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REDLINING:

AN ECONOMIC ANALYSIS
John P. Segala

I.
INTRODUCTION

The role of redlining
in the quality decline of
housing units in urban neighborhoods
has been the
Various
subject of heated debate in recent years.
consumer
and neighborhood
organizations
contend
that, whether figuratively
or literally, lending institutions draw red lines on maps around particular city
neighborhoods
and either refuse to grant mortgage
credit or offer comparatively
more stringent
terms
in the areas bounded by the lines. As evidence, they
often cite statistics showing a lower volume of lending, often with a higher cost to borrowers,
in particular urban compared to suburban
neighborhoods.
The antiredlining
groups argue that such behavior
by institutional
lenders is at best overly risk averse
They
and at worst discriminatory
and arbitrary.
claim that redlining is a major cause of neighborhood
decline since it denies the neighborhood
the mortgage
funds necessary
to maintain
stability
of property
values.
Many observers,
however, argue that it is not
necessary to construct a Devil Theory based on irrational behavior by lenders to explain the statistics
cited by antiredliners.
Instead, by examining rational
lender response to economic conditions
and regulatory constraints,
these analysts seek to explain the
relatively low supply of mortgage funds in certain
In part, this explanation
stresses
neighborhoods.
numerous borrower and neighborhood
characteristics
that increase the risk of lending beyond an acceptable
level. In this view, low levels of mortgage activity in
urban areas stem from general socioeconomic
problems in those areas such as the flight of the middle
class to the suburbs, low average incomes of city
residents, aging of the housing stock, and inadequate
It is also argued that
inner city public services.
usury ceilings often prevent lenders from charging
a rate of interest sufficient to compensate for the
high risk of mortgage lending in certain areas.
Coinciding
with this debate has been a growing
quantity of so-called antiredlining
legislation, enacted
In California,
stateat all levels of government.
licensed financial
institutions
are prohibited
from
denying a mortgage loan or adjusting the terms of a

loan on the basis of the age, location, or other “. . .
conditions, characteristics
or trends in the neighborhood or geographic
area surrounding
the housing
accommodation
unless the financial
institution
can
demonstrate
that such consideration
in a particular
case is required to avoid an unsafe and unsound business practice.”1
At the Federal level, the Community Reinvestment
Act (CRA)
encourages “regulated financial institutions to fulfill their , . . obligation to help meet the
credit needs of their communities,
including low and
moderate income neighborhoods
. . .”2 The encouragement is that an institution’s
compliance with the
CRA will be considered
by its supervisory
agency
when it applies for an expansion of services.
Local governments
have also enacted antiredlining
legislation.
A city law in Cleveland, Ohio empowers
the city to withdraw its accounts from financial institutions that fail to make sufficient loans within the
city.
In particular,
the law requires that the percentage of loans granted to city borrowers by a financial institution
must equal the percentage of deposits
held by city residents in that institution,
or else the
city may withdraw its funds [2].
Supporting
these and other antiredlining
actions
are numerous
empirical studies showing significant
differences in the type, number, and terms of mortgages granted across neighborhoods.
In particular,
these studies have found that lending institutions
located in certain urban neighborhoods,
and obtaining
a significant proportion
of their deposits from urban
residents, are directing the majority of their conventional mortgages to suburban
properties.
In some
quarters, this is viewed as evidence that urban neighborhoods are not receiving their “fair share” of mortgage funds, which in turn, allegedly contributes
to
depressed property values and neighborhood
deterioThere are, however, major deficiencies
in
ration.
many of the studies upon which antiredlining
actions
are based. Generally, the studies simply present evidence of differences in the relative number and terms
1 State
35810.

of California,

2 12 United
(1977).

States

FEDERAL RESERVE BANK OF RICHMOND

Health
Code

and Safety

Annotated

Code.

Sections

Section

2901 et seq.

3

of conventional
mortgages
granted
between urban
and suburban properties and conclude that the cause
is irrational
redlining behavior by lenders.
Totally
ignored are any underlying
economic causes for such
differences in mortgage activity.
The result may be
to foster legislation that produces a costly misallocation of mortgage funds.
Specifically,
if there are
rational economic reasons behind low levels of mortgage investment in certain areas, then legislation that
requires or “encourages”
institutions
to lend to these
areas may be counterproductive
in the long run. The
purpose of this article, therefore, is to determine the
economic causes, if any, behind redlining
behavior
and to briefly evaluate the impact of antiredlining
legislation on the mortgage market.
Before doing so, however, it is necessary to establish a working definition
of redlining.
As defined
here redlining occurs when lenders base any element
of the mortgage decision, including whether or not
to lend and the terms of the loan, on the geographic
location of the property or on the characteristics
of
surrounding
properties.
This
narrow
definition
directs attention to one of the primary allegations of
antiredliners,
namely that geographic location is not a
proper consideration
in mortgage lending.
Moreover,
because of the existence of legislation that prohibits
redlining as defined above [see 15], it is necessary
to determine how geographic location and neighborhood characteristics
affect the risk of a mortgage
loan

so that

the

economic

impact

of such

further that in this neighborhood
all housing units
possess identical economic characteristics
such that
the present market value, the expected future value,
and the expected variance (change) in future values
of each unit are the same. Thus, given the characteristics of the property, it is reasonable to expect that,
for any given rate of interest, the poorer household
will demand a larger loan (i.e., a smaller downpayment) with a longer term to maturity than will the
richer household.
The poorer household requires a
larger loan because it possesses fewer cash assets to
finance the downpayment.
Similarly,
it desires a
longer term to maturity
in order to reduce the
monthly mortgage payment.
It is also assumed that a household’s demand for
mortgage
loans varies inversely
with the cost of
borrowing, i.e., as interest rates rise both households
will demand a relatively smaller loan.
For a given
property, a smaller loan of course implies a greater
downpayment.
Thus, the higher the cost of money,
the less will be the loan-to-value
ratio desired by
borrowers.4
Figure 1, demand for mortgage loan terms, illustrates the loan-to-value
ratio desired by the poor and

4The loan-to-value
ratio is the value
by the market value of the property.

legislation

may be evaluated.
The remainder of this article contains five sections.
Section II develops a simple model of the mortgage
market that describes how mortgage funds are allocated among properties
and borrowers
possessing
different risk characteristics.
In Section III a number of market constraints
that act to reduce the availability of relatively
high risk mortgage
loans are
considered.
Section IV reviews problems with FHA
mortgage loans in urban areas, while racial discrimination in mortgage lending is addressed in Section
V. Conclusions
are presented in Section VI.
II.
A MODEL

OF THE

MORTGAGE

MARKET

3

Demand
For simplicity,
suppose
there are two
households,
one relatively
poor and one relatively
wealthy, that desire to obtain a mortgage
loan to
purchase a house in the same neighborhood.
Assume

3This section draws
lining and Mortgage

4

heavily on Glenn B. Canner’s
Lending
Practices”
[6].

ECONOMIC

“Red-

REVIEW, NOVEMBER/DECEMBER

1980

of the loan divided

wealthy households,
denoted by D and D’, respectively, as interest rates vary.5
Note first that the
loan demand D of the poorer household lies to the
right of comparable
loan demand D’ of the richer
household, indicating that for a given property, the
poorer household
desires a relatively
greater loan
than the richer household at every rate of interest.
Next, note the horizontal
dotted lines C and C':
These represent
“critical”
rates of interest for the
poorer and richer households respectively,
at which
demand falls to zero.
The idea behind the critical
rate is simple.
As interest
rates rise, borrowers
desire smaller loan-to-value
ratios due to the increased cost of borrowing.
This implies greater
downpayments
at higher rates of interest.
Thus,
once the interest rate reaches the critical level, prospective home buyers become either unwilling or unable to afford a greater downpayment
and choose not
to purchase the property.
Quantity demanded therefore falls to zero.
Supply
To facilitate
the analysis
of mortgage
loan supply, it is assumed that the market is purely
competitive, that there are no government
restrictions
on lenders and that all information
relevant to ‘the
lending decision is available to market participants
at zero cost. It is also assumed that lenders are risk
averse and therefore
willing to accept additional
risk only if compensated with higher rates of interest.
The analysis of mortgage loan supply focuses on the
relationship
between the risk of default on a mortgage loan and (a) the terms of the loan, (b) the
characteristics
of the property, and (c) the characteristics of the borrower.

likely (i.e., expected)
value at any time is $50,000.
There is of course some probability that its value will
deviate from this amount. In Figure 2, the horizontal
line V represents the expected value of the property
over time and P and P’ represent two possible probability distributions
of the property’s
future value.
These probability
distributions
depict the likelihood
that the property’s value will fall within some particular range.
If P is the relevant distribution,
for
example, then there is, say, approximately
a 70
percent chance that the property’s value, at any time,
will be between $47,000 and $53,000.
If P' is the
relevant distribution,
then there is only a 50 percent
chance that the property’s value will fall within the
$47,000 to $53,000 range.
Thus the flatter or the
more spread out the probability
distribution,
the
more likely it is that the value of the property will
deviate’ from its expected value of $50,000. The ‘term
variance will hereafter be used to describe the relative
flatness or spread of the probability
distributions.
The greater
the variance
of the distribution
the
greater the probability
that the property’s value will
deviate from its expected value.
Now suppose two households, one relatively poor
and one relatively
wealthy, wish to purchase this
$50,000 property.
The poor household
desires a
$45,000 loan with a 30-year maturity and the wealthy
household
desires a $40,000 loan with a 25-year
maturity.
In Figure 2, the downward-sloping
bowed

Holding the characteristics
of the borrower constant, the risk of default on a mortgage loan and the
cost to the lender in the event of default are closely
related to the terms of the loan, the market value of
the property at the time of sale, and future market
values of the property over the life of the mortgage.
The impact of these variables on risk and therefore
on interest rates is illustrated
in the following numerical example as well as in Figure 2.
Suppose that the market value
$50,000, and for simplicity, that
value of the property remains
over time. This does not mean
value will always be $50,000, but

of some property is
the expected future
constant at $50,000
that the property’s
rather, that its most

5In this analysis,
the loan-to-value
ratio is used rather
than the dollar size of the loan so that the demand and
supply curves
are adjusted
for differences
in property
Also, term to maturity
of the loan is ignored
value.
throughout
since it would greatly complicate
the analysis
and is relatively
unimportant.

