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Federal Funds and the Profits Squeeze-a New Awareness at Country Banks Excising Excises BUSINESS REVIEW is produced in the Department of Research. Jack C. Rothwell was primarily responsible for the article “ Federal Funds and the Profits Squeeze," and William D. Schwartz for "Excising Excises.” The authors will be glad to receive comments on their articles. Requests for additional copies should be addressed to Bank and Public Relations, Federal Reserve Bank of Philadelphia, DigitizedPhiladelphia, for FRASER Pennsylvania 19101. FEDERAL FUNDS AND T H E P R O F IT S S Q U E E Z E A NEW AW ARENESS AT COUNTRY B AN KS THIRD DISTRICT COUNTRY MEMBER BANKS tender spot— the profit margin. As the chart PER CENT shows, operating expenses have climbed relative 70 tax earnings as a percentage of total revenues. to total revenues, forcing a sharp dip in before As shown in Chart II, earnings per dollar of total assets and total capital also have leveled off. 60 But as the cartoon indicates, the country banker hasn’t taken the profit pressures lying down. Among other things, he has sought to 50 bolster profit margins by keeping a sharp eye on costs, by increasing the volume of loans rel ative to deposits, and by holding non-earning 40 assets— cash, excess reserves, and the like— to a minimum. Indeed, minimizing cash assets has become an objective which the country banker 30 has pursued with increasing ardor as profit pres sures have mounted.* The extent of this increasing attention given to the management of cash assets is illustrated 20 1946 1950 1955 I960 1965 particularly by the swelling number of country The figure in the chart above is a familiar one banks which have entered the federal funds mar to country bankers in the Third Federal Reserve ket in recent years. Yet though much has been District and to many in the nation as a whole. said For like their city cousins, country bankers funds, little has been done to measure the actual have been faced with two-pronged pressures in dimensions of this participation. about country-bank activity in federal recent years, with rapidly rising costs— espe To throw some light on this question, the cially in the interest paid on mounting time de Federal Reserve Bank of Philadelphia recently posits— and with generally stable interest rates conducted a complete census of Third District on loans and investments. The result has been increasing pressure in a * For an analysis of bank efforts to reduce cash assets, see Federal Reserve Bank of Philadelphia, Business Review, “What Price Liquidity,” September, 1964, p. 3. 3 business re v ie w C H A R T II one out of every three country banks partici THIRD DISTRICT COUNTRY MEMBER BANKS pated in the market, a substantial increase in Net earnings before taxes as percentage o f: PER CENT participation in only a few years. Indeed, as TOTAL ASSETS Chart III shows, the greatest spurt in fed eral funds activity occurred between 1962 and 1964, when the proportion of country banks which had been active in the funds market jumped from around 13 per cent to 34 per cent. W h a t size banks a re most active? As might be expected, the bigger country banks, which generally have a larger and more spe cialized staff, are most active in the market. All country banks in the over $100 million deposit class, for example, borrowed and lent funds in 1964, as did 70 per cent of banks in the $20- country banks, attempting to find out the num $100 million class (as shown in Chart IV ). ber of banks in the federal funds market, size C H A R T IV of transactions, and many other facts. What follows is a summary of findings, along with some implications both for the individual banker and for the Federal Reserve System. PERCENTAGE OF THIRD DISTRICT COUNTRY MEMBER BANKS PARTICIPATING IN THE FEDERAL FUNDS MARKET IN 1964, BY DEPOSIT SIZE How m a n y banks in th e m a rk e t? Before 1960, less than five out of every 100 Third District country member banks had any experience in the federal funds market. In 1964, C H A R T III PERCENTAGE OF THIRD DISTRICT COUNTRY MEMBER BANKS W HICH HAVE PARTICIPATED IN THE FEDERAL FUNDS MARKET, 1960-JANUARY, 1965 $2Mil. $100 Still, the smaller country bankers were by no means idle. A surprising 48 per cent of banks in the $10-$20 million size class were in the market and even the smallest banks, under $2 mil lion in deposits, participated at a rate reach ing almost 14 per cent of their number. The increasing significance of smaller coun try banks is illustrated also by the rapid growth I9 6 0 Digitized for 4FRASER in number participating in the market. As Chart business review federal funds market grew by 44 per cent be CHART V PERCENTAGE CHANGE IN PARTICIPATION RATE BY DEPOSIT SIZE, THIRD DISTRICT COUNTRY MEMBER BANKS 1 9 6 2 -1 9 6 4 tween 1962 and 1964 and a rapid increase in participation rates was also scored by banks in the $5-$10 million deposit class. PER CENT H ow o fte n a re banks in th e m a rke t? During 1964, the typical country banker bor rowed federal funds, on average, almost four times a month and lent funds over nine times. The bigger the bank, moreover, the more often was the average banker in the market. As Chart VI shows, a banker in the under $2 million class borrowed funds about one time every month and lent less than one time on average. His neighbor in the $20-$100 million deposit class, on the other hand, borrowed almost seven times each $ 2 Mil. $100 V shows, the portion of banks in the $10-$20 million deposit class which participate in the CHART VI AVERAGE NUMBER OF FEDERAL FUNDS TRANSACTIONS PER MONTH IN 1964 BY DEPOSIT SIZE, THIRD DISTRICT COUNTRY MEMBER BANKS month and lent nearly 11 times. C H A R T V II AVERAGE SIZE OF FEDERAL FUNDS TRANSACTIONS AS A PERCENTAGE OF AVERAGE CAPITAL AND SURPLUS, BY DEPOSIT SIZE, THIRD DISTRICT COUNTRY MEMBER BANKS How much in d o lla r am ount? In dollar terms, the typical country banker bor rowed federal funds amounting to about 30 per cent of his capital and surplus, on average, and lent funds which ran about 35 per cent of capital and surplus. Unlike the situation with respect to frequency, however, the smaller banks tended to borrow and S2 Mil. $100 lend funds in greater amounts relative to capital 5 business re v ie w FEDERAL FUNDS: AN ANATOMY What is a federal funds transaction? When one bank lends to another bank funds it holds on deposit with a Federal Reserve Bank, it has consummated a “ typical” federal funds transaction. The qualifier “ typical” must be added because other organizations (such as Government securities dealers) borrow and lend federal funds and because under a recent ruling of the Board of Governors of the Federal Reserve System* a bank may lend funds directly to a correspondent, funds which it holds on deposit with that or another correspondent, and