The full text on this page is automatically extracted from the file linked above and may contain errors and inconsistencies.
JULY-AUGUST 1975
Income Taxation of
Commercial Banks . . . . . . . . . . . . . page 3
Treasury Cash
Balances . . . . . . . . . . . . . . . . . . . page 12
Income Taxation of
Commercial Banks
By Margaret E. Bedford
ommercial banks are subject to a variety of
taxes , including income or profits taxes , property taxe , taxes on the owner hip of bank hare
or capital , franchi e taxe , and an a sortment of
other mi cellaneous taxes. Of these , income taxe
are clearly the mo t important. In 1974, the mo t
recent date for which figure are available , income
taxes amounted to $1 . 8 billion and are estimated
to account for three-fourths of all taxes paid by
commercial banks. Federal income taxes comprised 77 per cent of this amount, and state and
local income taxes comprised 23 per cent.
In view of the importance of income taxation
to commercial banks , this article examines the
extent to which the income tax burden of banks
has changed in recent years. Attention is given
to the impact of tax code modifications on the tax
burden and the various approaches commercial
banks have taken to minimize their tax burdens.
Also examined is the differential burden imposed
by Federal income taxes and state and local income taxes on banks in the nation, the Tenth Federal Reserve District, and on banks of varying
deposit sizes.
C
FEDERAL INCOME TAXATION OF BANKS
Federal income taxes for banks are computed by
first determining net taxable income. In general,
the base for taxable income represents income from
operating transactions , such as interest on loans
and securities (excluding interest on municipal securities), trust department income, service charges,
etc., less allowable operating expenses, including
Monthly Review • July-August 1975
wages , interest paid on deposits and borrowed money, occupancy expense of bank premises, etc. This
figure is then adju sted to make allowance for net
loan losses or recoveries, net ecunt1es gains or
losses, and for a variety of other modifications
to income.
Federal Tax Burden
The average tax burden for commercial banks
has fallen significantly between 1961 and 1974. 1
I/Throughout this article the tax burden , or effective tax rate , of
commercial banks is measured by dividing "provision for income
taxes" by net income or profits . Provision for income taxes, as
reported annually to the FDIC, includes estimated income taxes
related to the current years' operations but does not reflect adjustments (refunds or additional taxes. paid) for previous years . Net income
as used in measuring the tax burden is equivalent to gross profits before
taxes . It is not taxable income , but rather total income less normal
operating expenses . More specifically, net income includes such items
as interest earned on state and local government securities, net longterm capital gains, etc .
Thi s ratio is, of course, potentially subject to certain distortions .
For example, a bank 's provision for income taxes in a given year may
differ significantly from the bank 's actual income tax liability . A systematic bias in the figures for all banks though is unlikely . No adjustment has been made for the fact that the interest yield on tax -exempt
ecurities is generally less than on taxable issues , thus imposing an
implicit tax burden on investors in tax-exempts . Also net income could
be biased by the timing of realizing loan losses and long-term capital
gains or losses as well as changes in depreciation methods, etc . The
importance of most of these possible biases cannot be determined , but
none is likely to result in a regular distortion over time .
Since bank reporting procedures were modified in 1969, the figures have been adjusted to maintain comparability over the 1961-74
period . Some slight variations, however, still exist. A complete description of the 1969 changes in reporting procedures appeared in the
Federal Reserve Bulletin , July 1970, pp. 564-72. For the 1961-68
period, net profits and recoveries (or net losses and charge-offs) on
loans, securities , and other transactions were added to (subtracted
from) net current operating earnings to obtain the pretax net income
figures used in this article . For the 1969-74 period , interest paid on
capital notes and debentures, which was reported by banks as an operating expense in the lates_t period but included with dividends on preferred stock in the 1961-68 period , was added to the FDIC figures for
income before taxes and securities gains or losses . In addition , gross
securities gains (losses) and gross extraordinary credits (charges) were
added to (deducted from) net operating income to obtain the 1969-74
net income figures.
3
Income Taxation of Commercial Banks
Table 1 indicates that the ratio of Federal income
taxes to net income for all insured commercial
banks over this period moved from 34. 8 per cent
to 14.5 per cent, a drop of 20.3 percentage points .
Similarly, the effective tax rate at Tenth District
banks declined 17. 7 percentage points to 18. 6 per
cent over the same interval.
Banks of all sizes generally experienced a reduced tax burden between 1961 and 1974. The
sharpest declines , however, were experienced by
the largest banks . The effective tax rate for banks
with deposits under $10 million dropped by only
one-fifth or 5.2 percentage points, but banks with
deposits over $100 million cut their effective tax
rates by two-thirds or 23. 3 percentage points. As
a result , the effective tax rate in 1974 generally
declined as bank size increased, gi ving the overall tax structure the appearance of regress ivity.
U . S. banks with deposits under $ 10 million , for
example , paid Federal taxes equal to 23 .4 per cent
of net income, compared with 16.3 per cent for
banks with deposits between $10 and $100 million
and 13 .0 per cent for larger banks. Effective tax
rates for banks of different sizes in the Tenth District were somewhat greater than the national averages , but exhibited the same general trends.
The shifts in effective tax rates reflect both
modifications in tax laws and bank efficiency in
exercising legal tax shelters . Federal income tax
rates applicable to commercial banks generally
fell from 1961 to 1965 , but tended to rise thereafter. Specifically, between 1961 and 1965 the
tax rate on the first $25 ,000 of taxable income
was reduced from 30 per cent to 22 per cent and
on income over $25 ,000 from 52 per cent to 48
per cent. In 1969 and the first quarter of 1970, a
10 per cent surtax was imposed on all taxable
income. Also, in 1969 banks were required for
the first time to treat net long-term capital gains
on securities as ordinary income. The tax rate
for long-term c~pital gains on secu rities taken
during a tran sitional period after 1969 and the tax
rate on other long-term ga ins were raised. These
tax law modifications suggest that reductions in
tax rates contributed importantly to the sharp drop
in the Federal tax burden experienced by commer4
Table 1
FEDERAL TAX BURDENS AT INSURED
COMMERCIAL BANKS
UNITED STATES AND TENTH DISTRICT
(In per cent)
Ratio of Federal
income taxes paid
to net income
All banks:
United States
Tenth District
By deposit size :
Less than $10 million
Un ited States
Tenth District
$10 to $100 million
United States
Tenth District
$100 million and over
United States
Tenth District
Changes in
effective
tax rates
1961
1965
1969
1974 1961 -74
34. 8
36.3
23 .5
27.0
20.4
25.7
14. 5 - 20. 3
18.6 -1 7.7
28 .6
30. 1
21.5
22.5
19. 7
21.9
23.4
23.6
- 5 .2
-6 .5
33.6
36 .3
25 .7
27. 1
22 .2
24 .3
16.3
18. 2
-1 7.3
- 18 . l
36 .3
41.6
23 .0
30 .8
19.7
30.3
13.0 - 23 .3
16.0 - 25.6
NOTE : Data far 1961 -68 are not ,trictly compara ble with data far 1969-74 .
SOURCE , Reports of Income, Federal Deposit Insurance Corporation .
cial banks between 1961 and 1965 . The remainder of the drop during this period , however, and
that which has occurred since then is primarily
attributable to bank utilization of tax shelters.
Tax Shelters
A number of provisions in the tax laws permit
banks to reduce their tax liabilities. Two of these
options are investing in tate and local government obligations, the interest from which is wholly
tax exempt at the Federal level , and transferring
funds to bad debt reserves to allow for future losses
on loans . Tax benefits are also realized by banks
engaged in lease financing and foreign operations.