FEDERAL RESERVE BANK OF RICHMOND

5

out curves represent the outstanding
balance of each
loan over time for the poor and wealthy households
respectively.
Notice that in both cases, the outstanding loan balance declines at an increasing rate. This
is because for the first few years, most of the monthly
mortgage payment goes to the interest charge, so that
initially, the principal declines very slowly. Then, as
the outstanding
loan balance is reduced, the proportion of the mortgage payment that is applied to the
interest charge is reduced, thereby increasing
the
proportion
of the payment
that is applied to the
principal.
Having

established

this

analytical

framework,

it

is a simple task to show how loan terms and property
characteristics
In Figure

influence

the risk and cost of default.

2, notice that for each probability

distribu-

tion P and P' the likelihood that the value of the
property will at any time fall below the outstanding
loan balance is greater for loan L than for loan L'.
More generally,
the greater the loan-to-value
ratio
and the longer the term to maturity of a mortgage
loan, the greater is the chance that the property’s
market value may fall below the outstanding
loan
balance.
And if the property’s value does fall below
the loan balance, the borrower has an economic incentive to default on the loan. For example, suppose
that after five years the value of the property
in
Figure 2 falls to $42,500 (point B) and for some
reason the borrower with loan L has to relocate. He
could either sell his property at its market value and
prepay the mortgage or default on the loan.
If he
prepays
the mortgage
his loss will be $7,500
($50,000 - $42,500), whereas if he defaults his loss
will be only $6,000 (the $5,000 downpayment
+
$1,000 of repaid principal).
Thus, he has an economic incentive to default on the loan. In effect, by
defaulting he is selling the property to the lender at a
price above its market value.
Note that under the
same circumstances,
the borrower with loan L' has
no incentive to default as the property’s value at B
is still greater than his outstanding
loan balance. The
upshot is that for a given property and borrower,
lenders will charge a higher rate of interest
the
greater the loan and the longer its term to maturity
in order to compensate
for the increased
risk of
default. This implies an upward sloping loan supply
curve such as S in Figure 3, where the interest rate
is measured on the vertical axis and mortgage credit
per dollar of property value (e.g., the loan-to-value
ratio) is measured on the horizontal axis.

that a property’s value may fall below the outstanding loan balance for any given loan terms.
Thus,
greater variances of property values imply a greater
risk of default and thus a higher interest rate for any
particular combination
of loan terms.6 Higher variances therefore
increase
the slope of the supply
schedule.
Differences
in borrower
characteristics,
such as
level and stability of income, will also alter the slope
of the supply schedule.
Borrowers with low incomes
and/or whose job stability is closely related to the
business cycle pose a higher risk of default due to
inability to meet mortgage payments
than do borrowers with relatively high incomes and secure occupations.
Therefore, holding all else constant, lenders
will require higher interest rates from households
with low or highly variable incomes.7
Taken together, the above factors imply that for
each combination
of borrower
and property
characteristics there is a unique supply schedule repre6 It should be noted
that lenders are only interested
in
the lower half of the probability
distribution
of the property’s future value.
That is, the probability
that the
property’s
value falls below its mean.
7 The value
of the property
being purchased
relative
to
the borrower’s
income is an important
determinant
of
default risk.
Although
ignored here by assuming
all else
constant.
this factor is discussed
in Section
III.

Differences
in the expected variance of a property’s future value also influence risk.
Specifically,
the greater the variance the greater the probability
6

ECONOMIC

REVIEW, NOVEMBER/DECEMBER

1960

senting the loan terms available at each interest rate.
In Figure
3, the loan supply schedule
becomes
steeper as (1) the expected variance
in property
value increases and (2) as borrower income declines
(or becomes more variable).
Supply and Demand
Figure 4 combines
the loan
demand schedules of a poor and a rich household
with the supply schedules available for two properties, one with low risk S and one with high risk
S'. To simplify the exposition,
it is assumed that
lenders ignore risk differentials
between poor and
wealthy households.
Note that for the low risk property both households can obtain a loan. The richer
household will get loan L1 at an interest rate of rl
while the poorer household will get loan L2 at a rate
of r2. Concerning
the high risk property, note that
although the richer household and the lender may
reach mutually acceptable loan terms, of L3 at rate r3,
there are no mutually acceptable loan terms at which
the poorer household and the lender can agree for
that property.
That is, the poorer household will not
obtain a loan for the high risk property because the
household demands a greater loan-to-value
ratio at
every rate of interest than the lender is willing to
supply. The same is true for all households with still
lower wealth.
Now consider an urban neighborhood
undergoing
a change in residents where the upper and middle
income households
are moving to the suburbs and
being replaced by relatively low income households.
Because low income households require more liberal
financing terms and also pose a higher risk of default,
many of the new residents may be priced out of the
mortgage market.
That is, at every rate of interest
the relatively poor households demand a greater loanto-value ratio than lenders are willing to supply. Put
differently,
given the risks involved the lender will
not make a loan on terms that prospective borrowers
are willing to accept.
This may be what has been
occurring
in urban neighborhoods
during the past
twenty years.
Due to the migration
of middle and
upper income households to the suburbs, there has
been a corresponding
shift in central city population
distributions
from high and middle income households to low income households.
This demographic
shift produces several effects.
First, it causes the demand for owner-occupied
housing units in the central city to decline and, given a
fixed supply of housing units, acts to lower property
values in the city relative to the suburbs.
Second,
since high income households are replaced with relatively low income households, the risk. of lending to
the new residents is greater. Thus by increasing risk,

these two factors cause a reduction in the supply of
mortgage credit (e.g., an increase in the slope of the
loan supply schedule)
to city relative to suburban
neighborhoods.
Finally, since low income households
desire relatively greater loan-to-value
ratios than high
income households at each rate of interest and cease
borrowing
altogether at lower critical rates, a relatively larger number of the new lower income residents may be priced out of the mortgage market.
The implication
of this analysis
is that neighborhoods characterized
by declining property values
and/or low resident incomes will receive relatively
little mortgage financing.
The mortgages
that are
granted will tend to embody relatively higher interest
rates than mortgages made to higher income neighborhoods where property
values are rising.
The
reason is not that lenders arbitrarily
restrict credit to
these areas. Rather, high risk levels produce a price
of mortgage credit that is beyond the financial means
of the borrowers.
Thus, although certain neighborhoods may be redlined in the sense that mortgage
terms and availability
are unfavorable
relative to
those of other neighborhoods,
this does not necessarily signify the existence of unreasonable
lending
practices.
Note, however, that while the above framework
explains how rational economic behavior may lead to

FEDERAL RESERVE BANK OF RICHMOND

7

differences
in the number
and terms of mortgage
loans made across areas, it totally ignores government regulation
and costly information,
two constraints under which all lenders must operate.
The
next section describes how these factors act to reduce
mortgage supply, especially to high risk borrowers
and properties.
III.
MARKET

CONSTRAINTS

Virtually all depository institutions
in the United
States are subject to extensive examinations
by Federal and/or state regulatory agencies.
One aspect of
these examinations,
portfolio regulation, consists of a
review of the institution’s
loan portfolio and the
classification
of its loans into risk categories
[14].
Generally,
the categories are termed standard,
substandard, doubtful, and loss. If too many loans fall
into the last two categories, the regulator will conduct a detailed analysis in an attempt to establish the
cause of the situation.
Moreover,
a formal
letter
is sent out to the bank’s
directors,
asking for a detailed
explanation
of the
portfolio
problems.
The institution’s
directors
must
respond
by mail and promise
to correct
the situation.
The regulator’s
letter
is a form of moral
suasion.
Ultimately,
the regulators
may resort
to
more stringent
measures.
These measures
include:
publication
of examination
reports,
the institution
of proceedings
designed
to remove
bank officers
and directors
that
continue
unsound
or unsafe
practices,
the placement
of the bank into receivership, the termination
of insurance
and the requirement that more funds be placed into the category,
loss reserves.8

These sanctions
act as .a strong disincentive
to
making
relatively
risky mortgage
loans, even if
lenders are able to compensate for the risks with high
interest rates. The reason is that portfolio regulation
is more concerned with the number of “poor” loans
than with the overall risk/return
relationship
of the
portfolio.
Thus, the net effect of portfolio regulation
is to reduce the supply of institutional
mortgage
credit to high risk borrowers and areas.
One manifestation
of portfolio regulation
that is
of particular
importance
to the redlining
issue has
been the development and widespread use of rules of
Althumb to estimate risk in mortgage lending.
though such rules would certainly exist in the absence
of portfolio regulation due to high information
costs,
it is portfolio regulation
which sets the standard of
acceptable risk for the rules of thumb.
For example,
the most widely used rule is that the value of the
8 Statement
by Leo Labell,
Chief Examiner
of the Federal Reserve
Bank of Boston,
contained
in “Redlining
and Mortgage
Lending
Practices,”
pp. 152-153 [6].

