conversion. 
-11-

C. Livestock Feeding and Breeding 

1. Deduction of prepaid expenses and development 

costs -- Farmers have been allowed for 50 years to 

utilize the cash method of accounting and have not 

been required to maintain inventory accounts. This 

allows expenses to be deducted in the year actually 

paid without regard to whether they produce income 

in that year or not, and encourages the year-end 

purchase of supplies which will not be used until 

the following year. 

2. Accelerated depreciation -- Purchased animals held 

for breeding purposes and equipment can be depreciated for tax purposes at a rate in excess of 

economic depreciation during the early years of 

the investment. 

3. Conversion of ordinary income into capital gains --

.. In general, 1ivestock.heldfor breeding purposes 

for more than 24 months before being sold generate 

capital gains. This is particularly important in 

':-reedingoperations because there is no recapture 

of either depreciation (since raised animals have 

a zero "basis") or farm losses generally (if the 

investor kept his annual farm losses under $25,000). 

Only the investor's profit on the sale of purchased 
breeding animals is subject to recapture of previous 

depreciation deductions. 

D. Motion Pictures 

1. Accelerated depreciation -- The "income forecast" 

method allows investors to determine depreciation 

deductions based on the ratio of the annual income 

of the film to the film's total estimated income. 

This method can result in deductions in excess of 

ecanomic depreciation during the early years of the 

investment. 2. Expensing of production costs -- The cost of producing a film paid by a so-called production service 

partnership which does not own the film it produces 

are often deducted in the year paid or incurred 

rather than capitalized. 

E. Fruit, Tree, Nut, and Vegetable: Forestry 

1. Accelerated depreciation may be claimed with 

respect to equipment and purchased plants or trees. 

2. "Preproductive period" development costs may often 

be expen,..edin the year paid or incurred rather 

than capitalized. 

3. Conversion of ordinary income into capital gains. 
-13-

F. Equipment - Rental, Leasing 

1. Accelerated depreciation or 5-year amortization 

for certain equipment. 

2. First year "bonus" depreciation -- For the first 

year the property is placed in service, a deduction 

is allowed for additional "bonus" depreciation of 

20 percent of the cost of property. 

3. Asset depreciation range (ADR) - Depreciation 

lives allowed under ADR may be as much as 20 

percent shorter than guidelines lives. 

Since tax preferences tend to be reflected in gross losses, 

unincorporated business income in the preferentially taxed industries should be characterized by a relatively high incidence 

of gross losses relative to gross profits. Table 1 presents 

gross profit and loss information for various industries classified by Standard Industrial Classification divisions, and for 

selected four digit piibindustries which as we have indicated are 

preferentially taxed: Oil and Gas Extraction; Real Estate 

Operators: Livestock Feeding and Breeding; Fruit, Tree, Nut, 

and Vegetable; Forestry; Equipment Rental and Lasing; and 

Motion Picture Production and Distribution. 

Several observations can be made based on these data. 

First, both the ratio of loss entities to profit entities and 

the ratio of dollars of loss to dollars of profit tend to be 
-14-

TABLE 1 

Ratio of Loss/Profit Entities and Dollars: 

Unincorporated Business by Industry (Weighted Data) 

: Number of : 

: Entities : Dollars 

Agriculture, Forestry, Fishing

Fruit, Tree, Nut, Vegetable

Livestock 

Forestry 

Mining

Oil and Gas Extraction 

Construction 

Manufacturing 

Transportation, Communication, Gas 

Electric, Sanitary Services 

Wholesale Trade 

Retail Trade 

Finance, Insurance, Real Estate 

Real Estate Operators except

Developers and Lessors of BuiLd.j.ngs 

.611 .381 

.595 .435 

.708 .515 

.925* .468 

1.404 1.879 

1.479 2.351 

.140 ,093 

.290 .138 

.310 .152 

.312 .005 

.453 .148 

.692 .367 

1.018 1.342 

Services 

Business Services-Equipment

Rental, Leasing 

Motion Picture Production,

Distribution, etc. 

