Some philosophies I hold dear, like the the need for a level playing field, market and institutional transparency, a suspicion of near-monopolies, and the need for a well-functioning and prudent government that can make our economy function better.
All agree taxes are necessary for a well-functioning economy. Lately, Washington is discussing the end to some sacred tax-deduction cows.
We’ve discussed the possible repeal of the mortgage-interest deduction, offered with good intentions but resulting in a more regressive tax code. Corporations also have their share of tax advantages, and Obama promises that these too may be reformed.
Economists almost universally agree the corporate income tax makes little sense. If the goal is to ensure a share of the fruits of production go to the public coffers, it is more effective to tax these fruits once they are distributed to the shareholders through higher dividends and capital-gains taxes.To tax at the corporate level causes companies to engage in tax-avoidance strategies instead of innovation and production. Or, they forum-shop for friendly countries like Canada with its 15 percent corporate tax rate. Worse, the corporate tax raises the price of our export goods above our global competitors.
The more troubling issue is then why some companies are taxed while competitors are not. Perhaps now we should create a more level playing field based on an overriding principle — first, do no harm to economic efficiency.
The U.S. has a history of tax exemptions for organizations that selflessly pursue the betterment of society. Such exemptions are not because they are not-for-profit or because they have volunteer boards of directors. Rather, they are offered for service in the greater public good.
Some financial corporations are afforded tax-exempt status, even though they compete with other corporations that are not afforded this benefit. Corporations like credit unions and mutual funds divert their profits to their depositor/owners through payments to their share accounts or through lower than market interest rates when their owners borrow. In essence, such institutions are treated as mutual-benefit societies in which Peter pays Paul who repays Peter, with little interference from the IRS or the regulatory authorities.
A general tax policy principle is “if it walks like a duck, and quacks like a duck, it’s a duck.” The IRS taxes based on the substance of the transaction, not the form of corporate organization. The substance of mutual financial companies is little different than the traditional financial intermediation of community banks, led by boards of local citizens and designed to serve the needs of households and their commercial enterprises in the community.
I sit on a community bank board, and I had been a credit union member most of my life. Both organizations do great work in their communities and have similar missions. But, credit unions are afforded a tax advantage that holds small and community banks at a disadvantage. Banks live by the spread between what they receive in lending and what they pay out to depositors, with any residual going first to overhead, then to the IRS, and finally to shareholders. Corporate income taxes take a big slice from the spread. Mutual savings banks and credit unions are exempt from these same taxes.
While they continue to grow in management sophistication, community banks function much like they have promised their neighbors for a century. Meanwhile, despite the tax-exemption advantage, credit unions and mutual banks have been increasingly expanding their portfolio of services they provide to their community, including recent forays into commercial lending and residential mortgages.
Mutual financial institutions were granted their tax-exempt status in a sweep of Great Depression banking regulation. They probably could not successfully argue for their tax-exempt status based on the principles of the modern tax code. These tax-exempt organizations have also managed to escape many of the regulatory burdens placed on community banks arising as Congress reacts to the economic perils of U.S.banks too-big-to-fail. Tax-exempt financial institutions have gone unscathed by arguing they were different, even as they made great strides to become similar to, and compete side by side with, community banks.
Regulatory burdens increasingly imposed on community banks, and the tax and regulatory advantages afforded competing institutions, are two defining qualities that now make various community-based financial institutions unequal. We should be wary of banks too-big-to-fail. But, perhaps mutual banks and credit unions should advocate for less disparate tax treatment for their community banking cousins just as ardently as they argue to retain their preferred tax treatment. We should encourage equally our community-based organizations, even if we harbor a healthy skepticism about large investment banks.
Tax-exempt financial institutions are not alone. In fact, many other community-based organizations raise money, pay employees and avoid paying taxes based on their tax-exempt status. Some, like our local service organizations, are obviously performing a greater public service to us all. However, others merely scratch each other’s back as they engage in tax-exempt commerce.
If we aspire for a level playing field, either we tax identically all institutions that compete in similar commercial markets, or we repeal the notion of corporate income taxation. Meanwhile, if it quacks like a duck ...
Colin Read contributes to Bloomberg.com and has published eight books on finance and economics with MacMillan Palgrave Press. He chairs the Department of Finance and Economics at SUNY Plattsburgh.