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December 22, 1937 To; Board of Governors From: Mr. Groldenweiser Attached is a memorandum on "Taxation and the Interest Rate Structure" which -was sent privately to Mr# McKee by a person familiar with the bond market. Comments on the memorandum by Miss Burr are also attached. The -writer of this memorandum wishes it to be understood that in its present form it represents only a somewhat hastily written preliminary draft for the purpose of presenting the general observations which form its main thesis. Any illustrative material used is to be considered subject to correction and any comments or corrections will be gratefully received. November 3, 1937 TAXATION AND THE INTEREST RATE STRUCTURE In theory, a capital market is an integrated structure. The relation of its components is supposed to be determined by comparative risk, measured by disparities of the rate of return. In fact, the rate structure of our market is largely influenced by an extremely complex system of tax exemptions. Of the negotiable, interest- bearing investments in the market, the major fraction is composed of governmental issues, Federal and local, enjoying a greater or less degree of tax exemption: 1. U.S•Government bonds ($20,000,000,000) (a) Tax-exempt to corporations. 2. U.S. notes and bills ($15,000,000,000) (a) Totally tax exempt to individuals and corporations. 3. Local government issues ($20,000,000,000) (a) Totally tax exempt to individuals and corporations. 4. Corporate issues (a) Income fully taxable to corporations and individuals. - 2 - TAX EXEMPTION AND THE BOND MARKET The fact that long governments are tax exempt to institutions and not to individuals has several consequencos. 1# A long government is worth more to an institution than it is to an individual. 2. A long government is worth more than the best corporate to an institution* 3. Long governments gravitate out of the hands of individuals into institutions. 4. Corporate bonds, no matter how good, to find any market at all, must yield more by the corporate tax differential. 5. To a surtaxed individual a corporate bond must yield over 6%9 because the highest grade tax exempt bonds yield over 6# Owing to the differentials between corporation taxes and individual surtaxes, a high gradfc corporate is worth more than 6fo to a financial institution. The net consequence of this elaborate system of tax exemptions and tax differentials is to create two categories of bonds: 1. Those suitable for institutions find a market in institutions at a very low yield. 2» Those not suitable for institutions must have an extremely high yield to find any market among individual investors. 3« a. This high yield must be combined with a safety equal to that obtainable on the highest grade municipal a manifest impossibility. - 3 - The net result of this combination of tax exemptions, tax differentials, and compartmenting is: 1. Governments and the highest grade corporate bonds gravitate into institutions. 2. Tax-exempt locals gravitate into the hands of surtaxed individuals. 3. There is, and can be, no real demand of magnitude for corporate bonds below the institutional grade. 4. The same reasoning applied to such fixedincome issues as preferred stocks. We can pause a moment and consider the consequences of these circumstances. !• Long goverrmients cannot be held by individual investors, since their market is made by an institutional buyer to whom they are tax exempt • 2. Gilt-edge corporates cannot be held by individuals (a) because of tho differential between the corporation tax and the individuals surtax and (b) because the net yield to a surtaxed individual is inferior to that obtainable on tax-exempts of equal quality and maturity. In short, tho taxation forces tho long governments and gilt-edge corporatos into institutions, just as it forces municipals into hands of individuals. Instead of these three types of long-term securities being compononts of a single market, they are components of two distinct compartmented markets almost without intercommunication. The institutional demand 4 and the individual demand, even within this limited area, is canalized by taxation. Most of that former unity conceived as the gilt-edge market or the pure interest rate is quite unreal in contemporary America. The liaison between these two markets is maintained by the totally tax-exempt five-year Federal note and the high grade local, both of which are tax-exempt to both holders. Even this liaison is interrupted, as we saw on September 15, when in spite of the increase in member bank reserves, individuals took $100 million of the current note offering away from the banks. Not only has the tax differential compartmented the gilt-edge market; it has destroyed the second grade and preferred stock market. The second grade bond and the second grade preferred stock may be defined as one entitled to sell at 5% or higher in a 3 to market. Such a security is not quite of institutional caliber, but it formerly had a real market among individuals. But such a security now yields net to the individual in the higher brackets no more than ho can obtain on a first rate tax-exempt; in fact, it docs not compete until it sells to yield 8 per cent — time it has lost claim to being second grade. by which In short, there is an institu- tional market for gilt-edge corporate fixed income securities; but from the class there is no market for any fixed income security until it sells on an equity basis. The importance of this fact will be discussed later. It is not necessary to emphasize the important part always played in financing by the second grade fixed-income security. Its elimination has profoundly weakened our whole scheme of capital distribution. 