consider the transaction a loan of federal funds. Obviously, then, the term “ federal funds” is an evolving one. The recent Federal Reserve Board ruling has simplified the bookkeeping involved in the borrowing and lending of federal funds and has helped stimulate vigorous regional markets in federal funds. It is with this “ new wrinkle” in federal funds—the rapidly growing regional markets—that this article is primarily concerned. Why do banks borrow and lend federal funds? Banks are in business to earn a profit, hence they lend and invest the funds their depositors leave with them after they have provided for cash needs, required reserves, and the like. Often, however, banks find that they have temporary excesses in funds—more than needed to meet cash and re serve requirements. Other banks have temporary deficiencies— less funds than needed to meet their immediate needs. If the surplus and deficit banks can get together and agree upon terms for a loan of excess funds, then the surplus banks earn a profit on funds that might otherwise be held as idle cash and the deficit banks obtain the funds they need to meet demands upon them. What are the details of the new type of federal funds transaction? “ Fed funds,” answers the manager of the federal funds department. The place is the X City Bank. It is 2:10 in the afternoon and this is one of several calls from country correspondents which typically will come in between 9:20 a.m. and 2:30 p.m. "Hello, Joe,” says a voice at the other end of the line, "this is Crawford at Y Country Bank. I have 200 to lend for a day, what’s the rate?” “ Can take 200 at 4 per cent. All right?” “ Done. Charge my account.” “ Righto. Talk to you tomorrow.” “ Thanks, Joe.” Click. The conversation above resulted in a loan of $200,000 in federal funds by the Y Country Bank to its correspondent, the X City Bank. The Y Country Bank will earn about $22 for its effort, which is the approximate return on $200,000 lent for one day at 4 per cent. But the transaction doesn’t stop here. Word of the loan must go to many people in the X City Bank. Let’s follow the repercussions of the transaction as it spreads in widening circles through out the many departments of the X City Bank, for several people must cooperate if the fed funds transaction is to be consummated effectively. The transaction begins as the federal funds manager, still talking on the phone, fills out the following form. * For details of this ruling see Federal Reserve Bulletin, August, 1964, and P. 1000. 6 business review THE X C IT Y BANK W e promise to pay $__ Q ® Q you f o r _________________ i_______ day ( s ) a t ____on 30 M w A Date for Federal Funds borrowed from per cent per annum. 3/ _______ RECEIPT OF FUNDS IS ACKNOWLEDGED □ By your wire transfer through Federal Reserve System 0 ^ B y charging your account with us INTEREST PAYMENT 0 ^ W e credit your account with us □ W e enclose our cashier’s check □ You are authorized to charge our account with you In repayment of loan w e w ill return funds through the same channel as received, as indicated above, unless w e receive other instructions from you. Interest [^Secured 2kj M R. Authorized Signature He hands this form to his secretary who uses the information to type a multiple-part form, d if ferent leaves of which go to different parts of the bank and to the country correspondent. The first leaf goes to the country correspondent to confirm the transaction. The next three leaves go to the City Bank’s accounting department with instructions for proper bookkeeping entries: to record receipt of the federal funds, to pay the funds back the following day, and to pay the proper amount of interest to the Country Bank. Another leaf of the multiple-leaf form goes to the City Bank’s filing department to be kept as a permanent record of the transaction. A leaf also goes to the City Bank’s money and wire transfer department as a memorandum. The last two leaves go to the custody department. If the trans action is so drawn, the custody department will earmark Government securities of the City Bank as collateral for the City Bank’s borrowing of federal funds. This may be for the entire amount of the transaction or only for part. The collateral exempts the Country Bank from laws specifying that loans to one borrower may be only a certain fraction of capital and surplus. and surplus. This tendency can be seen in Chart both sides of the market; almost half of par VII, though it is evident that borrowings bear a ticipating country banks both borrow and lend more consistent relation to size than loans. funds while 22 per cent borrow funds only and 29 per cent lend funds only, as shown in Table 1. W hich side o f th e m a rk e t? One might suspect that country bankers, who TABLE 1 traditionally have kept a greater cushion of ex THIRD DISTRICT COUNTRY MEMBER BANKS WHICH PARTICIPATE IN THE FEDERAL FUNDS MARKET cess reserves than their city cousins, would more often be lenders than borrowers of federal funds. And indeed, both the frequency and magnitude of federal funds loans by District country bank ers are greater than of borrowing. It is interesting to note, however, that a large number of District country bankers operate on Side of market Percentage of participating banks Borrow federal funds only Lend federal funds only Both borrow and lend federal funds Total 22 29 49 100 7 business re v ie w Table 3. This choice reflects, among other things, TABLE 2 THIRD DISTRICT COUNTRY MEMBER BANKS W HICH PARTICIPATE IN THE FEDERAL FUNDS MARKET Borrow federal funds only as a percentage of banks which only borrow and only lend Deposit size (millions) Lend federal funds only as a percentage of banks which only borrow and only lend Under $2 $2-5 $5-10 67 78 65 33 22 35 $10-20 $20-100 $100 and over 29 8 0 71 92 100 the intensification of city-bank efforts in recent years to inform their country correspondents about the federal funds market. It also reflects the willingness of the city banks to accommodate country-bank needs in relatively small dollar amounts. Whereas federal funds transactions once were denominated in millions of dollars, a country bank needing $100,000 in funds may now obtain accommodation from city banks. If th e need arose A final question asked District country bankers in the survey of federal funds activity was this: Moreover, Table 2 shows that those banks “ Even if you do not borrow federal funds now, which operate only on one side of the market would you do so in the future in response to (only borrow or only lend) tend to be clus temporary reserve deficiencies?” tered into two groups: smaller banks which, A surprisingly large proportion said that in rather unexpectedly, most often are on the bor- deed they would borrow federal funds if needed. row-only side of the market, and larger banks, Thirty-three per cent of banks which had never which are most often on the lend-only side. been in the market at all— either on the borrow TABLE 4 Through w hom a re funds b o rro w e d and THIRD DISTRICT COUNTRY MEMBER BANKS lent? By far the large majority of country bankers use the services of their city correspondent to execute federal funds transactions, as shown in TABLE 3 THIRD DISTRICT COUNTRY MEMBER BANKS W HICH PARTICIPATE IN THE FEDERAL FUNDS MARKET Percentage placing transaction through: Correspondent Federal funds broker Other bank Borrow* 97 7 1 Not in the market but would borrow if needed Sell only but would borrow if needed Under $2 $2-5 $5-10 $10-20 $20-100 $100 and over 36 31 32 41 21* 100 100 75 83 67 100 All country banks 33 79 * All participate. Lend or lend side— said they would borrow funds if the 99 5 2 that have lent but never borrowed funds would * Does not add to 100 per cent because some banks execute transactions through more than one class of inter mediary. 