*Sample < 200 tax returns (unweighted) 

,279 .070 

.565 .391 

.614* 1.162 
-15-

lower in industry divisions receiving fewer tax preferences. 

Compare, for example, the ratios for Construction, Manufacturing, Transportation, Wholesale and Retail Trade with those 

for Agriculture, Mining, Finance, and Services. Second, within 

these latter divisions, the subindustries on which preferential 

taxation is targeted tend to have higher ratios than the division as a whole. Third, shelter subindustries Oil and Gas Extraction, Real Estate, Motion Pictures, and Livestock stand 

out as having particularly high incidence of losses, in terms 

of both entities and dollars. Finally, three of these four 

subindustries (excluding Livestock) are the only ones for which 

the ratio of dollars of gross loss to dollars of gross profits 

.exceedsthe ratio of number of loss to profit entities, which 

indicates they are the only subindustries for which average 

entity loss exceeds average entity profit. 

Thus, we select for analysis Oil and Gas and Real Estate 

- as the most preferentially taxed subindustries in our sample.13/ 

Motion pictures are eliminated due cto their small sample size. 

For comparison, we select Wholesale Trade and Retail Trade as 

non-preferentially taxed industries, and Manufacturing as a 

partially taxed industry. 
-16-

IV. The Distribution of Unincorporated Business Losses 

Section I1 demonstrated that an individual's choice among 

numerous differentially taxed assets will be influenced by his 

marginal tax rate. Section I11 suggested that in the absence 

of data on asset or investment holdings, and since short-term 

tax losses are frequently the vehicle through which preferential 

tax benefits are taken, the distribution of gross losses is 

likely to be a good proxy for the distribution of assets. 

Accordingly, this section presents cumulative distributions 

of gross losses by Adjusted Gross Income and pre-investment MTR 

for those preferentially taxed industries identified in Section 

111. 

The AGI distributions are presented in Table 2, in which 

each individual's gross losses (in the specified industry) are 

classified by the AGI reported on his tax return. Since AGI is 

directly related to MTR with aggregated data, we would expect 

+hzt the more preferential-lytaxed industrier would have gross 

loss distributions which are more skewed toward higher AGI 

classes. This is particularly noticeable for Real Estate and 

Oil and Gas Extraction when compared to Wholesale Trade, Retail 

Trade, and Manufacturing. The AGI at which median loss occurs 

is $69,943 for Oil and Gas and $35,571 for Real Estate, compared 

to $3,776 for Retail Trade, $6,269 for Wholesale Trade, and 
-17-

TABLE 2 

Cumulated Proportion of Unincorporated Business Losses 

for Selected Industries, 

Cumulated by Adjusted Gross Income of Investor 

AG I : Retail ,: Wholesale : Manufac- : Real : Oil & Gas 

(1000's) : Trade : Trade : turing : Estate : Extraction 

No AGI .355 .279 .476 .274 .162 

0 - 5 .547 .449 .672 .294 .181 

5 - 10 .708 .650 .752 .332 .219 

10 - 15 .821 .699 .789 .361 .225 

15 - 20 .882 .836 .808 .390 .247 

20 - 25 .896 .867 .821 .426 .263 

25 - 50 .964 .914 .877 .601 .429 

50 -100 .983 ,970 .924 .769 .607 

100-200 .992 .983 .950 .878 .771 

200 1.000 1.000 1.000 1.000 1.000 

Approximate AGI of: -1/ 

1st loss 

quintile $ 0 $ 0 $ 0 $ 0 $7 I 500 

Median 

LOSS , ., r'l6 $6 ,269 $612 $35,571 $69,943 

5th loss 

quintile $14 ,071 $18 ,686 $17,895 $128,440 >$200,000 

-1/ Calculated assuming uniform distribution within each class. 
-18-

$612 for Manufacturing. The AGI at which the fifth loss quintile occurs is greater than $200,000 for Oil and Gas, $128,440 

for Real Estate, compared to $14,071 for Retail Trade, $18,686 

for Wholesale Trade, and $17,895 for Manufacturing. 