5 It'will be objected that in this discussion, I have assumed an individual tax rate of 50 per cent. Under the 1936 tax act this does not extend below incomes of $100,000, but combined with state income taxes, it applies to that income bracket. 30 per cent tax. From $50,000 to $100,000 one may assume a The reason I have assumed rather high brackets is because of the former role of these individuals in the primary distribution of new securities. The person with an income of less than $50,000 is not much of a prospect for an underwriting and distributing house. If we assume he saves 10 per cent of his income, above his insurance, his net annual capacity is only 5 bonds a year; and the cost of effecting an initial distribution to such clients would be pretty high; even assuming they were not stock-minded. There is, of course, a market among trust companies, which can parcel them out among their less surtaxed clients, thus effecting a secondary distribution at almost no cost. It is not, therefore, quite correct to say that there is no market for second grade fixed income new issues; it is more accurate to say that what was once a big market, and an integral although unconscious functioning element of our system of financing, has been groat'ly shrunken by our system of tax differentials. If one analyses the new financing of the past two years, he will understand the reasons for its peculiar character. - 6 - (1) From 1931 through 1934, there was little formation of capital. The numerous defaults and suspensions of dividends pretty well dried up the sources of individual saving. (2) In 1935-6 and early 1937, there was a considerable formation of capital, and contrary to general belief, an enormous demand for new issues. This was especially true in 1936 and early 1937. was not for corporate issues. But the demand The public bought investments by the billion — but they vrere tax exempt governments and locals* So avid was the demand for fixed income securities that in the fiscal year 1937 (following the tax act of 1937), the public not only took the whole deficit, but bought $1,500 million from the banks portfolios — and the data show that a good part of what the public bought was the tax-exempt governments. There was also a great institutional refinancing market, exchanging gilt-edge corporates for gilter edge corporates. But there was no market at all for second grade corporates. In short, the whole new issue market in 1935-6-7 has been dominated by the fact that the market was acutely tax conscious. Institutions would buy available gilt-edge corporates, but individuals v/ould buy only tax-exempts — and, indeed, could afford to buy nothing else. All sorts of other reasons have been advanced — S.E.C. regula- tions, a strike of capital, lack of confidence, sun spots, and what not. The reason is perfectly obvious. The first grade securities found an institu- tional buyer; the below institutional securities were not offered on terms that competed with the tax-exempts. - 7 - To illustrate this, let us consider three recent issues — the Continental Can preferred, the Piire Oil preferred and the Bethlehem Steel bonds• The Continental Can issue was distinctly first grade; in quality it competed with the best tax-exempts -- the five-year note. The issue was small. Even to a person in the 50 per cent bracket, it offered a yield just over 2 per cent. It could compete and did compete in quality and price with its tax-exempt competitors. The Pure Oil issue was distinctly second grade. To a person in the higher brackets, it offered only 2-1/2 per cent net, which was distinctly not competitive in quality or yield. It was, it is true, brought out at a most untimely moment; but I question if it could have been sold on those terns at any time since the high surtaxes were restored. succeeded on a 7 or 8 per cent basis. It might have The success of the Continental Can issue and the failure of the Pure Oil issue illustrates what I mean by saying that the market for second grade, fixed-income issues is gone. It cannot compote with tax-exempts. The Bethlehem Steel issue illustrates the most curious anomaly of tho year. It too was unfortunately timed; but the fact remains that as a bond it was priced as an absolutely gilt-edge issue, and it was gilded only on about three edges. It was not a mortgage bond, and, being new, it was unseasoned. As a bond, it was priced on a bank basis, but it was not quite of institutional grade in a year when banks were selling their investments to take on loans. But it m s a double barreled issue; convertible. At 3-l/2J&, the individual was expected to accept a l*-3/4$ yield on a not quite firstgrade bond while waiting for a conversion price well above par for a stock - 8 - paying no dividend, and with an erratic earning record. That is, one barrel was aimed in the general direction of the banks, and the other in the general direction of the individual. Both barrels went high. It was obvious from the trend of bank investments over 12 months that it would not find a market there; and to the individual investor, the yield after taxation was so negligible, as to offer no more than chance to buy Bethlehem Steel Common 20 points above the market. Even at that, the conversion features, subject to the capital gains tax was of most- uncertain vnluo. It is, of cotirse, not very difficult to be wise in retrospect. But it is only by examining typical cases, both