8 Deposit Size (millions $) need arose, and almost 80 per cent of the banks come into the market on the borrow side if the need arose. Table 4 summarizes the replies by size of bank. business review Some im plications fo r th e banks Like other firms in other industries, banks are lets for funds— loans and investments. But like most innovations in banking, the in business to make a profit. In today’s in borrowing and lending of federal funds is no creasingly competitive markets, banks— also like panacea, no automatic machine where the press other firms— find it necessary to innovate, to of a button brings forth an instant balance be search out new procedures for controlling costs tween the need for profit and the requirements and to find new sources of funds and uses for of liquidity. those funds if profit margins are to be main tained. The sizable expansion in country bank par ticipation in the federal funds market raises On the other hand, banks are unlike other some interesting questions. Perhaps most im businesses in at least one respect. A large por portant, since most banks entered the market tion of their liabilities— the checking account after 1960, a period of generally easy money deposits of their customers— are payable on de conditions, what might happen if money should mand. Banks must stand ready both to convert become tight? deposits into currency and to meet the claims of other banks on a moment’s notice. Should the current expansion in economic activity accelerate to a point where inflationary Herein lies both the challenge and the art of pressures threaten, and should monetary policy banking. To make a profit, banks must employ shift to a posture of less ease, then country funds in loans and investments. To meet the banks may find wholly new conditions in the demands of depositors, banks must hold some federal funds market— conditions which they funds in cash and other assets must be readily may not now anticipate. convertible into cash with little or no loss or With limited experience in the market, some delay. This is the art of banking and the art has banks may expect federal funds to be available changed little in basic, underlying concept from even in the event of tighter money. This ex the days of the early Italian bankers, through pectation may not in fact be realized. The re the great age of European merchant banking to sult: a necessary return to more traditional the present. Now, as in the past, the quest for techniques of adjusting cash positions, a return profit must be tempered by the need for liquidity for which the prudent banker will be prepared. and the exercise of sound judgment. By the same token, an important question The federal funds market provides a useful exists for larger correspondents which are the vehicle both to increase profits and to enhance major lenders and borrowers of funds from coun liquidity. Funds temporarily in excess of needs try banks. How will the larger correspondents may be lent for very short periods— overnight react when the needs o f country banks conflict or for two or three days with little more than with their own money position? As the availa a phone call. Temporary deficiencies may be bility of funds from country banks diminishes met by borrowing federal funds. and as larger banks are called upon to supply The market thus allows both individual banks and the banking system to economize on cash, to keep less in the form of cash and near-cash assets, and to increase the more profitable out funds, their own cash positions may well be strained. Indeed, to illustrate the extent of the possible pinch, the survey of federal funds activity 9 business re v ie w showed that many banks not even borrowing eral funds to country correspondents, for ex funds would do so if the need arose. As already ample, will be a factor in determining the ap noted, 33 per cent of banks which have never been propriateness of city-bank borrowing. in the market indicated a willingness to borrow funds if needed, as did almost 80 per cent of In conclusion banks which had lent but never borrowed funds. The new environment in which banks today are operating was appraised with particular thought Im plications fo r F ed eral Reserve policy fulness by J. L. Robertson, a member of the If experience in the Third District is indicative Board of Governors of the Federal Reserve Sys of an evolving national trend, developments in tem, at a recent meeting of the Ohio Bankers the federal funds market have important im Association.* plications for Federal Reserve policy. The large Governor Robertson discussed a broad spec increase in country-bank participation in the trum of developments in banking, especially re funds market and the declining cushion of cash cent efforts by banks to open new sources of reserves held by country banks means that a funds— certificates of deposit, capital notes and move toward restraint would tend to result in a debentures, as well as federal funds. He indi quicker and more pervasive tightening. In other cated some of the advantages of the new areas words, a given unit of restraint would tend to of competition for funds as well as some pos produce a greater tightening effect now than sible difficulties. Following is a particularly inter in the past, and the Fed would certainly want esting quote from Governor Robertson’s speech. to take this into consideration both in formulat Some of the consequences of this change [in ing and in implementing its monetary policy. sources and uses of funds] can be seen, and oth The question also arises of administration of ers can be guessed at. For one thing, sophisti the Fed’s discount window. Regulation A pre cated management skills are clearly of increasing scribes that “ . . . credit is generally extended importance in this new banking market. Tapping on a short-term basis to a member bank in order the new sources of funds is