Banks leasing equipment are able to realize tax
savings from the investment tax credit and from
deductions for depreciation . Banks with foreign
operations are permitted deductions for most taxes
paid to foreig n governments, or, alternatively,
foreign income taxes may be claimed as a tax
credit rather than a deduction . During the 1960' ,
the differential treatment of long-term capital gains
and losses on securities also served to reduce the
tax burden of commercial banks .
Federal Reserve Bank of Kansas City
Income Taxation of Commercial Banks
Table 2
SELECTED TAX ADVANTAGES OF ALL INSURED COMMERCIAl BANKS, 1972
Percentage
Description of tax advantage
Interest on state and local obligations
Net transfers to bad debt reserves deduction
Gross depreciation deduction *
Investment tax credit t
Foreign tax credit t
Income deduction
or tax credit
Estimated
tax benefit
claimed in 1972
(In millions of dollars)
3,489
1,675
485
233
1,389
667
90
90
221
221
Federal income taxes paid
1, 289
2,886
increase in
total tax if
no benefit
129.9
18.1
51.7
7 .0
17. 1
223.9
• Deprecia tion deductions cannot be separated between depreciation for ordinary bank assets and depreciation for lea sed assets. In addition , the
depreciation deduction figure includes the deduction taken by noninsured commercial banks and mutual savings banks.
t Tax credits include those taken by noninsured commercial banks and mutual savings banks.
Each of these tax code fea tures will be discussed in detail subsequently , but their relative
importance for commercial bank s in 1972 ha
been estimated in Table 2 . 2 As can be seen, sizable tax benefits were realized from the interest
exemption on state and local government securities and the net transfers to bad debt reserves .
Gross depreciation also resulted in a sizable tax
saving, but the significance of this figure must
be heavily discounted. Available data do not permit the segregation of depreciation on leased assets from that on assets used directly in bank operations. Depreciation on regular plant and equipment is an expense of doing business, while depreciation benefits realized through leasing operations reflect, at least in part, a tax shelter. 3 Finally, the investment and foreign tax credits resulted
in small, but noteworthy, tax savings. On balance,
2/The figures in the firs t column of Table 2 are for 1972, the most recent year for which comprehensive fig ures are available , and were
supplied by the Internal Revenue Service and the Federal Deposit
Insurance Corporation. While the magnitude of individual entries has
almost certainly changed since 1972 , tax regulations have not experienced any major revisions, suggesting that the relative importance
of the individual entries is probably the same.
In examin ing the figures , a number of data limitations must be
remembered. The calculation of tax benefits assumes a marginal tax
rate of 48 per cent applicable to all banks . Insofar as some banks wo uld
have been subject to lower tax rates , the tax benefits shown in the
table would be overestimates . Also , as explained in the text , the inabi lity to isolate depreciation and the tax credit associated with leasing
operatio ns results in an overstatement of the tax benefits. On the
other hand, data are not available for estimating the tax saving invol ved on long-term capi tal gains on secu rities. Banks realizing such
gains o n securities acqui red prior to July 11, 1969, would have received a tax benefit. In addition, foreign taxes taken as a deduc tion
from income rather than as a tax credit are not shown. In this sense, the
table underestimates possible tax savings. Unfortunately it is impossible with present data to determine the extent of these potential biases.
Monthly Review • July-August 1975
if these features had all been eliminated , the tax
liability of commercial banks in 1972 wou ld have
more than doub led . The e tax shelters have clearly been very important to the profitability of commercial banks.
Bank Investment in Municipal Securities.
The largest single tax savi ng for commercial
banks, as shown above , is derived from investing in state and local government securities. While
bank holdings of state and local obligations have
a slight tendency to fluctuate inversely with the
demand for loans, Chart 1 indicates that the relative importance of these securities in banks ' earn3/The tax benefits realized by banks engaged in leasi ng operati ons
vary with the nature of the lease and the deg ree to w hi ch these tax
benefits may be passed o n to renters . Reg ulations governi ng bank
holding companies require that leases must be the fun c tional equivalent of loans and that the holding com pan y must recover both the
full acquisition cost of the equip ment and the estimated cost of finan cing the property during the period covered by the lease . These costs
may be realized through a com bination of rental payments , es tim ated
tax benefits (investment tax credit, gain from tax deferral from accelerated depreciation , and other lax benefits with a si m ilar effect),
and estimated residual values of the property at the time the lease
expires . Banks generally follow these same rules, and similar regulations have recently been proposed for national banks .
The potential benefits from leasing can be seen from an exam ple .
If a bank makes a loan for the purchase of equipment , the borrower
is able to deduct interest paid on the loan and depreciation on the
equipment as ex penses in computing taxable income; the bank receives
no special tax advantage . However , if the bank were to lease the
eq uipment to the customer , the custo mer is able to deduct rental
payments to the bank wh ic h are equivalent to interest on the loan plus
the repayment of principal (less any sc rap value of the equipment) .
The bank is able to ded uct depreciation on the equipment and may
utilize the investment tax credi t. In effect , therefore, the bank is allowed a deduction o r tax credit for the fun c tional eq ui valent of the
principal of a loan . If the bank uses an accelerated depreciation schedule, add itional benefi ts would be received through tax deferrals. Normal lease arrangeme nts permit both the lessee and lessor to realize a
portion of these tax savings but which o f the two receives the majority
of the tax benefit cannot be determined.
5
Income Taxation of Commercial Banks
Chart 1
STATE AND LOCAL GOVERNMENT SECURITY
HOLDINGS AS A PER CENT OF EARNING ASSETS
Per Cent
18.0 - - - - - - - - - - - - - - - - - - ,
Al I Insured Banks
16.0
14.0
United States
12·0
•
___ __ /
10.0
-~--~-f- ---
Tenth District
8.0
14 0
- [Less Than $ 10 Mil lion in Deposits
12.0
10.0
--------------
---------=-
8.0
20.0
,,/]
-=-=-=-=--=---- -
$10-$100 Million in Deposits
18.0
16.0
14.0
12.0
10.0
18.0
16.0
Over $100 Million in Deposits
14.0
,,, ,,
12.0
,,
/
10.0
8.0
6.0 ____,__._...,____.,_....._......._...._.......___,....__.____,...._....___.,_.....___.
1961 '62 '63 '64 '65 '66 '67 '68 '69 '70 '71 '72'73 '74
ing asset portfolios has increased for all groups
of banks since 1961. The largest rise , however,
has· been experienced by banks with deposits over
$10 million. Banks with deposits under $10 million had only a slight increase in the fraction of
earning assets invested in municipals. The chart
also shows that in recent years Tenth District
banks have had a slightly higher proportion of their
portfolios invested in municipals than all U. S.
banks generally . 4
The different behavior of large and small banks
regarding holdings of municipals probably is due
4/ Although Tenth Di strict bank s have a hi gher ratio of municipal
sec urities to earning assets than U . S. banks, the District tax burden
is higher . This reflects. in part , the greater use of other tax shelte rs
by U . S . banks than by Tenth District banks and other factors affecting bank taxes and earn ings which are not explicitly discussed here .
6
to the fact that the tax advantages of municipals
are considerably greater for banks with larger net
taxable incomes. A bank in the 22 per cent tax
bracket would receive a hjgher return from investing in taxable securities if the pretax yield on these
securities is more than 1.28 times the return on taxexempts. Similarly , a bank in the 48 per cent tax
bracket would require a minimum return on a taxable security of 1. 92 times the return on a taxexempt issue to benefit from investing in a taxable security. 5 A comparison of interest rates
on intermediate-term U. S. Government issues
with the rates on state and local Aaa securities
during 1961-74 reveals that banks in the 48 per
cent tax bracket were always ahead to invest in
tax-exempts . Banks in the lower tax bracket , on
the other hand, were often able to earn the hi ghest
after-tax return by electing taxable issues. 6 Smaller banks , which must rely mainly on their security
holdings for a liquidity reserve, may also have
been deterred from acquiring large amounts of
municipals from a concern about their marketability during periods of strong loan demand.