successful and unsuccessful, that it is possible to test the thesis of this memorandum. This thesis is: that our whole structure of fixed income securi- ties is dominated by complicated tax differentials. Some of these are of such recent creation that formulae based on the experience of the 20* s are utterly unapplicable. In my opinion, most of the complaints about the new issue market are completely wide of the mark. These tax differentials exist; and as long as they exist our whole interest rate structure and every pattern of new financing — if any — must take cognizance of them. As far as fixed interest corporate securities is concerned, there is a market for the giltedge — and that is all. The market for second-grade fixed interest corporate securities is gone with the wind of recently created tax differentials. The fact that a few issues were put over in contradiction to this general thesis in no way invalidates the conclusion. ~ 9 - The Continental Can issue was aimed at a specific compartment of the market; it scored a bullfs eye. in particular. It was a failure. The Pure Oil issue was aimed at no one The Bethlehem Steel issue was aimed at two different targets — the institution and the individual; and it hit neither. But together they point a moral and adorn a tale. There is a gilt edge market in institutions in competition with tax-exempts; there is a gilt edge market among individuals, in competition with tax-exempts; and there is an equity market, that also competes v/ith taxexempts, on a different basis. But there is no market at all for the second grade fixed income corporate security. It is eliminated under our system of taxation. Now let*s look at the other side of the picture. Stripped of its meretricious convertibility, the Bethlehem issuo is finding a market as a high class second grade bond to yield 5% or thereabouts to maturity, which gives a price of about 80. The Pure Oil issue has been taken over by the Guaranty Trust at 50 — which is hardboilod banking; in this capital market, as a 7% stock it can find buyers in the vicinity of 70. Oil put one over on the issuers. Bethlehem and Pure But how about Continental Can? The Conti- nental Can issue was a "success" to the issuers, but in my opinion Continental Can was the sucker. It is paying 4- 1/2 per cent for money that it could have obtained from banks at half the price; because it not only has to pay for its money (and that kind of money is obtainable at 2-l/2 per cent), but it has to pay the investors income tax as well. If Continental Can could have made an issue free of income and surtaxes up to 50%, it could have got the money at close to 2-l/4 per cent -- then it would have realized that it was paying - 10 - 2-l/4 per cent for the money and 2-l/4 per cent for taxes. If it had been put up to then that way, I think they would have preferred a bank loan. In the same way, what does it cost the Federal Government to borrow at 2 per cent on five-year notes? It costs 2 per cent plus 2 per cent or 3 per cent — whatever is the bracket of the individual buyer ~ and most of the individual buyers of that kind of issues are in the 50 per cent bracket or higher. That is, the Treasury itself paid on its September 15 financing between 4 per cent and 5 per cent — which is a good stoop rate on a note. If the Treasury had come out frankly on September 7 with the aimouncenent that it felt itself obligated to offer 4-l/2 per cent for a fivo-yoar note, v/e should have had a terrific decline in the stock market; and all the economists would have got out their slide rules and demonstrated mathematically why the market went down* Our first thesis was that the process of compartmenting the giltedge market by a complicated system of tax exemption had almost utterly destroyed the market for second grade, fixed income corporate securities. Our second thesis is that the supply of credit is cheap and plentiful and the supply of capital is costly and scarce. It is scarcely necessary to argue that credit is cheap and plentiful — any banker will supply the necessary proof. The actual cost of capital in the new issue market, where the appeal is to capital rather than bank credit, is sufficient proof that capital for corporate enterprise is scarce and dear, (a) It is scarce because the high taxes prevent the formation of capital on the scale to which our 11 - economy is geared and (b) it is dear because enterprise has to carry the surtax on the investors income -- which means approximately a doubling of the rate. So what? The supply of credit under our system is virtually unlimited; it can be, has been, and will be manufactured ad lib under a system of irredeemable money, regulated solely by the dogma that the supply must always meet the demand at a "low" rate. The supply of capital is limited first by the profitability of the economy, and second by the taxation on capital in the process of formation. In my opinion, cheap fiat credit plus high income taxation inevitably not only implies but causes scarce and dear capital. All this year we have looked at a set of credit money rates, seen how low they were, and assumed that they had the same representative significance that they had under entirely different conditions. In the days of intercommunicating markets, and when tax considerations were inconsequential, one could take a given money rate say the commercial paper rate or the yield on Atchison general 4 ! s, and like Roy Chapman Andrews reconstructing a dinosaur from a single toe bone, outline the whole rate structure of the market. Now we have compartmented markets and