not child’s play. To to enable it to adjust its asset position when the extent that these funds represent borrowing necessary because of developments such as a sud from the market what used to be borrowed from den withdrawal of deposits or seasonal require correspondents and the Federal Reserve, the bor ments for credit beyond those which can reason rower may find the market, in times of need, ably be met by use of the bank’s own resources.” to be much colder and far less understanding. Clearly, Regulation A precludes continued ac While banks can now gain funds from a greater commodation at the discount window in cases variety of sources (and incidentally be emanci where over-loaned or over-invested positions re pated from sult in frequent cash needs. sources), by and large these new funds are much sole dependence on local area In determining the appropriateness of bor “ hotter” — more volatile— than the old deposit rowing, the Federal Reserve Banks will also flows. In this field the personal customer rela want to look at flows of funds between city banks and their country correspondents. The extent to which city banks are lenders of fed 10 * “The Changing World of Banking,” remarks of J. L. Robertson, member of the Board of Governors of the Fed eral Reserve System, before the m idwinter meeting of the Ohio Bankers Association, Columbus, Ohio, February 12, 1965. business review tionship is not as important today as the quoted Reserve System. The discount window will, of rate— as both the customer and the bank become course, always be there to protect communities aware of alternatives. and to meet the emergency needs of banks. But Banks have always been borrowers— that is it would not be wise to count on its being there how they get their resources— but the latest de to save bankers from the consequences of going velopments are something new. They are new overboard in borrowing short and lending long. because more banks are now aggressively seek Furthermore, supervisory authorities should not ing short-term, price-sensitive money. This in count too heavily on the use of the discount win creasing emphasis on short-term funds from the dow to paper over their mistakes and deficiencies. market may actually increase the exposure of The essence of Governor Robertson’s remarks individual banks to sudden adverse drains— seems to be this. The federal funds market, as particularly since policy changes by the Federal well as other new sources of funds, must be Reserve that once influenced mainly your port approached with caution and with judgment if folios now also powerfully influence the relative maximum benefits are to be derived. Now, as in cost and stability of your liabilities. As a result, the past, indiscriminate action is likely to result in adversity many banks may be more dependent in haphazard, even dangerous operating results. than ever on correspondent relations and ulti For unlike modern cake mixes and coffees, there mately on the lender of last resort— the Federal is no instant wisdom. Excise taxation has never been especially pop unhappiness. That was in 1794. In 1965, tax ular in this country. The first such American payers with grievances resort to more civilized levy, on liquor, spurred western Pennsylvania methods of protest such as appearing at House farmers to stage a rebellion; militiamen were Committee hearings and sending lobbyists to needed to quell this demonstration of taxpayer Washington. Despite the change in tactics, the 11 business re v ie w EXCISES ARE LEVIED O N A WIDE RANGE OF GOODS The classifications used here are those in the Treasury Bulletin ALCOHOL TAXES Distilled spirits Wines Beer TOBACCO TAXES Cigars Cigarettes Other RETAILERS’ EXCISE TAXES Furs Jewelry, etc. Luggage, etc. Toilet preparations MANUFACTURERS’ EXCISE TAXES Gasoline Lubricating oils, etc. Tires, tubes, and tread rubber Passenger automobiles, chassis, bodies, etc. Trucks and buses, chassis, bodies, etc. Parts and accessories for automobiles, trucks, etc. Radio and TV sets, phonographs, components, etc. Refrigerators, freezers, air conditioners, etc. Electric, gas, and oil appliances Pistols and revolvers Phonograph records Musical instruments Sporting goods, (other than fishing rods, creels, etc.) Fishing rods, creels, etc. Business and store machines Cameras, lenses, film, and projectors Electric light bulbs and tubes Firearms (other than pistols and revolvers), shells and cartridges Mechanical pencils, pens, and lighters Matches DOCUMENTARY AND CERTAIN OTHER STAMP TAXES Documentary stamp taxes Playing cards Silver bullion sales or transfers MISCELLANEOUS EXCISE TAXES Admissions to theaters, concerts, etc. Admissions to cabarets, roof gardens, etc. Club dues and initiation fees Toll telephone service, telegraph, cable, radio, etc., wire mileage service, wire and equipment service General telephone service Transportation of persons Use of safe deposit boxes Sugar Diesel and special motor fuels Narcotics and marihuana including occupational taxes Coin-operated amusement devices Coin-operated gaming devices Bowling alleys, pool tables, etc. Wagering occupational tax Wagers Use tax on highway motor vehicles weighing over 26,000 pounds Adulterated and process or renovated butter, filled cheese, and imported oleomargarine Firearms transfer and occupational taxes Interest equalization goals remain the same— abolition of the offend recordkeeping burdens on small business. Some ing duties. distort consumer choices as among different The Federal excise-tax structure today is ex traordinarily complex, frequently frustrating, kinds of goods. . . . I believe it is vital that we correct the most pressing of these deficiencies and, in some cases, seemingly irrational. Taxes this year. . . . In addition to improving the tax are levied on such diverse goods as alcohol and system, the recommended changes will increase automobiles, matches and mechanical pencils. purchasing power and stimulate further growth Rates range from 5 per cent to more than 100 per in the economy. cent of a commodity’s value. In fiscal 1964, Although the President laid emphasis on the the excise tax on alcohol produced $3.6 billion reform aspects of his proposed reductions, their in revenue; the levy on various butter, cheese, impact on the economy is also important. Ques and oleomargarine products yielded $3,000. tions have been raised about the economy’s abil This year the Administration plans to ask ity to continue strong in the second half of this Congress to reduce excise taxes. In his budget year and through 1966; any reduction in excise message President Johnson said it was time to taxes should provide at least modest stimulus to “ revise and adjust” excises, and asked for a further expansion. reduction of about $1.75 billion, effective July 1. Preparatory to this year’s legislative consid He further