THE TAXATION OF INCOME FLOWING THROUGH 

FINANCIAL INSTITUTIONS: GENERAL FRAMEWORK 

AND SUMMARY OF TAX ISSUES 

Thomas Neubig and C. Eugene Steuerle 

U.S. Treasury Department 

OTA Paper 52 September 1983 

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 authors, and 

do not reflect Treasury policy. Comments are invited, but 

OTA Papers should not be quoted without permission from the 

authors. 

Office of Tax Analysis

U.S. Treasury Department, Room 4040 

Washington, D.C. 20220 

Issued: September 1983 
ii 

analyzed. This framework will allow many problems and anomalies 

to be traced to the same roots. While we will not deal with 

every aspect of the tax laws affecting such institutions, we will 

set forth general rules with regard to income flows from such 

transactions-rules which can be applied to all categories of 

f inanc ial institutions . 

A word of caution. Substantial changes in the tax treatment 

of financial institutions can involve large, perhaps undesired, 

changes in relative tax burdens across taxpayers. Moreover, it 

is difficult to provide for changes in the tax treatment of one 

type of institution without simultaneously altering the tax 

treatment of other institutions. It may be both inequitable and 

inefficient, for instance, to eliminate a special tax preference 

or tax penalty levied against one type of institution if similar 

provisions are not eliminated for other competing institutions. 

The very complexity of the laws, however, makes it difficult to 

understand, much less adopt, anything but piecemeal changes. 

While this study provides a general framework or model against 

which the tax laws and proposed changes in those laws can be 

measured, it does not suggest any easy means of attaining greater 

uniformity in the tax treatment of financial institutions. 
THE TAXATION OF INCOME FLOWING THROUGH FINANCIAL INSTITUTIONS: 

GENERAL FRAMEWORK AND SUMMARY OF TAX ISSUES* 

Part 1 

A GENERAL FRAMEWORK OF ANALYSIS 

To analyze income as it flows through financial institutions, 

we will use a general framework which identifies four broad 

classes of issues: the measurement of total economic income, the 

allocation of income among recipients, the attribution of income 

by type of activity, and the timing of income receipt. Section I 

presents an overview of the economic functions and attributes of 

financial institutions. Readers who are familiar with this 

material may choose to proceed directly to the presentation of 

the general framework in section 11. 

I. OVERVIEW OF FINANCIAL INSTITUTIONS AND THEIR SERVICES 

A. Economic Functions and Types of Financial Institutions 

Financial institutions play an extremely important role in 

the modern economy by performing four general economic functions. 

First, they borrow and lend funds, thus creating a secondary 

market between savers and investors. Second, they perform 

brokerage services by facilitating financial transactions 

directly between savers and investors. Third, financial institutions offer insurance and related services, such as pension - management. Finally, financial institutions offer direct 

services, such as financial consulting, record- and safe-keeping, 

* and check clearing. A single financial institution may perform 

any number of these functions. 

* We are indebted to Ralph Bristol, Larry Dildine, Seymour

Fiekowsky, Harry Grubert, Hudson Milner, Andrew Pike,

Ted Sims, and Eric Toder for helpful comments and to 

Eunice Taylor for her assistance in the preparation of 

the manuscript. 
-2-

I n te rmed ia t ion Se r vic e s 

It is in the first economic function of borrowing and lending 

that financial institutions can best be described as intermediaries. In one sense, of course, all financial instruments 

possess an "intermediation effect .I1 IIThrough the intermediation 

of financial instruments the current surpluses of some spending 

units are made available to finance the deficits of other 

spending units." -1/ In the more narrow sense used here, 

however, financial intermediation involves an exchange between 

lenders and borrowers, or savers and investors, which is 

facilitated through the creation of new assets and liabilities 

by the financial institution itself. Typically, the financial 

intermediary arranges the exchange of assets and liabilities 

between lenders and borrowers without requiring the liabilities 

Oof borrowers to be purchased directly by lenders. Each lender 

acquires an asset of the financial institution, while each 

borrower incurs a liability to that institution. The institution 

in turn holds both an asset (the debt of the borrower) and a 

liability (the asset of the lender). The financial institution 

generally covers some or all of its costs, as well as earns a 

profit, through arbitrage between the rates of return paid to 

lenders and the rates of payment made by borrowers. 

Few financial transactions are conducted solely between an 

individual lender and borrower. -2/ Typically, borrowers are 

unable to find an individual lender who would propose terms of a 

contract that are better than those offered by a financial 

institution. A financial institution in its role as an intermediary can create new securities or obligations with different 

characteristics, such as siie of the loan or deposit, maturity, 

repayment schedule, or riskiness. In this way, financial 

institutions increase the opportunity set available to both 

-1/ Basil J. Moore, An Introduction to the Theory of Finance 

(New York: The Free Press, 1968), p. 17. 

-_ 

.w 

hY 

-2/ Paul F. Smith, Economics of Financial Institutions and 

Markets (Homewood, Illinois: Richard D. Irwin, Inc ., 

1971), p. 64. 

c 
-3-

lenders and borrowers. The economic function of intermediation 

has been described as "a transformation process within the 

financial markets between the asset and liability sides of the 

public's balance sheet." -3/ 

Broke rage Services 

As a broker or dealer, a financial institution performs a 

function somewhat similar to that of an intermediary. -4/ In both 

cases, it arranges an exchange of assets and liabilities among 

economic actors. A broker or dealer, however, may not participate directly in the financial transaction, but simply bring 

together savers and investors (or lenders and borrowers) for a 

fee or commission. To facilitate the process, the dealer may 

actually purchase a security or liability (or, more likely, a 

block of securities or liabilities) from one party and then 

resell that same security in the market for a price slightly 

higher than that at which it was purchased. 

In one type of transaction it is especially difficult to 

distinguish between the role of financial broker and that of 

financial intermediary. The security or obligation issued by a 

financial institution may be matched against or tied to a given 

set of equity or debt obligations which have been purchased by or 

made available to the institution. Mutual funds, for instance, 

ascribe to each shareholder a partial ownership of the pool of 

financial assets that it holds. The institution's role is closer 

to that of a conduit or broker than that of an arbitrager or 

intermediary. Nonetheless, it issues a security or obligation of 

its own and does not simply transfer the assets purchased 

directly to the lenders or savers. 

-3/ Board of Governors of the Federal Reserve System,

Introduction to Flow of Funds, June 1980, p. 6. 

-4/ Smith, Economics of Financial Institutions and Markets, 

p. 64. 
-4-

Insurance Services 

The third function performed by many financial institutions 

is that of insurance. An insurer accepts conditional liabilities 

and incurs liabilities when certain specified conditions are met. 

It is the probabilistic nature of these conditions that causes 

the obligation to be labeled insurance. Strictly speaking, the 

insurance function can be one purely of service, not intermediation. Indeed, if the conditional liabilities are paid contemporaneously with the receipt of premiums, and if the total payout 

relative to premiums is established with certainty, the insurer 

may be viewed merely as the paid dealer of a card game. Each 

participant in that game has an _.-

ex ante expected return equal to 

his contribution to the pot, less the dealer's percentage. Ex 

post, each participant receives a greater or lesser share (often 

zero). It is likely, however, that the total payout relative to 

premiums will not have a certain value. In that case, it would 

be more correct to view the insurer as the house in a roulette 

wheel game rather than as a non-playing dealer in a card game. 

Such conditional liabilities make it prudent for insurers to 

maintain reserves in order to pay claims under almost all 

circumstances or contingencies. 

Note that the insurer does not necessarily play the role of 

intermediary between savers and investors. -5/ If term insurance 

were available for one day at a time, for instance, the insurer 

could technically transfer total premiums less fees to "winners" 

without separately depositing those premiums into income-bearing 

accounts. This example is so extreme, however, that it becomes 

obvious why insurers typically also serve as financial intermediaries. Even for term insurance, there is a lapse of time 

between when premiums are paid and when insurance amounts are 

returned. 

-5/ Ibid, p. 90. 
-5-

During this lapse of time, premium payments of individuals 

are converted into income-bearing financial assets which in turn 

are used to meet future contingent liabilities of the insurer. 

The return to the policyholder of the income on those assets may 

take the form of a lower price paid for the insurance. In the 

case of pensions especially, premiums are held for long periods 

of time to cover contingent liabilities far in the future. It is 

often quite difficult to separate funds devoted to this insurance 

function from those devoted to the strict intermediation 

function. It is equally difficult to apportion ownership of 

reserves, and income returns from those reserves, between the 

insurer and those insured. 

Other Financial Services 

Finally, a financial institution may offer a variety of 

direct financial services such as consulting, record- and 

safe-keeping, check clearing, credit card services, etc. 

Although these services may theoretically be separated from other 

functions such as intermediation, in practice the functions are 

almost always tied together. Many financial institutions do not 

charge separately for the time of their staff or the amount of 

operation costs incurred for each customer transaction. Instead 

those costs are often paid by the customer when he accepts a rate 

of return lower than he might receive on depositing his savings 

elsewhere. Even in dealings with brokers, charges are seldom 

based on the actual costs or actual time spent by the broker, but 

are subsumed into a fee which is related to the size or amount of 

the actual transaction. Certainly the failure to establish more 

elaborate cost functions and mechanisms for charging customers 

can be viewed as a realistic means of economizing on administrative costs. Separate itemization of each transaction cost 

could become enormously expensive because it would entail 

substantial efforts to measure, record, and store many items of 

information. The tax system also encourages the vertical 
-6-

integration of financial services because of the particular way 

in which income net of transactions costs and certain service 

costs are reported to the customer. 

Types of Financial Institutions 

Financial institutions are typically defined by the 

economic function which they emphasize. In the past, government 

laws and regulations have accentuated differences among institutions by limiting certain overlaps of functions. The GlassSteagall Banking Act of 1933, for instance, denies commercial 

banks the opportunity to offer investment banking as a service. 

The tax laws may also place special penalties on institutions 

which diversify. As an example, savings and loan associations 

may lose the advantage of special loss deductions when they 

reduce the percentage of their assets held in residential 

mortgages. 

Recent trends toward expansion and diversification of 

services have narrowed substantially the differences among types 

of financial institutions. Deregulation has further accelerated 

these trends. Today a brokerage house may offer not only 

brokerage services, but checking accounts, credit cards, 

insurance and pension services as well. Investment annuities and 

variable life insurance are packaged by a variety of sellers and 

are often sold more as investment vehicles than as life insurance 

or pension guarantees. A typical means of accomplishing diversification is to subcontract out those particular transactions that 

are disallowed to the financial institution per se. In some 

cases, it is possible to create a "subcontractor" which is simply 

another financial institution within the same group or holding 

company of institutions. 
-7-

The main financial institutions considered in this study, 

separated according to traditional definitions, g/ include: 

Insurance Institutions 

- Legal reserve life insurance companies 

- Property and liability insurance companies 

Depo sit Inst itut ion s 

- Commercial banks 

- Thrift institutions 

Mutual savings banks 

Savings and loan associations 

Credit unions 

Investment Institutions 

- Investment companies, mutual funds and real 

estate investment trusts 

B. Special Attributes or Characteristics of Financial 

Institutions 

Financial institutions exist because they per form certain 

economic functions that other enterprises or individuals could 

not do as well. Specialization has resulted in the acquisition 

by financial institutions of various attributes or 

characteristics that allow them to perform their functions 

efficiently . These attr ibukes include diver si f ication of their 

asset portfolios, pooling of conditional liabilities, economies 

of scale, and financial expertise. Although these attributes are 

not unique to financial institutions, the combination of 

attributes enables these institutions to be especially adept at 

per forming their economic functions. 

-6/ Herbert E. Dougall and Jack E. Goumnitz, Capital Markets and 

Institutions, 3rd edition (Englewood Cliffs, New Jersey:

Prentice-Hall, Inc., 1975), p. 13. 
-- 

-8-

Diversification of Asset Portfolios 

Perhaps the most common characteristic of financial 

institutions is the diversification of assets. I/ Through 

diversification, institutions can offer savers a higher rate of 

return for a given level of risk. Risk reduction is possible 

whenever the returns on two or more assets are uncorrelated or 

correlated less than 100 percent. Then the overall risk of a 

portfolio containing two or more assets is less than the risk 

associated with each of the assets by itself. 8J 

Financial institutions are able to offer services, such as 

lending and insurance, that would be severely limited if 

individuals tried to finance investments or insure against risks 

themselves or directly with other individuals. For instance, 

pooling investments through deposits or shares in financial 

institutions enables savers to invest in securities with large 

face amounts (and higher yields) than they otherwise could 

obtain. Similarly, pooling investments increases the liquidity 

for a single saver even when the institution is holding primarily 

long-term assets. -9/ As long as the institution can expect 

inflows of funds to match outflows, it can borrow short term, 

while lending long term. Of course, the advantages of using 

financial institutions lie not just with the savers. By pooling 

investments, financial intermediaries reduce the risk premium 

they charge for lending funds as well. 

-7/ E. J. Kane and S. J. Buser, "Portfolio Diversification of 

Commercial Banks," Journal of Finance, 34 (March 1979) , 

pp. 19-34. 

-8/ H. M. Markowitz, "Portfolio Selection," Journal of Finance, 

7 (March 1952), pp. 77-91 and W. F. Sharpe, Portfolio Theory

and Capital Markets (New York: McGraw-Hill, 1970) 

-9/ Smith, op. cit., p. 65. 