8

ECONOMIC

home being purchased should not exceed 2½ times
the borrower’s
gross annual income and that total
monthly mortgage payments
should not exceed 25
percent of the borrower’s gross monthly income [11].
Thus, whereas loans in excess of these amounts
would be available if there were no portfolio constraint, (albeit at a relatively high rate of interest),
under the constraint
such high risk loans are generally not available.
The way in which these rules
contribute
to redlining
is described below.
First, it should be emphasized that the above rule
applies to an average size family with an average income. Low income families generally have to spend a
greater proportion
of their income on nonhousing
related necessities (such as food, clothing, and transportation),
leaving a relatively smaller proportion
of
their income to finance a mortgage.
Thus, as income
declines, lenders will reduce. the amount they are
willing to lend per dollar of income.
The purpose is
to reduce the risk associated with making loans to
lower income households
to a level comparable
to
that of an average income family falling within the
rule of thumb.
Recall from the framework developed in Section II
that low income families face a steeper loan supply
schedule than high income families.
Although
low
income groups are charged a higher rate of interest
for a given loan, they are able to obtain a loan if
they are willing to pay the necessary rate of interest.
In

contrast,

the

consequence

of substituting

risk

re-

ducing rules of thumb for higher interest rates is
that lenders will automatically
refuse a mortgage loan
application if it possesses more risk than is generally
acceptable.
That is, the automatic price rationing of
the market is replaced with rules-of-thumb
rationing
of lenders.
Figure 5 demonstrates
this graphically
in terms
of the model developed in Section II. S represents
the supply schedule for a loan of average risk where
the borrower
has an income of $15,000 and the
market value of the property is $30,000.
S' represents the supply schedule for a higher risk loan
where the value and characteristics
of the property are the same, but where the borrower has an
income of only $10,000.
D is the demand schedule
of the low income borrower.
Notice that without
any market constraints
the borrower can obtain loan
terms L1 at an interest rate of r1. Recalling that the
interest rate is in part a compensation
for risk, a
regulatory constraint that restricts the amount of risk
may be viewed as a limit on interest rates.
Therefore, if, because of portfolio regulation,. lenders are
unwilling to make any loans at interest rates above
rP (represented
by the horizontal
dotted line), then

REVIEW, NOVEMBER/DECEMBER

1980

the borrower will be unable to obtain these terms.
Lenders are willing to grant terms L2 at an interest
rate of rP to the low income borrower, but he is either
unwilling
or unable to purchase the home on such
restrictive terms. Using a rule of thumb, the lender
may determine that in order for the low income borrower to face the average risk supply schedule, S,
the value of the property being purchased should be
no more than twice his annual income, or $20,000.
Thus, the borrower is unable to obtain conventional
mortgage financing for any home valued at more than
$20,000.
If perfect and costless information
were
available, the lender might find this particular
low
income borrower to be so frugal that even for the
$30,000 home he should face the average risk supply
schedule.
But since lenders do not have such information, they must base their actions on past experience which tells them that generally,
low income
borrowers
are greater risks.
Therefore,
given the
portfolio constraint
and imperfect information,
lenders will push the borrower
onto the average risk
supply schedule, S, by granting a loan only for property worth $20,000 or less. Thus, in neighborhoods
where home values are high relative to resident incomes, one would expect fairly low levels of conventional mortgage investment and relatively few owneroccupied units.
And, since many redlining
studies
focus on conventional
mortgage activity and the percentage of owner-occupied
units, lenders in such areas

may be cited for not meeting the credit needs of their
community.
However,
although
lenders
may be
willing to make such high risk loans in low income
neighborhoods
(albeit at high rates of interest),
they
are unable to do so because of the portfolio constraint.
Rules of thumb may also be applied at the neighborhood level, in which case they are often dubbed
“statistical
discrimination.”
For example, if there
is a significant difference in the average default rate
for individuals
in various educational,
occupational,
racial, or income groups, then the average risk of
default in a neighborhood
composed of a particular
mix of individuals can be estimated.
If the composition of neighborhood
residents is such that lenders
determine that the risk of lending to the area is too
great, then conceivably, lenders may draw a red line
around the neighborhood
and refuse to make any
mortgage loans within its boundary.
This may occur
if lenders believe that the cost of processing applications that will be denied exceeds the benefit from
those few applications
that are approved.
A similar
situation may arise if property values in the neighborhood are declining.
Under these circumstances,
even credit-worthy
applicants may be denied mortgage credit.
Such drastic forms of redlining behavior, although
rational from the individual
lender’s point of view,
may not be socially optimal.
This is an important
point often raised by antiredlining
groups.
The
argument is that when lenders, although acting independently,
decide as a group that lending to a particular neighborhood
is too risky, the result of their
decision is a self-fulfilling
prophecy.
That is, as
mortgage money becomes scarce in a certain geographic
area, property
values will decline more
rapidly than otherwise as sellers are forced to compete for those few buyers who can obtain credit.
And, as property values drop, the degree of risk and
the severity of redlining
in the neighborhood
will
increase.
Although
one lender granting
mortgages
in such an area is likely to lose his investment,
participation of an entire group of lenders may not only
stem the neighborhood’s
decline, but may also show a
profit.9 In short, because of portfolio regulation and
costly information,
actions that are rational from the
individual
lender’s, point of view may prevent an
outcome that is beneficial to all involved.
The last market constraint
to be considered here,
usury ceilings, are laws that place a limit on the
interest rate that may be charged on residential mort9 Working on
this premise,
a number
of cooperative
ventures have been undertaken
in various cities throughout the United States.
For a summary
of several such
programs,
see [1].

FEDERAL RESERVE BANK OF RICHMOND

9

gage loans.
The impact of usury ceilings on the
mortgage market is, therefore, very similar to that of
portfolio regulation.
Recall that, by restricting
risk
in mortgage lending, portfolio regulation
effectively
limits the interest rate charge to some maximum.
Similarly, by limiting the interest rate charge, usury
ceilings ‘restrict the risk that lenders may assume on
mortgage loans to some maximum.
Thus, both portfolio regulation and usury ceilings reduce the availability of relatively
high risk mortgage
credit.10
There is, however, a quantitative
difference in the
impact of these two constraints
that depends upon
(a) the general level of interest rates and (b) the
difference in the maximum
interest rate allowable
under the portfolio and usury constraints.
The level of interest rates is important
because
usury ceilings limit the nominal rate of interest
whereas portfolio regulation,
in effect, limits the real
rate of interest.”
When interest rates are rising, as
during periods of inflation, the implied portfolio constraint limit on interest rates will also rise so that
lenders will be able to extend loans up to the same
risk level as before the general interest rate rise.
However,
under the same circumstances,
a fixed
usury ceiling will force lenders to grant progressively
safer and safer loans as mortgage interest rates approach the ceilings.
Even when interest rates for
average risk mortgage loans are well below usury
ceilings, the ceiling may still restrict high risk mortgage credit if the interest rate necessary to compensate for the risks is above the ceiling. The respective
impact of a usury ceiling and a portfolio constraint
on the mortgage market will, therefore, depend critically upon where their interest rate limits are set in
relation to each other and where they are set in
relation to rates on mortgage and other long term
investments.
There is, however, a method by which lenders may
raise the effective interest rate on a mortgage loan
above a fixed usury ceiling.
This is done, where
legal, by charging points or closing fees when the
mortgage is made. A point is equal to one percent
of the value of the mortgage loan, and, as a rule of
thumb, lenders will charge two points for every onequarter of a percent that the market rate is above the
For example, if there is a 9
usury ceilings [10].
10 Figure 5, illustrating
the effect of portfolio
regulation,
may also be used to illustrate
the impact of usury ceilings. Rather than rp representing
the portfolio constraint
on interest rates, let it represent
the usury ceiling.
11 The nominal interest
rate is the rate actually charged
by lenders, and is comprised
of a compensation
for the
use of funds, plus a risk premium and an inflation premium. The real rate of interest is the nominal rate minus
the inflation
premium.

10

ECONOMIC

percent usury ceiling and market interest rates are
10.25 percent, then lenders will charge ten points.
On a $30,000 mortgage loan ten points requires a
$3,000 payment
to the lender in addition
to the
regular downpayment.
In effect, the lender is making a $27,000 loan ($30,000 - $3,000) but receives
monthly payments
as if a $30,000 loan had been
made. The increase in the effective yield to the lender
will therefore depend upon how soon the mortgage
is repaid.
If it is repaid in one year, then the yield
on the mortgage is increased by approximately
11
percent ($3,000, the value of the points, divided by
$27,000, the effective value of the loan). The greater
the repayment period, the less will be the increase in
effective yield.
The use of points to raise yields to market rates
has important
implications
for the redlining
issue.
Although
the effective interest
rate may not be
greater than the market rate if the repayment period
is lengthy, the cash burden at the time of purchase
is substantially
increased by the use of points.
In
the previous example, if the downpayment
were 10
percent on a $33,000 home, then the cash burden at
the time of purchase would be increased from $3,300
(the regular downpayment)
to $6,300 (the downpayment plus the value of the points).
Such increases
in the effective downpayment
resulting
from usury
ceilings
are especially
detrimental
to low-income
households inasmuch as they are more likely to be
able to afford a slightly larger monthly payment resulting from a higher interest
rate than a much
greater downpayment
resulting from the payment of
points.
IV.
THE

FHA IN URBAN

NEIGHBORHOODS

A major issue in the redlining controversy
is the
predominance
of government
insured FHA mortgage
loans in central city neighborhoods.
Antiredlining
organizations
often criticize the FHA for allegedly
contributing
to the deterioration
and abandonment
of
certain urban neighborhood
properties.
These criticisms are ironic inasrriuch as amendments
to the
National Housing Act in 1968 directed the FHA to
extend credit insurance to properties located in older
declining urban areas with the goal of encouraging
inner city homeownership
and social stability.
The
difficulty
the FHA
has experienced
in achieving
these goals, however, is understandable
given the
characteristics
of the FHA mortgage loans.
First, FHA mortgage loans are generally insured
for 100 percent of the outstanding
loan balance.
That is, the FHA guarantees
that the lender will