noted that: eration, the House Committee on Ways and . . . Some of the present excises are costly and Means held hearings last summer on the Federal inefficient to administer. Some impose onerous Excise Tax Structure. Spread over three months, 12 business review the hearings produced more than 1,400 pages of from producers in the form of manufacturers’ testimony, panel discussion, and papers. The excises on automobiles, gasoline, tobacco, and Committee heard a panel of excise-tax experts alcohol. Retail excises are collected from the and then listened to industry spokesmen present final seller, who in turn collects all or part their cases. The consensus was that some excises of the tax from the consumer. These taxes should be cut; which and by how much were are levied on such items as jewelry, furs, and not agreed upon. luggage. In its examination of the forthcoming Ad But to know where a tax is collected by ministration requests, Congress will look at both the Internal Revenue Service is not necessarily the potential economic effects of a given reduc to know who actually bears the burden of the tion, and the technical and administrative dif tax. ficulties associated with particular levies. These searchers have long studied this question of tax are the primary considerations to be examined incidence. Does a manufacturer, for example, here. pay the 10 per cent manufacturers’ excise tax on Lawmakers, economists, and social re a particular good, in whole or in part, or does Excises— w h a t and how much? he shift it forward to the consumer in the form An excise is defined by Webster as “ an in of higher prices? Or shift it backward onto his ternal tax levied on the manufacture, sale, or workers and suppliers in the form of lower consumption of a commodity within a country.” wages and prices? Federal excise levies are sometimes termed se lective sales taxes, in contrast to a general sales Determination of a tax’s incidence is not al ways easy, but it is essential. Only if we know tax which may be levied against all products who actually bears the burden of the tax can sold, with specific legislative exemptions such we attempt to calculate the effects of adjusting as food and clothing. the levy. For not all taxpayers react the same Within the framework of Federal finance, excise duties play an important role. In fiscal way when they find themselves with additional cash. 1964, Federal excise-tax collections produced $14.0 billion for the Federal Government, ap W h a t stimulus fro m an excise t a x cut? proximately 12 per cent of total budget receipts The stimulus a particular reduction will give from the public; in fiscal ’65, excises are again the economy depends on many factors: absolute expected to produce about 12 per cent of budget dollar amount of reduction, pattern of demand receipts. As a proportion of total receipts, ex for the product on which the tax is levied, and cise collections have been stable over the past incidence of the levy, among others. six years, averaging about 12.3 per cent annually. In the following table, major excise levies have been listed in order of revenue produced in W h o pays? fiscal 1964. Everything else remaining the same, Federal excises are collected at both the whole repeal of the alcohol excises would probably sale and retail levels as manufacturers’ excise give the economy the biggest lift because it levies and retail taxes, respectively. The major would leave most additional revenue in the pri dollar volume of Federal excise collections comes vate sector of the economy. Abolition of the 13 business re v ie w tax on phonograph records would give the economy less of a boost. TABLE 1 Another consideration bearing on the stim RECEIPTS FROM SELECTED EXCISE TAXES — FISCAL 1964 ulus of a tax cut is the extent to which a cut in price will increase the quantity of goods de (in thousands of dollars) Percentage of total excise collections demand, or elasticity. If a reduction in price stim ulates a considerable increase in the quantity of goods demanded, the demand is said to be more manded. Economists call this price elasticity of Category Revenue Alcohol Gasoline $3,577,499 2,618,370 25.6 18.8 Tobacco 2,052,545 14.7 Passenger automobiles, chas sis, bodies, etc. elastic than if the same price reduction produces 1,745,969 12.5 a smaller increase in the quantity demanded. 530,588 475,013 3.8 General telephone service Retailers’ taxes* Tires, tubes, and tread rubber Toll telephone service, tele graph, cable, radio, etc. wire mileage service, wire and equipment service 411,483 3.4 2.9 It is very difficult to make meaningful quan titative judgments about the elasticity for a par ticular commodity. Economists must, therefore, 379,608 2.7 usually content themselves with making gen eral qualitative judgments about the elasticity Trucks and buses, chassis, bodies, etc. 350,945 2.5 Parts and accessories for automobiles, trucks, etc. 228,762 1.6 Radios and telephone sets, phonographs, components, etc. 197,595 1.4 Documentary and certain other stamp taxes 171,614 1.2 Diesel and fuels sets may be elastic over a broad range of 128,079 0.9 prices. In other words, it is doubtful if increas Transportation of persons 106,062 0.8 Use tax on highway motor vehicles weighing over 26,000 pounds ing the tax on cigarettes, with a corresponding special motor for various goods, as the following examples show. Demand for cigarettes seems relatively in elastic, whereas demand for color television rise in retail price, would discourage a great deal 100,199 0.7 Sugar 95,411 0.7 Electric, gas and oil appliances Lubricating oil, etc. 77,576 76,316 0.6 0.5 Club dues and initiation fees 75,120 0.5 Business and store machines 71,867 0.5 Refrigerators, freezers, air conditioning, etc. 62,799 0.5 color television sets, were the reduction passed on Admissions to theaters, con certs, etc. 47,053 0.3 to the consumer, would encourage purchases of Electric light bulbs and tubes 41,511 0.3 color televisions by persons who will not buy Admissions to cabarets, roof gardens, etc. 41,026 0.3 sets at the present higher prices. Again, how Cameras, lenses, film projectors 29,580 0.2 ever, such judgments are necessarily subjective. 25,098 0.2 A third consideration is the levy’s incidence, 232,544 1.7 that is, who bears the burden of the tax and 100.0** hence who would benefit from a reduction in Phonograph records All other Total and $13,950,232 * Includes tax on furs, jewelry, luggage, toilet prepara tions, etc. * * Items do not add to total because of rounding. Source: Treasury Bulletin, December, 1964. 