.I 
-9-

The advantages to savers and borrowers works through to the 

economy as a whole. The presence of financial institutions 

broadens the forms of financial investment and credit, and should 

result in higher levels of output, savings, investment and 

consumption in the economy. 10/ At any given expected rate of 

return, risk to the saver is reduced. At any given level of 

risk, therefore, institutions can offer savers a higher rate Of 

return and borrowers a lower rate of payment than would be 

required if the assets and liabilities were not pooled. The 

higher rate of return offered to savers for a given level of 

risk in turn may increase the amount of savings in the economy. 

At the same time, increased efficiency in capital markets due to 

financial intermediation, as well as any additional savings 

generated, reduces the cost of financing physical investment. 

Pooling of Conditional Liabilities 

Similar to diversification of investments, the pooling of 

conditional liabilities can reduce the cost of providing 

insurance or pensions. The law of large numbers insures that a 

conditional event will occur with more predictability--that is, 

with less deviation around the percentage of times it is expected 

to occur--the greater the number of policyholders insured against 

similar, but independent, -11/ conditional events. Thus, 

insurance companies generally can reduce the risk associated with 

any single insurance policy simply by offering insurance to a 

larger number of policyholders. By increasing the number of 

conditional liabilities, a financial institution can more 

accurately predict the amount of liabilities that it will pay 

relative to premiums it will receive. A financial institution 

-10/ Federal Reserve Board, Introduction to Flow of Funds, p.7. 

-11/ Independence of events is crucial. Many insurance 

companies, for instance, will not insure against death 

caused by war since the deaths of many policyholders would 

then be dependent upon the same event. 
-10-

requires fewer liquid reserves to meet conditional liabilities 

when expected outflows can be predicted with greater certainty. 

Each insurer can then invest in higher-yielding (more risky) 

assets, which in turn makes it possible to reduce the cost of 

providing insurance or to increase the return on the savings 

component of insurance policies. 

Economies of Scale 

Due to economies of scale, financial intermediaries have 

lower search and information costs than do individuals and most 

non-financial institutions. -12/ Such economies increase the net 

interest rate that can be offered to savers and lower the net 

interest rate that can be charged to borrowers. Check clearing, 

investment analysis, and portfolio trading are activities which 

financial intermediaries generally perform at significantly lower 

costs than individual investors. Economies of scale are of 

course not unique to financial institutions. Just as other 

businesses achieve scale economies in providing goods and 

services, financial institutions survive in a competitive economy 

by providing financial services at the lowest available cost. 

Note, however, that costs are typically not minimized at infinite 

or monopoly size; diseconomies of scale may set in when a firm 

becomes too large. 

Financial Expertise 

Individuals working for financial institutions develop 

financial expertise through the transactions they handle each 

day. Expertise acquired in handling one type of financial 

transaction may easily be transferred to other types of financial 

arrangements. While for some institutions the selling of its 

expertise may be the primary financial service that it performs, 

for others this expertise is applied to a variety of functions. 

-12/ G. J. Benston, "Economies of Scale in Financial 

Institutions," Journal of Money, Credit and Banking, 

4 (May 1982). 
-11-

Financial expertise also complements each of the other characteristics or attributes associated with financial institutions. 

For instance, optimal diversification, pooling and scale 

economies are reached through expert understanding of financial 

markets . 

11. LAYING THE FRAMEWORK 

In many ways, the general economic functions of different 

financial institutions, as well as their attributes, are quite 

similar. We now develop a general framework with which to 

analyze how these economic functions relate to (1) the calculation of total economic income associated with transactions 

involving financial institutions; (2) the allocation of income 

among recipients; (3) the attribution of income by type of 

activity; and (4) the timing of receipt of income. This 

framework is extremely important to the analysis of taxation of 

financial institutions because practically all problems of 

taxation can be related to the accounting or attribution of 

income according to these four categories. 

The columns of Table 1.1 present a simplified breakdown of 

the return to each economic actor for most types of transactions 

taking place through financial institutions. Although a wide 

variety of economic actors are involved in transactions with 

financial institutions, the various income recipients can 

typically be categorized into one of four groups. Depositors, 

pensioners, and policyholders who provide funds through a 

contractual obligation are called creditors (savers/lenders) . Others who provide funds with a claim to the residual income of 

the enterprise are called stockholders (equity owners). The 

economic functions performed by financial institutions also 

require payments to other factors of production, such as to labor 

and rentors or lessors of physical capital. Finally, the 

ultimate users of capital or services provided by financial 
. 

-12-

Table 1.1 

Expected Return to Recipients by Type of Activity

for Income Flowing Through Financial Institutions 

Total Income to Economic Actors

Suppliers of Factors . . . Employed by Financial . . Institutions : Ultimate : 

. :Other : Users : Total Return 

: Equity :Factor: or or Value 

Type of Activity :Creditors: Owners :Owners: Investors : of Product 

In te rmed ia t ion 

( Investment ) il i I -il-c c1 r-i' r 

Other Non-In te rmediation Servic'es i2 p- i2-~ c2 0 P 

Combination of 

Intermediation and 

Other Services i3 i'-i3+p-c3 c3 r-i' r+P 

r is the expected return from the investment or implicit 

return from consumption financed with loans; 

i' is the market interest charged to borrowers by the 

financial institutions; 

il is the interest paid at the market rate to creditors 

(lenders) by the financial institutions for the production

of income from intermediation; 

i2 is the interest paid at the market rate to creditors by the 

financial institution for the production of income from other 

non-in termed iat ion services ; 

i3 is the total interest paid to creditors in the provision

of both investment and other services; 

p is the market price of providing the services of the financial 

institution to the customer; 

c1 is the cost paid (wages, rent) to other factors in the production of intermediation services by the financial institution; 

c2 is the cost paid to other factors in the production of other 

service income by the financial institution;

c3 is the total cost paid to other factors in the provision of 

intermediation and other services. 
-- 

-- 

-13-

institutions are investors (businesses) who use the loans to 

purchase physical assets or other securities, and individuals who 

borrow for consumption or to finance purchases of durable goods 

and housing. 

For purposes of our framework, the main types of activities 

performed by financial institutions can be classified generally 

as financial intermediation or investment services, and 

non-intermediation services. If the non-intermediation service 

provides direct benefits to consumers, then it adds to total 

final value of goods and services or income in the economy. If 

the service is purchased by a business, then it is more likely 

to be an intermediate product and not add to income directly. 13/ 

Non-intermediation services in the second row of Table 1.1 are 

assumed to be of the former type. 

Pure intermediation in this simplified model. involves only 

monetary transactions in which the institution facilitates the 

exchange of funds while earning an arbitrage profit for 

performing one or more of the forms of intermediation. The 

arbitrage profit may be due to its own stock of physical capital 

such as buildings or human capital such as expertise. As shown 

in the first row of Table 1.1, the financial intermediary borrows 

funds from creditors at an interest rate, il, and lends the funds 

at a higher interest rate, i'. Creditors earn a rate of return 

per dollar, il; the equity owners earn a return, i'-i l-cl: other 

factors employed by the financial institution to perform 

intermediation earn a return, cl; and the ultimate user (the 

business) expects to earn a return of r-i', where r is the 

13/ In national income accounting, the distinction between final 

and intermediate financial services is not always easy 

to make. 
-14-

return, explicit or implicit, from the physical investment or 

other use financed with the loan. Note that the total return in 

the economy equals r and is irrespective of its division between 

the various income recipients. Indeed, in national income 

accounting, the total return to capital is equal to the net 

payment (net of depreciation of capital) made to all capital 

owners--regardless of the breakdown by type of recipient, e.g. 

creditors such as depositors in financial intermediaries vs. 

equity owners. 

Non-intermediation services involve the production of 

particular "commodities1' such as term insurance or check cashing. 

In the second row of the above diagram, a consumer purchases a 

service from a financial institution at the market price, p. 

Other factors employed by the financial institution in rendering 

the service earn a return, c2; the equity owners earn a return, 

p-c2; and the ultimate user (the consumer) earns no income (or 

return) from the product, but does receive the product valued at 

the market price, p. Note that the total return in the economy 

is equal to the value of the product when the service is 

considered to be final rather than intermediate. 

A. -Measurement of Total Economic Income 

As income flows through financial institutions, a first set 

of accounting problems arise simply in accounting for all income. 

For our purposes it will be useful to divide these measurement 

problems into five categories. First, in the case of intermediation, much income flows outside of the institution to 

creditors and others. Total income flowing through or out of the 

financial institution should be allocated in one way or another 

to all employed factors. If the equity owners of the institution 

deduct il plus c1 as payments to other factor owners, then it 

would be inconsistent for these other factor owners to count any 
-15-

more or less than il plus c1 as their actual income. There are 

few problems with measuring c1 since it is comprised principally 

of wage payments. It is in the simple recognition of il, 

especially when payments are made only indirectly to creditors, 

that many difficulties appear. 

Our next two categories of problems arise in separating the 

income flows to individual owners of capital from other payments 

passing out of the financial institutions. Cash payments may 

differ from income if some payments represent returns of capital 

or other forms of rebate which are unrelated to the actual income 

earned on the capital. Because of the inherent complexity of 

two related isssues--measuring investment income net of services 

and separating income from returns of capital--they are discussed 

further below. 

The last two categories involve measurement of income at the 

level of the institution. If the company does not recognize 

receipts as they flow in, then total income will be mismeasured 

no matter how it is later allocated. Similarly, if the company 

takes deductions which are unrelated to actual expenses or 

otherwise subtracts dollar amounts which are not paid out to 

creditors or other factors, then its income will be understated. 

Investment Income Net of Service Costs 

To account for income properly, the cost of earning 

investment income should be deducted at both the individual and 

company level. The net return, not the gross return, to 

investment is what is to be measured. I-f a financial institution 

provides a joint product of investment and non-intermediation 

services, on the other hand, economic income may be mismeasured 

if the cost of those services are also deducted from the 

investment income of the individual. 

. 
-16-

When any type of service is performed by a financial 

institution handling investment, then the cost of that service is 

typically excluded from the measure of investment income itself, 

which is reported on a net basis. If the services are performed 

separately from the investment, however, then the investment 

income is reported on a gross basis and the cost of the services 

may or may not be separately deductible. If financial services 

do not represent a cost of making investments or doing business, 

but rather provide a value to the individual independent of the 

investment income, then investment income will be understated 

when the value of the services are deducted. 

Two examples may clarify this situation. First, if a 

financial institution provides personal insurance in lieu of 

payments of interest on deposits yet the cost of those insurance 

services is not added to net investment income, then total income 

of the depositors will be measured incorrectly. 

Second, commercial banks often offer "free" checking accounts 

to some depositors even though they may charge a fee to less 

regular depositors for the same service. Depositors implicitly 

receive the market interest income, i2, on their deposits, while 

banks implicitly collect a fee, p, for providing the service by 

paying interest rates on checking deposits lower than rates on 

other savings deposits. In such cases of combined investment and 

services (see the third row of Table l.l), separating the income 

from investment from the value of services may be difficult if 

the price, p, is never explicitly stated. Similarly, attempts to 

distinguish between investment income and the value of the final 

services rendered to the depositor or policyholder may require an 

implicit or explicit attribution of total expenses, c3, between 

the two activities. 
-17-

Separation of Income from Returns of Capital 

At the individual level, it should be clear that total income 

does not include all payments received. In our roulette wheel 

analogy of insurance, the premium payments (or bets) are made out 

of income already counted. The returns on those bets do not add 

to income, but rather represent a redistribution of income. 

After accounting for this redistributional effect, the additional 

net income simply equals the return to the house for operating 

the roulette wheel. Similarly, income generated in the provision 

of pure insurance equals the cost of paying factors for that 

service. Policyholders as a group are willing to receive total 

insurance payments less than total premiums paid because the 

difference represents the value of service received. If the 

house (or insurance company) adds an investment policy which 

allows prepayment of future insurance costs, then the investment 

return on those savings also represent an addition to economic 

income. 

In addition to redistribution, the measurement of total 

income is complicated by payments to income recipients which 

include other returns of capital or price rebates. In the case 

of depository institutions, distributions to the depositor can 

include both a return of capital (the initial deposit) and the 

investment income earned on the deposit. Return of capital can 

also include a price rebate on a service. Some insurance 

companies, for instance, charge annual premiums in excess of 

expected liabilities with the prospect of giving the policyholders a "dividend" at the end of the year. The company invests 

the excess funds during the year and earns a return on the 

investments. The "dividends" paid to policyholders can therefore 

represent payments of investment income, price rebates on 

services rendered, and returns of excess premiums from prior 

years. 
-18-

Accurate measurement of these various types of income 

requires differentiation between investment income and return of 

capital. Such distinctions, while difficult to make, nonetheless 

are necessary for the correct measurement of income. 

B. Allocation of Income Among Recipients 

Even when accounting for total income is accurate, problems 

may arise in allocating that income among various recipients. 

We have separated these recipients into the following groups: 

creditors (depositors, policyholders), stockholders (equity 

owners), owners of other factors of production (labor, physical 

capital) and ultimate users of capital or services (investors and 

final consumers of services). 

Allocation problems are most acute when individuals perform 

several of these roles together. Some financial institutions are 

formed as "mutual institutions" in which no equity owners exist 

apart from the depositors or policyholders of the institution. 

In terms of Table 1.1, investment income to a mutual depositor 

would include the income of the creditor and the equity owner 

(il-cl). A mutual insurance policyholder could receive income as 

creditor (i2) and as "equity" owner (p-i2-c2), as well as receive 

and pay for the service rendered to the ultimate user. Another 

example is provided by the equity investor in a business who 

provides the savings for a particular investment directly without 

intermediation. In terms of Table 1.I, the self-financed 

investor plays the roles of creditor, equity owner, financial 

intermediary and investor together and earns the total return, r. 