Table 3 presents gross loss distributions by pre-investment 

MTR. This pre-investment MTR is based upon the assumption that 

each industry in turn represents the individual's marginal investment. Thus, in the Real Estate column of Table 3, gross 

real estate losses are added to the taxpayer's AGI and gross 

real estate profits are subtracted from AGI in order to establish pre-investment income. The MTR is then calculated based on 

the amount of this pre-investment income which is subject to tax. - Table 3 reinforces the results presented in Table 2--that 

the distribution of gross losses in an industry is more skewed 

as the degree of preferential taxation of the income from that 

industry increases. The MTR at which the median dollar of loss 

occurs differs dramatically, from .17 for Retail Trade to .55 I 

for Oil and Gas. The MTR at which the first quintile of loss 

occurs ranges from .OO in Wholesale Trade and Retail Trade to 

.39 in Oil and Gas. The MTR at which the last quintile of 

loss occurs ranges from less than .24 in Retail Trade to .65 in 

Oil and Gas. 
-19-

TABLE 3 

Cumulated Proportion of Unincorporated Business Losses 

for Selected Industries, Cumulated by Pre-Investment 

Marginal Tax Rate of Investor 

Marginal : Retail : Wholesale : Manufac- : Real : Oil & Gas 

Tax Rate : Trade : Trade : turing : Estate : Extraction 

0 .290 .206 .147 .lo6 .060 

13-20 -1/ .651 .474 .422 .132 .085 

21-25 .845 .695 .632 .204 .139 

26-30 .876 .775 .638 .230 .146 

31-35 .897 .830 .667 .254 .171 

36-40 .914 .891 .709 .319 .209 

41-45 .931 .goo .719 .354 .303 

46-50 .964 .910 .740 .499 .409 

51-55 .972 .928 .808 .590 .494 

56-60 ' .982 .968 .829 .686 .570 

61-65 .990 .989 .913 .837 .803 

)65 1.000 1.000 1.000 1.000 1.000 

Approximate marginal tax rate of: -2/ 

1st losr 

quinti1e .oo * .'iiu .oo a 25 .39 

Median 

loss .17 .20 .22 .50 .55 

5& loss 

quintile .24 .32 .54 .64 .65 

-1/ 

-2/ 

The first bracket rate is taken at 13 percent rather than 14 percent

due to the interaction of the normal rate schedule and the minimum 

tax. 

Interpolated to nearest percentage point or first bracket rate from 

above distributions. 
-20-

Lorenz curves may also be employed to highlight the substantial differences among the loss distributions of Table 3. 

For this purpose, it is useful to establish a reference distribution to which the individual industry loss distributions 

may be compared. For the initial computations, the broadest 

possible reference distribution available to us is used, namely 

the percentage distribution of all income tax returns by marginal tax rate. Again, the distribution is cumulated by preinvestment MTR, but in this case all net unincorporated business 

income, to the extent that an individual tax return has such 

income, is considered the marginal investment. Thus, as shown 

in Figure 1, the Lorenz curves relate the distribution of investors' losses for the particular industry in question (shown 

on the vertical axis) to the total distribution of individual 

tax returns (shown on the horizontal axis). 

The diagonal line indicates perfect equality in that the 

distribution of losses in a particular industry is no more skewed 

when cumulated by MTR than the dstribution of returns in general. A curve below the diagonal line indicates that any 

given%nercentage of returns receives a less than proportionate 

share of losses in a particular industry or, in other words, 

the loss distribution for the particular industry is skewed 

(relative to the distribution of all returns) to the upper end 

of the MTR range. We should note that pure scale effects cause 
-21-

some skewing of the industry loss distributions, simply because 

higher MTR investors will generally have more resources to invest (and therefore a greater share of the losses) than lower 

MTR investors. However, scale effects cannot explain why 

higher MTR investors should choose one industry over another, 

and our main concern here is with comparisons across industries, 

that is, with the differences in the Lorenz curves of industries 

which are characterized by varying degrees of p-referential taxation. Furthermore, as discussed below, while the choice of 

reference distribution will determine the absolute measure of 

inequality, or the degree of departure of the individual loss 

distributions from the diagonal line, it will not change the 

patterns across industries. 