14 of smoking. In general, demand tends to be inelas tic for those goods on which consumers spend small percentages of their incomes, such as cig arettes, salt, and pencils. It seems probable, how ever, that abolition of the 10 per cent levy on the tax. If taxes borne by low-income individ uals are reduced, then money would be left in the pockets of people more likely to spend new business review funds.1 A reduction benefiting higher-income of this might be elimination of the Federal ex groups would perhaps mean less of an absolute cise on automobiles, which yielded $1.75 bil increase in spending because high-income in lion in revenue in the past fiscal year.2 Automo dividuals tend to save a larger percentage of bile manufacturers point to the large amount of their income than low-income persons. By the money that would be released and say that any same token, reduction of a tax previously borne reduction in this 10 per cent manufacturers’ by corporations, the proceeds from which were excise levy will benefit consumers. used to build cash balances, would be less stim Less stimulation would probably come from ulative than if the funds released went to cor abolition of a low-yield tax, the released revenue porations which paid them out in dividends, spent them on new plant and equipment, or re duced prices. Repeal of certain taxes is not the only pos sibility. Congress may choose to reduce certain rates, raise some, or impose taxes on goods not TABLE 2 REVENUE RELEASED PER PERCENTAGE POINT REDUCTION IN TAX* (in thousands of dollars) already taxed by the Federal Government. There Automobiles (10 per cent) has been discussion outside the administration, Gasoline (4c per gallon) for example, of lowering some manufacturers’ ex cises to 7 or 5 per cent from 10 per cent, par ticularly the levy on automobiles. The table following shows how much revenue would be released by a one percentage point reduction in the tax rates on selected commodities. Under cer tain conditions, the table shows, a tax cut of 1 per cent of the automobile levy, for example, would release more revenue than a 5 per cent cut of the tax on radios and television sets. This kind of calculation permits comparisons among dif ferent reduction packages with regard to their $174,597 72,732 General telephone service (10 per cent) 53,059 Retail excises (10 per cent) 47,501 Toll telephone service, telegraph, cable, radio, etc. (10 per cent) Trucks and buses, chassis, bodies, etc. (10 per cent) 37,961 35,095 Parts and accessories for automobiles, trucks, etc. (8 per cent) 28,595 Air transportation of persons (5 per cent) 21,212 Radio and television sets, phonographs, components, etc. (10 per cent) 19,760 Electric, gas, and oil appliances (5 per cent) 15,515 Refrigerators, freezers, air conditioners, etc. (5 per cent) 12,560 Business and store machines (10 per cent) 7,187 Electric light bulbs and tubes (10 per cent) 4,151 * Derived from data in Treasury Bulletin: December, 1964. potential effects on the nation’s economy. Taking the above-mentioned factors into con from which would go to individuals or busi sideration, we can make some statements as to nesses with a low propensity to consume. One what cuts might, theoretically, give more and example of such a reduction might be abolition less stimulus. More stimulus might come from of the levy on club dues which affects mainly elimination or reduction of a tax which re higher-income groups. Persons with high in leased large absolute dollar amounts into the comes tend to spend a lower percentage of their hands of consumers with a high propensity to income than low-income individuals. Another consume wide ranges of products. An example i Past experience has shown that the average American consumer tends to spend about 92 per cent of his income. 2 Although the Administration has not mentioned this levy as a target for reduction, considerable pressure is being brought to bear on Congressmen to reduce or abolish this tax. Automobile makers talk about a 9-million-car year if the tax is abolished. 15 business re v ie w example might be abolition of the manufac show excise collections below what sales data turers’ excise tax on matches, which yields only would indicate. This causes friction between $4 million. Demand for matches tends to be very revenue agents and retailers who are trying to inelastic over a wide range of prices. comply with the law. Stimulus to the economy, however, will be Bookkeeping difficulties have not been the bane only one factor Congress will consider in the of small businessmen alone. A major oil com coming weeks. In some cases non-revenue fac pany, for example, points out that payment of tors may be more important in determining the fate of a levy. Let us look at some of these con the manufacturers’ excise levy on lubricating and cutting oils is complicated by the existence siderations and the taxes on which they bear. of “ hundreds of interpretations” of the law. N o n -re ve n u e considerations “ distort” consumer selections. Of course any In his budget message the President emphasized tax distorts consumer choice to some extent. The President also referred to levies which the reform aspects of his proposals. In particu Some taxes, however, are probably more im lar, he mentioned those excises “ costly and mediately guilty than others. An example of inefficient to administer,” those which “ impose such a tax, its opponents claim, is the 10 per onerous recordkeeping burdens on small busi cent tax on cameras and photographic equip ness,” consumer ment. Camera manufacturers and distributors choices as among different kinds of goods.” complain that the levy discriminates economi and those which “ distort Some of the levies which might fall in one or an cally against camera “ bugs” because it taxes one other of these categories are discussed below. form of recreation and not others. Phonograph- One levy costly to collect is the tax on cabaret record makers complain that the excise duty on admissions. This tax presents problems because their products discriminates against them be it must be collected from a large number of tax cause books and magnetic tape, for example, payers, and in relatively small dollar amounts are not taxed. from each. One estimate puts collection costs of The retail excise on fur goods was attacked this levy at several times those of most other by fur-garment makers on the grounds that it excises. Other levies costly to collect are the taxed their products but not perhaps equally retail excises on furs, jewelry, toiletries, and luxurious garments which had no fur on them. luggage. These, also, are collected from thou Makers of women’s handbags are unhappy about sands of individual taxpayers, who in turn col a tax on what they consider a necessity. “ The lect the tax from millions of customers. tax [on handbags] is discriminatory. The pock Compliance is difficult for storekeepers, par ets of the fair sex are taxed; those of the male ticularly drug store owners. The House Ways are tax free. This is contrary to the American and Means Committee heard testimony that concept of basic fairness.” 