REVIEW, NOVEMBER/DECEMBER

1980

receive the entire outstanding
loan balance in the
event of default.
This guarantee
reduces the incentive to lend prudently.
Without a financial stake in
the property
(i.e:, without facing the prospect of a
capital loss), the lender’s primary concern is receipt
of the monthly mortgage service payments.
Thus, if
the borrower
falls behind in these payments,
the
lender has a strong incentive
to foreclose on the
property.
An FHA mortgage may be contrasted
with a conventional
mortgage, where delayed payments are more likely to be tolerated and/or mortgage terms renegotiated
in order to avoid the costs of
foreclosing and a possible capital loss.
Second, FHA mortgage loans are all subject to
FHA-imposed
interest rate ceilings which are generally below market rates.
This causes lenders to
charge points (as in the case of usury ceilings),
thereby raising the initial cost of the mortgage to the
borrower.12
Also, because points are collected at the
time the mortgage is made, lenders realize a greater
rate of return the sooner the loan is repaid.
When
this fact is combined with 100 percent FHA mortgage insurance, the result is a strong financial incentive not only to foreclose in the event of default, but
also to make loans that are likely to default.13
For
example, a profitable practice is for speculators
to
purchase relatively
high risk, low price properties,
make minor repairs, and then resell the properties
at a higher price to low income households utilizing
FHA mortgage
loans.
When the household
defaults, often within. just one year, the lender forecloses, recaptures the principal from the FHA, and
keeps the points.14
The result is a neighborhood
containing
vacant, boarded
up government-owned
properties,
which adversely affect the value of all
homes in the area.
One proposal to improve FHA programs
is to
replace 100 percent insurance
with a sliding
scale
where the insured portion of the mortgage increases
with area and borrower risk, but is always less than
100 percent. By raising the lender’s financial interest
in the property,
this could reduce the FHA
foreclosure rate while continuing
to encourage mortgage
flows to relatively high risk areas.
Similarly, elimi12 Under FHA regulations,
sellers must assume responsibility for payment
of point charges.
However,
to the
extent that sellers can pass on part of this cost in the
form of a higher contract
selling price, it is generally
the
borrower
who bears this cost.
13 Since FHA insurance
eliminates
the risk of a capital
loss to the lender, the portfolio regulation
constraint
does
not apply.
14 Seventy-eight
percent
of foreclosed
FHA
loans
single family homes occur within 18 months [7].

on

nation of point charges by eliminating
interest
ings would reduce the incentive to foreclose.

ceil-

V.
RACIAL

DISCRIMINATION

MORTGAGE

AND

LENDING

In popular
usage, the term redlining
is often
synonymous
with racial discrimination
in the mortgage market.
This article, however, draws a distinction between the two.
Redlining
as here defined
exists when lenders base any element of the mortgage
decision (including
whether or not to lend and the
terms of the loan) on the geographic location of the
property
or on the characteristics
of surrounding
properties.
Thus,
racial discrimination
may be
viewed as a special type of redlining
(hereafter
referred to as racial redlining)
where lenders consider
the racial composition of the neighborhood
surrounding the property in making their mortgage decision.
This section examines the role of race in the mortgage market, and how this role effects mortgage
availability.
In discussing the impact of race on the mortgage
market, it is essential to distinguish
two separate
influences.
The first is how the racial preferences of
the population
in general may effect neighborhood
property values in racially mixed areas. The second
is how racial discrimination
by lenders affects the
availability and cost of mortgage funds how how this
in turn affects property values.
The former will be
examined first.
For a, variety of social, historic, and economic
reasons,
most metropolitan
areas in the United
States
are segregated
into either
predominately
white or predominately
black neighborhoods.
Areas
with a significant
racial mix are often in transition
from white to black.
These transitional
areas may
experience
relatively
large fluctuations
in property
values if “panic” selling occurs as minorities
enter
the previously white neighborhood.
In such neighborhoods, the increased variance in, property values
will cause lenders to decrease the supply of conventional mortgage credit to the neighborhood.
As the
neighborhood
becomes predominantly
black, however, property
values
should stabilize
near their
original level and lenders would have an incentive
to increase mortgage
supply to its original
level.
Thus, holding other characteristics
of the residents
constant, a U-shaped relationship between the percent
minority in a neighborhood
and the level of conventional mortgage activity is expected.
This is illustrated
in Figure
6, which depicts the level of

FEDERAL RESERVE BANK OF RICHMOND

11

conventional
mortgage
activity first declining
as a
neighborhood
changes from 100 percent white to
50 percent white, and then rising as the area becomes
behavior by
dominately
black.15 Nondiscriminatory
lenders is implied by the curve since mortgage activity in the all white and all black neighborhoods
are identical.
Thus, in the case where lenders are
reacting to an increased variance in property values,
they are not discriminating
by race, but rather are
adjusting
to market forces out of their control, e.g.,
the racial prejudices of the population.
It should be noted, however, that there is an important difference between lenders reacting to market
forces, as described
above, and lenders assuming
before the fact that an influx of minorities will initiate
property value fluctuations.
The latter reaction is the
case of racial discrimination
which could be a cause
and not a result. of panic selling.
For example, consider an all white neighborhood
in which the majority
of residents are free of prejudice, and which is experiencing
a gradual inflow of minority households.
If lenders use the racial composition of the neighborhood as a proxy for risk, then, as the neighborhood
becomes-integrated,
lenders will reduce the supply of
conventional
mortgage credit to the area. Assuming
that panic selling does not occur, i.e., that asking
prices are the same as if the neighborhood
were not
becoming integrated,
then a reduction
in mortgage
loan supply will force sellers to reduce their asking
price thereby initiating property value declines. This
occurs because reduced mortgage
loan supply increases the required downpayment
at every rate of
interest, which in turn prices some prospective buyers
out of the market at the original asking price. Thus,
in order to sell, homeowners will be forced to reduce
their asking price so that downpayment
requirements
are reduced.
Nearby residents may then interpret
the relatively low selling prices as a sign of panic
selling on the part of their neighbors,
creating an
incentive for them to sell before property values deTherefore,
the adjustment
of loan
cline further.
terms based on the racial composition of a neighborhood can initiate property value declines and contribute to eventual neighborhood
deterioration.
Evidence suggests that the mortgage industry does
indeed consider neighborhood
racial composition
in
evaluating
present and expected future changes in
property values.
For example, a widely used real
estate appraisal text states that,
The value levels in a residential neighborhood are
influenced more by the social characteristics
of its
15 This U-shaped
relationship
was found
study of redlining in Toledo, Ohio [12].

12

in an empirical

ECONOMIC

present
and prospective
occupants
than
by any
other factor.
Hence,
social data is a major
consideration
in residential
appraising.
No matter
how attractive
a particular
neighborhood
may be,
it does not possess maximum
desirability
unless it
is occupied by people who are reasonably
congenial.
This implies
a community
of interest
based upon
common social or cultural
backgrounds.16

Social characteristics
deemed instrumental
in determining value include, “. . . age groupings,
income
levels, type of employment of head of household, race
and religion, whether owner or renter, and amount
of equity in owner occupied properties”17
(emphasis
added).
Moreover, actual and expected changes in
social composition
are viewed as significant.
. . . As a general rule, homogenity
of the population
contributes
to stability
of real estate values.
Information
on the percentage
of native
born whites,
foreign
whites, and non-white
population
is important,
and the changes
in this composition
has a
significance.
As a general
rule, minority
groups
are found
at the bottom
of the socio-economic
ladder,
and problems
associated
with
minority
group segments
of the population
can hinder community
growth.18

Such assumptions
about the relationship
between
race and risk can create a self-fulfilling
prophecy.
16 American
Institute
of Real
Appraisal
of Real Estate
[4].

Estate

17 American
Savings
tices and Principles

Institute,

18 American
Institute
Outline-Course-I-A-Real

REVIEW, NOVEMBER/DECEMBER

1980

and
[5].

Loan

Appraisers,

The

Lending

Prac-

of Real Estate Appraisers,
Estate
Appraisal
[3].

Student

If lenders assume that, holding all else constant,
integrated
or minority
neighborhoods
pose higher
risks than all white neighborhoods,
and therefore
reduce mortgage loan supply, there will be downward
pressure on property values.19 And since depressed
property
values increase risk, the prophecy of increased risk in integrated
and minority
neighborhoods is fulfilled.
SUMMARY

AND

CONCLUSIONS

Generally, differences in mortgage terms and availability across neighborhoods
appear to result from
differences
in the risk related
characteristics
of
neighborhoods
and borrowers
and from differences
in the demand for mortgage loans between neighborhoods.
Specifically, in areas where property values
are declining or where resident incomes are low relative to property values the supply of mortgage funds
will be less than in, a more affluent area because of
The impact of lower
the higher risk of lending.
supply in such areas is compounded
by the greater
loan-to-value
ratios demanded by potential borrowers
and their lower critical rate of interest.
The upshot is that since there are sound economic
reasons behind so-called redlining
behavior,
legislation which assumes that geographic location is not a
valid risk consideration
and restricts its use may be
counterproductive
in the long run. For example, in
California it is now illegal for state-licensed
institutions to deny a mortgage loan or alter the terms of
such a loan based upon the conditions, characteristics,
or trends in the neighborhood
surrounding
the prop-.
Clearly, these are important
risk related
erty.20
considerations.
By severing the relationship
between
risk and rate of return, such regulations are likely to
increase default rates and reduce the overall quality
of mortgage loan portfolios of the affected instituThis in turn may adversely
affect profits,
tions.
deposit rates, and the quality and quantity of other
services provided by these institutions.
A better way to increase the availability
of urban
mortgage credit would be to eliminate usury ceilings
and rigid portfolio regulations that
reduce the availability of funds to high risk borrowers
and areas.
Also, a reevaluation
of FHA loan policies and procedures is in order.
The present system encourages
unsound lending and costly foreclosures.

Perhaps the only case where there may be economically unjustified
restrictions
in mortgage
loan
supply is the case of racial redlining.
This stems
from the unfounded
assumption
that integrated and
minority
neighborhoods
involve
relatively
greater
Therefore,
to ensure equal housing opporrisks.
tunity, more vigorous enforcement
of current antidiscrimination
laws and a review of underwriting
procedures which, in effect, may be discriminatory
is
desirable.
References

20 An institution
may refuse a mortgage
loan, or adjust
the terms of the loan, if it can prove that failure to do so
would result in an unsound business
practice.