Distinctions by type of income recipient may be difficult to 

make. Attribution of income between creditors and equity owners 

in many instances involve arbitrary division of a single 
-19-

individual's income. Because the tax system differentiates 

between types of income recipients, such distinctions are 

important to the allocation of resources in the economy and 

the distribution of tax burdens. 

Finally, even if allocation between groups can be made 

correctly, it is still difficult to attribute income accurately 

within groups, especially when individuals pool funds and 

maintain uncertain shares of returns from the pool. In the case 

of insurance, allocation among policyholders could involve 

distribution of costs, estimates of individual insurance rights 

and similar calculations. 

C. Attribution of Income by Type of Activity 

When income has to be allocated by type of activity, a third 

set of accounting problems may arise. In the first two rows of 

Table 1.1 it is assumed that intermediation services can be 

separated easily from other services performed by the same 

financial institution. While in theory the two functions can be 

separated: in practice, intermediation always involves some level 

of other service and vice-versa. The third row of Table 1.1 

assumes that both intermediation services and final services are 

provided by the financial institution, and that the total return 

to the former equals r, and to the latter, p. 

At the company level, there are two types of attribution 

problems. Payments by creditors, policyholders and other contributors of receipts may not be separated neatly into piles designating what portion is to be applied to what activity. For 

equity owners total income equals i'-i3+p-c3. Payments by 

depositors or policyholders, however, may not be separated into 

i' and p. By the same token, many of the costs of running the 

institution, such as building maintenance, managers' salaries, 

and equipment purchases are paid out (as c3) without necessarily 

being allocated among the various types of activities. 
-20-

The second type of attribution problem is less obvious from 

the table. Sometimes accounting rules will be made to differ 

across institutions according to their dominant activities. 

Insurance companies, for instance, may account for certain costs 

or loading expenses (the c2 component of c3) in one way, while 

that accounting procedure is denied to a depository institution 

for the insurance that it sells. If the accounting for income 

varies not just by activity, but by the dominant activity of the 

institution as well, then the total division of economic income 

will vary in strange ways often unrelated to the marginal 

activity of the firm. 

D. Timingof Income Receipt 

In many cases, future events will affect the amount of income 

a firm or individual will eventually receive from current 

activity. For a firm in existence more than one year, the number 

of such future contingencies is almost infinite. A firm may 

expect future increases in income from current activity if that 

activity creates goodwill, educates consumers, or involves 

research and development. Similarly, a firm may expect losses or 

future costs if some of its customers fail to pay debts, the 

product of the firm has some probability of failure (and there is 

a cost associated with such failure), or the firm promises to 

make payments in the case of other contingencies. Bad debt 

losses, warranty costs, and payment of insurance proceeds are 

examples of each of these types of costs. 

In accounting for the effect of future events on income, 

three rules generally, but not always, apply. First, future 

events are not allowed to offset current income unless they are 

due to current or past activities. Current income is not meant 

to reflect the income from future operations (although on 

occasion it may involve a catch-up or a re-accounting of past 

income). As an example, in accounting for today's income, 
-21-

current wages are deducted, but wages that will be paid to produce 

tomorrow's product, even if they are guaranteed, are not deductible 

until they are paid. 

Second, while expected losses or future liabilities are 

sometimes allowed to offset current income, expected future gains 

are almost never added to current income. This practice results 

from a long-standing tendency toward conservative financial 

accounting, although this bias is certainly reinforced by tax 

incentives to recognize losses as soon as possible, while deferring 

gains into the future. -14/ 

Third, if future losses or liabilities are allowed to offset 

current income, proper income measurement requires that only the 

present value of the expected losses can be deducted. When losses 

are variable, prudent management may require the maintenance of 

reserves in excess of expected needs, but the income will clearly be 

mismeasured if the amount of income deductions exceeds the present 

value of the expected loss or liability. 

Methods of Accounting for Future Liabilities 

Future liabilities are properly accounted for by one of three 

methods: the cash method of self-insurance, the cooperative 

insurance method, and the qualified reserve method. With selfinsurance under the cash method, a business recognizes future 

liabilities when they occur. This approach has the advantage of 

accurately accounting for all receipts and payments without imputing 

amounts that are difficult to calculate and verify. Moreover, it is 

consistent with the treatment of receipts since future expected 

receipts (e.g. from advertising or goodwill) are almost never 

-14/ This practice is not confined to present value accounting

of future events. In accounting for gains and losses on 

assets, estimates of unrealized capital losses are allowed 

for depreciable assets, but estimates of unrealized capital

gains are almost never added to income. See Eugene

Steuerle, "Adjusting Depreciations for Price Changes ,I1 Office 

of Tax Analysis Paper No. 37, Department of the Treasury,

March, 1979. 
-22-

counted in income currently, even if due to current activity. The 

cash method may actually involve setting aside specific assets in 

reserve to meet future contingencies, although the total assets of 

the firm may suffice as such reserves. However, no deduction is 

taken against current income for the maintenance of reserve assets. 

For our purposes, any such reserves will be referred to as 

nonqualified reserves. 

The most direct method of accounting currently for future 

liabilities or losses is for the firm to purchase insurance. 

Businesses and individuals thereby contribute to a common pool of 

funds for future losses. Under the cooperative insurance method, 

the insurance costs are deducted currently: moreover, these 

deductions measure accurately the cost to the firm of covering 

insured liabilities or losses resulting from current operations. 

Typically, when the future losses occur, the deduction for losses 

will be offset by the receipt of the insurance proceeds, with no net 

change in income in the year of the loss. Self-insurance against 

moderate losses, of course, may be more economical than cooperative 

insurance if the firm could earn a higher return on its own assets 

held in reserve or avoid administrative costs associated with 

cooperative insurance. -15/ 

Alternatively, a firm is sometimes allowed to recognize annually 

future liabilities resulting from current activities under the 

qualified reserve method. If a firm self-insures, yet accounts for 

future liabilities currently rather than using the cash method, it 

would treat additions to a qualified reserve account as a current 

expense. Future liabilities or losses are covered by withdrawals 

from the reserve assets. The drawdown of qualified reserves creates 

an offsetting income item to the expense charged for the year, 

except to the extent that loss payments exceed total reserves. -

16/

-15/ Seymour Fiekowsky, "Self-Insurance: Economics and Tax 

Treatment," mimeo, March, 1978, p. 6. 

-16/ In practice, reserve funds are often treated only as an 

accounting construct, and the reserves are commingled with 

the enterprise's other assets. A prudently managed firm, 

however, will at least regard reserves as a severable part

of its assets. 
-23-

This approach has the advantage of averaging several years' 

fluctuations in contingent liabilities incurred. In some cases, 

current recognition may provide a more accurate picture of the 

long-run position of the firm and of its expected net income from 

current operations. 

Reserve funds are not unique to financial institutions, but are 

used by many businesses to meet contingent liabilities such as 

product claims, bad debt losses, and other expected or unexpected 

losses. While reserve funds are often used to handle future 

liabilities, there is no necessary relationship between additions 

to reserves and deductions from current income. Nonqualified 

reserve funds or liquid assets are often maintained by firms to 

take care of expected future liabilities and losses even when 

there is not a current deduction for increases in those reserves 

or assets. Moreover, most firms will maintain reserves or liquid 

assets as a means of providing insurance against unexpected, as 

well as expected, losses or liabilities. 

If the amount of future liability or loss is known with 

certainty, the amount of reserve necessary to cover those 

liabilities can also be established with certainty if the 

business is willing to buy assets with rates of return that are 

certain to the date at which the liability must be paid. If 

the amount of liability is not known with certainty--the usual 

case in which insurance is offered--then the amount of reserve 

necessary to cover the liability will depend upon the expected 

value of the future liability. Similarly, if the rate of return 

on reserve assets is variable, then the amount of reserves will 

also depend upon the expected return on the assets. 

Equivalence of Qualified Reserve Method with Other Methods 

-of Accounting for Future Liabilities or Losses 

In present value terms and in the absence of an income tax, 

the qualified reserve method can be equivalent to the other 

methods of accounting for future contingencies if two accounting 
-24-

rules are followed. First, all income on assets held in 

qualified reserves must be counted as income when earned. 

Second, all withdrawals from qualified reserves must be counted 

in income. Excess (or shortfalls in) qualified reserves must be 

eventually withdrawn and counted in income (or as deductions). 

Inclusions of the withdrawal may be wholly or partially offset by 

a deduction for the payment of liabilities or losses incurred. 

If withdrawals are not used for those contingencies for which the 

fund was established, however, there may be no offset. 

Even if these strict accounting rules for reserves are 

followed, the annual accounting may still be inaccurate unless 

a third rule is applied: additions to qualified reserves are 

calculated on the basis of reasonable expectations of the future 

contingencies. lJ For instance, if the reserve account is 

funded based on a conservative assumption regarding the interest 

rate or the extent of th.e expected liabilities, then annual 

income will be underestimated when the reserve fund is being 

built up and overestimated when the reserve fund is depleted. 

At a minimum, qualified reserve funds should be accounted for 

separately from the sel f-insurers' other assets. 

Table 1.2 illustrates differences in reserve accounting 

according to whether future liabilities or losses and the return 

on reserves are estimated correctly. In example 1, reliable 

estimates are made. The firm expects to have future liabilities 

of $50 in the second and fourth years and to earn a 10 percent 

return on its assets. Additions to reserves are set equal to 

the present value of expected future liabilities, which is 

$75.47. -18/ The reserves are depleted when no further liabili­

-17/ No limit, however, is required for the amount of assets 

set aside in non-qualified reserves to meet self-imposed 

or government- impo sed requirements . -18/ Additions to reserves are assumed to be made at the 

beginning of the year and claims are paid at the end 

of the year. 
-- 

-- -- 

-- -- 

-- 

--- 

-- 

-- -- 

-- -- 

-- -- 

-25-

Table 1.2 

Reserve Rccounthg for ~scpedted Future Liabilitieswith Reliable and Incorrect Estimates 

Re1 iable Estimates 

~ncome 

: Additions : Estimate : Actual : Losses _I-

: Reserve Balance ­ Year : to Reserves :(i=10 .O%) :(i=10.O%) :Estimated:Actual:Estimated:Actual 

$75.47 $7.55 $7.55 $ O $ 0 $8 3.02 $8 3.02 

0 8.30 8.30 50.00 50.00 41.32 41.32 

0 4.13 4.13 0 0 45.45 45.45 

0 4.55 4.55 50.00 50.00 0 0 

Total 

Pr es en t 

va 1ue $75.47 $75.47 $75.47 $ O $ 0 

Example 2 

p---__--I-- Excess Reserves Due to Overestimate of Future Losses --_ 

Income 

: Additions : Estimate : Actual : Losses :Reserve Balance 

Year :to Reserves: (i=10 .O%) :(i=lO .O%) :Estimated:ActuaT:Estimated:Actual 

$9 0.57 $9.06 $9.06 $ 0 $ 0 $99.63 $99.63 

0 9.96 9.96 60.00 50.00 49.59 59.59 

0 4.96 5.96 0 0 54.55 65.55 

0 5.45 6.56 60.00 50.00 0 22.11 

To ta 1 

Present 

Va 1ue $90.57 $90.57 $75.47 $ 0 $15.10 

Example 3 

--_- I 

:

-Excess Reserves Due to Underestimate of Return on Reserves 

Income 

: Additions .~ : Estimate : Actual : Losses :Reserve Balance

Year :to Reserves: (i=5.O%) :(i=10 .O%) :Estimated:Actuai:Estimated:Actual 

$86.49 $4.32 $8.65 $ O $ 0 $90.81 $95.14 

0 4.55 9.51 50.00 50.00 45.36 54.65 

0 2.26 5.47 0 0 47.62 60.12 

0 2. 38 6.01 50.00 50.00 0 16.13 

To ta 1 

Present 

Va 1ue $86.49 $75.47 $75.47 $ 0 $11.02 

----I-­ * Additions to reserves are a ssum ed to be made at the beginning of 

the year while claims are paid at the end of the year. 
-26-

ties are expected. The value of correctly estimated additions to 

reserves is equivalent in present value terms to the cost of the 

self-insuring firm using the cash method, where $50 is paid out 

directly in the second and fourth years to cover the actual 

losses. Additions to reserves are also equivalent to the cost of 

cooperative insurance if the insurer charges $75.47 in premiums 

and invests in assets earning the same rate of return. 

Mismeasurement of annual income can result if the magnitude 

of loss, probability of occurrence, or the return on reserve 

investments is not accurately predicted. In example 2, future 

losses are overestimated. The firm expects the present value of 

future liabilities to be $90.57, but the present value of those 

losses is only $75.47. At the end of the fourth year, the firm 

has $22.11 remaining in its reserve with no additional expected 

liabilities. It should be noted that the difference between the 

present values of expected and actual losses ($90.57 - $75.47) 

equals the present value of the reserve balance, or $15.10. 

Thus, depletion of the excess reserves and its inclusion in 

income at the end of the fourth year (the second rule) would 

exactly compensate in present value terms for the prior excess 

deduction and resulting underestimate of income. 

Example 3 illustrates the annual mismeasurement of income 

when the return on reserve assets underestimated. The firm adds 

$86.49 to reserves, operating under the assumption that the rate 

of return on the reserve assets will be 5 percent. If the actual 

return is 10 percent, the firm will have a reserve balance of 

$16.13 at the end of the fourth year with no future liabilities. 