3* Excise levies apply payment of these taxes is difficult because so to men’s wallets, but not usually to trouser many items are involved. At the retail level, pockets. usually, collection from customers is only as good as the clerk behind the counter. One result is that audits of taxpayer returns frequently 16 s Burton S. Wirtschafter, Director, National Authority for the Ladies Handbag Industry, in U.S. Congress, House, Committee on Ways and Means, Federal Excise Tax Struc ture, 88th Congress, 2d session, 1964, p. 240. business review Business excise ta x e s among other items, the tax on lubricating and Another group of levies under heavy fire con cutting oils. He pointed out that the portion of sists of taxes on equipment and supplies used the tax collected from business concerns is ob by businesses. Some tax authorities argue that jectionable because businesses should not be business equipment and supplies should not be subjected to excise taxation on goods they use, subject to excise taxation because goods used in essentially production are not “ consumed” for the reasons discussed above. in the same Moreover, he argued, the portion of the tax way that hair spray, for example, is consumed falling on non-business users is undesirable be by a housewife. Rather, they argue, goods cur cause those taxpayers are satisfactorily taxed by rently taxed such as light bulbs, business ma the gasoline levy. chines, lubricating oils, and the like, are used by businesses in the production of other goods; “ U n d e s irab le ” and the taxes, opponents say, place an unfair and lo w -y ie ld ta x e s burden on firms using these goods. Insofar as Other levies have been attacked for tending to the tax burden is sometimes passed on to the discourage activities generally considered de final consumer, of course, manufacturers do not sirable. In this group are frequently included really shoulder the tax load, and in these cases taxes on musical instruments and on theater the above argument would be less persuasive. and concert admissions. Yielding about $20 mil If Congress, however, concurs with the op lion annually, the levy on musical instruments ponents of business excises, the 10 per cent tax on business and store machines might be re has been criticized because it may tend to dis duced or repealed. Similarly, the tax on electric Admissions taxes have been criticized for dis light bulbs— of which businesses are big users— couraging attendance at cultural events. At least might be abolished, as might the 10 per cent in the case of the Broadway theater, the tax levy on general telephone use and long-distance falls on an industry that has operated in the calls. Telephone taxes have been criticized on red for several years. David Merrick, the Broad the grounds that (a) large numbers of telephone way producer, testified that “ elimination of the calls are made by business firms as an essential crippling admission tax would be a most ef part of daily commercial operations, and (b) fective immediate measure in moving toward the tax is no longer needed to perform its initial the revitalization of the living theater. It would function of discouraging telephone use in a time be a concrete demonstration of recognition of of war.4 the importance which we place Appearing before the Ways and Means Com consumption discouragers courage musical instruction in some families.5 on cultural achievement.” 6 mittee, Professor John F. Due of the University There are several excise taxes which have of Illinois gave “ top priority for repeal” to, received attention as possible candidates for elimination on the grounds that they produce 4 Opponents of a reduction or elimination of the telephone levies cite two key reasons why the 10 per cent tax should not be adjusted this year. First, they note, domestic tele phone companies are prospering, and do not “ need” tax relief at this time. Second, the telephone levies might be good ones to retain until the economy shows signs of slow ing down because abolition of the taxes would then pump almost $1 billion into the stream of economic activity. 5 Professor Due noted in his presentation before the Com mittee that musical instruments are used by many persons to earn a living, and the tax is in part a business excise tax and, therefore, undesirable. 6 On behalf of National Association of the Legitimate Theatre, Inc., and the League of New York Theatres, Inc., in U.S. Congress, op. cit., p. 1185. 17 business re v ie w insignificant revenue, and so are not worth the said. In revenue terms the most important user cost of collection because of the inconvenience fee is the 4 cents per gallon tax on gasoline, which collection causes. Among such taxes are receipts from which go mainly into the High those on matches (yielding about $4 million an way Trust Fund. Other levies benefiting the nually), mechanical pencils, fountain pens, ball Fund include those on tires, tubes, rubber, and point pens, and lighters ($9 million), play vehicles over 26,000 pounds. As the President ($9 m illion), and safe-deposit-box further noted in his budget message, the esti rentals ($7 m illion). Their combined yields of about $29 million annually constitute about mated cost of completing the Interstate High ing cards way System has increased by $5.8 billion. A c .02 per cent of estimated budget receipts in the cordingly, coming fiscal year, and .21 per cent of estimated proposals “ specific recommendations for increas he said, he will include in his excise receipts in the same period. ing certain highway user charges.” U n lik ely candidates the 5 per cent tax on domestic airline tickets. Another user fee unlikely to be eliminated is There are several taxes that have not been Proceeds of this tax are used to offset in some mentioned often as targets for reduction or measure the funds the Federal Government has elimination. Indeed, some of them may actually spent to assist commercial air transportation in be raised. These levies fall into three classes: this country. sumptuary, user, and regulatory. Several taxes have regulatory functions as Sumptuary taxes are levied in part to dis their raison d’etre. Payment of these levies by courage consumption of goods which some per taxpayers provides the Government with a rec sons consider undesirable. Tobacco and alcohol ord of transactions in certain goods. The levies excises have long been grouped in this category. in this classification have not been widely men In addition to serving a sumptuary purpose, tioned as targets for reduction or elimination these two levies produced $5.6 billion in rev and include those on narcotics, marihuana, fire enue last year. There are two economic argu arms, documents, adulterated and processed but ments in favor of these taxes. First, because of ter and filled cheese. The revenue produced by the