Transfers to Bad Debt Reserves. Tax regulations permit banks to use one of two methods
in handling loan losses . Under the direct chargeoff method, recoveries or losses would be an addition to or deduction from taxable income in the
year they occurred. Under the reserve method , a
bank is allowed to build up a reserve for anticipated loan losses. Actual recoverie or losses
during the year are charged to the reserve rather
than to income. For tax purposes, however, allowable transfers to bad debt reserves are treated as
an operating expense and thus serve to reduce
net income subject to taxes.
5/For a taxable sec urity to be more profitable than a tax-exempt security, the following mu st hold tru e : (yield on taxable sec urit y) ( I - tax
rate) > (yield on tax-exempt sec urity) or (y ield on taxable securit y)/
(y ield o n tax-exempt sec urity) > 1/( I - tax rate). Ass umin g a yiel d
of 8 per cent on a tax able sec urity and a rate of 6 per cent on a taxexempt securi ty. investment in the taxable securit y will be mo re profitable for a bank in the 22 per cen t tax bracket since: 8%/6% = I . 33
1/(1- .22) = 1.28 . A bank in the 48 per cent brac ket will bene fit
more by in ves ting in the tax-exempt sec urity si nce : 8%/6% = 1.3 3
< 1/(1-. 48) = 1.92 .
6/This analysis assumes that the bank is making the purchase for the
inte rest return onl y and does not take in to co nsideration the tax effect
of a capital gain or loss .
>
Federal Reserve Bank of Kansas City
Income Taxation of Commercial Banks
The tax treatment of bad debt reserves has
been modified over time . 7 From 1954 to 1964,
banks were permitted to base tax free reserves
on an average experience factor derived from any
20 consecutive years after 1927 . This period , however, included the Depression years of the 1930's
when loan losses were unusually high. Consequently, many banks were able to transfer substantially larger amounts to bad debt reserves
than were needed to cover current losses. Banks
not in existence during the l 930's, though, were
at a disadvantage in using this method. To equalize the deduction s among banks, the rules for
computing bad debt reserves were modified in
1965. Under the change banks were al lowed to
build up reserves totaling 2.4 per cent of eligible
loans outstanding at the close of the taxable yea r.
Or, they were given the alternative of basing reserve on a probable experience met hod derived
from the ratio of net bad debts during the most
current 6 years to the sum of loans outstanding
at the close of those years.
Under the 1969 Tax Reform Act , banks were
further limited in the size of additions to bad debt
reserves. The law provided an 18-year transitional
period during which banks could claim additions
to reserves by the greater of a percentage method
or an experience method. The experience method
i similar to the procedure used during the 1965-69
period. Until 1976, the percentage method allows
a tax free reserve up to 1. 8 per cent of eligi ble
loans outstanding at the end of the taxable year.
Thi percentage will be further reduced to 1.2 per
cent from 197 6 to 1981 and to O. 6 per cent from
1982 to 1987 . Beginni ng in 1988, the average
actual loss experience will be the only allowable
method for computing bad debt reserves.
Although the allowable percentage of loans
that may be held as tax free bad debt reserves
has been reduced in recent years, the dollar volume of reserves has con tinued to grow with loan
volume and additions to these reserves in so me
years have been quite large. For example, in 1974 ,
U. S. banks had net transfers to bad debt reserves
of 9.4 per cent of pretax net income. Moreover,
the ratio of bad debt reserves to loans outstanding at U. S. banks tends to rise as bank size increases. This is a partial reflection of the fact that
larger banks mainly tend to utilize the reserve
method of accounting for loan losses, whereas
smaller banks frequently charge off loan losses
only when real ized and, consequently, have no
bad debt reserve. Thus , bad debt reserve deductions result in a greater tax reduction for larger
banks. In 197 4, had there been no allowable tax
free transfers to bad debt reserves, the total effective tax rate 8 would have been 3 . 1 per cent higher
for U. S. banks with more than $100 million in
deposits, 2.2 per cent greater for bank s with deposits of $JO to $100 million, and only 1.2 per cent
greater fo r banks with depo it under $10 milli on.
Security Swaps. Prior to 1969, commerc ial
banks were able to obtain important tax avings
by controlling the timing of realizing capi tal gain
and losses on securities. Rules in effect at the time
required that banks first offset any long-term capital losses with long-term gains. Beyond that , however, net losses could be deducted from regular
income without limit , producing roughly a 50 per
cent tax absorption of any loss for banks in the
highest tax bracket. Long-term gains, on the other
hand, were taxed at a maximum rate of 25 per cent.
Under these circumstances, banks could realize
the greatest tax benefit by taking capital losses
one year and capital ga ins an other. If gains and
losses of the same magnitude were both reali zed
in the same year, no tax saving would occur. But
if the capital loss were taken one year and the
gain in another, the bank would realize a tax saving of about 25 per cent of the loss . One justification for the preferential capital loss treatment was
that banks were often forced to sell bonds at capital losses during business cycle expansions to acquire funds to meet loan demands.
The Tax Reform Act of 1969 modified the tax
treatment of capital gains by requiring banks to
7 /T o prevent banks from concentrating transfers to bad debt reserves
in ye ars of extremely high income , certain limitations are placed on
the am o unt that can be added to the reserve in any one year.
8/ The effec t of these transfers co uld not be se parated between the
effect on Federal income tax burdens and the effec t on state and
local income tax burdens. Thus , figures for the effect on the total
income tax burden are given .
Monthly Review • July-August 19 75
7
Income Taxation of Commercial Banks
treat gains or losses on securities acquired after
July 11, 1969 , as ordinary income . The change
considerably reduced the advantage to banks of
alternating years of gain and losses, but did not
remove all incentive for undertaking security
swaps. If a bank realizes a loss on the sale of a
security and subsequently invests in a higher yielding bond, the bank would experience increased
interest income . In addition , the bank could benefit by reduced taxes in the year of the loss and the
postponement of the potential capital gains tax
on the new securities until future years . 9 In any
event, security swap have been utilized by banks
to moderate fluctuations in net income. Banks have
tended to take large ecurity lo ses in year of
sharply rising income and to boo t income by
realizing gain during periods of declining profitability. The 1969 revi ions did not al ter thi
tendency.
Investment and Foreign Tax Credits. Al though the dollar impact has been comparatively
small, both the investment tax credit and the foreign tax credit have reduced the domestic tax payments of commercial banks. A tax credit, of course,
reduces the dollar amount of taxes paid by the
amount of the credit. The investment tax credit
was initiated in 1962 to spur economic growth and
allowed a deduction from taxes up to 7 per cent
of the cost of a qualified inve tment in new or
used property for the first year that the property
i placed in service. The credit ha remained in
effect except for two brief periods of suspension
from October 1966 to March 1967 and from April
1969 to December 1970. Just recently, moreover,
the investment tax credit was raised to 10 per cent
for the period from January 22, 197 5, through
December 31, 1976.
Commercial banks have been able to utilize
the investment tax credit on purchases such as
computers used by the banks themselves and on
purchases made ~or their lease financing operations. Normal depreciation on bank leased assets
further serves to reduce tax payments. 1 Finally ,
°
9/For a description of the potential benefits , see Paul S . Nadler, " Are
Tax Swaps Dead?" Bankers Monthly, August 15, 1972, pp . 15-16.
IO/See footnote 3.