Again, the present value of the excess reserves equals the 

present value of the excess deductions. 

The problem of accounting for future liabilities sometimes 

interacts with the two other major classes of accounting problems 

of allocation among income recipients and by type of activity. 
-27-

For instance, when reserves of a financial institution are held 

for long periods of time, and additions to reserves have been 

found to be in excess of the amounts necessary to cover actual 

losses, the excess income (reserve balance) may technically need 

to be allocated back to prior income recipients, including 

individuals no longer engaged in transactions with the institution. Such attribution of income among numerous current and 

past income recipients, of course, would be quite difficult. 

In summary, in present value terms, the measurement of income 

involving expected future liabilities or losses can be accomplished by three equivalent methods--the cash method, the 

cooperative insurance method, or the qualified reserve method. 

Accurate qualified reserve accounting requires three additional 

specific accounting rules since it is based upon imputations or 

estimates of costs, not actual costs. First, income earned on 

reserve assets must be included in income in the current year. 

Second, all withdrawals of qualified reserves, including periodic 

withdrawals of excess reserve, must also be included in income. 

Finally, annual income will be mismeasured unless calculation of 

additions to qualified reserves are based on reasonable 

expectations of the future contingencies for the particular 

assets or liabilities of the individual financial institution. If any of these rules is not followed, income from 

transactions involving future expected liabilities or losses is 

likely to be mismeasured with the qualified reserve method. 
Part 2 

SUMMARY OF THE TAX ISSUES 

Having developed a general framework with which to measure 

and attribute economic income resulting from transactions 

involving financial institutions, we can turn to the issue of 

taxation. The method of measurement or attribution of income now 

becomes more than simply an academic question; the amount of 

taxes paid will be directly related to the measure of reported 

taxable income. Measurement of income subject to tax affects the 

allocation of the economy's resources, the distribution of tax 

burdens, and the efficiency, if not the level, of savings and 

investment. Incorrect measurement or attribution can result in 

differential rates of effective taxation across activities of 

equal merit, thereby creating a number of distortions in the way 

our economy operates. 

The number of specific tax issues which arise because of the 

provisions of the Tax Code are almost innumerable. To gain a 

general understanding of these issues and why they arise, we must 

first integrate taxation into our general framework. Many issues 

or problems of particular financial institutions can then be 

explained by simple reference back to this integrated framework. 

The paper concludes with a summary of general rules for the tax 

treatment of income flowing through financial institutions. 

I. ISSUES RELATED TO THE MEASUREMENT OF TOTAL TAXABLE INCOME 

In Table 1.1 we showed how total economic income flowed 

through financial institutions in a world without taxes. Total 

income did not depend on how the income was divided among the 

various economic actors involved or across the two general types 

of activities. 
-29-

The introduction of income taxation does not change this 

result. Table 2.1 modifies Table 1.1 and shows the after-tax 

return to each type of income recipient involved in the two 

general types of transactions with financial institutions. The 

total return in the economy must now cover all tax payments as 

well as the rewards to the suppliers of labor and capital 

services. Yet the total return to investment still sums to 

r and the value of other non-intermediation services still 

equals p. 

As the recipient of income tax payments, the government 

becomes an additional economic actor intimately involved in 

the transactions. Taxation may affect the efficiency of the 

transactions, their volume and even their after-tax values to 

individuals. While economic income may still add up to the 

same total, each recipients' share, including the government's, 

depends greatly upon how total income is allocated and taxed. 

An income tax ideally would include as taxable income the net 

economic income of each actor involved in transactions with 

financial institutions . Tax rules in some cases define taxable 

income differently from total economic income because of problems 

in measuring or defining net income and because of certain policy 

goals which allow the exclusion, deduction or deferral of income. 

We have divided these issues into five categories: 1) taxpreferred products offered to individuals by financial institutions, 2) the measurement of income net of the cost of services, 

3) the separation of returns of income from returns of capital, 

4) tax-preferred assets held by financial institutions, and 

5) other special tax preferences of financial institutions. 

Accurate measurement of total income also requires accounting 

for the timing of income receipt, but this topic is reserved 

for separate discussion in section IV. 
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-31-

A. Tax-Preferred - Products Offered to Individuals

by Financial Institutions 

Current tax laws allow certain financial institutions to 

offer products that carry with them substantial tax savings for 

the purchasers. In many cases, these tax preferences are not 

allowed for purchases of similar types of products from other 

financial institutions or businesses. The tax preferences 

generally fall into three catagories: the exclusion of 

investment income from taxation; the deferral of investment 

income from taxation; and the deduction or exclusion from 

income of the value of purchases of certain types of products. 

Income Exclusion 

A tax-exempt bond is one example of an asset yielding 

investment income excluded from taxable income. Individuals can 

purchase tax-exempt bonds directly or through certain financial 

institutions. Regulated investment companies or mutual funds 

can pass through the tax-exempt status of the interest earnings 

to their creditors or shareholders. Individuals may choose to 

invest in tax-exempt bonds through mutual funds in order to 

benefit from the several features of financial institutions 

described in Part 1, such as a diversified portfolio and 

financial expertise. 

Other exemptions of income from tax are specific to products 

offered by certain financial institutions. For instance, in 

1981, Congress exempted interest income on certain savings 

deposits labeled "All Savers Certificates." These certificates 

could only be offered by thrift institutions and commercial 

banks. 

Another exemption of income specific to one type of financial 

institution is the deathtime exclusion of cumulated investment 

income included in life insurance proceeds. Insurance proceeds 
-32-

include both a "pure insurance" component or a redistribution 

among policyholders, and an investment income component. The 

exclusion of the investment income for life insurance policy held 

until death makes savings for bequests through life insurance 

companies especially attractive. 

Deferral of Income from Taxation 

Deferral of income from taxation can also offer substantial 

tax savings. As a simple example, suppose a taxpayer in the 

25 percent tax bracket invests $1000 at an annual pre-tax return 

of 10 percent. Since the value of the investment would equal 

$10,835 after 25 years, the taxpayer's wealth after-tax would be 

$8,376, yielding an effective annual after-tax return of 8.87 

percent with deferral. This compares with after-tax wealth of 

$6,098, or an effective 7.5 percent annual return, if the 

investment income had been subject to tax when earned. The 

effective after-tax return approaches 10 percent, equivalent to 

outright exclusion, if the period of deferral becomes very long. 

The advantage of tax deferral is often greater than shown in this 

type of example because a taxpayer will elect to realize the 

taxable income when he is subject to a lower marginal tax rate. 

Because the present tax system generally taxes income upon 

realization rather than accrual, it provides numerous opportunities for tax deferral of investment income. Many assets 

benefit from tax deferral only if1 held in certain forms. Income 

earned on savings, for instance, is allowed tax-deferred status 

if those savings form part of a life insurance product. The 

investment income earned, or the "inside interest buildup," on 

permanent life insurance policies is not subject to tax until 

the policy is cancelled or surrendered. Thus, the tax treatment 

of investment income earned through life insurance companies 

differs from the tax treatment of interest paid by depository 

institutions. Investment income earned on deposits held with 

banks and thrift institutions, on the other hand, is subject 

to tax when earned. 
-33-

Deductions or Exclusion from Income for Purchases or Deposits 

The Tax Code allows deductions or exclusions for the cost of 

purchasing certain products and services. Many fringe benefits 

are excluded from the taxable compensation of employees. The 

exclusion of fringe benefits reduces the after-tax cost of 

purchasing those products. For instance, there are statutory 

exclusions for employer provided health insurance and a limited 

amount of employer-paid group term life insurance. These deductions or exclusions are product specific, and are often sold only 

through certain financial institutions because of regulatory and 

tax policies which encourage separation of financial functions. 

Deposits in pension funds and individual retirement accounts 

(IRA's) are also allowed to be excluded from income of employees. 

These special types of savings incentives at the same time 

provide for the deferral of investment income and the taxation of 

all withdrawals. When a taxpayer is in the same tax bracket at 

time of withdrawal as time of deposit, the tax savings are 

equivalent to nontaxation of the investment income. Pensions and 

IRA's are generally available through all financial institutions. 

Economic-Implications of Individual Tax Preferences 

Although there are many important economic issues related to 

tax-preferred products offered to individuals, our concern will 

be mainly with those which are product specific and can be 

offered only by certain financial institutions. Even if there 

are problems of equity and efficiency because of current 

pension rules, for instance, they will not be of concern here 

if they arise outside the context of the taxation of financial 

institutions. The tax benefits of pension savings, as well as 

many other individual preferences, apply primarily at the 
-34-

individual level and do not generally favor one type of financial 

institution over another. We are more concerned with tax provisions that may exempt income on one type of product offered by 

one type of financial institution when a similar exemption is not 

offered to other individuals who earn such income through other -. 

institutions. 

One result of individual exclusions, deductions and deferrals 

is that taxpayers will purchase more of the preferred products or 

invest their savings more in assets offering special tax savings 

on the investment income. There are two further implications at 

the level of the financial institution. First, individual tax 

preferences increase the size of the institutions allowed to sell 

the preferred products. The increased after-tax rate of return 

or reduced price of services will increase the demand for the 

favored assets or products. Economic theory holds that the 

benefits of tax preference may be shared between demanders and 

suppliers, and that financial institutions which supply the 

products may indirectly gain some of the benefit essentially 

aimed at individuals. In the short run, this benefit may be a 

higher level of profitability or returns to other factors; in 

the long run, it will more likely take the form of an increase 

in the size of the financial sector offering the favored 

products. 

Second, some taxes paid to government by certain financial 

institutions may not represent taxes on the llequity"owners of 

those institutions. A portion of the taxes levied at the company 

level may be aimed instead at creditors or customers as a partial 

offset for the tax exclusions, deferrals or deductions granted at 

the individual level. Thus, what might nominally be measured as 

corporate tax liability may actually represent tax collected at 

the company level on the individual beneficiaries of tax 

preferences. 
-35-

B. Investment Income Net of the Cost of Services 

at the Individual Level 

As we have noted before, investments flowing through 

financial institutions often involve some level of service 

regardless of the structure of the tax system. These financial 

services may not represent a cost of making investments or doing 

business, but may provide a value to the taxpayer which is 

independent of the investment income. In the case of joint 

products involving personal consumption services and investment 

income, the investment income is often reported net of the cost 

of the personal services. 

An income tax measures investment income as the net return on 

assets and allows an exclusion or deduction for the transaction 

costs and other costs of investment or intermediation services. 

The costs of personal consumption services, on the other hand, 

are generally not deductible and must be paid out of after-tax 

income. If the investment income is reported net of the cost of 

personal services, then taxable income will understate the total 

economic income by the value of the personal services. 

As a result of this netting process, taxpayers are encouraged 

to acquire services from institutions handling their investments 

rather than receive higher investment income and pay for such 

services separately. Even when the services are solely investment-related, and the costs clearly deductible, taxpayers who are 

non-itemizers will still have an incentive to avoid paying 

separately for the services. 

The favorable tax treatment of joint investment and service 

transactions can be seen in the case of checking accounts. Most 

individuals have the option of (1) investing their funds in the 

highest yielding assets and purchasing checking account services 

out of after-tax income or (2) depositing their funds in a lower 
-- 

-36-

yielding security in combination with "free" or reduced price 

checking services. In the first case, a saver would earn the 

highest market investment income, il, and purchase checking 

services for the market price, p, out of after-tax income, 

il(l-t), where t is the individual's marginal tax rate. It is 

more likely, however, that the individual could earn a higher 

after-tax rate of return from a financial institution offering a 

lower interest rate in combination with a reduced price on 

checking services. This individual would maximize his after-tax 

rate of return by investing directly in assets yielding the 

market interest rate only if il(l-t) were equal to or greater 

than the total after-tax return from the checking account without 

service charges, i2(l-t) + p, where i2 is the stated yield on the 

account. 

The tax treatment of financial income net of transactions 

and service costs permits individuals to purchase checking 

services with pre-tax income. The cost of checking services 

becomes an excludable expense of the consumer regardless of 

whether those expenses are otherwise deductible. Inefficiency 

results because individuals are encouraged to choose "free" 

checking services even when the foregone interest income, 

(i1-i2), exceeds their direct price, p. Ly/ 

A similar mismeasurement of taxable investment income occurs 

with other joint products offered by financial institutions. For 

instance, total premiums paid are treated as the cost basis for 

investment returns from a life insurance policy, even though part 

of the premiums are for the cost of personal insurance services. 

19/ Checking accounts without service charges are demanded if 

i2(1-t) + p > i (1-t) or (il-i2) < p/(l-t). Thus, (il-i2) 

can be greater ghan p as long as t > 0. 
-37-

Economic Implications of Measuring Taxable Investment Income 

Net of Service Costs 

The favorable tax treatment of joint service and investment 

income encourages the combination of economic functions and 

changes the allocation of capital resources between different 

financial institutions. The mismeasurement of investment income 

by the amount of personal services purchased is equivalent to 

allowing a deduction of the cost of those services. The 

effective price of the personal services is reduced and more are 

consumed. As long as only certain institutions are allowed to 

offer such joint products, moreover, the exclusion of their cost 

from the measurement of taxable income will increase the flow of 

capital to those institutions relative to other financial 

institutions. 

C. Separation of Income from Return of Capital 

The measurement of total income is complicated by payments to 

income recipients which include both income and return of capital 

or price rebate. An income tax must distinguish between returns 

-to capital (income) and returns -of capital. At the company 

level, any portion of the payment that represents investment 

income to creditors would be deductible as an interest expense. 