American
Banker,
April
18,
May 18, and May 22, 1979.

2.

American

3.

American
Institute
of Real
Student Outline-Course-I-A-Real
Chicago:
American
Institute
praisers,
1973.

4.

American
‘Institute
of Real
Estate
Appraisers.
The Appraisal
of Real Estate.
Chicago:
American
Institute
of Real Estate
Appraisers,
1973.

5.

American
Savings
and Loan Institute.
Practices
and Principles.
Chicago :
Savings
and Loan Institute
Press,
1971.

6.

Canner,
Glenn B. “Redlining
ing Practices.”
Unpublished
Brown University,
1979.

7.

Department
Disposition

8.

Divine,
Brenda

9.

Haney,
Richard.
“Race
and Housing
Value:
A
Review of Their Interrelationship.”
The Appraisal
Journal XLV
(July 1977) : 356-64.

10.

Hendershott,
Patric
H., and Villani,
Kevin
E.
Regulation
and Reform
of the Housing
Finance
System.
Washington,
D. C.: American
Enterprise
Institute
for Public Policy Research,
1977.

11.

Hoagland,
Henry E.; Stone, Leo D.; Brueggeman,
William
B.
Real Estate Finance.
Illinois:
Richard D. Irwin, Inc., 1977.

12.

Hutchinson,
Peter;
and Ostas,
James;
and Reed,
David.
“A Survey
and Comparisons
of Redlining
Influences
in Urban
Mortgage
Lending
Markets.”
Unpublished
paper,
Bowling
Green State
University, 1977.

13.

Ostas, James R. “Effects
of Usury Ceilings
Mortgage
Market.”
Journal
of Finance
(June
1976) : 821-34.

14.

Spong,
Kenneth,
and Hoeing,
Thomas.
“Bank
Examination
Classifications
and
Loan
Risk.”
Economic
Review, Federal
Reserve
Bank of Kansas
City (June 1979).

15.
19 For a review of studies focusing
on the relationship
between race and property values see [9].
Of 17 studies
reviewed, 6 found no relationship,
9 found a positive relationship,
and 2 found a negative
relationship.

1.

State of California,
tion 35810.

16.

12 United
States
et seq. (1977).

17.

Von Furstenburg,
George
M.
“Default
Risk on
FHA
Insured
Home Mortgages
as a Function
of
the Terms of Financing:
A Quantitative
Analysis.”
Journal
of Finance
24 (June 1969) : 459-77.

Banker,

May

of Housing
of Foreclosed

April

24,

May

11,

3, 1976.
Estate
Appraisers.
Estate Appraisal.
of Real Estate
Ap-

Lending
American

and Mortgage
LendPh.D.
dissertation,

and Urban
Development,
Houses.
August
1975.

Richard
J.; Rennie, Winston
O.; and Sims,
N.
Where
the Lender
Looks First:
A
Case Study of Mortgage
Disinvestment in
Bronx
County
New York,
1960-1970.
National
Urban
League. Paper,
1973.

FEDERAL RESERVE RANK OF RICHMOND

Health
Code

and Safety

Annotated

Code.
Sections

in the
XXXI

Sec2901

13

TAXING

CAPITAL GAINS
Roy H. Webb

This

article

forthcoming
Federal

draws
Federal

from

the

Reserve

author’s
System

paper
study

in a
of the

tax structure.

From the Boston Tea Party to Proposition
13,
taxation has been a particularly, contentious
political
issue in America.
While there has been considerable
debate on taxing income from capital, there remains
substantial
disagreement
concerning
the fairness and
economic effects of specific taxes on capital income,
especially taxes on capital gains.
Capital income in America is subject to very complex tax rules.
As a result, an individual’s
capital
income can be taxed at either much higher or much
lower rates than are applied to his labor income. The
capital gains tax occupies the extraordinary
position
of contributing
both to relatively low tax rates on
some capital income and relatively
high rates on
other capital income.
To establish a perspective for viewing capital gains
taxation, we will first review the concepts of fairness,
economic
efficiency,
capital,
and capital
income.
Effects of capital gains taxes can then be examined
in two steps. The first involves viewing the effects
of capital gains taxes in an inflation-free
economy.
The second step is, to add the complicating
factor of
inflation.
At this point some perverse
effects of
capital gains taxes will be evident.
Consequently,
potential remedial changes to tax laws comprise the
final topic.
PRELIMINARY

DEFINITIONS

Not surprisingly,
there is no universally
accepted
conception of fairness with which one can evaluate
any particular tax. Perhaps the most widely accepted
principle is horizontal equity, an economic corollary
of the idea that any law should apply equally to all
individuals.
With. respect to taxation,, horizontal
equity states that taxpayers
in equal economic circumstances should face equal tax burdens.
While it
is a useful necessary
condition,
horizontal
equity
alone would not ensure a tax system’s fairness.
To
do so would also require fair treatment
of unequals,
or vertical equity.
Unfortunately,
even the simpler
goal of horizontal equity is not completely unambiguous.
Moreover,
achieving
it would require sub14

ECONOMIC

stantial change in the current method of taxing capital gains.
Thus horizontal equity by itself requires
enough attention
so that the more complex goal of
vertical equity is not systematically
addressed below,
even though
many different
concepts
of vertical
equity repeatedly surface in tax analysis.
Besides equity, it is desirable
that a tax have
minimal adverse impact on the economy.
Most taxes
currently
levied have some adverse consequences;1
a desirable goal would be to collect a given amount
of revenue with the least possible harm.
Basically,
levying a tax on one source of economic satisfaction
induces people to shift their consumption
toward untaxed sources.
This distorted behavior leads to economic inefficiency,
in that the tax distorts individuals’ choices of what to consume and how to produce.
As a result, they enjoy less than the maximum
attainable
economic satisfaction.
The sources of economic satisfaction can be divided
into three categories:
current consumption
of goods
and services, future consumption,
and leisure.
Each
person must choose the fraction of time to spend in
productive activity.
Since productive activity yields
income in exchange for leisure this is equivalent to
choosing between (1) current and future consumption and (2) the amount of leisure.
Postponing
current consumption
to the future, of course, is saving.
While some saving merely takes the form of hoarding
cash or commodities,
savings can also be invested so
that future production as well as future consumption
possibilities
are raised.
Since investment
involves
formation
of capital, the means of providing
future
production, the additional consumption
potential from
investing
rather than hoarding can be regarded as
capital income.
This potential does not normally remain constant.
Relative price changes can alter capital asset values,
thereby changing the asset owner’s present and fuSuch asset revaluture consumption
possibilities.
ations are often referred to as capital gains and losses.
Although some definitions of income exclude capital.

1 If a tax reduces (increases),
production
or consumption
when a harmful (beneficial)
externality
is involved, then
the tax can improve social welfare.
Such taxes are not
major
contributors
to Federal
revenue,
although
some
observers
might put tobacco,
alcohol, or gasoline
excise
taxes in this category.

REVIEW, NOVEMBER/DECEMBER

1980

gains, many economists
prefer the definition
given
by J. R. Hicks, “A person’s income is what he can
consume during the week and still be as well off at
the end of the week as he was at the beginning”
(1946).
Under this definition,
which will be employed below, capital gains are clearly part of income.
The concept of capital is not limited to tangible
capital, such as machines or structures.
Individuals
can also accumulate
intangible
capital by limiting
present consumption
in order to acquire knowledge,
skills, and capabilities
that will raise their future
productivity.
Examples of intangible capital include
formal education, on-the-job
training,
research, and
exploration
for mineral deposits.
Investment
is facilitated
by financial
intermediation, through which people with productive uses for
capital indirectly acquire funds from others who have
the desire and ability to substitute future for current
consumption.
There is an important
distinction
between real capital described
above, and financial
capital.
The latter amounts to paper claims to real
capital and/or real capital income embodied in bonds,
common
stock, vested pension
benefits,
insurance
policies, and the like. An efficient system of financial
intermediation
directs funds to the most productive
investments.
Thus, the more efficient the system of
intermediation,
the more benefit accrues directly to
savers and capital users, and indirectly
to workers
(whose marginal product is raised) and consumers
(who see an increased supply of commodities).
TAXATION
OF CAPITAL GAINS
ABSENCE OF INFLATION

IN THE

-Equity and efficiency consequences of capital gains
taxes can be divided between consequences
unique to
taxes on capital gains, and consequences
resulting
from any tax on capita‘1 income.
Both are examined
in this section.
Some general consequences
of any
capital income tax are first examined.
We then describe some important features of U. S. tax law and
discuss some of their immediate impacts.
The final
task is to examine the distinct effects of taxes on
capital gains.
Taxing Capital Income
There is a clear qualitative effect on economic efficiency of taxing capital
income : since capital formation is a means of providing future consumption,
taxing capital income distorts individuals’ choices away from future consumption toward leisure or current consumption.
That
such distortions
could be significant is suggested by
Lawrence
Summers,
who estimated,
“the present
value of the welfare gain from a shift (from capital

income taxation)
to consumption
or wage taxation is
conservatively
estimated at 5 years’ GNP” (1978).
Unfortunately,
the current state of the art forces any
estimates of relative welfare costs of different taxes
to rely on heroic behavioral assumptions
and numerous judgmental
parameter estimates.
Thus any particular study, including that of Summers, can at most
be suggestive.
Another
concern is whether capital income taxation is consistent with horizontal
equity.
Perhaps
the most common view is that economic equals are
persons who receive the same amount of income,
regardless of its source. Under that view, horizontal
equity would require a taxpayer to pay the same rate
on capital and labor income.
This conventional
reasoning
has been challenged
by Martin Feldstein
(1978), who argues that horizontal equity requires capital income to be exempt
from taxation.
By interpreting
economic equals as
individuals
with the same present value of lifetime
consumption
expenditure,
he is able to show that
taxing consumption
would tax equals equally.
He
also notes that a proportional
consumption
tax is
equivalent to a proportional
tax on the present value
of lifetime income.
But such a tax is equivalent to
an annual income tax only when the annual tax is
proportional
to its base, namely income before capital
acquisition.
Accordingly,
since a tax on capital income violates this condition, Feldstein concludes that
it is inconsistent
with horizontal equity.
Box 1 contains an illustration
of this point.
While Feldstein’s argument does cast doubt on the
conventional
horizontal
equity assumption,
his definition of economic equals can also be questioned.
As
the example makes clear, his definition of economic
equality ignores valuable leisure. In addition, human
capital complicates discussions of the equity of taxing
capital income. An individual’s level of labor income
results from effort, human capital, rents to innate
ability, luck, and other factors.
Any tax on labor
income consequently
taxes the return to human capital.
If other capital income were not taxed, new
equity and efficiency problems would be created.
Some salient features of American
tax laws are
mentioned in Box 2 as a prelude to a discussion of
the effects of the American method of taxing capital
gains.2
Capital Gains Taxes and Economic
Efficiency
Adam Smith (1776) described the importance
of a
saver’s investment
choices :
2 The primary
source
Greisman
(1979).