8
if the equipment i ultimately sold for more than
its depreciated value, additional tax savings are
experienced. In bank leasing operations, tax benefits are often passed along to customers in the
form of lower leasing costs. However, since banks
are able to realize significant tax benefits which
would not be possible if a loan had been made to
purchase the equipment, leasing operations have
frequently been viewed as a major tax shelter for
commercial banks. These tax avings are undoubtedly responsible in large measure for the substantial growth in leasing operations by both banks
and bank holding companies . Nonetheless , it
should be recognized that , in periods of strong
inflation , these benefits are inadequate to allow
for full replacement costs. Some obs rver feel
these tax feature h uld be further liberalized to
reduce the poten ti al real capital hortage the country may face ov r the coming d cade.
The foreign tax credit has al o been called
a tax helter, but this observation i not fully justified. The credit was introduced to limit double
taxation of income by both the United States and
foreign countries. Before 1962, banks paid taxes
on foreign income only when it was repatriated
to U. S. shareholders through dividend distributions. However, since the Revenue Act of 1962
was passed, domestic corporations have been taxed
according to their share of income from foreign
sub idiarie . Banks have had the options of either
deducting foreign taxe from net income , or claiming a credit for foreign income taxe paid or accrued during the taxable year. The latter method
usually yields the greatest tax advantage, but the
former is easier to compute. 11
The sharp rise in foreign operations of large
banks since the mid-1960's and the temporary suspensions of the investment tax credit are jointly
I I/The foreign tax credit is subject to a " per country " limitation or
to an "overall" limitation . Under the per country limitation , the credit
as a proportion of the U. S . tax cannot exceed the ratio of taxable income from the foreign country to total taxable income . Under the
overall limitation, the proportion of all foreign taxes paid to the U. S .
tax can not exceed the ratio of the bank 's taxable income from all fo reign sources to all taxable income. Certain carryover and carryback
provisions also apply to the use of the two limitation method s to adjust
for variations in tax years between the United States and other countries and differences in the timing of including income or deductions
in calculating the tax base . Also, the 1963 law provides for "grossing
up " income from developed countries by the amount of the taxes
paid when a tax credit is claimed.
Federal Reserve Bank of Kansas City
Income Taxation of Commercial Banks
respon sible for the more rapid growth of foreign
tax credits than investment tax credits. As might
be expected, though, the investment tax credit
has been more important for smaller banks and
the foreign tax credit more important for larger
banks. Large banks initiated a significant expansion
of their foreign operations in the mid-1960' when
the Voluntary Foreign Credit Restrai nt (VFCR)
program restricted loans to foreigners. By lending
through foreign branches which were not ubject to
VFCR guidelines , these bank were able to meet
the growing credit needs of multinational corporations whose overseas operations were expanding .
Minimum Tax on Tax Preference Items. One
feature of the Tax Reform Act of 1969 which has
re ulted in greater equalization of tax burden between large and mall banks i the Minimum Tax
on Tax Preference Item . A preference item is e entially a provi ion in the tax codes whi ch allows
a bank to reduce its tax liability . The "minimum
tax '' imposes an additional 10 per cent tax on ome
items of preference after an exemption of $30,000
and applicable Federal income taxes . Preference
item of major interest to banks are contribution
to bad debt reserve in excess of experience, accelerated depreciation on certain assets , and long-term
capital gains. In general only the largest banks pay
th is tax . If this tax were eliminated, the disparity
between the tax burdens of large and small bank
would be even greater .
STATE AND LOCAL INCOME TAXATION OF BANKS
While states govern the types of taxes imposed
on state chartered banks, the states must follow
Federal statutes regarding taxation of nationally
chartered banks. Until recent years, states were
quite restricted in imposing taxes on national banks;
states could tax bank shares, the dividends of owners , or the bank' s net income. Interest received on
U. S. Government obligations was not taxable under
a direct income tax , but net income from all sources
could be taxed under an excise or franchise tax.
Only one of these methods of taxation could be
used, and a state could only tax national banks if
the head office was within the state . In addition,
states or localities were permitted to levy real propMonthly Review • July-August 1975
erty taxes on national banks . Although states were
free to impose any tax on state chartered banks,
competition between national and state chartered
bariks and equity considerations prompted most
states to treat the two groups of banks equally.
In December 1969, Congress liberalized the
laws regarding state taxation of banks . States were
allowed to levy any tax, except an intangible peronal property tax , on a national bank having its
main office in the state. States also were allowed
to impose sales or use taxe , real property or occupancy taxes, documentary taxes, tangible personal
property taxes, and license , registration, transfer,
or other taxes on a national bank not having its main
office in the state if those types of taxes were generally impo ed on a nondi cri minatory ba is . Subsequently a permanent amendment , pas ed in 1973 ,
allowed ' tates to treat nat ional bank as tate bank
for tax purpo es. The amendment further permitted
the imposition of intangible taxes but retained limits
on state taxation of nondomiciliary banks ' income .
Tax Burden
Income taxes are the most important single tax
levied by state and local governments. 12 Between
1961 and 1974 , the burden of state and local income taxes nearly doubled at all U. S. banks , rising
from 2.3 per cent of net income to 4.3 per cent.
(See Table 3.) This ri e reflects both the upward
movement of tax rate over the period and the imposition of income taxe in some states which had
previously not taxed bank profit . By comparison,
the average burden of state income taxes for Tenth
District banks rose only slightly over the period
from 2.3 to 2.6 per cent. The lower effective tax
rate for Tenth District banks than for banks in the
nation reflects the smaller tax burden of District
banks with deposits of $100 million and over. These
banks had a tax burden of 2.5 per cent in 1974,
compared with 5. 3 per cent for U. S. banks of sim12/ Banks also pay property taxes, sales taxes, documentary taxes,
and other miscellaneous taxes to state and local governments . Al though c urrent data on the volume of these taxes are unavailable , a
1969 st ud y by the Board of Governors of the Federal Reserve Sys tem
revealed that these taxes accounted for 62 per cent of all taxes paid to
state and local governments while income taxes accounted for 38
per cent.
9
Income Taxation of Commercial Banks
Table 3
STATE AND LOCAL INCOME TAX
BURDENS OF BANKS
UNITED STATES AND TENTH DISTRICT
(In per cent)
Rati o of state and local
inco me t a xes pa id
to net income
All banks:
United States
Tenth Di strict
Changes in
effective
tax rates
1961
1965
1969
2 .3
2.3
2 .6
2 .4
3.4
2.9
4.3
2.6
+2 .0
+ 0 .3
1.4
1.6
1. 7
2.2
1.7
2.1
2.5
2 .5
+ 1. 1
+ 0.9
1.5
2.2
1.5
2.7
1. 9
2.8
2.4
2.8 ·
+ 0.9
0.6
2.8
3 .1
3.1
2.2
4.3
3.5
5.3
2 .5
+ 2.5
- 0 .6
19 74 1961 -74
By deposit size:
Less tha n $1 0 million
United Sta tes
Tent h District
$1 0 to $1 00 mi ll ion
United States
Te nth Di~trict
$ 100 mi llio n a nd over
United States
Te nth District
NO TE : Data far 1961 -68 are not stri ctly comparable with data for 1969-74 .
SOURCE : Reports of Income, Federa l Deposi t Insu rance Corporation .
ilar size. On the other hand , Tenth District 13 banks
with deposits under $100 million had effective tax
rates equal to or above the national averages.
The slight change in the average tax burden for
Tenth District banks between 1961 and 197 4 tends
to mask the underlying shifts that have occurred
among the individual states . Over the period , banks
in Colorado , Missouri , and Oklahoma generally
experienced a reduced tax burden which was more
than offset by the imposition of income taxes by
Kansas (1964), Nebraska (1969), and New Mexico
(1969). (See Table 4 .) Wyomi ng remains the only
Tenth District state which does not impose an income tax on banks.