Similarly, a true price rebate would be deductible at the company 

level in order to properly measure net receipts. At the individual level, payments received would be nontaxable only when they 

can be reasonably identified as price rebates or return of 

capital contributed out of after-tax income. Any investment or 

service income would be included in taxable income at the 

individual level. 

While these general rule may appear easy to understand, the 

difficulty of their application can best be understood through 

some examples. 
-38-

Deposits 

An individual's deposit (investment) in a financial 

institution represents an increase in the institutionls liabilities, not its gross income. Thus, a deposit is normally not 

included in the institutionls taxable income when received nor 

deducted when paid out. The income earned on the associated 

assets of the institution is offset by the deduction of interest 

paid on the deposit. The interest received by the individual 

depositor is generally taxable even though the income may be 

retained in the institution and not distributed. 

In the case of deposits made with banks and thrift 

institutions, the application of these rules is fairly clear. 

In the case of insurance companies, where premiums cover both the 

cost of insurance services and the equivalent of a deposit in a 

savings account, the separation of the deposit from the price of 

the insurance service is often less explicit. The amount of the 

deposit portion is a liability of the insurance company which it 

must return to the policyholder at a later date and thus should 

not be included in taxable income of the company. The price of 

the insurance services, on the other hand, would be included in 

the company's taxable income, but would be largely offset by 

payment of insurance claims and expenses. 

Corporate Dividends 

Payments to shareholders may represent dividends paid out 

of income or returns of the initial investment. The Tax Code 

defines a dividend as a distribution received by a shareholder paid out of "earnings and profits" of the corporation. 

All payments normally are assumed to first come out of "earnings 

and profits" and, thus, are not deductible at the company level 

and are included in taxable income at the individual level. 
-39-

Distributions in excess of accumulated earnings and profits are 

treated as return of capital and are not subject to tax. Any 

return of capital reduces the shareholders' basis in the 

investment. 

"Price Rebates" 

"Policyholder or patronage dividends" to mutual shareholders 

or cooperative members consist of both return of capital (excess 

charges for the product in the current or prior years) and return 

to capital (income earned on investments or through the provision 

of services). There is often no simple procedure for determining 

the income portion of these dividends when the customer is also 

an equity owner or creditor with the company. 

Redistributions 

Part of the payments from insurance proceeds represents a 

redistribution of income among policyholders, rather than an 

addition to net economic income. If the redistributive element 

of insurance proceeds has already been included in taxable income 

(assuming the cost of the insurance is not excluded from the 

policyholders' taxable income), then it would be taxed twice if 

it were added to taxable income again upon distribution. If the 

insurance contract, on the other hand, includes an investment 

component, then the investment return represents an addition to 

economic income. Moreover, if the premiums are paid out of 

before-tax income, as in the case of employer-paid fringe 

benefits, then the entire insurance proceeds may be subject to 

tax not as redistributions, but as return of previously untaxed 

income. 

Borrowing and Other Partial Withdrawals 

If income has been allowed to accumulate without taxation, 

then partial withdrawals of funds, including loans against the 

funds, must be accounted as coming from capital or income. An 
-40-

ordering rule which assumes that any withdrawals are first made 

out of capital, rather than income, would allow the income to 

continue to receive tax-deferred status even when the initial 

savings contribution has been removed. Alternatively, the 

ordering rule could require the withdrawal to be made first 

from income. The latter rule is currently applied to partial 

withdrawals and loans from annuities and certain loans from 

qualified pension plans, while partial withdrawals and loans 

from life insurance policies currently fall under the former 

rule. 

Economic Implications of Correct Separation-of Income from 

Returns of Capital 

Incorrect attribution of payments as return of capital rather 

than income would significantly lower the effective rate of tax 

on investments. Similarly, attributing payments as "price 

rebates" when some portion represents income would significantly 

lower the effective rate of tax on the.incorrectly attributed 

service income. There would be too much investment in the 

favored assets and too little in the disfavored ones. 

D. Tax-Preferred - Assets Held by Financial Institutions

Financial institutions also hold tax-preferred assets in 

their own accounts. Sometimes the benefits of these tax 

preferences can be passed through to the individual level. 

Mutual funds and real estate investment trusts (REITs), for 

instance, receive integrated tax treatment under certain 

conditions, and hold tax-exempt bonds and real estate property 

for their owners. Other tax-preferred assets, however, are 

held by financial institutions mainly to increase the company's 

own after-tax income. 
-41-

Because most capital is contributed by creditors, depositors, 

and policyholders rather than equity owners, the financial 

institution's own income typically is a relatively small proportion (5-10 percent) of gross income from financial assets. In 

most cases, the company will hold most assets in taxable form to 

generate the highest market yield for their depositors. Taxexempt and tax-preferred income, on the other hand, can represent 

a large fraction of the -net (otherwise taxable) income of the 

company. Although tax-preferred assets are not uniquely held 

by financial institutions, their high debt-equity ratio 

distinguishes them from most other holders of these assets. 

-

Tax-exempt Bonds

Tax-exempt bonds are an example of tax-preferred assets held 

by many financial institutions. Some companies--in particular, 

commercial banks and property and casualty insurers--can effectively segregate "company" investment income from deductible 

investment income paid to creditors. These companies often find 

that tax-exempt bonds yield the highest after-tax return to the 

company. Typically, these companies will hold taxable securities 

up to the point that the taxable income receipts are offset by 

allowable deductions for costs and payments to depositors. 

Excess income that would otherwise be subject to the maximum 

corporate tax rate can then be earned from tax-exempt bonds. 

Because of their tax-preferred status, such assets have 

yields below the market return on fully taxable securities with 

comparable terms. In the case of tax-exempt bonds, short-term 

obligations historically have yielded between 50-60 percent of 

the comparable taxable yield, while long-term obligations have 

yielded between 65-75 percent of the'comparable taxable yield. 

Thus, financial institutions that hold tax-exempt bonds accept a 
-42-

lower pre-tax rate of return and accept an implicit tax rate of 

between 25-50 percent. Investors usually will hold tax-exempt 

bonds only if the "implicit tax rate" paid in the form of the 

reduced pre-tax yield is less than their actual marginal tax 

rate. 

Financial institutions that find tax-exempt bonds 

advantageous often pay only small amounts of Federal tax liability. They do, however, pay the implicit tax, although at a rate 

below the statutory corporate rate, to State and local governments in the form of lower interest receipts on the tax-exempt 

debt obligations. -20/ Many financial institutions participate in 

leasing of depreciable equipment and structures which also 

reduces their Federal tax payments. Lessors will pay a similar 

"implicit tax rate" by passing the benefit on to lessees in the 

form of lower rental charges. 

Intercorporate Dividend Deductions 

Corporations can generally claim a deduction for 85 percent 

of dividends received from holding shares of other corporations. 

The principal justification for a deduction for intercorporate 

dividends received is to reduce the possibility of triple 

taxation of dividend income. Income paid out as dividends 

otherwise could possibly be taxed to the originating corporation, 

the corporation holding the equity, and the receiving company's 

shareholders. Dividends would already be subject to double 

taxation if not flowed through other corporations. 

One difficulty with the triple taxation argument is that it 

depends heavily on what the receiving corporation does with the 

dividends of the paying corporation. If the dividends are not 

320/ Section 103 excludes from tax interest income on State and 

local government obligations, including certain industrial 

development bonds used for private business and other private

activity bonds. 
-43-

t 

One difficulty with the triple taxation argument is that it 

depends heavily on what the receiving corporation does with the 

dividends of the paying corporation. If the dividends are not 

passed on to the receiving corporation's shareholders, then only 

a double tax is involved, and the receiving corporation, even 

without a dividend-received deduction, may be no worse off than 

other dividend recipients. Similarly, if the dividend can be 

passed on in a nontaxable form or to nontaxable recipients, then 

one level of tax is avoided even without the dividend-received 

deduction. With the dividend-received deduction and no taxable 

income at the individual level, the income would be subject to 

tax at only the originating corporation. 

The receiving corporation may also borrow the money necessary 

to purchase the stock of the paying corporation. Interest 

payments on those borrowings are deductible. By using the 

dividends of the paying corporation to pay interest, and making 

use of the deduction for dividends received, the receiving 

corporation will reduce net corporate taxes paid by the two 

companies to almost zero. 

If the receiving corporation combines methods--deducting 

interest payments made with dividends of another Corporation, 

taking a dividend-received deduction, and making the interest 

payments in a nontaxable form--then total taxes paid by all 

corporations and individuals on the related capital income will 

be almost zero. The deduction for dividends received will allow 

the positive tax of the paying corporation to be offset by a 

negative tax of the receiving corporation (on interest payments), 

while zero taxes may be collected on interest and dividend 

recipients (if nontaxable). Thus, the so-called triple tax may 

end up to be no tax at all. 

The dividend-received deduction therefore creates problems 

whenever the receiving corporation has debt or can make payments 

in nontaxable form. All financial intermediaries fall into the 

first category, and many fall into the second. A large portion 
-44-

of their net investment income is earned through arbitrage of the 

rate paid on liabilities (e.g. to depositors and policyholders) 

and the rate received on assets. Because of a higher debt-equity 

ratio, most income received is offset by interest paid or similar 

deductions. 

Income paid in intercorporate dividends to financial 

institutions generally would be taxed at two levels --the originating corporation and the depositors and shareholders of the 

financial institution--even without the 85 percent dividend 

deduction. In many cases, therefore, the intercorporate 

dividend-received deduction makes corporate equity preferable to 

other sources of income because it can be used to shelter other 

income of the financial institution from tax. In some cases such 

as life insurance companies, the ability to pay out income in 

tax- preferred form (e.g., life insurance benefits excluded from 

taxation) means that almost no tax at all is paid on the income 

of the originating corporation. 

Capital Gains 

Gains and losses from the sale or exchange of capital assets 

are eligible for special treatment at the corporate level. -21/

Net long-term capital gains can be taxed at an alternative rate 

of 28 percent. Capital losses are allowed only against capital 

gains, but any excess losses may be carried back three years or 

forward five years. The special tax rate is available only for 

capital assets that are held generally for investment. Gains 

and losses from property held for sale to customers, such as 

inventory, receivables and depreciable OK real property used in a 

trade or business, are taxed as ordinary income. If income can 

be generated as capital gain rather than ordinary income, then a 

lower tax rate will apply. 

-21/ Capital gains and losses also receive special treatment at

the individual level, but this special treatment is generally 

not peculiar to transactions with financial institutions. 
-- 

-45-

Tax Arbitrage Issues 

Investors generally are denied interest deductions for 

borrowing to hold or carry tax-exempt bonds. While this rule is 

hard to apply in practice, the intent is to prevent investors 

from generating tax reductions while undertaking no savings 

whatsoever. With tax arbitrage, an investor can borrow $100, 

deposit that $100 in a tax-preferred asset (not just tax-exempt 

bonds) and generate positive after-tax income mainly through the 

tax reduction. Yet no net saving will have occurred, and 

before-tax income may be negative. 

. 

Alternative rules for limiting arbitrage include disallowing 

a portion of interest deductions attributable to carrying or 

purchasing tax-preferred assets and allocating part of the 

tax-exempt income to creditors. The former approach is applied 

in the case of banks. Fifteen percent of the interest deduction 

attributable to tax-exempt 'bonds is disallowed. The latter 

approach applies to life insurance companies which must prorate 

tax-exempt income between the company and policyholders in the 

same proportion as total investment income is allocated. Because 

income from life insurance products is not taxed currently to 

policyholders, there is little reason for life insurance 

companies to hold tax-exempt securities as part of policyholders' 

"savings accounts." 

Economic Implications of Tax-Preferred Assets at the Company 

Level 

Lack of uniformity in the taxation of income from capital 

drives up the demand for preferred assets and leads to a 

misallocation of savings and resources in society. In the case 

of financial institutions, there is a special problem with tax 

arbitrage because deductions for interest and other payments are 

allowed at the same time that receipts are not counted in income. 
-46-

While economic actors at all levels engage in tax arbitrage, 

financial institutions present a special case because of their 

high debt-to-equity or liability-to-asset ratio. 

E. Other SDecial Preferences of Financial Institutions 

Financial institutions may also receive special tax treatment 

of various receipts or costs. These special preferences 

generally can be classified into three types: exemption of income 

from company level tax; deferral of income from taxation; and 

additional deductions or exclusions unrelated to the cost of 

earning income. 

As an example of the first type of preference, the Tax Code 

exempts from company level taxation income received by groups 

organized for mutual benefit purposes. Exemptions are granted to 

credit unions, voluntary employees' beneficiary associations 

which provide for the payment of life, sickness, accident or 

other benefits to members of their dependents, and certain 

"small" mutual insurance companies. The favored organizations 

pay no taxes and therefore can offer financial services at lower 

cost than taxable businesses. Because of their size, mutual 

savings and loan associations and most mutual insurance companies 

are subject to corporate tax. 

Second, companies can often defer income from taxation 

through special accounting techniques. In addition to excess 

deductions for additions to reserves (see section VI) certain 

financial institutions are allowed to place income into special 

accounts and defer tax on that income. Mutual property and 

casualty insurance companies, for instance, can defer at least 

one-quarter of their underwriting income for up to five years 

and, under certain conditions, a poktion can be deferred 
-47-

indefinitely. Life insurance companies can defer one-half of 

their underwriting income until such funds are distributed to 

shareholders, a process which effectively permits indefinite 

deferral. 