FEDERAL RESERVE BANK OF RICHMOND

for

this

discussion

is

Bernard

15

Box 1
AN EXAMPLE

OF A TAX

ON CAPITAL

ONE VIEW

OF HORIZONTAL

Imagine
a society whose residents
have infinite
lives (this unrealistic
assumption
keeps the arithmetic simple but does not affect any qualitative
conclusions),
in which the interest
rate remains
constant
at 10 percent,
and in which income from
capital
and labor is taxed at a 20 percent
rate.
Consider
(1) an athlete who receives
a salary of
$100,000, and (2) a laborer
who receives
$10,000
every year. Because of declining ability the athlete
will play only one year, investing
his initial earnings and then living off income from capital, while
the laborer intends to work and earn $10,000 each
year (for simplicity,
assume that each receives
his
entire
annual
salary
on January
1).
Both
the
athlete and the laborer have identical present values
of lifetime before-tax
income, $100,000 (the present
value V of an infinite income stream I at interest
rate r is V = I/r).

INCOME

THAT

VIOLATES

EQUITY

The athlete would pay a tax of $20,000 on the
one year’s
labor income.
Thus
he could save
$80,000, earning $8,000 interest annually, and would
pay a $1,600 annual tax on the interest
income.
Therefore
his interest taxes have a present value of
$16,000,
and his combined
lifetime
taxes
would
have a present value of $36,000.
In contrast,
the
present
value
of the laborer’s
taxes
would
be
$20,000.
It can be seen that only if capital income
were not taxed would these
Feldsteinian
equals
before tax have equal tax obligations.
This
example
also illustrates
a weakness
in
Feldstein’s
argument.
The athlete
can enjoy
a
substantially
greater amount of valuable leisure in
his lifetime.
Thus although
equal by Feldstein’s
definition,
the athlete
has a greater
before-tax
access to sources of economic
satisfaction
(that is,
both consumption
and leisure)
than the laborer.

Box 2
SOME

RELEVANT

Capital
gains are taxed when realized,
not as
accrued.
This allows taxes to be postponed,
thereby reducing
the present
value of tax payments.
Also, a person with a tax rate which varies over
time can choose to realize gains when the rate is
abnormally
low.
If capital gains are not realized
before a taxpayer’s
death, an estate tax is levied on
the market value of the asset but no tax is assessed
on accrued capital gains.
Gains from sales of assets held one year or less
are taxed at the same rate as other capital income.
If assets are held longer, 60 percent of the gain is
excluded from the personal income tax. The maximum tax rate on taxable capital income is 70 percent, as opposed to a 50 percent maximum
on taxable labor income.
Due to the 60 percent exclusion,
the maximum
rate on long-term
capital
gains is
28 percent (ignoring
for simplicity
the “alternative
minimum
tax” which affects very few taxpayers).
Different
assets are taxed at different
effective
rates.
Capital gains in real estate can be postponed
by “swap transactions,”
and owner-occupied
homes
provide
even more ways to avoid capital
gains
taxes.
Also, income from capital owned by corporations
is taxed at different
rates from personal
capital
income.
The existence
of a corporate
income tax
in addition to the personal income tax is consistent
with the traditional
legal view of a corporation
and
its owners as separate entities.
The resulting
tax
structure
is relevant
since ownership
of corporate
stock accounts for a significant
fraction
of taxable
capital gains.
Corporate
financial
decisions
can affect capital
income taxes.
Corporate
capital income paid as
interest
reduces
taxable
corporate
income;
however, capital income used for dividends or retained
earnings is taxed at the corporate
level.
Dividends
are also taxed as personal
income in the year re-

16

ECONOMIC

TAX

REGULATIONS
ceived, and retained
earnings
can provide capital
gains that will eventually
be realized
and taxed.
income
from
real
capital
assets
Consequently,
owned indirectly
through corporations
is taxed at a
different
rate from
capital
income
from
assets
owned by a proprietor
or by a partnership.
The existence
of intangible
capital further complicates
matters.
Business
investments
in intangible capital,
for example
research
expenditures,
receive
more favorable
tax treatment
than corporate tangible capital investments,
since intangible
investment
can often be counted as a current
exIncome from personal investment
in human
pense.
capital
that increases
marketable
skills
is taxed
when labor income rises.
But human capital that
directly
augments
consumption
possibilities
(i.e.,
music lessons
adding to enjoyment
of symphony
concerts)
is not taxed.
Some capital
owners
are not required
to pay
personal
taxes on capital income.
Reserve
funds
of life insurance
companies,
pension
funds,
and
charitable
foundations
are prominent
examples
of
tax exempt institutions.
Their tax exemption
provides a strong
incentive
for individuals
to own
stock indirectly,
i.e., by owning obligations
of pension funds,
rather
than by personal
ownership.
Personal
taxes on capital income can also be postponed if assets are placed into individual retirement
plans, which some people are allowed to use to a
limited extent.
Capital losses are not treated symmetrically
with
capital gains.
The maximum
loss deduction from
ordinary income is $3,000 per year; however, additional losses can be “carried over” for possible use
in later years.
The full amount
of short-term
losses, and 50 percent of long-term
losses, are deductible to that extent.
Also, 100 percent of capital
losses can be deducted from capital gains realized
in the same year.

REVIEW, NOVEMBER/DECEMBER

1980

Every individual
is continually
exerting himself to
find out the most advantageous
employment
for
whatever
capital
he can command.
It is his own
advantage,
indeed,
and not that
of the society,
which he has in view.
But the study of his own
advantage
naturally,
or rather
necessarily,
leads
him to prefer
that employment
which is most advantageous
to society.
. . . As every individual,
therefore,
endeavours
. . . to employ his capital
. . .
that its produce
may be of greatest
value;
every
individual
necessarily
labours to render the annual
revenue
of the society
as great
as he can.
. . .
[H]e is in this, as in many other cases, led by an
invisible
hand to promote
an end which was no
part of his intention.

In short, Smith noted that a saver seeking his own
maximum
return helps maximize the social benefit
yielded by valuable resources, the leisure and consumption foregone in order to produce capital.
This result can be changed by a particular
tax
system, however.
Since the taxes described in Box 2
alter rates of return, the taxes can lead investors to
substitute
lightly taxed assets with low before-tax
yields for more highly taxed assets. with higher
before-tax yields.
Since the total return to all elements of society is represented
by the before-tax
yield, the social return to capital formation declines
when such substitutions
are made. The welfare loss
from tax-induced
capital misallocation
was estimated
by Patric Hendershott
and Sheng-Cheng
Hu to have
been $7.85 billion in 1976-77. Again, the amount of
judgment
necessary to make such estimates renders
them suggestive rather than definitive.
The discussion above did not take account of an
important
feature affecting investment,
namely that
the return to an investment
is not precisely known
before the investment
is made.
The risk of low
returns
would affect investors
even in a tax-free
The current tax system changes matters
economy.
even more.
When investment
losses are possible,
capital misallocation
can result from the asymmetric
treatment
of gains and losses.
Taking an example,
suppose there are three equally likely results one year
after investing $1,000 in a new company : a gain of
$180, a gain of $90, or a loss of $90. If investors
financed a large number
of such companies,
they
would expect to gain, on average, $180 ×
1/3 +
$90 × 1/3 + (-$90)
× 1/3 = $60, a 6 percent
With symmetric
treatment
of
before-tax
return.
gains and losses, an investor in the 50 percent bracket
would expect to average. $30, a 3 percent return.
But if the investor
had previously exhausted
his
allowable loss deduction,
(and expects to exhaust
future deductions)
he would average .5 ×
$180 ×
1/3 + .5 × $90 ×
1/3 + (-$90)
× 1/3 = $15, a
1.5 percent return.
Therefore, although on average,
investors
in new companies
might receive higher
yields than available from other investments,
limited

deductibility
of losses
less risky investments
return.

could direct
with lower

savers toward
social rates of

Suppose that full-loss offset, the ability to fully
deduct any losses, were available.
Would taxes then
affect risk taking?
James Tobin (1958) and many
other writers have argued that, with full-loss offset, a
proportional
tax would actually
increase personal
risk taking.
Defining risk as the variance
of a security’s return, Tobin noted that a proportional
tax
would lower both the risk and yield of each security.
Making
special assumptions
concerning
investor
preferences
and opportunities,
Tobin was then able
to prove his result.
Feldstein
(1969) pointed out
the restrictiveness
of the basic assumptions
by Tobin
et. al. Either by allowing more general (and intuitively appealing)
investor preferences, or by removing the implausible assumption
of the existence of a
riskless asset, Feldstein was able to show that taxation could generate either greater or lesser amounts
of risk taking, depending
on unknown
parameter
values (such as those describing an individual’s marginal utility of income).
Thus he concluded that the
effect of taxation on risk taking was an unanswered
empirical question.
Feldstein
(1976) conducted
an empirical
study,
using 1962 data. Tax laws at that time were similar
to, but not identical with, current laws. Rather than
looking at the risk and ownership
of particular
investments,
i.e., IBM stock versus General Motors
stock, he studied six classes of financial
assets:
common and preferred
stocks; taxable, municipal,
and savings bonds; and bank accounts.
At this broad
level, he was able to conclude that although “The
personal income tax has a very powerful effect on
individuals’
demands for portfolio assets . . . the
portfolio variance
of real pretax one-year
rate of
return is affected very little by the individual’s
tax
situation.”
There are many possible portfolio compositions
with the same overall level of risk.
Of particular
interest are portfolios which contain small innovative
companies, which are said to be especially dependent
on non-dividend-paying
equity capital.
That dependence is assumed to be due to two factors. The first
is a typical small company’s cash flow, which can be
high on average but subject to wide fluctuation,
thereby raising the possibility
of bankruptcy
in a
temporarily
bad period if fixed charges are high.
The second characteristic
is a high rate of return on
investment,
making it desirable to reinvest capital
income rather than pay interest and dividends.
These
factors have been used to argue for low capital gains

FEDERAL RESERVE BANK OF RICHMOND

17

taxes relative to taxes
As one investor put it,

on other

forms

of income.