Differences in income tax burdens among states
tend to reflect in part alternative definitions of tax able income. In general, taxable income in most
District states is based on the Federal definition ,
but with certain additions or subtractions. The most
important differences result from the treatment of
income from Federal and municipal government
securities and the allowable deductions for bad
debt reserves and Federal taxes paid. Among Tenth
13/Colorado , Kansas, Nebraska , Wyomi ng , 43 western Missouri
counties , northern New Mexico , and most of Oklahoma.
10
District states, Kansas, New Mexico , and Missouri
require adjustments to Federal taxable income to
include interest income from state and local obligations, while Colorado and Oklahoma include interest from out-of-state municipal securities. Colorado also allows banks to deduct interest income
from Federal obligations from taxable income and
Missouri allows a deduction for Federal income
taxes paid . Missouri , however, permits banks to
claim only actual net bad debt charge-offs as a deduction rather than additions to bad debt reserves
as allowed on the Federal form.
Differences in income tax burdens among Tenth
District states also reflect variations in tax rates
among the states. Banks in Kansas and New Mexico,
which reported the highest ratios of state and local
income taxes to net inco me, have relatively high
tax rates . Tax burdens for these two states were
above the national average. Tax burdens for banks
in Colorado and Missouri were close to the District
average as adjustments to the tax base partly offset
their comparatively high tax rates . For banks in
Nebraska and Oklahoma , the ratios of state and
local income taxes to net income were as low as
1. 7 per cent and 1. 9 per cent, respectively , in 1974,
reflecting in part that these two states have two of
the lowest income tax rates in the nation.
In Colorado , Kansas, and Missouri, small banks
paid the lowest effective income tax rates. In Nebraska and Oklahoma, however , where only minor
adjustments are made to the Federal tax base in
computing taxable state income , large banks- i.e .,
with deposits over $100 million-had the smallest
tax burdens . The tax burden of the Federal income
tax structure, it will be recalled , also was smallest
for the largest size banks . In New Mexico, banks
of all sizes had nearly equal state income tax burdens.
CONCLUDING REMARKS
Between 1961 and 197 4 the effective Federal
tax burden on commercial banks dropped about 60
per cent, with large banks generally realizing the
sharpest decl ines. Reduction s in tax rates account
for a portion of the decline , but the largest share
has resulted from bank utilization of legal tax shelters . The more important of these include investFederal Reserve Bank of Kansas City
Income Tax at ion of Commercial Banks
Table 4
STATE AND LOCAL INCOME TAX BURDENS OF BANKS
TENTH DISTRICT STATES, BY DEPOSIT SIZE
States by deposit si ze
Ra ti o of state and local
income taxes paid to net income
(In per cent)
State tax rates
appl icable to
banks' net income
1961
1974
1974
Colorado
Less than $ 10 million
$ 10 to $100 million
$100 million and over
6.4
6 .5
6 .6
6.2
2.5
1. 9
2.5
2. 8
5%
Kansas
Less than $10 mi llion
$10 to $100 million
$100 million and over
-
4 .4
3 .7
4. 6
5.0
Missouri *
Less than $10 million
$10 to $100 million
$100 million and over
2.9
l. 5
l. 7
4. 1
2.4
1.7
2. 6
2. 3
791
Nebraska
Less than $10 million
$10 to $100 million
$100 million and over
-
1. 7
2.7591
-
l.8
1. 9
1. 1
-
-
{ 5% on income < $25,000
7. 25% on income>$25, 000
6%
-
5. 1
5 .3
5.1
5. 1
Oklahoma *
Less than $10 million
$10 to $100 million
$ 100 million and over
2 .7
3. 1
2.6
2.6
l.9
2.5
2.0
1.4
4%
Wyoming
-
-
New Mexico*
Less than $10 million
$10 to $100 million
$100 million and over
-
-
0
• Bank s in Tenth Distr ict por tion of state .
SOURCE : Reports of Income . Federal Deposit Insurance Corporation .
ments in state and local government sec urities,
creation of reserves for bad debts substantially in
excess of actual losses, and the development of
equipment leasing operations . Banks in the Tenth
Federal Reserve District generally experienced similar trends, but over the period were subject to an
effective Federal tax burden above the national
average . In 1974 , fo r example, the Federal tax
Monthly Review • July-August 1975
burden was 18 .6 per cent for Tenth District bank s,
compared with 14.5 per cent for all banks in the
nation . On the other hand, the state and local income tax burden of Tenth District banks was somewhat below the national average . On balance, Tenth
District banks averaged a total income tax burden
of 21.2 per cent , compared with 18.8 per cent for
U . S . banks .
11
Treasury Cash Balances
By Peggy Brockschmidt
n May 23, 1975 , the ecretary of the
Treasury formall y reque ted C ongre s to
provide the Treasury with a uthorization to invest its idle tax and loa n account bala nces in
short-term earning assets . These balances
traditionally have been interest-free deposits
at commercial banks and th us have pro vided
no explicit return to the Treasury.
This article examines th e rationale underlying the recent T reasury proposal. The first
section of the article briefly discusses the Treasury's cash management system , with particular emphasis on the tax a nd loan account system. The next section reviews the major findings and recomm endatio ns of the Treasury's
1974 report dealin g with tax and loan accounts. 1 The final section of the article exam ines the extent to which Treasury cash balances ha ve changed in recent years and the
implications of these changes for the conduct
of monetary policy.
0
TREASURY CASH MANAGEMENT SYSTEM
The Federal government must maintain a
cash operating balance just like individuals
and businesses. -The purpose of such a balance
is to provide a cushion for meeting current obligations because receipts never precisely
match disbursements in timing and amount.
1/ Report on a Study of Tax and Loan Accounts. Department of
the Treasury , June 1974.
12
The governm ent ho lds its cash balan ce in two
ty pes of acco unts, in dema nd depo it bal an e
at Federal Reserve Ba nk and in tax a nd loan
accounts at commercial banks . Paymen ts are
made fro m balances at the Federal Reserve,
while most receipts are deposited in tax and
loan accounts and then transferred as needed
to the account at the Federal Reserve .
Treasury balances at Federal Reserve
Banks would probably be sufficient to handle
the fl ow of government funds if these flows
were not very large and subject to wide
swings. The average balance of Treasury funds
at commercial banks and Federal Reserve
Banks in fiscal year (FY) 1975 was $4 .6
billion and weekly averages ranged from a
high of $13 .5 billion to a low of $0.5 billion.
Given these large magnitudes, it is clear that
fluctuations in the Treasury's operating balance could ca use marked disturbances in the
orderly flow of funds through the nation 's financial markets. In recognition of this potential problem, the system of tax and loan accounts was developed.
Tax and Loan Accounts
The principal purpose of tax and loan accounts is to promote the smooth functioning of
the economy by reducing the impact of the
government's financial operations on the nation's money market. Flows of funds between
Federal Reserve Bank of Kansas City
Treasury C a sh Balances
the public and the Federal government could
affect com mercial bank reserves a nd cause un desirable fluctuations in money market interest rates. The payment of taxes to the Treasury
could drain reserves from the banking system
and place upward pressure on interest ra tes,
while Treasury disbursement s cou ld augment
bank reserves and tend to depress interest
rates . Tax an d loan acco unts help prevent
these flows of funds from affecting bank reserves and interest rates . When taxes are paid
int o tax and loan accounts, bank reserves are
not a ffected because the funds are transferred
on the bank' s books from the taxpayer's account to the Treasury's tax and loan account.