Finally, there are a whole series of deductions or exclusions 

which are unrelated to the cost of earning income. While the 

costs of earning income are generally deductible at the company 

level, these special deductions appear designed simply to reduce 

companies' tax liabilities without regard to the measurement of economic income. Often these special deductions are 

limited to one type of financial institution. Unlike other 

mortgage lenders, thrift institutions are allowed a special bad 

debt deduction if they hold a certain percentage of their assets 

in "qualified real property loans." The special deduction is 

unrelated to the amount of their bad debts. Similarly, life 

insurance companies are allowed a special deduction for a percentage of premiums paid on group term and health and accident 

policies. The deduction has little or no relationship to the 

proper measure of total economic income and is not available to 

other companies writing similar insurance contracts. 

Economic-Implications of Special Company Tax -Preferences 

The benefits of special company tax preferences will accrue 

partially to the customers, employees, creditors, and owners of 

the favored institutions. The favored companies will be able 

to offer lower prices, higher wages or interest rates, and higher 

profits as a result of the tax preferences. The amount of 

investments and services provided by favored institutions will 

most likely increase, while there will be less goods and services 

offered by other sectors of the economy. 

Tax preferences that are specific to a particular type of 

financial institution will more likely accrue to the owners in 

the short run or if entry to the favored sector is restricted. 
-48-

Over the long term, those financial institutions that have 

special tax breaks will expand their size, entry into the market 

will diffuse the benefits, and there will be additional activity 

or production in the preferred sectors. 

11. ISSUES RELATED TO THE ATTRIBUTION OF TAXABLE INCOME AMONG 

RECIPIENTS 

As was shown in Table 2.1, the introduction of income 

taxation does not affect the measurement of total income. If 

total income is measured the same way, why do distinctions among 

types of income recipients become so important for tax purposes? 

To the extent that one recipient's measure of income was too low, 

another's would often be too high by the same amount. The total 

amount of income subject to tax in many cases would be the same. 

Distinctions are requir.ed under the current income tax system 

primarily because the same tax rate does not apply to all 

taxpayers. Creditors (savers/lenders), equity owners, incorporated financial institutions and consumers are each differentiated by the Internal Revenue Code and charged different tax rates 

or allowed different deductions according to the group within 

which they fall. Different tax rates may also apply to individual taxpayers within each group. Both the individual income tax 

and, to some extent, the corporate income tax contain progressive rate schedules. Moreover, all tax systems distinguish 

between taxpayers with a zero tax rate (usually because of low 

or negative taxable income) and those with a positive rate. 

Attribution of income to a profitable corporation, for instance, 

would bring about a different tax result than attribution to a 

non-profitable one even if the corporate tax were a "flat-rate" 

tax. Although the distinctions among income recipients may at 

times appear to be arbritrary, such as separating the income of 
-49-

a creditor from that of an owner of the financial institution 

when they are one and the same person, such distinctions are 

important as long as different tax rates apply in the two cases. 

Although the terms listed in Table 2.1 have become more 

lengthy than in Table 1.1, the essential differences in tax rates 

among economic actors are due either to variations in individual 

marginal tax rates or to the difference between the corporate tax 

rate and whatever individual rate might apply. E/ In Table 2.1, 

the after-tax investment income of corporate equity owners is 

equal to (i'-il-cl)(1-tc)(1-te), where a tax rate, tc, is levied 

on the income earned at the level of the corporation while a tax 

rate, te, is paid on income distributed to individual equity 

owners. Current law attributes corporate income to the corporation, not its owner; that is, the tax system is unintegrated. 

Corporations can deduct interest payments to creditors but cannot 

deduct dividend payments and similar distributions to equity 

owners. 

If the financial institution is not corporate, or the income 

is deemed to flow through directly to individuals, then all 

income (not just dividends) is attributed to the owners of the 

institution at the individual level only (tc=O). A further 

simplification of Table 2.1 is possible if those owners are in 

turn the creditors or lenders. Then the tax rate applying to the 

investment income of the noncorporate financial institution is 

the same as the tax rate applying to the income attributed to the 

creditors; their total income equals il(l-ts) + (il-il-cl)(1-ts), 

or simply (i'-cl)(1-ts). 

22/ Whatever tax rate applies, the final incidence of a tax does 

not necessarily rest with the taxpayer who actually pays the 

tax. In the case of financial institutions subject to 

corporate tax, for instance, factor prices such as interest 

paid to lenders, i3, or wages paid to workers, c3, may

decrease, and product prices, p, or interest charged to 

borrowers, i', may increase. Thus, part of the burden of a 

tax on the income of a financial institution may be shifted 

to savers, wage earners, consumers or other capital owners. 
-- 

-50-

Differential rates of taxation, regardless of whether they 

apply at the individual or corporate level, may have effects at 

both levels. For instance, the tax exemption of interest earned 

on All-Savers Certificates, available through commercial banks 

and thrift institutions, increased the flow of funds to those 

institutions. The tax exemption of interest income on these 

certificates induced many investors to purchase these tax-exempt 

assets even though the statutory tax-exempt interest rate was 

lower than market yields on other investments. Favored financial 

institutions were able to attract funds at lower interest rates 

than on other liabilities. The reduced cost of funds could be 

used to increase the number of loans made by reducing the 

interest charge on borrowed funds (it) thereby increasing demand 

for loans as well, or increasing the income of the institutions' 

equity owners (it-il-cl). Similarly, a reduction in the 

effective rate of tax paid at the corporate level by a particular 

type of financial institution could be used to increase its share 

of the financial market if it offered higher yields to lenders 

and lower interest rates to borrowers. Thus, tax rates at both 

the individual and corporate level can affect the share of the 

market held by each financial institution and the division of the 

total return between the various income recipients. 

A. Allocation of Income Between Companies and 

DeDositors or Policvholders 

Some argue that under an ideal tax system, one would 

attribute no income to financial institutions qua institutions, 

but rather attribute all income directly to individuals, whether 

owners, creditors, depositors or policyholders. -23/ Individuals 

are the ultimate recipients of income and bear the burden of 

23/ - U.S. Department of the Treasury, Blueprints for Basic

Tax Reform, Washington, D.C., 1977. 
-51-

taxes, whether levied statutorily on an -ad hominium (persons) or 

on an --ad rem (thing or entity) basis. Since some financial 

institutions are corporate, while others are not, the tax rates 

faced by their owners are different under an unintegrated tax 

system. If the corporate tax rate, plus the effective rate 

resulting from taxation of dividends and capital gains, is higher 

than the individual tax rate on current equity income, then the 

business organized in corporate form is disadvantaged relative to 

the noncorporate business. Like many other tax wedges, this rate 

differential can result in misallocation of the economy's capital 

resources, affecting not only the amount of financial intermediation offered in the corporate sector, but the total amount of 

financial services in the economy as well, -24/ 

Under current tax law, most income earned by financial 

institutions is passed through to individuals and is not taxed at 

the corporate level. Problems arise in the allocation of income 

between those depositors or policyholders for whom integration is 

effectively provided and those equity owners from whom corporate 

tax is collected. As long as a corporate tax applies to capital 

income of other corporations, there is no good reason to favor 

income generated from activity within financial institutions over 

income generated within other corporations. Such favoritism 

would create its own form of inequity as well as to encourage 

relatively too much investment in activities related to financial 

intermediation and services. 

B. Allocation of Income to Specific Individuals 

Integration would solve one allocation problem, but it would 

leave many others. As long as tax rates (or rules for calculating income) differ among individual taxpayers, accurate 

-24/ For a summary of the recent literature on the capital

allocation effects of the unintegrated corporate tax and its 

interaction with corporate financial behavior, see J. Cordes 

and S. Sheffrin, "Taxation and the Sectoral Allocation of 

Capital in the U.S.", Office of Tax Analysis Paper No 49, 

June 1981. 
-52-

allocation of income between income recipients will still be 

important. In the absence of precise allocation rules, income 

would always tend to be allocated to the taxpayer with the lowest 

rate of tax. The tax savings would then be divided among 

participants through various compensating mechanisms, such as 

price changes. 

In cases where attribution of income to specific individuals 

is difficult, a "substitute tax" may be used to prevent exemption 

of that income from taxation. Such a tax levied at the business 

level would be a substitute for, rather than an addition to, 

taxation at the individual level. When total taxes paid over to 

the government by a business represent both a proxy tax on 

individuals and a business tax on owners, it is inappropriate to 

measure the effective business tax rate by dividing total taxes 

paid by business income. 

In practice, a substitute tax rate would normally be assessed 

either at a business tax rate or some flat rate which approximates the average marginal rates of actual income recipients. 

This type of flat rate, however, can create problems of its own. 

Potential investors with rates higher than the substitute rate 

would be encouraged to flow income through the financial 

institution. As this shifting takes place, the substitute tax 

rate can become too low when the average marginal tax rate of 

income recipients rises above the substitute tax rate. If this 

were to happen, the relevant financial instrument could become 

converted from its original purpose into a tax shelter. Substitute tax rates, therefore, should never be used when income can 

be attributed without undue complexity to the actual recipients. 

A limit should also be placed on the extent to which income 

flowing through a financial institution can be sheltered through 

means of a substitute tax rate below the highest individual tax 

rate; for instance, special rules might apply to large marginal 

investments of any one individual. 
-53-

C. Mutual vs. Stock OwnershiD 

Certain "mutual institutions," even though organized in 

corporate form, are treated like partnerships in which current 

income is attributable and taxable to individual owners. These 

qualifying corporations--primarily mutual funds and certain 

cooperative ventures--can deduct dividend distributions if they 

distribute a large percentage (e.g., 90 percent in the case of 

regulated investment companies and 95 percent in the case of real 

estate investment trusts) of current income to their "shareholders." In these instances, the income of the corporation is 

distributed to creditors and policyholders and is taxed only at 

the individual level. -25/ The requirement that a large percentage of corporate income be distributed currently limits the 

corporation from accumulating large amounts of retained earnings 

within the firm, and practically eliminates the normal corporate 

advantages of tax deferral and conversion of ordinary income into 

capital gains. 

There is a continual policy debate over the extent to which 

other mutual owners should be treated like unincorporated 

partners or as corporate owners of their companies. This 

question is somewhat related to whether payments of income 

generated at the corporate level should be treated as payments 

of debt deductible at the corporate level or as nondeductible 

dividend payments to owners of the corporation. 

The optimal taxation of mutual owners is an issue of both 

equity and efficiency. Mutual companies may argue for parity 

between themselves and noncorporate partnerships or tax-exempt 

-

25/ Capital gain income can also be passed through to

shareholders and receive favorable individual income tax 

treatment. 
-54-

mutual organizations. Stock corporations, on the other hand, 

may argue that they are disadvantaged in competing in the 

marketplace if only they have to pay corporate tax. If a 

tax-exempt organization keeps its costs competitive and passes 

through its cost savings to its customers, then its market share 

will grow at the expense of taxable entities. The latter concern 

has been reflected by the corporate taxation of several types of 

mutual organizations with large market shares, such as life 

insurance companies, property and casualty insurers, savings 

banks, and savings and loan associations. 

Tax rules cannot deal only with comparisons of average tax 

rates between two companies, but instead must determine the 

amount of equivalence to apply all the way through the system. 

Parity implies equal treatment of both investment and noninvestment income at both the corporate and individual levels. At the 

corporate level, the amount of income that is deductible as 

payments to depositors and policyholders must be separated from 

the income that is taxable to the mutual company. Some investment income of a mutual company could be treated as equivalent to 

interest income paid to creditors or as a pass-through of passive 

income similar to that made to noncorporate partners or to mutual 

fund owners. 

Some degree of parity must also be established at the 

individual level. For stock companies, both interest payments to 

creditors and dividend payments to stockholders are subject to 

tax. The problem of parity between mutual and stock companies is 

especially acute when the difference between individual and 

corporate rates is large. In the case of income earned by life 

insurance companies, for instance, much income passed through to 

individuals is exempted from tax. A simple rule that would go a 

long way toward insuring equal tax treatment of mutual and stock 

companies, and lessening many of the conflicts between them, 

would be to require that all income be subject to tax at least 

once at either the individual or corporate level. 
-55-

One administrative difficulty with taxing mutual owners 

similarly to equity owners comes in measuring the income earned 

by the mutual company. Because mutual owners are also creditors 

and customers, any "equity income" can be deducted by being paid 

out as interest to creditors, or as a reduction in the price of 

services. A mutual company can run on a nonprofit basis by 

simply relabeling its distributions or retentions. In the case 

of insurance companies, distributions are often called policyholder dividends regardless of whether they represent income or 

return of capital. 

Any attempt to tax mutual companies, therefore, will be 

frustrated by their ability to reduce taxable income through 

distributions in the form of price reductions or increases in 

deductible payments. Without an imputation of a return on the 

nonfinancial capital of mutual companies, their taxable income 

is likely in practice to be limited to a portion of observable 

returns from financial investment, or to retained capital, 

whether it represents total earnings or not. In the case of life 

insurance companies, Congress in 1959 attempted to achieve parity 

by giving stock companies several special deductions to reduce 

their tax liability. Since the deductions were not based upon 

income, the problem of mismeasurement and parity remained, albeit 

at lower average tax rates for both mutual and stock life 

insurance sectors. 

D. Economic Implications of the Allocation of Income 

Among Recipients 

As long as there are differences in tax rates among 

taxpayers, accurate attribution of income to taxpayers will 

be necessary to insure fairness among taxpayers with equal 

incomes and the efficient allocation of investment and service 

activity among financial institutions. When a given participant 

can be engaged in transactions with financial institutions in 
-56-

different roles--as customer, creditor or owner of the institution--some simplification can be gained by taxing him at the 

same rate in any role. On the other hand, efficiency also 

demands that he not be taxed at a lower or higher rate on income 

generated from financial institutions than on other income. As 

long as the income tax system remains unintegrated for all 

corporations, it will be impossible to meet both standards. 