relatively inelastic demand for these goods, most of these duties is low, with the excep a tax on them probably does not distort pro tion of the stamp tax on documents which con duction and consumption patterns as much as tributed $163 million to the Treasury in fiscal a tax on a good for which demand might be 1964. more elastic. Second, some maintain, there is a real social cost to the use of tobacco and al O u tlo o k cohol which is not fully reflected in the selling The excise tax structure in this country remains price; this cost is said to be the manhours lost complicated despite legislative efforts since the to alcoholism and other illnesses. Korean War to make the code more nearly uni User fees were singled out by the President form with respect to rates and other require in his budget message. “ Fairness to all taxpayers ments. Hundreds of different items are taxed at demands that those who enjoy special benefits different rates and for different reasons. In its should bear a greater share of the costs,” he deliberations Congress will have in mind many 18 business review factors affecting each tax— some fjscal, some tional chamber has urged the Congress to elim technical and administrative, some political. inate selective excise taxes— except in wartime— At present the outlook for excise tax reduc and to substitute for them a low-rate uniform tion and reform this year seems bright. The excise tax on all goods and services except med Administration does face two major problems icine, rent, and food consumed ‘off premises.’ ” 7 in requesting such a reduction, however. First, One of the arguments against a national sales, Congress will be, and is already, under pres or excise, tax is that it would squeeze state and sure to exceed the requested $1.75 billion pack local governments out of what has evolved as age. Secretary of the Treasury Dillon has stated their taxable domain. For this reason alone, that a $2 billion cut probably would not be in such a proposal would probably meet heavy flationary, but that a reduction of $3 billion Congressional opposition. might well be. Concern over incipient inflation Another proposal has been that rather than ary pressures may be one reason the Presiden eliminate certain excises, they should be low tial request was smaller than generally had been ered to, say, 7 or 5 per cent, from 10 per cent. anticipated. Secondly, the list of proposed items In certain cases, the Administration has indi must be presented to the House Ways and Means cated, some reductions may be sought. The Committee, and acted on by that body and the President made clear, however, that a primary entire House, within a relatively short time, or reason he seeks cuts this year is that collection many fear a general buyers’ “ strike” against and compliance problems in some areas are in goods whose taxes might be reduced or abol ordinately difficult. Reduction rather than elim ished. Already there are reports that some con ination probably would not solve these prob sumers are awaiting the outcome of the House lems. deliberations before making major expenditures Whatever the final package that emerges from on goods whose taxes might be affected. One the House deliberations, the key fact is that for widely discussed possible solution may be a the first time the Administration, Congress, man system of rebates to persons who purchase af ufacturers, fected goods before a reduced price goes into demonstrated considerable unanimity of opinion consumers, and economists have effect. This might prove effective at the manu and are prepared to act on this consensus. How facturers’ level and on big-ticket items, such as much stimulus the final cut will give the econ automobiles, but retailers seem skeptical about omy and to what extent increased state levies application of such a system for small items on will offset any stimulative effects of a Federal which the tax is but a few cents or a few dollars. cut remain unknown. But at least it seems vir Not everyone, however, is in favor of cutting tually certain that a modest reform of the Fed excises without some compensating adjustments. eral excise tax structure will take place this The President, as noted above, has indicated year. This will be viewed favorably by many that some excises may be raised. The Chamber interest groups, not least by consumers. of Commerce of the United States reiterated its position last summer: “ For many years the na 7 Joel Barlow, chairman, committee on taxation, Chamber of Commerce of the United States, Ibid., p. 124. 19 F O R THE R E C O R D . . . BILLIONS $ Third Federal Reserve District United States Per cent change Per cent change Jan. 1965 from Jan. 1965 from MEMBER BANKS, 3RD F.R.D. Department Storet Factory* Employ ment Payrolls Sales Checkf Payments Per cent change Jan. 1965 from Per cent change Jan. 1965 from Per cent change Jan. 1965 from Per cent change Jan. 1965 from SUMMARY mo. ago year ago LOCAL CHANGES mo. ago year ago 0 + 8 MANUFACTURING Production........ .............................. Electric power consumed........... Man-hours, to ta l* ........................ Employment, to ta l.......................... W age income*.............................. - CONSTRUCTION” ........................ -1 0 - 4 -1 3 - 7 COAL PRODUCTION...................... + 16 + 1 - + 2 TRADE” * Department store sales................. Department store stocks............... -5 9 BANKING (All member banks) Deposits.......................................... Loans............................................... Investments..................................... U.S. Govt, securities................... O ther............................................ Check paym ents***...................... PRICES W holesale...................................... Consumer........................................ ‘ Production workers only. “ Value of contracts. “ ’ Adjusted for seasonal variation. i 2 0 2 + 9 +10 + 3 +12 1 +11 mo. ago year ago mo. ago ot + 8 +10 + 4 - 1 + 13 + 2 + It + - 3 2 1 2 1 3 0 0 + + + + + 9 13 3 2 13 4 mo. ago year ago mo. ago year ago Lehigh Valley. . . . + 3 + 6 + 5 +21 - 7 + Harrisburg............ + 1 + 4 0 + 19 - 3 + 9 Lancaster.............. - 1 + 4 - 2 + 16 -5 8 +10 - 8 +13 Philadelphia......... - 1 + 2 - 3 + 10 -5 9 +11 -1 0 + 2 0 + 2 0 + 11 -5 6 + 16 -1 6 1 + 0 + 9 -6 5 + 11 - 6 + 6 Reading................. 0 0 + 2 + 2 + 3 - 8 year ago Scranton............... - 1 5 0 + 8 Trenton................. 0 + 1 0 + 2 -6 0 - Wilkes-Barre. . . . + 1 + 6 + 1 + 18 -6 4 + 12 + 3 + 10 W ilmington.......... 0 + 6 - 7 + 11 -6 1 + 15 - + 5 2 + ii - 1 +25 -6 1 +21 -1 1 1 5 -1 4 0 + 1 JPhiladelphia York...................... - + 4 ’ N o t restricted to corporate limits of cities but covers areas of one or more counties. fAdjusted for seasonal variation.
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