In thi manner, funds are left in the banking
system until they are required for outpayments. At that time, the Trea ury can draw
do wn its tax and loan balances as it needs to
cover disbursements, thereby matching the
fl ow of receipts from the public to the flow of
disbursements to the public. In the absence of
the tax and loan account system, the impact of
th ese flows of funds on bank reserves and financial markets could be offset by the Federal
R eserve through its open market operations .
However, the required frequency and size of
these offsetting operations would unduly complicate the Federal Reserve's co nduct of monetary policy.
Another function of the system of tax and
loan accounts is to facilitate the disbursement
of Treasury securities by provi ding an incentive for banks to serve as "underw riters" and
dist ributors of new Treasury securities . The incentive consists of allowing banks that subscribe to certain new issues of the Treasury to
pay fo r them by crediting the T reasury's tax
and loan account. After a few days, the Treasur y transfers the payment to its account at a
Federal R eserve Bank, thereby a llowing banks
to earn a yield on the funds during the interim .
This incentive has served to build an underwriting network th~t has enabled the Treasury
to market securities without commissions or
Monthly Review • July-August 1975
spreads of any kind . With the market for Treasury securities now more highly developed , the
need for thi s method of distribution has diminished. It nevertheless co ntinu es to be a significant function of th e tax and loan acco unt system.
The system also provides an efficient
m echa nism for the co ll ection of Treasury revenues, as most Treasury receipts flow through
the tax and loan acco unts . A business co ncern ,
for exam ple, makes its tax payments through
its own bank. The company's check for the
ta xes does not flo w beyond that ba nk . The bank
charges its customer's account and simultaneously credit s the Treasury ' s ta x an d loan acco unt. This facilitates chec k c lea rin gs a nd
avoids the expense to th e Treasury o f handling
large vo lumes of remittances, which enta il not
on ly detailed intern al process in g and depositing in banks but also burdens incident to returned unco llectible checks.
The Treasury maintains tax and loan acco unts at almost all commercial banks . Any incorporated bank m ay be designated as a special depositary for the Treasury. A bank makes
application for quali ficatio n through the Federal R eserve Bank in its district and a rra nges
for posting collateral to c over the balance of
the tax a nd loan account. The bank then creates a balance in the acco unt by persuadin g its
customers to pay taxes th ro ugh the account o r
to buy government securities, or by subscribing itself to government securities . Most deposits in to tax and loan accounts ari se from
taxes due the Federal government. These
taxes include withheld income taxes, FICA
ta xes , and corporate income taxes.
Th e Treasury makes use of tax and loan
balances by transferring them to its account
with a Federal Reserve Bank , from which all
Treasury disbursements a re made. In transferring funds from tax a nd loan accounts to Federal Reserve Banks , the Treasury has established a system whereby commercial banks are
divided into three classes-A , B, and C banks .
13
Treasury Cash Balances
As of the latest classification, A banks are
those with credits of less than $7 .5 million
during calendar year 1974. B banks had credits between $7 .5 million and $80 million , or
had credits over $80 million but total bank
deposits less than $50 million . C banks had
credits exceeding $80 million and total bank
deposits exceeding $50 million. As of March
1975, there were 11, 166 A banks, 2,226 B
banks, and 330 C banks.
Withdrawals from tax and loan accounts
are made in an identical manner for every
bank within a class. An equa l percentage of
the balance as of a la ted date is withdrawn , or
"called," from each bank. Calls on A banks
are generall y i ued twice a month with payment 7 days later, B bank ca ll twice a week
with payment 3 day s later, and C bank ca lls
dail y. The flow of funds through the accounts
can be speeded in several ways. Calls can be issued more frequentl y, the nu mber of days between the time of call and ti me of withdrawal
can be shortened, and th e percentage withdrawn can be increased .
Funds in tax and loan accounts are available for investment by commercial banks . The
banks can thereby realize revenue from these
deposits but pay no interest on them to the
Treas ury . However, banks do not necessarily
realize a net profit on the tax and loan accounts because they perform services for the
Treasury for which they are not directly compensated .
Among the services performed by banks
for the Treasury, the most obvious is the actual
maintenance of the tax and loan account itself,
including handling debits and credits and processing Federal Tax Deposit forms. in a ddition, banks participate in the sa le and redemption of savings bonds . They operate as iss uing
agents in over the co unt er sa les and as managers of their own payroll savings plans.
Banks also assist other bus inesses in setting
up and maintaining savings plans. Furthermore, almost all redemptions of savings bonds
14
are made through commercial banks. Another
service is the support of subscriptions to government securities. When banks purchase new
Treasury issues, they serve as underwriters of
the issue without cost to the Treasury. Other
functions performed for the Treasury include
the handling of large vo lumes of maturing
public debt and the cashing of large numbers
of government checks. Banks also report large
or unusual currency transactions to the Treasury. In performing these services for the Treasury, banks experience costs for which they
are not directly compensated. In as es ing the
net profitability to the ban ks of tax and loan
accou nts, bank costs must be compared with
the revenues from the accounts .
THE TREASURY'S 197 4 REPORT ON
TAX AND LOAN ACCOUNTS
To analyze the net profitability of tax and
loan accounts to commercial banks , the Treasury has conducted three studies within the
past 20 years . One study was published in
1960 an d covered the yea r 1958; the second
appeared in 1964 and was based on 1963 data;
and the most recent study-based on 1972
data-was published in 1974. 2 The two earlier
studies co ncluded that the tax and loan acco unts were not a source of profit to the banking system. It was found that the cos ts to the
banks of s pecific serv ices performed for the
Treasury exceeded the earning value of the tax
and loan acco unts . The 1974 report, however,
found that the earning val ue of the accounts to
banks was far in excess of the value of related
services the banks provided the Treasury .
The Value of the Accounts to the
Value of Services
The basic findings of the 1974 report pertaining to the aggregate cost a nd earning val2/
Report on Treasu ry Tax and l oan Accounts and R elated
Mail ers, Treas ury Department, December 2 1, 1964: a nd Report
on Treasur v Tax and Loan A ccounrs, Services R endered bi• Banks
fo r th e Federal Government and Other R elat ed Mail ers , Treas ury
Depa rt ment , June I 5, I 960 .
Federal Reserve Bank of Kansas City
Treasury Cash Balances
ue of tax and loan accounts to banks is shown
in Table 1. The findings of the 1964 study also
are shown for comparison. For both studies,
the data were obtained by surveying 600
banks, including all C banks and a sampling
of the A and B banks . The sampling wa designed to be representative of the total ystem,
thereby permitting extrapolation of the data
for a reasonable estimate for the banking system as a whole.
In comparison with previous studies, the
1974 report found that the earnings value of
the accounts exceeded the cos t of providing
related ervices du e to three major factors:
(I) high er tax a nd loan account balance ,
(2) hi gher interest rate level , and (3)
few er allowable expen es. As shown in Table
I , average daily balances increased n a rl y 40
per cent between 1963 and 1972-from $4.9
billion to $6.8 billion . After dedu cting required reserves against the e balances, the net
balance was $4.0 billion in 1963 and $5.9
billion in 1972. To compute the earnings on
these net balances , a Treasury bill rate was
taken as a representative yield. For 1963, the
rate used was 3 .162 per cent, which was the average auction yield on 3-mon th Treasury bills
during the year; and for 1972 the rate used
was 5 .50 per cent, which wa the average au ction rate o n 3-month bill s during the 5-year
period ended December 1972. After applying
these rates, th e earning on net balance wa
$126 million in 1963 and $325 million in
1972.