More generally, as long as there are any tax rate differentials 

on income--whether because of an unintegrated corporate tax, a 

progressive rate schedule, zero tax rates for some income, or the 

lack of tax refunds for losses or negative income--it will be 

necessary to allocate income correctly among recipients. Where 

attributation of income to specific individuals is administratively infeasible, a substitute tax levied at the business level 

could be used to insure that income is included in the tax base 

at least once. Where the income earned by mutual companies can 

be distributed through price reductions, or nontaxable policyholder dividends, limits are necessary to prevent all income from 

being made nontaxable. In addition, parity between mutual and 

stock companies may require some imputation for returns from 

nonfinancial capital of the mutual owners. 

111. ISSUES RELATED TO THE ATTRIBUTION OF INCOME BY TYPE 

OF ACTIVITY 

Economic theory holds that resources will not be allocated 

efficiently if taxpayers face different tax rates for providing 

equally valuable services or products in the economy. We have 

seen that resources can be misallocated when the tax rate is 

related solely to the form of organization (e.g., corporate or 

noncorporate) providing goods and services. In like manner, 

inefficiency may result whenever different tax rates apply to 

the same amount of income merely according to the type of 

activity generating that income. If firms or persons are taxed 

differently according to whether they produce apples or chairs, 
-57-

then too few apples or too many chairs may be produced. 

Similarly, if financial institutions are taxed differently 

according to the type of financial activity they perform, or 

income from different products is taxed differently then too 

much or too little of each activity may result. 

If differential rates are established for different 

activities, then proper measurement and attribution by type of 

activity becomes necessary to avoid all income being taxed at the 

rate applicable to the lowest taxed activity. Equation 2.1 can 

be used to illustrate the incentive of different marginal tax 

rates on the effects of attribution of net income between 

activities. 

2.1) Yc = (1-tcl) (it-il-cl)+ (1-tc2) (p-i2-c2) 

Total after-tax company income, Yc, equals the sum of net 

after-tax investment income, i'-il-cl, and net after-tax service 

income, p-i2-c2. If the marginal tax rate on investment income, 

tcl is greater than the marginal tax rate on service income, tc2, 

then as high a proportion of receipts (i' and p) as possible 

would be attributed by the taxpayer to service activity, while 

expenses (i3 and c3) would be used to offset investment income 

wherever possible. Such attribution would reduce tax liability 

and increase after-tax income. 

Unbundling products into investment and service components is 

theoretically possible, but in practice the accurate measurement 

of each component is exceedingly difficult. A company selling a 

joint product can alter terms of the contract. The allocation of 

income and expenses can then occur simply in the pricing of the 

joint product. 
-58-

A. Attribution According to Activities of the Taxpayer 

Differential tax rates across activities occur primarily at 

the company level. The Tax Code, for instance, distinguishes 

between investment income and underwriting income in determining 

the tax of insurance companies. Underwriting income, or income 

from the sale of services, is generally subject to a lower rate 

of tax. The lower effective tax rate on underwriting income is 

due to special deductions which can only be taken against 

underwriting income, and not against investment income. 

One result of such rules is obvious. Firms first attempt to 

reallocate gross receipts to the activity with the lowest marginal tax rate. Costs, on the other hand, will be allocated to the 

activity with the highest marginal tax rate. Tax policymakers 

and administrators in turn attempt to devise further rules to 

restrict such reallocation, and so forth. Because many costs are 

common to both investment and noninvestment activities, these 

rules can become quite complex because they require a matching of 

income and costs even when such items are more or less fungible. 

Rules are not only required within companies but across 

companies as well. In the case of a life insurance company, 

for instance, gross income at one time could be converted from 

investment income to underwriting income through a reinsurance 

agreement in which a company with excess investment income 

effectively sold that income to another company and received back 

compensation which was treated as underwriting income. Another 

method of reducing taxes is through consolidation of life 

insurance companies; by adding together the income of each 

affiliated company rather than counting each company's income 

separately, it is often possible to reduce total liability. 

Attempts to limit each of these types of arbitrage do not address 

the underlying incentives of differential tax rates and, thus, 

leave the potential for more novel ways to convert income and 

costs. 
-59-

B. Attribution to Financial Institutions 

by Types of Products Sold 

In addition to rules which distinguish between sources of 

income within the financial institution, broader tax rules 

distinguish income earned for selling particular products 

according to the "typer1of financial institution. Distinquishing 

between types of financial institutions and types of products, 

however, is increasingly more difficult as deregulation and 

diversification occurs in the financial services sector. The Tax 

Code does not reflect the increasing similarity of institutions 

and their products or services. Each major type of financial 

institution is still subject to its own peculiar set of tax rules 

at the company level, and special tax treatment at the individual 

level may be allowed only if a product is sold by a particular 

industry. These different tax rules create substantial barriers 

to effective deregulation and diversification and cause taxinduced competitive imbalances. 

The division between institutions often is quite arbitrary. 

A life insurance company, for instance, is defined as a company 

with at least 50 percent of its total reserves for life, annuity, 

and health considerations. Some insurance companies may qualify 

as either life companies or property and casualty companies, with 

completely different tax rules, depending on how certain pension 

reserves are classified. Distinctions between mutual savings 

banks and savings and loan associations with respect to the 

favorable bad debt reserve deduction is also fairly arbitrary 

and has encouraged some stock companies to switch to mutual 

ownership. 

Acquisition of subsidiaries, mergers, consolidations and 

other reorganizations are increasingly used to take advantage of 

differential tax regimes across financial institutions. Life 

insurance companies, for instance, have allocated income between 
-60-

themselves and property and casualty insurance subsidiaries so 

that gains are taxed at lower rates to the life insurance parent, 

while losses offset income of the property and casualty 

subsidiary with the higher rate of tax. 

Differential tax treatment of institutions by type of 

products requires further arbitrary distinctions. Favorable tax 

treatment of investment income of life insurance products is 

allowed only when those products are sold by life insurance 

companies. Many investment vehicles that contain very little 

insurance protection are currently treated as life insurance for 

tax purposes. If no limits were established, all financial 

institutions would begin combining their savings investment with 

a minimal insurance vvwrappervvin order to gain access to favorable tax treatment as life insurance. 

C. Economic Implications of Differential -Tax Rates Across

Activities 

Differential rates of tax across activities of a company will 

distort the level of each type of activity undertaken. Companies 

often go the great lengths to reallocate income and expenses 

between activities to minimize tax. Differences in the tax 

treatment of various types of financial institutions their products will also affect economic efficiency and encourage various 

forms of reorganizations for tax purposes. Rules allocating 

income and costs between activities and defining different 

institutions are necessary to prevent these tax games, but such 

rules may themselves be arbitrary and cause other distortions as 

market forces change. The induced inefficiences and complexity 

of rules will be a positive function of the difference in 

effective tax rates across activities. 
-61-

IV. ISSUES RELATED TO THE TIMING OF INCOME RECEIPT 

Rules of accounting for expected future losses or liabilities 

have a major impact on income tax liabilities. Just as improper 

attributions to the wrong taxpayer or the wrong type of activity 

can affect the total amount of taxes to be paid, so also can 

attribution to the wrong time period affect the present value of 

taxes paid and the present value of after-tax income. 

Improper accounting of contingent liabilities or losses 

affects tax liabilities primarily through the exemption, deferral 

or speed-up of tax on some income. Tax deferral, for instance, 

can significantly reduce the effective tax rate on income, and is 

often equivalent to borrowing current tax liability from the 

Federal government at a zero interest rate. 

A. Methods of Tax Accounting for Expected Future Losses 

or Liabilities 

Three methods of accounting for future expected losses or 

liabilities were described in Part 1. First, under a selfinsurance cash method, a business can recognize and deduct future 

liabilities when they occur. Second, under the cooperative 

insurance method, businesses with expected future liabilities 

from current operations can purchase insurance to cover such 

liabilities and deduct the cost of insurance when paid. Current 

accounting for future liabilities through cooperative insurance 

not only speeds up the deduction for those liabilities, but 

changes the timing of the associated tax payments. A deduction 

for future liabilities is taken when they occur, but the 

deduction is fully or partly offset by the inclusion of the 

insurance proceeds in taxable income. The present value of the 

insurance premiums (deductions) should equal the present value of 

expected future losses plus the return to the insurer. 
-62-

Under the third method of accounting for expected future 

liabilities, the qualified reserve method, firms self-insure and 

treat additions to reserves as a current expense. When the 

qualified reserve method is used to measure taxable income, 

three rules are necessary for the qualified reserve method to be 

equivalent to the other two methods for tax as well as other 

accounting purposes. These rules are essential to insure that 

the qualified reserve method is not abused. First, all income on 

qualified reserve assets must be counted as income when earned. 

No further deduction should be allowed when the income is 

credited to the reserve to meet future liabilities. 

Second, since all additions to qualified reserves are 

deducted currently, all withdrawals of qualified reserves must be 

included in the current year's taxable income. Inclusion of the 

withdrawal may be partially or wholly offset by a deduction for 

the payment of liabilities or losses. Firms must also make 

withdrawals of excess reserves on a periodic basis. -26/ This 

requirement prevents taxpayers from timing withdrawals for 

periods when their taxable income is temporarily low. To be 

more exact, the rate of tax on the withdrawal of any excess 

reserve needs to equal the rate of tax which was applied to 

the earlier excess deposit. 

Third, current deductions for additions to qualified reserves 

must be limited to reasonable expectations of the future contingencies for liabilities or losses. In the absence of taxes, this 

third rule was necessary only to insure equivalence of annual 

accounting, but not the present value of total income over time. 

With taxes, however, the present value of after-tax income can 

also be changed if taxes are deferred or accelerated through use 

of unreasonable expectations. 

-26/ Withdrawal of excess reserves requires the valuation of 

reserve assets. Such valuation must take into account the 

market value of the reserve assets because a company could 

always sell or reinsure its liabilities at their true market 

cost. 
-63-

There would be no limit, however, on the amount of funds 

placed in nonqualified reserve accounts to meet self-imposed or 

government-imposed regulations nor on the use of the cash method 

of accounting for future expected contingencies--except that 

losses or liabilities must be paid first from qualified accounts 

set aside for tax purposes. To insure both that withdrawals from 

qualified reserves are made only for the purpose of covering 

expected future liabilities and also that tax deductions are not 

allowed for payments that may never take place, qualified reserve 

investments should be maintained and separately accounted from 

the firm's other assets. -27/ 

When all three accounting rules for tax deductible additions 

to qualified reserves for future contingencies are followed, 

there is less likelihood of a tax advantage to a firm that 

self-insures and uses the qualified reserve method over a firm 

that uses the cash or cooperative insurance method. 

B. Equivalence of Proper Qualified Reserve Method 

with Accountina for Future Losses When Thev Occur 

To examine more rigorously the rationale behind these rules, 

let us compare a firm using the cash method, and establishing 

nonqualified reserves for future contingencies out of after-tax 

dollars, with a firm using the qualified reserve method. The 

future value of the nonqualified reserves for a firm investing an 

amount of funds out of after-tax dollars, A(1-t), earning a 

constant rate of return, r, over T periods and with liabilities 

of L in period T is shown in.equation 2.2. Note that the return 

on the investment, as well as income used to make the initial 

deposit, is subject to tax. 

2.2) EV= [A(l-t)l [l+r(l-t)lT - L 

-

27/ At least one author argues that reserve funds should be

severed from the control of self-insurers and should not 

include securities or notes of the insurer. See 

Seymour Fiekowsky, "Self-Insurance," pp. 12-13. 
-64-

On the other hand, suppose that additions to qualified 

reserves are deductible and, therefore, that the reserves for 

certain types of liabilities or losses are established out of 

pre-tax income. Our rules state that all withdrawals of qualified reserves, as well as income on reserve assets, must be 

subject to tax. In this case, the future value of the qualified 

reserves established out of pre-tax income, A, is shown in 

equation 2.3. Note that the future value (or present value at 

time T) is exactly the same as in equation 2.2. 

2.3) FV = [A] [l+r(l-t)IT(l-t) - L 

Table 2.2 illustrates the potential equivalence of these 

alternative methods of accounting for expected future liabilities 

with a specific example. A firm is assumed to be subject to a 

constant marginal tax rate of 50 percent and to earn a pre-tax 

rate of return of 20 percent on its investments. As in Table 

1.2, the firm has receipts of $90.57 for its services in the 

initial year and expects future liabilities from the initial 

year's activity with a present value of $75.47. 

The first example shows a firm using the cash method of 

self-insurance; future liabilities are deducted when they occur. 

The firm pays a large tax liability in the initial year because 

it has no expenses to deduct. After-tax income is then set aside 

in a nonqualified reserve for the expected future liabilities. 

In this example, after-tax income is placed in the column labeled 

"Other Assets'' to distinguish it from qualified reserve assets 

established out of pre-tax income. Investment income is subject 

to tax in the current year. In the second year, losses of $50 

occur. Since those losses are deducted and used to offset the 

firm's other income, tax liability on other income is reduced by 

$25. The value of the firm's assets falls by $20.02 (-$50.00 + 

$25.00 + $4.98) between the first and second year. When the 

final expected expense occurs in the fourth year, a similar 
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-66-

offset occurs and the loss is again deducted. At the end of the 

fourth year the firm's final net worth is $11.05 after all income 

and expenses are accounted for, and no further losses are expected. Unlike qualified reserves, withdrawals from nonqualified 

reserve accounts are not included in taxable income because they 

have been established out of after-tax income. 