compartmented rate structures. The fact that the supply of credit is unlimited and its price correspondingly cheap should not obscure the fact that the supply of capital is small and shrinking, and that its price must not merely coyer an interest rate, but cover the tax rate of the investor * December 22, 1937 COMMENTS ON MEMORANDUM "TAXATION AND THE INTEREST RATE STRUCTURE." Susan S. Burr The significant points made in the memorandum are: (l) That all except the highest grade bonds of corporations must find a market outside of institutional investors, and that at the present time there is no active demand for new offerings of such securities. (2) That, during a period when the volume of tax-exempt obligations is increasing, high progressive surtaxes on individual incomes tend to discourage direct purchases by individuals of corporate securities. The discussion in the memorandum emphasizes the great need at the present time for more adequate information on the supply of funds available for investment in corporate securities below the highest grade. In our judgment, the memorandum overemphasizes the effect of the tax exemption of Government bonds on the corporate bond market. There is also a tendency in the memorandum to draw broad conclusions concerning the capital market on the basis of conditions for new issues during October and November of this year. Comments on various points in the memorandum follow: 1. Despite the advantages of tax-exempt securities, individuals in the higher income brackets do not hold an important part of the amounts outstanding. At the end of 1934 individuals with net incomes of $5,000 and over held about $4,500,000,000 of a total of $31,000,000,000 of Government securities outstanding outside of Government accounts and Sinking funds which were exempt 2 from normal income tax and surtax. Such holdings included 13,100,000,000 of $17,000,000,000 of state and local securities, which are the long-term obligations fully exempt to individuals. Although this information is compiled from individual income tax returns and may not be complete, it is reasonably satisfactory as a rough indication of the proportion of the total thus held. Of the large increase since 1934 in the outstanding amount of Government securities the major part has consisted of Federal bonds subject to surtax. 2. The yield on second-grade corporate obligations declined substantially during the period 1933-1936 when the major part of the depression increase in tax-exempt securities took place. At the end of 1936 the average yield on second-grade corporate obligations, as shown by the Moody's average of Baa corporate bonds was percent, about 3/4 of one percent lower than at any time in the 1920*s. As shown in the table the spread between average yields on second-grade corporates and on high-grade municipals at the end of 1936 was not quite as narrow as in the twenties. Average yield on Spread between corporate corporate Baa bonds Baa and high-grade (Moody1 s) municipals (Percent) December 1927 (low of the 1920*s for Baa) May 1932 (high of the depression for Baa) December 1935 December 1936 November 1937 5.32 11.63 5.30 4.53 6.01 1.42 6.86 1.99 1.77 2.84 - 3 - After the sharp declines in security prices this fall the average yield of the lower-grade corporates "was higher than since the latter part of 1934. 3. The value of tax exemption to wealthy individuals is only one of a number of factors determining their investment in taxable as compared with tax-exempt obligations. Other factors are: (l) State and local obligations, the long-term tax-exempt obligations available to individuals, are not as attractive as the memorandum implies because they involve varying risks depending on the issuing government. (2) Individuals can and do make indirect investments in corporate bonds through ownership of stock in closely-owned corporations and in investment trusts. 4. Details of three security issues are discussed in comparing the markets for corporate issues and tax-exempts, the Bethlehem Steel debenture issue and the Pure Oil preferred stock issue, both offered in September, and the Continental Can issue offered in October of this year. In the current capital market situation, which these illustrateinstability in security prices and uncertainty concerning the future of business profits have been important in the reception of new issues and have affected the lower-grade corporate issues in particular. 5. For ujuajujjlig, '•fhe outstanding amounts of tax-exempt obligations shown on page 1 are not the amounts "in the market", that is available for current purchase by investors. The floating supply of Governments is usually small and additional holdings are usually acquired largely from new offerings. Furthermore, such offerings will probably be smaller from now on* _ 4 - 6. In commenting on the large demand for new issues during the period 1935-1936 and early 1937, it is stated that "there was no market ... for second-grade corporates." This statement could be somewhat modified in view of the increase during these years, as compared with 1932-1934, in the corporate securities offerings for new capital which usually include bonds and notes below the highest grade. The pertinent data are summarized below. Securities issued for new capital i f Calendar year Increase in publicly offered Federal debt (in millions of dollars) Yearly av, 1932-34 1935 1936 1937 (Jan.-June) 221 163 683 3,396 404 1,192 795 334 839 516 855 735 427 1,448 3,751 1,237 1/ As published by Commercial and Financial Chronicle
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