Allowable bank expenses also differed in
the two reports, although the costs of servicing
the tax and loan account itself were deemed
appropriate in both instances. Similarly, bank
co ts of issuing and redeeming savings bonds
were consider ed an allowab le expense. Be3/
porti o n of this increase "as due to a change in th e co ncept
u ed fo r daily balances . The 1964 t ud) used balance per the book
of th e Federal Reser ve- hich woul d always be lower th an bala nces
on the books of commercial banks by the amount of cred its in
tran it. o rrecting for th i difference. 1963 _balances ~\ ou ld have
averaged 5.3 bill ion rather than $4.9 billion. reducing the 1nc rea e to about 30 per cent.
Monthly Review • July-August 1975
Table 1
SUMMARY OF INCOME AND EXPENSES
ONT AX AND LOAN ACCOUNTS
(In millions of dollars)
Earnings
1963
$4,864
828
4 ,037
3 . 16 %
Average da ily balance
Less rese rves
Net balance
Trea su ry bill rate
Earn ing val ue on net ba la nce
1972
$6,845
934
5,911
5 .50%
$126 $325
Expenses
Servicin g ta x and loan a cco unts
Savings bo nd s: iss ua nce a nd rede mption
Handling of other U.S . securities
Handling of Trea sury ch ecks
Other
Mork -up o f expenses (20 per cent)
Tota l e xpenses
Net earnings
$16
33
$ 18
46
15
40
13
23
$139 $ 6 4
-$13
$261
cause of altered banki ng practices, however,
certain expenses allowed in the 1964 study
were not dedu cted in the 1974 report. These
were the costs of handling subscriptio ns for
new iss ues of T reasury securities (other than
savings bo nds), handling mat ured Treasu ry
sec unt1e , han d ling Treasury checks, and
ot her miscellaneous bank services. The e costs
were disallowed on the basi t hat the ervice
wa not specifica ll y related to mai ntaini ng t he
tax and loan account , but wa·s primari ly a customer service o r marketi ng device fo r whi ch
the Treasu ry should not com pensate the ba nk.
Also, if the cost of a service was recovered in
one way or another by the ba nk from its customers, it was disallowed in t he 1974 re port.
An additional expense not exp licitly allowed in
the recent study was a profit mark-up over
expenses of 20 per cent, although the study did
recognize that a rea onable profit margin was
necessary to make the system work efficiently.
In summary, total expenses were estimated at
$139 million in 1963 but only $64 million in
1972.
15
Treasury Cash Balances
The aggregate net earnings on the tax and
loan accounts was estimated to be $261 million in 1972 compared with a loss of $13 million in 1963. The 1974 report stated, therefore,
that " the implicit costs to the Treasury of holding interest-free tax and loan accounts has
risen substantially beyond the value to the
Treasury of those services provided by the
banks . .. ."
Ways the Treasury Could Increase Its Return
Three potentia l methods by which the
Treasury could realize a greater return o n its
tax and loan balances were exami ned in the
1974 repo rt. On e method, and the most direct,
would be for commercia l bank to pay interest
direct ly on tax a nd loan balance . Thi method
wa originally authorized by Congres in 1917
when legislation was passed establishing the
tax and loan system. In 1933, however,
interest payments on dem and deposits were
prohibited by Congress out of concern that
large banks might compete unfairly with small
banks and thereby cause a ratcheting up of interest costs. For the Treasury to seek new legislation to remove the prohibition solely for
Government deposits, therefore, would be in
conflict with the intent of the 1933 law and
also place the government in a privileged position vis-a-vis other bank depositors.
A second method would be for the Treasury to place some of its balances in interest
bearing time deposits at commercial banks .
Current Federal Reserve regulations, however, allow interest to be paid on deposits only
if the maturity of the deposit is 30 days or
longer. This rules out the Treasury's use of
time deposits as an effective means of capturing earnings because the average life of a tax
and loan deposit is only about 10 days .
A third way for the Treasury to reali ze
earnings on tax and loan balances would be to
invest its unneeded balances in short-term
money market instruments, preferably with
banks holding tax and loan balances. For in16
stance, the Treasury might make loans on a secured basis to each bank having a tax and loan
account. In practice, the Treasury would make
a short-term investment with a bank by drawing down its tax and loan account held at that
bank . By so doing, funds would not leave the
banking system and would not disrupt money
market rates , even though the magnitude of
uch in vestments might be large. A difficu lty
with this meth od, though, is that the Treasury
does not have the authority at the present time
to invest its idle fund s in short-term earning
assets.
Conclusions of the Report
The repo rt concluded that tax and loan accou nts should be retained becau e th ey a re
useful for money management purposes, but
that a method should be d eveloped to provide
added returns to the Treasury on its idle balances. The preferred method was the direct investment technique because it is simple, direct, and consistent with cash management
practices in industry and state and local governments. Accordingly , it was reco mmended
the Treas ury be given authorization to invest
in money market instruments.
In recognition that Congressional action
would be necessary to provide investment authority , the report indicated the Treasury
would continue its recent efforts to decrease
balances in tax and loan accou nts . Conversely,
the Treasury would intensify its efforts to increase balances at Federal Reserve Banks.
This meant, in effect, the Treasury would manage its cash position in a way designed to capture greater earnings on its operating balances . Earnings would be increased because as
the Treasury transferred funds to its Federal
Reserve account, the Federal Reserve would
tend to enlarge its portfolio of go vernment securities to prevent a drop in bank reserves. In
turn, the larger portfolio of the Federal Reserve would yield increased earnings, a major
portion of which would be transferred back to
Federal Reserve Bank of Kansas City
Treasury Cash Balances
the Treasury under current practices. Another
im plication is that the Federal Reserve would
have to compensate for greater swi ngs in Treasury balances a t Federal Reserve Banks
through existing techniques such as open market operations.
CHANGES IN
TREASURY OPERATING BALANCES
Chart 1
TREASURY TAX AND LOAN ACCOUNT
BALANCE
Level and Per Cent of Total Treasu ry Balance
Per Cent
100
6.0
5.0 ~"'-~"":""-- - ~
4.0
80
60
3.0
40
2.0
1.0
-- · Level (left scale)
- Per Cent ( right scale)
20
0 .__....__.._....._..,......._...._,,_.___._---:-_____.._--:--"_....._:--' 0
'75
'73
1963
'65
'67
'69
'71
Fiscal Year
Monthly Review • July-August 1975
Billions of Dollars
Per Cent
3.0 , - - - - - - - - - - - - - - - - - - - , 100
• - •Level ( left scale)
-Per Cent ( rioht scale)
I
,,
,
2.0
In the past few yea rs , there have been
marked changes in the Treasury 's operating
balances . These changes have occurred prima rily because the Treasury has set out to
reduce th e proportion of its tota l operating balances held in tax and loan acco unts and increase the proportion held at Federal R ese rve
Ba nk s. As see n in Cha rt I, during t he fisca l
yea rs 1963 to 197 1 th e proporti on of t he tota l
bala nce held in tax and loan accou nts ranged
from about 80 to 90 pe r cent. Beginn ing in FY
1972, the proportion began a steady decline,
falling from 84 per cent in 197 l to 75 per cent
in 1972 and to 40 per cent in 1975. Due to a
larger total balance, the dollar amounts in tax
and loan accounts in 1972 an d 1973 were
somew hat higher than in prior years . However, the dollar amo unts declined thereafterfrom $5.6 billion in 1973 to $3.9 billi on in
Billions of Dollars
Chart 2
TREASURY BALANCE AT FEDERAL RESERVE
Level and Per Cent of Total Treasury Balance
I
I
I
I
I
,'
,, ....,
80
60
40
1.0
20
0 i....,_....._____..._...1...-......1..._1--.....__--1.._.1.-.-1....-1._...1...-....J 0
1
1
'67
'71
'75
1963
'65
73
69
Fiscal Year
1974 . A further ha rp dec lin e to $ 1.9 billi on
occurred in FY 1975.