In the second example, the firm is allowed to use the 

qualified reserve method of self-insurance and deduct additions 

to qualified reserves in the current year. The example assumes 

that the firm correctly estimates the present value of future 

losses and follows the three strict accounting rules previously 

described. When the magnitude of losses, probability of occurrence of losses, and return on reserve assets are correctly 

estimated, the qualified reserve balance is exactly depleted 

when no further liabilities are expected. The present value of 

current deductions (additions to qualified reserves) is equal to 

the present value of future liabilities. No excess reserve 

assets exist at the end of the fourth year. Moreover, income on 

all reserve assets is subject to tax in the current year. While 

withdrawals of qualified reserve assets are technically subject 

to tax, in this example they are exactly offset by deductions for 

payments of the actual liabilities. The firm's net worth at the 

end of the fourth year is $11.05, exactly the same as the firm 

which accounted for liabilities under the cash method. 

The third example illustrates that if our first two 

accounting rules are enforced, the qualified reserve method 

can be nondistortionary even when the estimated present value of 

the expected liabilities differs from the actual liabilities. 

Excessive additions to qualified reserves may have been made 

because either the estimated liabilities were overestimated or 

the rate of return on reserve assets was underestimated. Income 

on all reserves, including excess reserves, is subject to tax in 

each year. Because withdrawals of excess reserves, $22.10 (equal 
-67-

to $15.10 in present value) are not offset by losses or liabilities, our rules also require taxable income to increase by the 

amount of excess qualified reserves. The inclusion of all 

withdrawals of excess reserves ($15.10) in taxable income exactly 

offsets in present value terms the prior excess deductions 

($90.57 - $75.47). The firm's net worth at the end of the fourth 

year is $11.05, which is identical to the two preceeding cases. 

The necessity of our third accounting rule can be seen by 

examining the assumptions in Table 2.2 and in equations 2.2 and 

2.3 to achieve equivalence of the alternative methods. First, 

the tax rate must be the same over time. If the tax rate upon 

withdrawal of reserves is lower than the tax rate at the time 

that the deposits to reserves are made, then the qualified 

reserve method of self-insurance creates a greater future value 

for a firm than will the cash method of self-insurance. 

Different tax rates may apply at different times because a firm 

has current or future losses and cannot fully take advantage of 

a current deduction. Thus, a firm in a current loss situation 

would probably prefer the cash method; a firm with sufficient 

current profits would probably prefer the qualified reserve 

method since future losses may not be fully deductible. -28/ 

Second, if the tax rate differs between the firm and the 

insurance company offering cooperative insurance, then the firm 

will prefer to self-insure if its rate is lower. The company 

will prefer to purchase cooperative insurance if the rate of tax 

on earnings of the insurance company, including earnings on its 

own reserves, are lower. The company also may prefer to purchase 

cooperative insurance if the tax treatment of the insurance 

company reserves is favorable. 

-28/ One reason for the lack of full deductibility is limitations 

of operating loss carrybacks under current tax law. 
-68-

Finally, the example assumes that rates of return are 

equivalent under all alternatives. If reserve investments are 

restricted, for instance, they may receive a lower rate of return 

than would unrestricted investments. In that case, a firm may 

prefer the cash method over the qualified reserve method if the 

former method allows assets of the firm to serve as implicit 

reserves, while the latter method requires explicitly that there 

be separate funding and more investment of qualified 

reserve assets. 

C. Deviations from Proper Tax Accounting of Reserves 

As can be seen by these examples, strict rules are required 

for firms to be treated equivalently under the alternative 

accounting methods, For this reason, the use of the cash method 

or cooperative insurance method is often preferable to the use of 

the qualified reserve method. Firms will generally not be at a 

disadvantage if they can only deduct expenses when they are paid, 

Unfortunately, the current tax system often provides unequal 

treatment of qualified reserve accounting and other methods of 

accounting for future contingencies. The deviations from proper 

reserve accounting fall into three general categories. First, 

investment income on reserve accounts is seldom fully subject to 

taxation. Partial or no taxation of income on reserves increases 

the amount of outstanding reserves and lowers the amount of 

additions needed to cover future liabilities. A firm's overall 

tax liability is lowered below what it would be if future 

expenses were deducted as they occur under the cash method of 

self-insurance or were covered by cooperative insurance. A 

deduction for additions to qualified reserves, combined with 

nontaxation of the earnings on the reserves and full taxation of 

withdrawals [case 11, is equivalent to exemption of all capital 

income on nonqualified reserves (established out of after-tax 

income) [case 21 as can be seen in equation 2.4: 

2.4) FV = [AI 1l+r] (1-t) [A(l-t)] [l+rIT 

[case 11 [case 21 
-69-

We need to distinguish here between nontaxation of investment 

income at the individual and the company level. If the qualified 

reserves are essentially the deposits of individuals, a company 

level deduction is proper for income on those reserves. The 

failure to tax reserve income currently in that case provides 

Lhe tax preference at the individual level. Even if such a 

preference is desired, it should not be dependent upon the method 

of accounting used. In particular, the individual preference (as 

we11 as indirect gains to the institutions which can offer this 

preference) should not be an accidental by-product of qualified 

reserve accounting. For reserves which represent assets of the 

company, of course, favorable treatment of reserve income is of 

benefit to the company. Where the taxation of the income on 

reserves is a hybrid--excluded or deferred if attributed to 

individuals, but taxable if attributed to the company--a company 

wight gain significant benefits if it could allocate more to 

individuals currently than later events would warrant. 

Second, tax accounting rules for qualified reserve accounts 

seldom require the withdrawal and inclusion of excess reserves 

in taxable income. In some cases, the amount of additions to 

reserves is unrelated to the frequency or magnitude of the 

expected losses or to the expected return on reserve assets. 

Certain thrift institutions, for instance, can deduct up to 40 

percent of their taxable income as additions to bad debt 

reserves. -29/ These additions generally need be made only on

paper; amounts are never required to be withdrawn and subject to 

tax. The reserve method thus enables a significant share of 

thrift institutions' income to escape taxation permanently. 

Third, even if the first two problems were met--earnings 

on reserves were taxed and excess reserves were withdrawn 

periodically--it is likely that the withdrawals would not be 

subject fully to tax if earnings on reserves were taxed. 

Instead, it would be argued that earnings that were taxed and 

29/ - Excess bad debt loss deductions may be subject to the 

corporate minimum tax. 
-70-

redeposited should be treated as withdrawals of capital. While 

this double taxation argument would be correct by itself, it 

would ignore the double tax which exists on all income which is 

saved, for instance, by other income earners or taxpayers using 

the cash method of self-insurance. If one examines equations 

2.2 and 2.3? it will be seen that equivalence is reached because 

there is a tax assessed twice in each case. 

Even when reserve accounting is fairly accurate, and all the 

proper rules are followed, attribution of income among recipients 

can be difficult. For instance, the appropriate rate to apply to 

reserves would be the tax rate of each beneficiary. The owner of 

a firm may prefer to keep passive investments in the firm if 

those investments would be taxed at a lower rate (as reserves) 

than if distributed. Similarly, creditors or policyholders may 

prefer that a financial institution keep some of their deposits 

or premiums as reserves if the rate of tax on those reserves were 

lower than their personal rate of tax and if they could be 

insured some right of eventual withdrawal or other use of the 

funds 

Since reserve accounting changes the timing of income 

receipt, "current" income recipients or future policyholders may 

also benefit from excess deductions which were paid for by 

current savers or policyholders. Technically, the income and 

tax liability associated with the withdrawal of excess reserves 

would be taxed to the beneficiaries, but those beneficiaries may 

include some taxpayers no longer engaged in transactions with the 

institution. One method of more closely allocating income across 

time would again be to require that deposits to reserves be 

calculated as accurately as possible, and that there be periodic 

withdrawal of excess reserves. Such withdrawals would decrease 

the transfer of tax liabilities across time from one group of 

taxpayers to another. 
---- 

-71-

V. SUMMARY: GENERAL RULES FOR THE TAX TREATMENT OF INCOME 

FLOWING THROUGH FINANCIAL INSTITUTIONS 

For transactions involving financial institutions, both 

efficiency and equity require proper rules of accounting and 

attribution of total economic income by type of income recipient, 

type of activity, and timing of income receipt. This section 

sets forth seven general rules regarding the taxation of income 

flowing through all categories of financial institutions. In 

cases where conflicting public policy goals are present, the 

rules specify "second-best" alternatives designed to minimize 

possible distortions. 

Rule #l. The initial tax base of individuals and businesses 

should include all economic income. Correct measurement of net 

economic income requires separating costs of earning investment 

income from costs of consumption of services; separating the 

return to capital from the return of capital; and allowing 

deductions related only to the proper measurement of net economic 

income. If total revenue from a tax base of economic income is 

considered to be too high, the effective tax rate should be 

lowered directly (or through an equivalent across-the-board 

deduction) rather than through special provisions which 

simultaneously distort the measure of income and allocation of 

resources. 

Rule #2. If special tax preferences are still provided, 

they should apply as directly as possible to the activity that 

is to be encouraged. If saving or investment is the favored 

activity, then the tax preference should be based upon total 

saving, investment or income from capital. If policy objectives 

are nonetheless pursued with specific assets receiving favorable 

tax treatment, then competitive balance among financial institutions can be attained only if the same tax preference applies to 

income from the asset regardless of the financial institution 
-- 

-72-

handling the asset. Moreover, fairness among investors and 

savers requires that any special preference be straight-forward 

and simple so as to avoid favoring only investors who can arrange 

complex transactions. 

If the preferred activity is consumption of a particular 

service, then the preference should be based upon the cost of 

the service. Thus, if a preferred form of financial service is 

provided along with investment services as a single joint 

product, the value of the tax preference should not be related 

to the amount of investment income. 

At the level of the financial institution, tax preferences on 

investment income or deductions for expenses of borrowing may 

need to be limited to reduce tax arbitrage--that is, borrowing to 

purchase preferred assets. Competitive balance again requires 

that company-level preferences for certain types of activity or 

investment be made available on a uniform basis to all types of 

financial institutions and nonfinancial businesses as well. 

These preferences should also be explicit and straightforward to 

facilitate proper evaluation of their cost and effectiveness. 

Rule #3. Economic income may need to be imputed or taxed 

indirectly i n-a few special cases where income cannot be directly 

observed. In the case of mutual organizations, the customer may 

receive a price reduction or later "dividend" which is equivalent 

to a return to his equity ownership. Parity between mutual and 

stock companies may require use of this imputation to avoid 

higher effective tax rates on the income of stock companies when 

they perform identical services at identical costs. The use of 

arbitrary deductions to lower the taxes paid by competitive stock 

companies, however, will almost always create disparities among 

different types of stock institutions. 

Rule #4. Where the allocation of income among specific--individuals is difficult, administrative simplicity may require a tax 

levied-­at the business level as a substitute for, rather than-as 
-- 

-73-

an addition to, taxation at the individual level. Such a 

"substitute tax" should not be available for large marginal 

investments of any one individual (that is, if the substitute tax 

rate is below the highest individual rate, then some limit must 

be placed on the extent to which income flowing through the 

financial institution can be sheltered) . 

Rule #5. The tax system should not differentiate among 

sources of income by type of activity generating that income. 

Investment income and income from other services should be 

taxed at the same rate. Different institutions should not pay 

different tax rates according to their principal activity or the 

percentage of their assets in specific forms. If certain types 

of financial products are granted special treatment, it will be 

necessary to develop rules to identify intended beneficiaries 

and to prevent tax-motivated consolidations and transactions. 

Rule #6. Since most firms accurately account for economic 

income by taking deductions only when actual losses and liabili-­

ties occur, or when premiums for cooperative insurance-­are paid, 

alternative forms of reserve accounting should not create 

competitive imbalance by assessing less tax--­ on the same income. 

Current deductions for future liabilities and losses should be 

allowed only if the taxpayer elects to adhere to specific rules 

governing "qualified" reserve accounts, as outlined in Rule #7. 

Since most contingent liabilities or losses of nonfinancial 

businesses are met without use of qualified reserves, the types 

of assets and liabilities for which qualified reserves are used 

must be defined by statute or regulation. There is no limit, 

however, on the amount of after-tax dollars that can be placed 

in nonqualified reserve accounts to meet any self-imposed or 

government- imposed regula ti ons . 

Rule #7. Current deductions for additions to reserve 

accounts, if allowed, should-be limited to additions to "quali-­

fied" reserve accounts governed under the following strict tax 

accounting rules: 
-74-

a) All income earned on qualified reserves must either 

be subject to tax currently at the company level or credited 

to individuals and taxed similarly to other individual 

sources of capital income. 

b) All withdrawals of qualified reserves must be included 

in the current year's taxable income. As actual losses or 

liabilities occur, they must be covered first out of qualified reserves established for those contingencies. The 

incurrence of the loss or the payment of the liability is 

deductible from income, and will generally offset income 

made taxable by withdrawal of qualified reserves. Excess 

qualified reserves, however, must be withdrawn periodically 

and subject to tax on the full amount of the withdrawal. 

c) Calculation of additions to qualified reserves must 

be based on reasonable expectations of future contingencies 

for liabilities or losses. Reasonable expectations should be 

based as closely as possible on the riskiness and amount of 

each type of asset or liability involved. 
-75-

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