Figure 1 is striking visual evidence of these different 

distributional patterns. Retail Trade has a Gini coefficient 

of only .019, indicating very little inequality in the general 

population's holdings of Retail Trade losses, though there is 

overrepresentation for both the very lowest and highest MTR's. 

Contrasted with this are the Oil and Gas and Real Estate Gini 

coefficients -5 .840 and .749, respectively, indicating extreme 

inequality in the general population's holdings of losses in 

these preferentially taxed industries. 

As noted, the overall skewness of the industry loss distributions depends upon the choice of the reference distribution. 
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-24-

If we restrict our analysis solely to investors with unincorporated business income, we should expect individual industry 

Lorenz curves to be closer to the diagonal line. This is 

because returns with no business income whatsoever tend on the 

average to be lower MTR returns, and eliminating these returns 

makes the reference distribution and the industry loss distributions much closer together. Figure 2 presents Lorenz curves 

with the reference distribution (by MTR) of all individuals 

with unincorporated business income. Despite the lower Gini 

coefficients (G), the relationship of the industry curves to 

each other remains the same. Oil and Gas (G=.803) and Real 

Estate (G=.704) are still the most concentrated among investors 

. with higher MTR's, Retail Trade (G=-.073) and Wholesale Trade 

(G=.150) are the most equally distributed, and Manufacturing 

(G=.279) is moderately skewed to higher MTR's. 

V. Qualifications 

The nature of the data used in this study is such that 

some qualifications are required in interpreting these results. 

First, the MTR we observed may not be the MTR upon which 

the individual's investment decision was based--transitory 

income may cloud the calculation. Furthermore, since any 

losses which we observe are combinations of tax and economic 

losses, it may be that some investments incur genuine economic 

losses unrelated to tax considerations, even in the case of 

investments in real estate or oil and gas. 
-25-

A second set of considerations derives from the fact that 

many returns have unincorporated business income from investments in more than one tax preferred industry. In this case, 

the MTR calculated for each industry separately is less than 

that obtained from looking at total tax preferred investments 

as a whole. Investors in tax sheltered industries are then 

classified in lower pre-investment MTR's than they really 

should be, and the tax preferred industry Lorenz curves appear 

less skewed. Such problems are inherent in a study which 

attempts to exanine loss distributions for each industry individually. 

A similar result occurs due to the fact noted above that ., 

.L we call preferentially taxed industries are really a mixture of tax favored and non-tax favored elements. This also 

imparts to these industries a tendency towards greater equality 

in the Lorenz curves than would appear with uniformly taxed 

- industries.14/ 

While such qualifications are worth noting, 

they do not change the basic conclusions of this paper. On 

the contrary, they strengthen these conclusions since they generally make it even harder for the data to show departures 

from equality. 

VI. Conclusions 

The results shown in Tables 2 and 3 and Figures 1 and 2 

clearly indicate that investors with higher pre-investment MTR's 
-26-

tend to acquire disproportionate shares of losses in those 

industries such as Real Estate and Oil and Gas Extraction which 

receive relatively favorable tax treatment. In contrast, investors with lower pre-investment MTR's tend to acquire disproportionate shares of losses in those industries such as Wholesale and Retail Trade which have relatively less access to 

favorable tax treatment. This is indeed confirming evidence 

of Bailey's assertions concerning portfolio choice and progressivity--that assets receiving preferential tax treatment 

generate tax losses which can be used to reduce taxes on other 

income, the value of which is a positive function of one's 

pre-investment MTR; that this allows high tax bracket investors 

to offer higher prices for these assets (accepting lower beforetax returns) in exchange for the relatively higher tax savings 

and after-tax rate of return: and that these assets therefore 

tend (other things equal) to settle disproportionately into 

the portfolios of investors with high-* pre-investment MTR's. '*I., 

The consequence of this is a lower effective degree of progression in the tax structure. 
Footnotes 

* Associate Director, Office of Tax Analysis, Department of 

Treasury; 

** Economist, Program Analysis Division, General Accounting

Offjw 

Mike Kaufman, Emil Sunley, Phil Weisner and Pat Hendershott 

provided valuable comments. Any errors remain the authors', 

responsibility. The views expressed are the authors', and do 

not necessarily represent those of the Treasury Department or 

the General Accounting Office. 