[Due to capital
gains
incentives]
innovation
has
been encouraged
and flourished,
technological
development
has been accelerated,
hundreds
of thousands of new jobs have been created,
the economy
has been stimulated
in a sound and meaningful
manner,
exports
have been increased
dramatically,
our nation’s
standard
of living has been improved,
the forces of inflation
have been resisted,
and the
national
security
of our nation has been enhanced.3

Most investors hold diversified
portfolios ; consequently, the risk of a financial asset is the changed
risk of a portfolio with and without that asset. The
widely
used mean-variance
capital
asset pricing
model explicitly
defines this risk.
For example,
Copeland and Weston (1979) wrote, “[A]t the margin, the change in the contribution
of asset i to portfolio risk is simply COV (Ri, R
p).”
(COV stands
for covariance,
Ri is the return to owning asset i,
and R p is the return on the rest of the portfolio.)
In
many cases the earnings of a particular
small company will depend on internal or local conditions to a
much greater extent than on the general market
environment.
If so, the covariance between the return to owning that company’s stock and the return
on the rest of an investor’s portfolio may well be
small.
Consequently,
adding the company’s
stock
would not add substantial
risk to a diversified portfolio, even if that stock alone was very risky. Thus,
it is not clear that investors need special tax breaks
to induce them to hold risky individual
stocks in
diversified
portfolios.
Also considering
Feldstein’s
empirical findings and the possibility that low taxes
on capital gains could favor assets like gold bullion
or unimproved
land over investment
in corporations
through bonds or dividend-paying
stock, the hypothesis that an optimal amount of corporate risk-taking
requires capital gains taxes to be lower than other
capital income taxes must be regarded as unproven.
If a capital asset appreciates
substantially,
the
accumulated
capital gains tax liability upon realization can deter the asset’s sale.
This is sometimes
referred to as a lock-in effect, which is relevant both
for individual investors and for projecting
tax revenues under potential alterations of tax laws. Examining data for 1973, Feldstein,
Joel Slemrod, and
Shlomo Yitzhaki
(1978)
found evidence that the

3 Reid
W.
Dennis,
executive
vice-president,
National
Venture
Capital Association
in Congressional
testimony
(1978).
Statements
such as this ignore the incentive that
low capital gains taxes give to hold assets such as unimproved land or precious
metals instead of assets which
finance
corporate
capital
purchase
(such as bonds or
dividend-paying
stock).

18

ECONOMIC

amount of realized capital gains is sensitive to marginal tax rates.
In fact, they argued that lowering
capital gains taxes would actually increase tax revenue by increasing
the turnover
rate of corporate
stock. A study of time series data by Slemrod and
Feldstein
(1978) also found strong empirical support for a lock-in effect.
Finally, Yitzhaki
(1979)
examined the yield sacrificed by investors due to the
lock-in effect.
Using 1962 data he found that the
lock-in effect lowered the annual return of high tax
bracket investors by about 1½ percent.
As would
be expected, the effect was weaker in low brackets.
Unfortunately,
no studies have sought lock-in effects
for assets other than common stock.
Capital Gains Taxes and Horizontal
Equity
The
current system of taxing capital gains violates horizontal equity in several respects.
First, capital income received as realized capital gains is taxed at
40 percent of the rate for other forms of capital income.
But for capital
assets
indirectly
owned
through
corporations,
a corporate
income tax is
collected on capital income before additional
taxes
are assessed on the person receiving capital gains
(assuming
a constant price-earnings
ratio and positive marginal
product of capital, retained
earnings
would necessarily raise the price of corporate stock).
Thus, while the capital gains tax allows commodity
or real estate holders to pay lower taxes on capital
income

than

capital

owners

who

receive

interest

or

dividends,
the case is less clear for recipients
of
capital gains on corporate stock. A final judgment
would require knowledge
of the incidence
of the
corporate income tax, an unresolved
although much
debated issue.
In addition, capital gains are not taxed until they
are realized.
Since the owner of an appreciating
asset can often benefit without realizing a gain, capital gains recipients
are favored over persons for
whom accrued and realized incomes are equal. The
latter class includes most recipients of labor income
as well as persons earning
interest
or dividends.
Box 3 contains
an extreme
example of the taxreducing effect of taxing only realized gains.
Moreover, taxing only upon realization especially benefits
owners of large, well-diversified
asset portfolios.
At
the same time that a portfolio as a whole can show a
gain, individual
assets may well incur losses.
The
owner can then sell enough assets to realize the portfolio gain by selling its losers along with some other
This adverse selection could conceivably reassets.
duce the owner’s capital gains tax to zero.
This concludes the discussion of capital gains taxes
In several ways,
in an economy without inflation.

REVIEW, NOVEMBER/DECEMBER

1980

Box 3
A TAX

AVOIDANCE

Suppose a corporation
receives a marginal return
r on its capital assets.
If it pays this return to
stockholders
as dividends,
a stockholder
can keep
his wealth constant
and consume
after
personal taxes, where
is the personal income tax
rate and V0 is the stock’s value (for future reference, this amount of consumption
will be labeled
Cd).
The corporation
can immediately
lower its
shareholders’
taxes by reinvesting
the income;
assuming a constant
price-earnings
ratio, shareholders can receive their income as long-term
capital
gains which, are taxed at 40 percent of the rate on
dividend
income.
There
is additional
room for
lowering
taxes, however.
With
the corporation
reinvesting
earnings,
the
stock
value will appreciate
at the continuously
compounded
rate r. In other words, at an instant
of time t,

STRATEGY
(3).
Now we can substitute
the expression
(1) for Vt in (2) and rearrange
terms,

for Vt
yielding

in

(4).
Differentiating

(4)

we can obtain
(5).

Substituting
terms gives

for Lt and

in (3)

and rearranging

(6).
How does this compare with consumption
dividends, Cd? Remembering
that
for all t, we get

from

(1).
Suppose the shareholder
can borrow at the market
rate of interest
which is assumed
to be equal to
the marginal product of capital, r. We will examine the strategy
of having the shareholder
borrow
and consume
an amount equal to accrued capital
While
this strategy
would keep his net
gains.
worth
(assets
minus liabilities)
intact,
it avoids
capital gains taxes while generating
tax deductions
for interest paid.
Letting
Lt be the outstanding
debt at time t,
the assumption
of constant
net worth equal to V0
can be written as
V0 =

Vt -

(2).

Lt

The amount consumed
at an instant
of time, Cb ,
t
is equal to new borrowing,
labeled Lt, minus aftertax interest
on outstanding
debt (1 - )rLt,
or

the current
tributes
same

to

approach
a system

before-tax

system

is

to taxing
that

income

inconsistent

can
at

with

capital

tax

gains

persons

different
horizontal

con-

with

rates.

the

Such

equity,

a

and

can also lead to capital misallocation.
The next step
is to add the complicating
factor of inflation into the
picture.
INFLATION,
CAPITAL GAINS TAXES, AND
POSSIBLE STRUCTURAL
CHANGES

In the absence of taxes it is possible to imagine a
neutral inflation with no relative price changes as all
prices
rise equiproportionally,
including
prices of
capital goods. By definition such price increases are

(7).
In words, if a stockholder
follows the strategy
of
(1) buying stock issued by a company which rein-.
vests all earnings
and (2) borrowing
and consuming an amount equal to accrued capital gains, then
he can consume
more than’ if he bought
stock
which paid all earnings as dividends (in both cases
keeping net worth constant).
The additional consumption
potential
results
from totally
avoiding
income tax by receiving
income as unrealized
capital gains.
Moreover,
the additional
consumption
increases
with a taxpayer’s
marginal
tax rate as
well as the length of time the stock is held.
Although
oversimplified
in many
places,
this
example illustrates
how taxing only on realization
can create strategies
for tax avoidance,
especially
by taxpayers
facing high marginal
tax rates.

not capital income, since capital owners’ feasible consumption possibilities
have not expanded.
Such increases can be labeled inflation effects (as opposed
to net capital revaluations
which result from relative
price changes and which do represent
changes in
capital owners’ consumption
possibilities).
The sum
of net capital revaluations
and inflaton
effects can
be designated gross capital rvaluations.4
Tax regulations do not distinguish
between gross and net

4In place of the terms “gross capital gains” and “net
capital gains” some authors use “nominal capital gains”
and “real capital gains,” respectively.
These terms would
be confusing
in this paper, however,
due to our earlier
distinction
between real and financial capital.