The decline in the proportion of the total
balance held in tax and loan acco un ts has been
accompan ied by ari increase in both the proportion and the do llar amounts held in balances at Federal Reserve Banks. (See Chart
2.) Prior to FY 1972, balances at Federal Reserve Banks averaged between $700 million
and $1 billion. Thes~ balances rose in 1972
and 1973, fell somewhat in 1974, but jumped
sharply to $2.8 billion in 1975.
The T reasu ry has thus been successful in
reduci ng the amounts held in tax and loan accoun ts and increasing the amounts held at
Federal Reserve Banks . In thi s way, the Treasury has been able to realize a greater return
on its idle balances and reduce the interest
expense burden to the taxpayer. However, by
keeping a lower level in the tax and loan acco unts, the normally wide fluctuations in total
operatin g balances have been reflected in
greater volatility in balances at Federal Reserve Banks . The increased volatility in these
ba lances, in turn , has created potential di ffi cu lties for the Federal Reserve System in its
conduct of monetary policy. As seen in Chart
3, which shows weekl y c hanges in Treasury
balances at Federal R eserve Banks, the vola17
Chart 3
(0
CHANGES IN AVERAGE WEEKLY BALANCES OF
TREASURY ACCOUNTS AT
FEDERAL RESERVE BANKS
Bil I ions of Dollars
5.0------------------------------------------------4.0
3.0
2.0
1.0
0
-1.0
"Tl
~
0..
..,
~
9... -2.0
,0
~
lG
~
~
-3.0
OJ
0
::::,
~
2.
"'
0
::::,
fl
c,,
()
~
-4.0
Fiscal Year
1971
1972
1973
1974
1975
Treasury Cash Balances
tility of these balances has increased steadily
since FY 1971. The trend toward increased
volatility also is confirmed by other statistical
measures. For example, for the two fiscal
years 1971 and 1972, the absolute average
weekly change in balances at Federal Reserve
Banks was $226 million. For 1973 and 1974,
this figure increased to $482 million and rose
further to $940 million during FY 1975. 4
Volatility in Treasury balances at Federal
Reserve Banks creates potential difficulties for
the conduct of monetary policy because
changes in these balances cause changes in the
reserves of the banking system. In cond uctin g
monetary policy, the Federal Reserve attempts, among other things, to keep bank reserves within certai n limits by providing or absorbing re erves main ly through buying and
selling U. S. Government securities. Before
deciding on the volume of reserves to provide
or absorb, the Federal Reserve must first estimate the volume of reserves that will be provided or absorbed by fact ors other than Federal Reserve operations. These factors include
float , flows of currency to and from the public,
and changes in Treasury balances at Federal
Reserve Banks.
In each planning period, therefore, the
manager of the Federal Reserve's open market
operations must estimate the amount that
Treasury balances will change. If the balances
are expected to rise, the manager would plan
to offset the resulting reserve drain by pro viding reserves. If Treasury balances are expected to decline, the manager would plan to absorb reserves. To the extent the estimate of
changes in Treasury balances is inacc urate,
4 / The - absolute average c ha nge is the average of changes when
computed by igno ri ng the direction o f the cha nges. For example,
while the simple average of a n increase of I 00 an d a decline of
100 is zero , the absol ute average wo uld be 100. A more soph istica ted measure of volatility is th e standard deviation, which i the
square root of the average of the quared deviations from the
mea n. The standard deviation of weekly Treasury balances a t th e
Federal Reserve Banks confirms th e trend to ward in creased
volatility . For the two fiscal years 1971 and 1972, the standard
devia tion of these balances was $663 million . For 1973 and 1974, it
rose to $1 ,0 I 8 million, and increased furthe r to $2,068 million
during FY 1975.
Monthly Review • July-August 1975
the manager will provide or absorb more or
less reserves than he considers desirable. Consequently, when changes in Treasury balances
are small, the amount by which the manager
might potentially err in providing or absorbing
reserves would be small. Similarly, when
changes in Treasury balances are large, the
amount of the potential error would be large.
In this way, an increase in the volatility of
Treasury balances at the Federal Reserve
Banks can reduce the precision of the manager's control over bank reserves .
SUMMARY AND CONCLUSION
Severa l legislati ve proposals have been
introduced recently in Congress to allow the
Treasury to rea li ze a return on its tax and loa n
balances. These proposals a re based essentially on the principal finding of the Treasury's
1974 report that the earning value of tax and
loan accounts to ba nks is in excess of the cost
to banks of those services directly attributable
to handling the accounts. At the present time,
no formal legislati ve action has yet been taken
on any of these proposals.
One of these proposals woul d require the
payment of interest o·n Treasury funds held on
demand deposit in commercial banks. Such interest would be paid at a rate not less than I
percentage point below the Federal funds rate.
In effect, this proposal would amend the 1933
law , which has prohibited the payment of interest on demand depo sits. The proposal also
would a uthori ze the Treasury to reimburse
commercial banks for services performed for
the government. 5
Another proposal, put forward by the Secretary of the Treasury , closely follows the recommendation of the Treasury ' s 1974 report.
This proposal would authorize the Treasury to
5/ The above proposa l wa introdu ced in the H o use of Rep re entatives a H . R . 3035 . A Sena te bill , S .547 , is s imilar but does no t
consider the question of com pensation fo r services. An other H ouse
bill, H .R . 3353, would te r minate the FD IC insura nce o f any bank
which fai led to pa y inte rest at the Federal funds ra te on tax an d
loa n a cco unts. I n the la tt e r bill, co mpensation fo r banking se rvices to the governmen t wo uld be au th ori zed .
19
Treasury Cash Balances
invest tax and loan balances for periods up to
90 days in obligations of depositaries maintaining tax and loan accounts and in obligations of the U. S. Government and agencies
thereof. Loans to depositaries would be secured by a pledge of collateral and would bear
interest at rates related to the Treasury's shortterm borrowing costs. By lending excess balances to banks maintaining tax and loan accounts, it is felt, the Treasury would not actually be entering the money market and the impact on short-term interest rates would be negligible. The proposal also would allow the
Treasury to compensate banks for services
rendered. For handling th e tax and loan account and related tax deposits, banks would be
compensated through the earn in gs value of the
account itself. Compensation for other services, such as the issuance and redemption of
savings bonds, would be acco mplished by the
payment of direct fees fro m appropriated
funds .
Pending Congressional action on measures to allow the Treasury to realize earnings
on tax and loan money, the Treasury has
20
sought to minimize the size of its idle tax and
loan balances. By the same token, the Treasury has sought to increase its balances at Federal Reserve Banks. By reducing the level of
tax and loan balances, however, the normally
wide fluctuations in the flow of total government funds has led to greater swings in Treasury balances at the Federal Reserve.
The volatility of Treasury balances at Federal Reserve Banks has increased substantially
in recent years, and particularly during the
past 2 years. This , in turn, has created potential difficulties for the Federal Reserve in its
co nduct of monetary policy . In practice, the
larger the volatility of these balances the more
diffi cult it is for the Federal Reserve to exe rt
precise control over the rese rves available to
the ba nking system . lt is recommended, therefore, that while there may be a dequate
grounds for the Treasury to seek methods to
capture earnings on its tax and loan balances,
these methods should be consistent with the
maintenance of money market stability and
should not unduly complicate the conduct of
monetary policy.
Federal Reserve Bank of Kansas City
@FedFRASER