1. Martin 3. Bailey, "Progressivity and Investment Yields under 

U.S. Income Taxation," Journal of Political Economy, 1974, 

NO. 6, pp. 1157-1175. 

2. Dorothy S. Projector and Gertrude S. Weiss, Survey of 

Financial Characteristics of Consumers, Washington, D.C., 

Federal Reserve Technical Papers, 1966. 

3. Martin Feldstein, "Personal Taxation and Portfolio Composition: An Econometric Analysis," Econometrica, 1976, 

NO. 4, pp. 631-650. _ 3 i _I L 

4. David Ott and Allan H. Meltzer, Federai'iiaxTreatment of 

State and Local Securities, Brookings Institution, Washington, D.C., 1963. They cite as their source a study by 

Roland I. Robinson, The Postwar Market for State and Local 

Government Securities, National Bureau of Economic 

Research, 1960. 
-2-

5. Harvey Galper and George Peterson, "The Equity Effects of 

a Taxable Municipal Bond Subsidy," National Tax Journal, 

December 1973, pp. 611-624. Their estimates are derived 

from special tabulations of bond holdings by income class 

in Joseph Pechman and Benjamin Okner, "Individual Income 

Tax Erosion by Income Class," in U.S. Congress, Joint 

Economic Committee, The Economics of Federal Subsidy Programs, Part I - General Study Papers (U.S. Government 

Printing Office, Washington, D.C., 1972). 

6. The pre-investment marginal tax rate literally applies to 

just the first dollar of investment income. Additional 

dollars of income may be taxed at higher rates, but this 

would depend on the size of the investment itself. Therefore, the only tax rate exogenous to the investment decision 

is that applicable to the first dollar. 

7. Bailey, z. ­cit. 

8. Actually, as Bailey, -Ibid., has noted, there may even be 

;,uely taxed assets such that the after-ta 

return is increased by the application of the tax code. 

These effects are ignored here. 

9. It is fully consistent that high tax bracket investors will 

be observed to hold some high ZL investments which they 

would not find profitable as a marginal investment. The 
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The Tax Reform Act of 1976 altered the benefits of many of 

these preferences. Also, the Act provided restrictions on 

the deduction for prepaid interest, substantially increased 

the impact of the minimum tax on individuals utilizing 

these preferential tax provisions, and tightened the depreciation re @a ture rules, including a provision for recapture

of amounts deducted for intangible drilling expenses on 

productive wells. For a good summary of these provisions, 

see "Summary of the Tax Reform Act of 1976" (H.R. 10612, 

94th Congress, Public Law 94-455), Joint Committee on Taxation, October 4, 1976. 

13. It must be noted that livestock feeding and breeding, although also preferentially taxed, is unlike the other industries in that its primary preferential tax provision 

is capital gains. Not only are the benefits of capital 

gains taxation not reflected as tax losses, but they are 

not even reported as unincorporated business profits. 

Instead, they are reported on the 1040 return as capit 

gains income, never appearing on Schedules C and E. Thus, 

the .515 gross loss to gross profit ratio for Livestock 

in Table 1 is overstated, for the denominator (gross 

profit) does not even include the income attributable to 

its primary preferential tax provision. The losses shown, 

therefore, are likely to represent genuine economic losses. 

For these reasons, livestock was left out of the analysis. 
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14. For example, accelerated depreciation in real estate varies 

between residential and non-residential buildings, and 

between new and used buildings. The distribution of total 

real estate losses will therefore underestimate the skewness 

of that portion of real estate investment which is most 

preferentially taxed.