Magazine article American Banker

Treasury Department Overview on Tax Reform Report

Magazine article American Banker

Treasury Department Overview on Tax Reform Report

Article excerpt

Most types of financial institutions presently benefit from preferential tax treatment. Besides being unfair and distortionary relative to the taxation of the rest of the economy, these tax preferences create distortions within the financial sector that are inconsistent with the administration's efforts to deregulate financial markets. Equity and neutrality demand that all financial institutions be taxed uniformly on all of their net income. These special preferences are especially inappropriate in a world in which the corporate tax rate is lowered and both individuals and other corporations are taxed on their economic income.

Banks and thrift institutions are allowed to deduct an arbitrary fraction of outstanding loans or otherwise taxable income as an addition to a reserve against bad debts, without regard to the actual losses they experience on bad debts. In theory, reserve accounting is consistent with accrual accounting, but in practice, reserve accounting for banks and thrift institutions has borne little relation to expected losses, and therefore little relation to proper accrual accounting. The special bad debt deduction for thrift institutions is tied to specialization in residential mortgage lending, and only benefits profitable thrift institutions. The special rules are at variance with the general rules that are applied to nondepository institutions and the correct income measurement rule. This arbitrary deduction involves a tax subsidy for financial institutions that has no place in an income tax system; it should be repealed.

Taxpayers generally are prohibited from deducting interest on debt incurred to finance holding of tax exempt bonds. Banks benefit from an exception to this rule; they are able to deduct 80% of interest incurred to carry tax exempt securities, and thus offset taxable income from other soucres, in many cases totally eliminating income tax liability. Because of the special rule that allows banks to earn arbitrage profits, borrowing costs of state and local governments are subject to greater volatility because of the excessive demand created for their taxpreferred bonds. The Treasury Department proposed extending to banks the general rule that fully disallows interest deduction on debt incurred to carry tax exempt securities.

Credit unions, which compete with banks and thrift institutions, curently are tax exempt. This exemption allows deferral of tax on members' interest income that is retained in the credit union. This tax break for their members gives credit unions a competitive advantage in attracting deposits from other financial institutions. The exemption should be repealed.

Life insurance companies traditionally have been allowed a deduction for increases in policy reserves that exceed the amount of policyholder's savings and interest income represented by the actual increase in the cash value of the policies they underwrite. In addition, they are allowed a special deduction for 20% of otherwise taxable income (60% for small companies). This extra deduction is equivalent to applying a lower tax rate to the income fo life insurance companies. Deductions for increases in reserves should be limited to increases in cash value, and the special deduction should be repealed.

Amounts earned by policyholders on the cash value of life insurance (the "inside buildup') generally escape income tax under present law. …

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