FEDERAL RESERVE BANK OF RICHMOND

19

gains, since taxable capital gains are defined as gross
gains.
Thus the tax rate on net capital revaluations
increases with the rate of inflation.
Using tax returns from 1973, Feldstein and Slemrod (1978) examined the effect of inflation on capital
gains taxes levied on common stock transactions.
While they found aggregate gross capital gains reported at $4.6 billion, adjusting
for inflation
converted the reported gain to a $900 million net loss.
According to their study, the tax burden was by no
means uniform.
Investors whose adjusted gross incomes were under $100,000 showed a $3.3 billion net
loss, and also faced capital gains taxes of $258 million. Higher income investors,
however, had a net
gain of $2.4 billion, and a tax bill for $880 million.
The uneven distribution
of the tax burden can also be
seen another way.
Of taxpayers
who reported
a
$2,000-$5,000 gross capital gain, half had a net gain
in the same range, one-third had a net gain between
$1,000 and $2,000, and one-sixth
had either a net
loss, or a net gain less than $1,000.
Interpreting
their
study
is not a completely
straightforward
matter, however.
The authors only
had access to data on realized gains.
Since owners
of large portfolios can lower taxes by offsetting gains
and losses, accrued income can be substantially
higher
than the realized income provided by data from tax
returns.
In short, inflation can worsen horizontal
equity
violations by the capital gains tax.
Investors
who
receive no net income may nevertheless
face tax
obligations.
bracket with
taxes

Moreover,
investors
the same net gains

if the cumulative

over their holding

price

in the same tax
will pay different

level

change

differed

periods.

Possible
Structural
Changes
Even in a world
without inflation,
capital gains taxes are part of a
tax system inconsistent
with horizontal
equity, a
system
that can misallocate
the flow of investment funds.
With inflation,
capital gains taxes
can increase capital income tax rates in a capricious
manner.
Such distortions
are not inevitable,
however. Changes could be made in the tax laws which
would either eliminate
or substantially
lessen the
worst distortions.
One possibility is taxing an individual’s entire capital income at the same rate, his
Compared
to the current
labor income tax rate.
situation, achieving that goal would improve capital
allocation and horizontal equity simply by equalizing
tax rates on capital income.
No judgment
is made
on revenue effects of proposed changes;
rather, an
optimum level of tax rates is assumed.
20

ECONOMIC

A large number of changes are involved in achieving the goal of equal tax rates.
Many are only
loosely related to capital gains taxes and will not be
considered here. Examples of such topics are taxing
the income from assets such as owner-occupied
housing and removing the inflation premium before taxation of interest income.
Many other changes are easily dealt with. Taxing
net rather than gross capital revaluations
could be
accomplished
by adjusting
the purchase price of an
asset in line with the rise in some price index. Other
changes could actually simplify tax computation,
including treating losses in the same manner as gains
and removing the 60 percent capital gains exclusion.
Finally, lowering the maximum
tax rate on capital
income to 50 percent (the maximum
on labor income) would only involve changing a few tax tables.
These changes move in the direction of taxing all
income at the same rate.
Some effects of the particular
changes mentioned
in the preceding paragraph
have been projected by
Feldstein
and Slemrod
(1978).
Applied to 1973
corporate
stock transactions,
the above changes
would have reduced capital gains taxes by 28 percent.5 Potential tax reductions
stemming from adjusting the purchase price for inflation, allowing fullloss offset, and lowering the maximum
rate would
have been partially
offset by higher taxes from
eliminating
the capital gains exclusion.
Taxpayers
with adjusted gross incomes above $100,000 would
have faced a tax increase;
however, those below
$100,000 would have received a substantial
tax cut.
For example, taxpayers
in the $10,000-$20,000
income range had capital gains tax bills for $23 million;
the proposed changes would have given them a $112
million tax credit.
Conversely,
investors
with incomes above $500,000, who actually
had a $374
million tax liability would have had a $520 million
tax bill with the proposed changes.
Such changes are unfortunately
not sufficient to
equalize capital income tax rates. Two major stumbling blocks remain : the deferral of capital gains
taxes by assessing taxes only when gains are realized,
and the corporate income tax.
Capital Gains Tax Deferral
Although
it was
argued above that taxing only realized gains is inconsistent
with horizontal
equity, there are arguments in favor of taxing only realized gains. Taxing

5 The authors ignore the lock-in effect by only examining
transactions which actually occurred. Also, as mentioned
above, their reliance on realized rather than accrued income makes their results rather difficult to interpret.

REVIEW, NOVEMBER/DECEMBER

1980

accrued capital gains requires periodic valuation
of
capital assets.
While actively traded assets such as
corporate stock or precious metals are easily valued,
values of other assets such as real estate or paintings
can be only approximately estimated,
often at considerable expense.
Also, if an indivisible asset like a
house appreciates,
it might be difficult to acquire
funds to pay taxes on accrued gains.
Despite these objections, some type of accrual taxation can be imagined.
Asset owners could include
end of year asset values on tax returns, which would
For
also serve as the basis for the next year’s return.
an asset not priced on a stock or commodity
exchange, alternative
values such as declared insurance
valuations
or local property tax assessments
could
be used to check the reasonableness
of an owner’s
estimates.
Spot checks and penalties for underestimates of price change might be used to deter against
large underestimates.
Unfortunately,
compliance
and enforcement
costs could well be large.
As to
indivisibility,
homeowners
could arrange to include
capital gains taxes in monthly payments, as is currently done with local property taxes.
If only net
gains were taxed, this would probably -not be an
insurmountable
burden.
Other indivisible
assets,
such as paintings, are presumably
owned by persons
who hold large diversified portfolios, so that divisible
assets could be sold to pay taxes on appreciation
of
indivisible assets.
The Corporate
Income Tax In order to tax capital incomes equally, there would have to be an integration
of corporate
and personal
income taxes.
Otherwise,
investment
undertaken
by a corporation
would not be taxed at the same rate as identical investment undertaken
by a proprietor or by a partnership.
However,
there is no simple approach
to
integration
without major drawbacks.
One approach to integration
would eliminate the
corporate
income tax.
Corporate
capital income
would still be taxed when received as interest or
by shareholders
as capital gains and dividends.
A
major drawback is that many owners of corporate
stock-pension
funds, certain foreign investors, etc.
-do
not pay personal income taxes.
To the extent
that they own corporate stock, capital income would
not be taxed.
To remedy this defect, it has been proposed that
the corporate income tax be treated as a withholding
tax. Shareholders
would periodically receive a statement giving their pro rata share of the corporate income tax paid.
On a shareholder’s
personal tax
return, this would either decrease his tax liability or
increase his refund.
However,
special features in

the tax code such as the investment
tax credit and
employee stock ownership plans would quickly lose
their appeal under this type of integration.
A $1
investment tax credit, for example, would lower corporate tax payments by $1, but it would also lower
shareholders’ tax credits by $1. Thus the net effect
on taxes is zero.
Consequently,
this form of integration would negate the effects of many features
that have acquired vocal constituencies.
The opposite approach would be to retain the tax
on corporate income but to eliminate personal taxes
on interest, dividends, and capital gains on corporate
stock (to the extent that capital gains result from
retained earnings).
However, unless a shareholder’s
marginal personal tax rate happened to equal the
corporate
rate, capital income would still not be
taxed at a rate equal to each taxpayer’s personal rate.
Thus this form of integration
is most appropriate
when there is a proportional
personal tax system,
A variation on this theme would add an individual
stockholder’s
share of taxable corporate
profits to
his taxable personal income while treating his share
of the corporate income tax as personal tax withheld.
Thus low income shareholders
would receive refunds
while high income shareholders
would have to pay
additional taxes.
A drawback occurs to the extent
that a corporation’s ultimate tax payment differs from
its first estimate, thereby causing intertemporal
inequity among shareholders.
Nevertheless,
objections
to this form of integration
appear less persuasive
than objections to either the current system or other
methods of integration.
CONCLUSION

The capital gains tax plays a key role in a tax
system which taxes different forms of capital income
at widely varying rates.
While this conclusion
is
true without regard to the price level, inflation results
in taxes on spurious capital gains, thereby worsening
an already questionable
tax structure.
There are changes which could make tax rates on
The
income from different
sources more equal.
existence of such changes does not mean that immediate change is necessarily
desirable, however.
Current capital asset values are based on the current tax structure.
Unanticipated
changes, including
those mentioned above, would alter asset values and
To ameliorate
would injure many asset holders.
such losses might require a lengthy phase-in period
for tax changes.
That, in turn, leads to another cost of change.
The changes discussed above might well substantially
increase the burden of tax preparation
and collection.

FEDERAL RESERVE BANK OF RICHMOND

21

A gradual
phase-in
would further
enlarge
that
burden.
Thus we conclude on an ambiguous
note. While
capital gains taxes are imperfect
with respect to
horizontal equity and economic efficiency, substantial

changes would be necessary to approach those. goals.
In light of our highly uncertain
estimates
of the
magnitudes
of costs and benefits of change, it is not
surprising that an admittedly imperfect tax structure
has endured for many years.

References
1.

Copeland,

Theory

1979,
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3.

4.

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p. 169.

7.
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Economy

“Personal
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“The

Taxation.”
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on

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Cost of Capital
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of Political Economy 86 (April

, and Slemrod,
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“Inflation
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Tax
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1978) :

come Tax.

Bernard,
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Slemrod, Joel, and Feldstein,
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Effect
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1978).

11.

Smith, Adam.
London,
1975
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12.

Summers. Lawrence.
“Tax Policy in a Life Cycle
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13.

Tobin, James.
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Greisman,

George

J. Fred.
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of the Federal

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1979)

of

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ECONOMIC

5080.

REVIEW, NOVEMBER/DECEMBER

1980

the

Review

Richmond.
Subscriptions
are available to the Public without charge. Address inquiries to Bank and
Public Relations, Federal
Reserve
Bank of Richmond,
P. O. Box 27622, Richmond,
Virginia

igan 48106.

25

Senate.

Act of 1978.

23261.

1,

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of economics
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Department

Vol.

: