Tax expenditures


Material Information

Tax expenditures relationships to spending programs and background material on individual provisions
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vii, 358 p. ; 24 cm.
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Tax expenditures -- United States   ( lcsh )
Government spending policy -- United States   ( lcsh )
federal government publication   ( marcgt )
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Sept. 1978.
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At head of title: 95th Congress, 2d session. Committee print.
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Committee on the Budget, United States Senate.

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Full Text

95th Congress } COMMITTEE PRINT
2d Session I


Relationships to Spending Programs and
Background Material on Individual



Printed for the use of the Committee on the Budget

Digitized by

the Internet Archive
in 2013

95th Congress }
2d Session I



Relationships to Spending Programs and

Background Material on Individual





Printed for the use of the Committee on the Budget


For sale by the Superintendent of Documents, U.S. Government Printing Office
Washington, D.C. 20402



EDMUND S. MUSKIE, Maine, Chairman

ERNEST F. HOLLINGS, South Carolina
JOSEPH R. BIDEN, JR., Delaware
JIM SASSER, Tennessee

SAM 1. ItAYAKAWA. California
11. JOHN HEINZ Ill. t'vansyIva', a

JoHN T. McEvoy, Staff DiTrtor
ROBERT S. BOYD, Mitority Staff Director
W. TIIOMAs FOXWELL, Dirfctor oJ Publications


Letter of transmittal ---------------------------------------------------- vii

Introduction ----------------------------------------------------------- 3
National defense:
Exclusion of benefits and allowances to Armed Forces personnel --- 9
Exclusion of military disability pensions-_- 11
International affairs:
Exclusion of certain income earned abroad by U.S. citizens ----------- 13
Deferral of income of domestic international sales corporations
(DISC) ------------------------------------ 17
Deferral of income of controlled foreign corporations ---------------- 21
Special rate for Western HIemisphere trade corl)orations_ 25
General science, space and technology:
Expensing of research and development costs --- 27
Expensing of intangible drilling, exploration and development costs_- 29
Excess of percentage over cost depletion -----------33
Capital gains treatment of royalties on coal ------------------------37
Natural resources and environment:
Capital gains treatment of royalties on iron ore .... 37
Exclusion of interest on State and local government pollution control
bonds ------------------ 39
Contributions to capital of regulated public utilities in aid of con-
struction_ -- 43
5-year amortization of pollution control facilities --- --- 45
Tax incentives for preservation of historical structures ---------------- 47
Timber: Capital gains treatment of certain income ------------------49
Expensing of certain outlays-_ 51
Capital gains treatment of certain income -- 53
Cooperatives: Deductibility of noncash )atronage dividends and
certain other items-------------------------------------- 5
Commerce and housing credit:
Dividend exclusion ---- 59
Exclusion of interest on State and local industrial development bonds (1
Exemption of credit unions ------------------------------------- 65
Bad debt deductions of financial institutions in excess of actual los-ses- 67
Deductibility of mortgage interest and property taxes on owner-
occupied homes --------------------------------------------- 69
Deductibility of interest on consumer credit ----------------------- 71
Expensing of construction period interest and taxes ------------------ 73

Commerce and housing credit-continued
Excess first-year depreciation ---- 75
depreciation on rental housing in excess of straight-line, and deprecia-
tion on buildings (other than rental housing) in excess of straight-
line - -- 77
Asset delreciation range 81
Capit al gains (other than farming, timber, iron ore, and coal) --- 83
1)eferrzd of capital gains on hoine sales ----- 87
Exclusion and deferral of capital gains transferred at death and by gift- 89
Corporate surtax exemption_ 93
Investment tax credit ------------------------------ 9
l)eductibilitv of nonbusiness State gasoline taxes ------------------- 99
Railroad rolling stock: 5-year amortization ------------- 101
Deferral of tax for shipping companies --------------------------- 103
Community and regional development:
tHousing rehabilitation: 3-year amortization ------------------------ 105
Education, training, employment and social services:
Exclusion of scholarships and fellowships_-107
Parental personal exemption for students age 19 or over -- 109
Exclusion of employee meals and lodging (other than military) -------111
Exclusion of contributions to prepaid legal services plans ----------- 113
Investment credit for employee stock ownership plans-- 115
Deductibility of charitable contributions (educational and other
institutions) ------------------------ 117
Maximum tax on earned income --------------- 121
Credit for child and dependent care expenses -- 123
Credit for employing AFDC recipients and public assistance recipients
under work incentive (WIN) program --------------------- 125
New jobs tax credit ----------. .-- 127
Excluion of employer contributions for medical insurance premiumns
and medical care -------------------- 131
De luetibility of medical expenses -- ----------- 133
reductionn for eliminating barriers to the handicapped_ 135
I)eductilbility of charitable contributions (health institutions) ------- 117
Income security:
Exclusion of social security benefits (for the aged, the disabled, and
for dep ndents and survivors) ----- 137
Exclusion of railroad retirement benefits -------------------------- 139
Exclusion of workers' compensation benefit ----------------------- 141
Exclusion of special benefits for disabled coal miners-------------- 143
Exclusion of unemlloyment insurance benefits ------------------- 145
Exclusion of lmblic a-sistance benefit -------------------------------147
l;xclusion of sick pay -------------------------------------- 149
N< t exclusion of pension contriai)tions and earnings:
Employer plans ------------------------------------- 131
Plans for self-employed andI others --------------------------- 153
Exclusion of other employee b enefits:
Premiums on group term life insurance ------------------------ 155
Premiums on accident and accidental death insurance_ ........ 157
Privately financed supplementary unemployment benefits ------- 159
Exclu-ion of inteest on life insurance saving ----------------------- 161

Income security-Continued

Exclusion of capital gains on home sales for person:' age 65 or over-
Additional exemption for the elderly --
Additional exemption for the blind
Deductibility of casualty losses_ -- -
T ax credit for the elderly ---------.............. ----------------
E arned incom e credit ------------------------ ------------------
Veterans benefits and services:
Exclusion of disability compensation, pensions, and GI bill benefits_
General government:
Credits and deductions for political contributions - -
General purpose fiscal assistance:
Exclusion of interest on general purpose State and local debt -------
Deductibility of nonbusiness State and local taxes (other than on
owner-occupied homes and gasoline) --
Tax credit for corporations doing business in Puerto Rico and U.S.
p o s s e s s io n s . . . . . . . . . . . . . . . . . . ..-. -- - - -
Deferral of income on savings bonds ...........................

Appendix A
Form s of tax expenditures ------------------------------------------

Appendix B

Capital gains .............


In tro d u ctio n - -- -- -- -- - -- --- - --- --- - -- -- -- -
Military manpower_ -- -
Export promotion-_
Energy supply development-
Pollution control_
Homeownership -
Rental housing -
Higher education ....
Child care services
Employment programs --
Retirement programs -
Disability compensation---
Unemployment compensation --- --
Veterans benefits ----------------
General purpose fiscal assistance -











The Congressional Budget and Impoundment Control Act of 1974
requires that the Budget Committees and the Congress examine tax
expenditures as part of overall Federal budgetary policy. This require-
ment stems from a recognition that numerous provisions of Federal
tax law confer benefits on some individuals and institutions that are
comparable to direct Federal spending, but that these tax law benefits
seldom are reviewed, in comparison with direct spending programs.
The first part of this Committee print updates basic background
information concerning tax expenditures first published by the Budget
Committee in March 1976. This information is provided in a series of
summaries which describe the operation and impact of each tax ex-
penditure; indicate the authorization and rationale for their enactment
and perpetuation; estimate both the revenue loss attributable to each
provision and, where provisions affect individual taxpayers directly,
the percentage distribution by expanded gross income class of the tax
savings conferred by the provision; and cite selected bibliography for
each provision.
The second part of this Committee print compares 17 groups of tax
expenditures to major spending programs with related or similar
purposes. These comparisons analyze diverse areas of Federal
policy including, for example, retirement programs, health policy,
export incentives, military manpower costs, and general purpose fiscal
assistance programs. These analyses indicate the need for policymakers
to coordinate both tax expenditure and directt spending programs
affecting the same policy areas when these areas are the subject of
legislative consideration.
Failure to take tax expenditures into account in the budget process
would be to overlook significant segments of Federal policy. They
should be given particularly thorough scrutiny because, as this volume
indicates, tax expenditures are generally enacted as permanent
legislation and thus are comparable to continuing direct spending
entitlement programs, often with increasing annual revenue losses.
This volume was prepared jointly by the Budget Committee staff,
the Congressional Budget Office, the Congressional Research Service,
and the General Accounting Office.
Nothing in this volume should be interpreted as representing the
views or recommendations of the Budget Committee or any of its
individual members.
Ranking Minority Member. Chairman.

Compendium of Background Material
on Individual Tax Expenditure Provisions


The first part of this compendium gathers basic information con-
cerning 84 Federal income tax provisions currently treated as tax
expenditures. These provisions are the same as those listed in Tax
Expenditre Badgets prepared for FY 1979 by the Office of Manage-
ment and Budget, the Joint Tax Committee, and the Congressional
Budget Office. With respect to each of these tax expenditures, this
compendium provides:
An estimate of the Federal revenue loss associated with the
provision for individual and corporate taxpayers, for fiscal years
1978, 1979, and 19S0;
The legal authorization for the provision (e.g., Internal Revenue
Code section, Treasury Department regulation, or Treasury
A description of the tax expenditure, including an example of
its operation where this is useful;
A brief analysis of the impact of the provision;
An estimate, where applicable, of the percentage distribution-
by expanded gross income clacs-of the individual income tax
saving resulting from the provision;
A brief statement of the rationale for the adoption of the tax
expenditure where it is known, including relevant legislative
history; and
References to selected bibliography.
The information presented for each of these tax expenditures is not
intended to be exhaustive or definitive. Rather, it is intended to pro-
vide an introductory understanding of the nature, effect, and back-
ground of each of -these provisions. Good starting points for further
research on each item are listed in the selected bibliography following
each provision.
Defining Tax Expenditures
Tax expenditures are revenue losses resulting from Federal tax
provisions that grant special tax relief designed to encourage certain
kinds of behavior by taxpayers or to aid taxpayers in special circum-
stances. These provisions may, in effect, be viewed as the equivalent
of a simultaneous collection of revenue and a direct budget outlay of an
equal amount to the beneficiary taxpayer.
Section 3(a)(3) of the Congressional Budget and Impoundment
Control Act of 1974 specifically defines tax expenditures as: ,-
. those revenue losses attributable to provisions of the Federal tax laws
which allow a special exclusion, exemption, or deduction from gross income or
which provide a special credit, a preferential rate of tax, or a deferral of tax
liability; ....
In the legislative history of the Congressional Budget Act, provisions
classified as tax expenditures are contrasted with those provisions

which are part of the "normal structure" of the individual and cor-
porate income tax necessary to collect government revenues.
The concept of tax expenditures is relatively new, having been
develope(l over only the past decade. Tax expenditure budgets which
list the estimated annual revenue losses associated with each tax
expenditure first were required to be published in 1975 as part of the
Administration budget for FY 1976, and have been required to be
published by the Budget Committees since 1976. The tax expenditure
concept is still being refined, and therefore the classification of certain
provisions as tax expenditures continues to be discussed. Nevertheless,
there is widespread agreement for the treatment as tax expenditures of
most. of the provisions included in this compendium.'
The listing of a provision as a tax expenditure in no way implies
any judgment about its desirability or effectiveness relative to other
tax or nontax provisions that provide benefits to specific classes of
individuals anl corporations. Rather, the listing of tax expenditures,
taken in conjunction with the listing of direct spending )rograms, is
intende(1 to allow Congress to scrutinize all Federal prograins-both
nontax and tax-when it develops its annual budget. Only if tax ex-
penditures are included will Congressional budget (lecisions take into
account the full spectrum of Federal programs.
Because any qualified taxpayer may reduce tax liability through
use of a tax expen(liture, such provisions are comparable to entitle-
ment programs under which benefits are paid to all eligible persons.
Since tax expenditures are generally enacte(l as )ermanent legislation,
it is important that, as entitlement programs, they be given thorough
periodic consideration to sec whether they are efficiently meeting the
national needs and goals that were the reasons for their initial
Major Types of Tax Expenditures
Tax expenditures may take any of the following forms: (1) exclu-
sions, exemptions, "and deductions, which re(luce taxable income;
(2) preferential tax rates, which reduce taxes by applying lower
rates to )art or all of a taxpayer's income; (3) credits, which are
subtracted from taxes as ordinarily computed; and (4) deferrals of
tax, which result from delaye, recognition of income or from allowing
in the current year (le(luctions that are properly attributable to a
future year.'
The amount of tax relief per dollar of each exclusion, exemption,
and deduction increases with the taxpayer's marginal tax rate. Thus,
the exclusion from tax of interest income from State and local bonds
sa ve $50 for every $100 of interest for the taxpayer in the 50 percent
tax )racket, whereas the s avlngs for the taxpayer in the 25 )ercent
bracket is only $25. Similarly the extra exemption for persons age
65 or over ani any itemized d ed action is worth twice as much in tax
sting to a t'axpay er in the 50 percent bracket as to one in the 25 per-
cent 1)racket.
A tax credit is sil)tractel (lirectlv front the tax liability that would
ot herwise be (e; thus the amount of tax reduction i-, the amount of
the credit- which does not lepeut,1 on the mar-inal tax rate.
1 F1 a diSCINioii of so1 Oft h11 eoilipt'll rT pi Ihoni itivolved in defining tax expen(itures, see The Budwt
of the ( it Id Stat .s Gorernmcit, Fiscal .r 979, "Special Analysis (," pp. 149-1.53.
2 See Appendix A for further analysis of these types of tax expedint tires.

The numerous tax expenditures that take the form of exclusions,
deductions, and exemptions are relatively more valuable to upper than
to lower or middle income individuals. However, this fact should be
viewed in the context of recent substantial increases in the standard
deduction, which provide more tax saving for certain low-middle in-
come taxpayers than itemize(d deductions, thus reducing the number
of them who itemize.
Moreover, even though some tax expenditures may provide most
of their tax relief to those with high taxable incomes, this may be
the consequence of overriding economic considerations. For example,
tax expenditures directed toward capital formation may deliberately
benefit savers who are primarily higher income taxpayers.

Estimating Tax Expenditures
The estimated revenue losses for all the listed tax expenditures are
based upon work (lone by the staffs of the Treasury Department and
the Joint Committee on Taxation.3 The estimates are identical to those
that appear for the same provisions in the Administration's FY 1979
tax expenditure budget.4
In calculating the revenue loss from each tax expenditure, it is
assume( that only the provision in question is deleted and that all
other aspects of the tax system remain the same. In usinr the tax
expen(liture estimates, several points should be noted.
First, in some cases, if two or more items were clininated, the
combination of changes would probably produce a lesser or greater
revenue effect than the sum of the amounts shown for the individual
Second, the amounts shown for the various tax expenditure items
do not take into account any effects that the removal of one or more
of the items might have on investment and consumption patterns
or on any other aspects of in(lividual taxpayer behavior, general
economic activity, or decisions regarding other Federal budget outlays
or receipts.
Finally, the revenue effect of new tax expenditure items added to
the tax law may not be fully felt for several years. As a result, the
eventual annual cost of some provisions is not fully reflected until
some time after enactment. Similarly, if items now in the law were
eliminated, it is unlikely that the full revenue effects would be
immediately realized.
However, these tax expenditure estimating considerations are similar
to estimating considerations involving entitlement programs. Like tax
expenditures, annual budget estimates for each transfer and income
security program are computed separately. However, if one program,
such as veterans' pensions, were either terminated or increased, this
would affect the level of payments under other programs, such as
welfare payments. Also, like tax expenditure estimates, the elimination
or curtailment of a spending program, such as military spending or
unemployment benefits, would have substantial effects on consumption
patterns and economic activity that would directly affect the levels
of other spending programs. Finally, like tax expenditures, the budg-
etary effect of terminating certain entitlement programs would not be
3 The revenue estimates are based on the tax code as of Dec. 31, 1977.
i The Budget of the United States Government, Fiscal Yar 1979, "Special Analysis G," pp. 158-160.

fully reflected until several years later because the termination of
benefits is usuallV only for new recipients with persons already receiv-
ing benefits continued under "grandfather" provisions.
Expanded Gross Income Class Distributions
Di-tributions of the tax benefits by "expanded gross income" class
are given for almost all tax expenditures providing direct tax relief to in-
dividual taxpayers. These distribution figures show the portion of the
total estimated revenue loss attributed to each tax expenditure that
goes to all taxpayers with expanded gross income falling within the
boundaries of the respective income (lasses. No distribution to in-
dividual income classes is made of the tax expenditure benefits
provided directly to corporations, since to do so would require un-
substantiated assumptions concerning the ultimate beneficiaries of
these corporate tax relief provisions.
Expanded gross income is a broader concept than the "adjusted
gross income" concept that appears on income tax returns. In addition
to '"adjusted gross income,'' it includes the untaxed part of capital
gains, percentage depletion in excess of cost depletion, and other tax
l)references subject to the minimum tax. However, it excludes the
reductionn of investment interest up to the amount of investment
income. It therefore comes closer to real economic income than does
adjusted gross income.
Individual income tax returns falling within each expanded gross
income class for calendar 1977 were estimated by the Treasury
Department as follows:

Thousands of Percent of
returns returns in each
Expanded income class ($000) filed class
0 to 5 ------------------------------------------------- 25,474 29.0
5 to 10 - --------------------------------------------------- 20, 109 22.9
10 to 15 -------------------------------------------------------- 16,106 18.3
15 to 20 ------------------------------------------------------- 11,824 13.4
20 to 30 -------------------------------------------------------- 9,907 11.3
30 to 50 -.... -... -------------------------------------........ 3,347 3.8
50 to 100 -------------------------------------.---------------- 985 1. 1
100 to 200 ----------------------------------------------------- 198 0.2
200 and over -------------------------------------------------- 49 0.1
Total ..----------------------------------------------- 87,998

The tax expenditure distributions by expan(led gross income class
are taken from a study (lone by the Treasury Departlnent in early 1978
at the request of Chairman Edmund S. Muskie, and are the most
recent estimates of this type. These distributions indicate in a general
way whether specific tax expenditures provide tax benefits largely to
lower, middle, or high income taxpayers.
Order of Presentation
The tax expenditures are presented in an order which generally
parallels the budget functional categories used in the Congressional
budget, i.e., tax exi)enditures related to "national defense" are listed
first, and those related to "international affairs" are listed next. In a

few instances, two or three closely related tax expenditures derived
from the same Internal Revenue Code provision have been combined
in a single summary to avoid repetitive references even though the tax
expen(litures are related to different functional categories. This parallel
format is consistent with the requirement of Section 301(d)(6) of
the Budget Act, which requires the tax expenditure budgets published
by the Budget Committees as parts of their April 15 reports to present
thie estimated levels of tax expenditures "by major functional cate-
The material on each tax expenditure contains a brief statement of
the rationale for the adoption of the tax expenditure where it is known.
These rationales are the principal ones which were publicly given at the
time the provisions were enacted.

Further Comment
In the case of a number of tax expenditures, additional information is
provided under the heading "Further Comment." It is material which
either focuses attention on some of the principal issues related to a pro-
vision or describes recent legislative proposals to amend a provision.
This is material that (toes not fit within the other elements of the
format of the compendium-either in the "Description," "Impact," or
"Rationale" sections. As the examples which are provided in the
descriptions of only some of the tax expenditures, the "Further
Coinment" sections are included only where they were deemed to be
useful. Providing information under the "Further Comment" sections
for only certain tax expenditures in no way implies any judgment about
these provisions.


Estimated Revenue Loss

[In millions of dollars]
Fiscal year Individuals Corporations Total

1980 ------ 1,470 1,470
1979 ------ 1,370 1,370
1978 ------ 1, 260 ------ 1, 260

Sections 112 and 113,1 Regulation 1.61-2,2 and court decisions.

Military personnel are not taxed on a variety of in-kind benefits
and cash payments given in lieu of such benefits. These t:ax-free bene-
fits include quarters and meals or-alternatively-eash allowances
for these purposes, certain combat pay, and a number of less signifi-
cant items.
All military personnel receive one or more of these benefits which
are generally greater in the higher pay brackets. The amount of tax
relief increases with the individual's tax bracket, and therefore (le-
pends on a variety of factors unrelated to the taxpayer's military
pay, such as other income including income from a spouse, and the
amount of itemized deductions. Therefore, the exclusion of these bene-
fits from taxation alters the distribution of net pay to service personnel.

Estimated Distribution of Individual Income Tax Expenditure by
Expanded Gross Income Class
Expanded gross income class (thousands of dollars): distribution
0 to 10 ...- 52.5
10 to 20 ---------------------------------------------------- 37.0
20 to 30 ------------- 5.0
30 to 50 ----------------------------------------------------- 4. 1
50 and over -------------------------------------------------- 1.4
The word "Section" denotes a section of the Internal Revenue Code of 1954 as amended unless other-
wise noted.
2 Reference to "regulations" are to Income Tax Regulations unless otherwise noted.


Although tle principle of exemption of armed forces benefits an({
allowances appeared early in the history of the income tax, it has
evolved through subsequent specific statutes, regulations, revenue
rulings, and/ court decisions. For some benefits, the rationale was a
specific desire to reduce tax bur(lens of military personnel (luring
wartime (as in the use of combat pay provisions); other preferences
were apparently based on the belief that certain types of benefits
\\-ere not strictly compensatory but rather intrinsic elements in the
military structure.
Further Comment
A(minist rative difficulties anl complications could be encountere(l
in taxing some military benefits and allowances that are tax exempt;
for example, it coul( be difficult to value meals and lodging when the
option to receive cash is not available. Itowever, eliminating the ex-
clusions and adjusting pay scales accordingly might simplify (lecision-
making about military pay levels and make "actual" salary more
apparent to recipients.

Selected Bibliography
Binkin, Martin. The Militaryl Pay -1Mdle, The Brookings Institu-
tion, Washington, D.C., April 1975.


Estimated Revenue Loss
[In millions of dollars]
Fiscal year Individuals Corporations Total

1980_..... 130 130
1979 ------ 120 120
1978 ------ 115 115

Section 104(a)(4) and 104(b).
Service personnel who joined the armed forces on or before Septem-
ber 24, 1975, and have at least a 30-percent disability or at least 20
years of service and any amount of disability may draw retirement
pay from the Department of Defense based on either percentage of
disability or years of service. If the chosen pension is less than 50
percent of the basic pay, it will be raised to 50 percent during the first
5 years of retirement. Pay based on percentage of disability is fully
excluded from gross income under section 104. If pay is based on years
of service, only the portion that would have been paid on the basis
of disability is excluded from income.
Members of the armed forces who join the service after September
24, 1975, are allowed to exclude military disability payments only if
the payments are directly attributable to combat-related injuries. The
term "combat-related injury" means personal injury or sickness which
is incurred (1) as a direct result of armed conflict, (2) while engaged in
extra-hazardous service, (3) under conditions simulating war, or
which is (4) caused by an instrumentality of war.
Disability payments administered by the Veterans Administration
are excluded from gross income. These payments are based on degree
of disability rather than length of service. A serviceman who joins the
armed forces after September 24, 1975, retires on disability, and
receives taxable disability payments from the Department of Defense,
is allowed to exclude from income an amount equivalent to what he
would have been entitled to if his payments had been received from
the Veterans Administration.


Disability payments that are exempt from tax provide more net
income than taxable benefits at the same level. The tax benefit of this
provision increases as the pensioner's marginal tax rate increases.
Thus, the after-tax pension benefits increase as a percentage of active
duty pay as the individual's tax bracket increases.
Estimated Distribution of Individual Income Tax Expenditure by
Expanded Gross Income Class
Expanded gross income class (thousands of dollars): distribution
0 to 10------------------------------------------------------ 47. (
10 to 20 ------------------------------------------------------ 38. 1
20 to 30 ----------------------- 9. 5
30 to 50 ------------------------------------------------------ 3.8
50 and over --------------------------------------------------- 0. 9
Prior to 1976, military personnel could exclude from income pen-
sions for personal injuries paid by the Department of Defense. The
rationale was not (lear for the exclusion, which was adopted (luring
World War II in 1942. In limiting the exclusion, in 1976, Congress
soilght to eliminate abuses by armed forces personnel who were classi-
fied as disabled shortly before becoming eligible for retirement in order
to obtain tax exempt treatment for their )ension benefits. After retir-
ing from military service, most of these individuals would earn income
froin other employment while receiving tax-free military pensions.
Since present armed forces personnel may have joined or continued
their service because of the expectation of tax exempt disability bene-
fits, Congress deemed it equitable to limit changes in the tax treatment
of disabilityy payments to future )ersonnel.

Selected Bibliography
Binkin, Martin. Tle 3il tary Pay Viddle, The Brookings Institu-
tion, Washington, D.C., April 1975.
U.S. ( ongres-. Joint( ( oimittee on Taxation. Geiteral Explanation
of the Tax Rhforn let of 1976, Dec. 29, 1976, pp. 129-31.


Estimated Revenue Loss
[In millions of dollars]

Fiscal year Individuals Corporations Total
1980 ----- 415 415
1979 ------ 385 385
1978 ----- 360 360

Sections 911-912.
U.S. citizens are generally taxable on their worldwide income. How-
ever, under the law existing prior to the Tax Reform Act of 1976, up
to $20,000 of foreign earned income largelyy salary income) may be
excluded annually from income under section 911 by a citizen who (1)
is a bona fide resident of a foreign country for an uninterrupted period
that includes a taxable year, or (2) has been present in a foreign country
for 510 days out of 18 consecutive months. The annual exclusion is
raised to $25,000 for an individual who has been a bona fide resident
of a foreign country for at least 3 consecutive years. A qualifying indi-
vidual can claim a foreign tax cre(lit for foreign income taxes paid on
the income subject to the exclusion as well as any additional income.
The Tax Reform Act of 1976 made major changes in the exclusion.
Under these provisions, up to $15,000 of foreign earned income gen-
erally may be excluded annually from income under section 911 by a
qualifying individual who (1) is a bona fide resident of a foreign country
for an uninterrupted period that includes a taxable year, or (2) has
been present in a foreign country for 510 days out of 18 consecutive
months. The limit is $20,000 for employees of charitable organizations.
The exclusion is achieved by an "exclusion with progression" method
where the U.S. tax liability is the difference between tax liability on
total income and tax liability on the excluded amount with itemized
deductions allocated between those amounts. A taxpayer may take
a credit against U.S. income tax liability for foreign income taxes
paid, but these creditable taxes do not include the foreign taxes paid
on the excluded income.
Congress delayed the implementation of the 1976 Tax Reform Act
changes to apply first to taxable years beginning in 1977. It is likely
the revisions Inade in the 1976 Act will be delayed again, and that they
will never actually come into effect. However, since the Code now pro-
vides that the 1976 changes will be in effect in 1977 and the following

years, the estimated revenue losses indicated above for section, 911
and 912 are based upon the 1976 law.
Section 911 does not apply to salaries received from the U.S. Govern-
ment. However, section 912 exempts from tax certain allowances that
are received by Federal civilian employees working abroad and in
Alaska and Hawaii. The principal exeml)t allowances are for high
local living costs, education, and housing.

/),e -1976 Low,. Assue a married taxiayer has S-.000 of income.
,10.000 of itemized deductions, and qualifie'z for the $20.000 exclusion
under the pre-1976 law. The tax before any foreign tax credit would 1)e
conil)teri bv subtractiin" from the W0.000. the $20.000 exclusion plus
the $10.000 of itemized deductions, plus $1.500 for personal exemptions.
This would result in taxable income of 58.500 and tax liability of
$1490. Without the exclusion the tax liability would have been the
tax on 028,500 (140,000 minus 110.000 and $i.500). which is 57.377.
Thus, the provision would result in a tax saving of $5,887.
1976 Act. Under the 1976 Act rule,, the taxpayer calculates the
tax liabilitV without any exclusion, which from the previous example
is $7,377. This amount, is reduced by the tax on the excluded $15,000
less a pro rata part of the itemized deductions. Thus, the $15,000
exclusion must be reduced by 15/40 of the $10,000 of itemized deduc-
tions, leaving $11,250. The tax on that amount is $2,095. This $2,095
is subtracted from the total tax of $7,377, leaving a tax liability of
Some U.S. citizens living abroad pay no income taxes to the coun-
tries in which they reside. The pre-1976 Tax Reform Act version of
section 911 allows their income ut) to the appropriate ceiling to be
free from United States tax as well.
In cases where U.S. citizens pay foreign income taxes, those taxes,
including the taxes paid on the income excluded from taxation under
this section, can be credited against any U.S. tax liability that would
otherwise exist on other foreign income: earned income above the
$20,000 or $25,000 excludable limits and investment income. This
allows U.S. taxpayers to offset all the foreign tax-including that paid
on the amount of excluded income-against U.S. tax that would
otherwise be due on the income in excess of the excluded amount.
Thus, the combination of the exclusion and the foreign tax credit can
result in levels of income actually exempt from U.S. tax in excess of the
stated limits.
The value of the exclusion is the difference between the tax savings
an(l the amount of foreign tax credit which would have been claimed
on the excluded amount in the absence of the exclusion. This difference
is the greatest, an(l thus the exclusion ha, the greate't value, for tax-
payers living in those countries where tax rates on the excludable
portion are nonexistent or much lower than the U.S. rate. Those
countries with substantial numbers of U.S. employees which tend to
have lower tax rates include Iran, Singapore, Venezuela, Saudi Arabia,
Switzer1and, the Philippines, and the Marhall Islands.
In addition to the U.S. citizens who directly claim the benefits
from this favorable treatment on their tax returns, overseas employers

also benefit to the extent that salary levels are lower because of the
exclusion. In fact, many U.S. firms follow a practice of "tax pro-
tection," under which employees' salaries are set at levels to give
them the same after-tax salary they would receive in the United States.
When this practice is followed, all the direct benefits of section 911
accrue to the employers rather than the employees. U.S. corporations
that bid on overseas construction projects assert that the salary sav-
ings make them more competitive with foreign bidders, some of the
employees of which also enjoy similar tax benefits under the laws
of their home countries.
The Treasury Department has estimated that in 1975, approximately
100,000 civilian government employees received one or more allow-
ances that are excluded from income under section 912. Approximately
40,000 of these persons were employed in foreign countries, about
20,000 in U.S. territories, and about 40,000 in Alaska and Hawaii.
Roughly 60 percent of the total were civilian employees of the De-
partment of Defense.
The value of the section 912 exemption for allowances received
by Federal civilian employees working abroad increases with the
recipient's tax bracket. The value therefore depends on a variety of
factors including the level of the recipient's Federal salary, the extent
of his other income, and the amount of his itemize(l deductions.

Estimated Distribution of Individual Income Tax Expenditure by
Expanded Gross Income Class
Pi rant7age
Expanded gross income class (thousands of dollars): distribution
0 to 10 7.3
10 to 20.. 12. 5
20 to 30 ---- 18. 7
30 to 50 -- 32. 1
50 and over --- 29. 4
A less restrictive form of section 911 was first enacted in 1926
to encourage foreign trade. After World War 11, the exclusion was
justified as part of the Marshall Plan to encourage persons with
technical knowledge to work abroad. Although the provision was
revised on several occasions, dollar limitations were first enacted in
1953 at $20,000 and $35,000. The latter figure was reduced to $25,000
in 1964.
The exemption for civilian Federal employee overseas allowances
was enacted in 1943. The principal rationale was to provide additional
compensation for these employees, who were performing vital wartime
Further Comment
After enactment of the Tax Reform Act of 1976, substantial con-
troversy developed about the 1976 revisions. Congress acted to
delay the application of the changes from 1976 to 1977. Congress is
now considering several different proposals to liberalize the provisions
enacted in 1976, and, as indicated previously, it appears unlikely that
the revisions made in the 1976 Act will ever apply. The proposals
now under consideration include a series of special deductions for

cost of living, housing, and educational expenses, as well as combina-
tions of special reductionss and flat exclusions.

Selected Bibliography
Fiehl, Marc i, and Brian Gregg. "U.S. Taxation of Allowances
Paid to U.S. Government Employees," in U.S. Department of the
Treasury, Essays 1'a Ititernational Taxation: 1976, Tax Policy Research
Stu(ly No. 3, 1976.
1U.1-, Taxation of Foreign Earned Income of Private
Employees," in U.S. Dei)artment of the Treasury, E~salys 1i Inter-
mational Taxaht*o : 1976, Tax Policy Reesearch Study No. 3, 1976.
U.S. Congress. House. Committee on Ways and Means. General Tax
IReffom, Panel Discussions, Part lI-Tax Treatment of Foreign
Income, 93d Cong., 1,t sess., Feb. 28, 1973, P). 1671-S88.
U.S. Department of the Treasury. Taxation mf Aericans W orking
Overscas: I'wct e As pects of Recent Lgilathe (ha iiges and Pro-
po.als, February 197S.
U.S. General Accountfig Office. Impact (in Tradc of rangeses in
Jaxatboi of U.S. (I'Iizi) s E nplodye(! Oers cas, Report to the Congress
by the Con)trolleir General of the United States, ID-78-13, Feb. 21,
R, ic 0E 's,,natres IUndr Var'ou ,u J thods of Taxing Amer-
aWhIs -lbroa,/, Report to the Con-tress by thme Comptroller General of
the Unite(I Sttes, ]D-7S-52, July 27, 1978.
U.S. Library of Congress. ('ongre-sional Research Service. "U.,".
Taxation of ('itizens Working in Other Countries: An Economic
Analsis," by Jane G. Gravelle anI Donald W. Kiefer, Multilith
7S-91E, Apr. 20, 1978.


Estimated Revenue Loss
[In millions of dollars]
Fiscal year Individuals Corporations Total
1980 3 1,525 3,525
1979 ------1------ 1,335 1,335
1978 ------ ------ 1,135 1,135

Sections 991-997.
A U.S. corporation will qualify as a DISC (Domestic International
Sales Corporation) if at least 95 percent of its assets are related to
export functions, and if at least 95 percent of its gross receipts stem
from export sale or lease transactions.
DISC's typically are wholly owned subsidiary corporations through
which parent corporations channel their export sales. DISC's are not
themselves subject to corporate income tax, but their parent corpora-
tions are taxed on the DISC income when it is distributed or attributed
to them.
The tax savings from using a DISC result principally from two
interrelated aspects of the tax law: (1) the allocation rules that allow
at least half of the total combined profit of the parent and DISC from
export sales to be attributed to the DISC; and (2) the potentially
permanent deferral which is allowed on half of the DISC profits
attributable to exports exceeding a base level. This level is 67 percent
of average export receipts (luring a prior 4-year base period. Through
1979, the base period is 1972-75. Beginning in 19S0, the base period
will move up 1 year each year, so that the base period in 1980 will be
1973-76, in 1981 will be 1974-77, and so forth. This incremental rule
does not apply to DISC's with income of $100,000 or less. This in-
cremental rule exemption is phased out over the $100,000 to $150,000
income range.
The allocation rules provide that a DISC is deemed to have earned
either: (1) 50 percent of the combined taxable income of the parent
corporation and DISC from export sales or, (2) 4 percent of the gross
receipts from export sales, whichever is greater. The 50 percent alloca-
tion is used much more frequently. The rules for allocating DISC
profits are much more favorable than the otherwise applicable tax law
standard (section 482), which allocates profits between two corpora-
tions under the same control as if transactions between them occurred
at an arm's length price. Generally, if the section 482 rule were applied

to DISC's, only a relatively small, or no sales commission would be
allocated to the DISC, while the proportionately larger profits from
production woull go to the parent corporation.
The deferral of tax continues as long as the undistributed DISC
income is invested in qualified assets; the duration may be indefinite,
and in such cases constitutes the practical equivalent of a permanent
tax exemption. The income allocable to a DISC that is not eligible for
deferral is either actually or deemed to be distributed annually to its
parent corporation.
Certain exports are not eligible for DISC treatment. These include
oil, gas, hard minerals, and products subject to export control under
the Export Administration Act of 1969. DISC deferral on exported
military goods is limited to half the amount which would otherwise be
A company formed a DISC in 1974, and sold $8,000,000 of exports
in that year and $10,000,000 in 1975. Its sales in 1978 are $10,000,000,
with total costs of $8,000,000 and pre-tax income of $2,000,000. The
allocation rule attributes 50 percent of the $2,000,000 tetal net profit
in 1978 to the DISC and 50 percent to the parent firm. Of the
$1,000,000 allocated to the DISC, one-half, or $500,000 is potentially
eligible for deferral before the incremental rule is applied. Average
exports for 1972-75 are $4,500,000 ($8,000,000 plus $10,000,000
divided by 4, with non-DISC years counted as zero) ; 67 percent of this
amount is roughly $3,000,000. Under the incremental rule, therefore,
70 percent ($10,000,000 minus $3,000,000/$10,000,000) of the DISC
income is eligible for deferral. Therefore $350,000 (0.70X$500,000)
benefits from deferral reducing tax liability by $168,000 (0.48X$350,-
000). This tax saving reduce-, the tax rate by 8.4 percentage points
($168,000/$2,000,000), reducing the effective tax rate on export in-
come from the statutory 48 l)ercent to 39.6 percent. If the incremental
rules had not been applicable, the effective tax rate would have been
36 percent. Impact

Apart from the incremental rule, the provision reduces the marginal
tax rate on most DISC related export income to 36 percent (and to
24 percent in the relatively fewer cases where the total profit on ex-
port sales of the DISC and its parent is no more than 4 percent of
gross export receipts).
The incremental rule reduces these benefits for companies that (1o
not experience increasing exports, and affects either less substantially
or not it all rapidly growing exporters (whose relatively smaller base
would be advant ageous), new DISC's, an(l small exporters. The incre-
mental rule wtas designed to provide more stimulus to exports at a
lower cost because the export incentive is aimed at marginal exports.
however, the Treasury Deptartnment has indicated that the incre-
mental rule reduces the incentive effect with respect to additional
exports as well by 40 percent since the exporter must take into account
the fact that additional exports now will increase the export base
and reduce future DISC benefits.

Whether U.S. exporters reduce export prices in response to reduced
effective tax rates is unclear. To the extent they do, foreign purchasers
as well as domestic exporters would be subsidized.
According to the Treasury Department, the overall impact of
DISC in stimulating exports has been small in comparison to its
annual revenue cost. Over the long run, the Treasury contends that
adjustments in exchange rates tend to offset any effects the DISC
law may have on the balance of trade. U.S. exports have increased
dramatically since the DISC provisions were added, but the increase
is said to be primarily due to the devaluation of the dollar and world-
wide inflation.
On the other hand, many U.S. companies which utilize these pro-
visions argue that DISC should be retained because in their view:
(1) the law has substantially increased exports which, in turn, have
increased U.S. employment levels; and (2) U.S. industry can remain
competitive only if the United States provides subsidies to offset the
variety of export promotion devices employed by other countries.
The Treasury Department study cited below in the bibliography
reported that for DISC year 1976 before the incremental rule gen-
erally became effective, 65 percent of the net income of the 4,822
DISC's with corporate owners for which asset size data were available
accrued to 367 companies with gross assets in excess of $250 million.
Originally adopted as part of the Revenue Act of 1971, the DISC
concept was intended to stimulate exports and enhance the attractive-
ness of domestic manufacturing vis-a-vis manufacturing through
foreign subsidiaries. Restrictions on the benefits for natural resource
products and scarce products were adopted in the Tax Reduction
Act of 1975. The incremental rule adopted in the Tax Reform Act
of 1976 was designed to continue to provide stimulus to exports with
a smaller revenue loss.
Further Comment
The DISC provisions have been the subject of some international
concern. The European Economic Community lodged a formal com-
plaint under GATT (General Agreement on Tariffs and Trade) in
July 1972, arguing that the DISC provision violated GATT rules
prohibiting tax subsidies for exports. In 1973, the United States also
brought complaints against France, Belgium, and the Netherlands
against their tax practices. The panels appointed to consider these
questions concluded in 1976 that there was a prima face case for alt
of these coml)laints. The United States has recommended adoption
of all (our panel reports, while the European countries expressed reser-
vations. None of the reports has been adopted to date.

Selected Bibliography
U.S. Congress. House. Committee on Ways and Means. Gelleral Tax
Reform, Panel Discussions, Part II-Tax Treatment of Foreign In-
come, 9.3d Cong., 1st sess., Feb. 28, 1973, pp. 1671-1SSS.


U.S. Congress. Joint Committee on Taxation. General EplanationM
of the Tax Reform Act of 1976, Dec. 29, 1976, pp. 290-:300.
U.S. Congress. Senate. Committee on the Budget. Task Force on
Tax Policy and Tax Expenditures. Seminar-DISC: In Eralation of
the (sts and Beneefits, Committee Print, November 1975.
U.S. Department of the Treasury. The Operation and E.fct of the
Domestic Ilternational Sales ( orporatio Legislation: 1976 winual
Report, April 1978.
U.S. Library of Congress. Congressional Research Service. "De-
ferral and I)1St: Two Targets of Tax Reform," by Jane G. Gravelle
and Donald W. Kiefer, Multilith 78-20E, Feb. 3, 1978.


Estimated Revenue Loss
[In millions of dollars]

Fiscal year Individuals Corporations Total
1980 ------------- 720 720
1979 ------ ------- -65 665
1978 ------------- 615 615

Sections'1(f), 882 and 951-964.
A U.S. corporate parent of a foreign subsidiary is not taxed on the
subsitliary's income until the income is remitted (or "re)atriate(d")
to the parent. The deferral of U.S. tax liability on the subsidiary's
income continues indefinitely as long as the income is reinvested in the
subsidiary or other foreign subsidiaries, rather than remitted to the
U.S. parent. A tax credit in the amount of foreign taxes paid on re-
patriated income after gross-up (i.e. after adding back foreign income
taxes paid to the actual dividend) is allowed at the time of repatriation.
An exception to the general deferral principle is )rovi(ed under
subpart F of the Code (sections 951-964). Under these sections,
income from so-called tax haven activities conducted by corporations
controlled by U.S. shareholders is deemed distributed to the share-
holders and taxed to them as earned. Tax haven activities are generally
sales and services artificially structured to channel income from high
tax jurisdictions to lower tax jurisdictions.
By comparison to the treatment of foreign subsidiary income,
income from all foreign branches of U.S. corporations is taxed the
same as income earned in the United States since the branches are
parts of U.S. corporations. Impact

Companies that operate subsidiaries in countries with effective in-
come tax rates lower than the U.S. rate may receive tax benefits
from this provision.
A substantial portion of the revenue loss is attributable to deferral
on shipping income, which is estimated to account for about $200
million of the current revenue loss. This occurs because shipping firms
are often based in countries without income taxes, such as Liberia and

Panama. U.S. Department of Commerce data indicate that 445 of the
706 foreign flag ships owned by U.S. corporations and their subsid-
iares are registered in Panama or Liberia. Much (508) of tis' total
shipping fleet is como)osed of tankers.

Historically, the Unit ed States has not taxed foreign source income
of foreign corporations on the preinse that only domestic corporations
or income with a U.S. source i subject to U.S. jurls(iction. The
searate corporate status of foreign subsidiaries of (tonestic corpora-
tions generally has been respected. In 1962, these principles were
abrograte(l for tax haven income un(ler subpart F of the Code. Subpart F
was subsequently strengthened by the Tax Reduction Act of 1975 ani
the Tax Reforin Act of 1976. Such income is taxed even though earned
abroad an(l even though not repatriated.

Further Comment
Opponents of deferral allege it encourages investment in forein'n
countries an(l re(lces (loniestic investment. They argue this reduces
U.S. tax revenues an(l U.S. exports, anti adtversely affects the balance
of' payments, the balance of tra(le, anti domestic employment. Propo-
nents (leny such allegations, an(] argue that referral mut be continued
fol. U.S. corporations to remain competitive with foreign companies in
overseas markets.
Deferral of tax on foreign profits is not neutral coi)aredl to in-
vestment in the Unitedt States in the sense that if the foreign country
tax rate is less than the U.S. tax rate an(l tile 1ncoe is not ,oin,,"
to be repatriate(I, a, U.S. corporation has a tax incentive to invest
abroa(I usin' a foreg-n subsidiary instead( of investing at home. How-
ever, the referrall rules (Io neutralize a(tvantages foren coilpetitors
may have over U.S. corporations operat in abroad. Moreover, there
are also offsettuig tax rules which favor investment in the Unitel
States by domestic companies rather than abroad, such as the general
linitation of the investment credit anl asset (lepreciation range
(AlI)) depreciation to assets used( in the United States.

Selected Bibliography
Krause, Lawrence B., and Kenneth W. Dam. Iederal Tax Tratinel, t
of Foreil Income, The Brookings Istitution, Washington, D.C., 1964.
Miusgrave, Peggy. "Tax Preferences to Foreign Investinent," in
U.S. congresss Joint Economic( Committee, The Ecoiiomics of Federal
Subsidy Programs, Part 2-International Subsidies, July 15, 1972,
pp1. 176-219.
U.S. Congress. House. Committee on Ways and -Meani;. General
Tax IHform, Panel Discussions, Part 11-Tax Treatmemit of Foreign
Income, 92) ( Coiig., 1st sess., Feb. 28, 1973, pp. 1671-188S.
U.S. Taxaton ,!f Poreiqn Income- Deferral and the Foreign
Tax Credit, Committee Print, 94th Cong., 1st sess., Sept. 27, 1975.


U.S. Department of the Treasury. Essays iii international Taxratio:
1976, Tax Policy Research Study No. 3, 1976. See particularly "U.S.
Taxation of the Undistributed Income of Controlled Foreign Corpora-
tions," by Gary Hufbauer and David Foster, and "Tax Treatment of
Income from International Shipping," by Marcia Field and Richard
U.S. Library of Congress. Congressional Research Service. "Deferral
and DISC: Two Targets of Tax Reform," by Jane G. Gravelle an([
Donald W. Kiefer, Multilith 78-20E, Feb. 3, 1978.
U.S. Taxation of American Businiess Abroad: At E xchi-ge of V'ievws,
AEI-Hoover Policy Studies, American Enterprise 1ntitute, Wash -
ington, D.C., 1975.


Estimated Revenue Loss
[In millions of dollars]
Fiscal year Individuals Corporations Total

1980 5 5
1979 ------ 15 15
1978 ------ 25 25

Section- 921 and 922.
Western Hemisphere Trade Corporations (WHTC's) are granted a
special deduction which has the effect of reducing the tax rate on their
income by as much as 5 percentage points in 1978. This provision is
currently being phased out-to 2 percent in 1979 and elimination in
1980 and after.' The amount of the special deduction is the taxable
income of the corporation (before the special deduction) multiplied
by a fraction, the numerator of which is the appropriate percentage
(e.g. 5 percent in 1978) and the denominator of which is the overall
tax rate (the sum of the normal tax rate and the surtax rate, or 48
percent) on the corporation's total taxable income.
A WHTC is a U.S. corporation: (1) all of whose business is done
in the Western Hemisphere; (2) 95 percent or more of whose income
over the last 3 years was derived from sources outside the U.S.; and
(3) 90 percent or more of whose income over the same 3 years was
derived from the active conduct of a trade or business.
WHTC's may not defer U.S. taxation of their income (as in the
case of a controlled foreign corporation), but they may take a tax
credit for foreign taxes imposed on that income. The WHTC deduc-
tion may not be taken for a taxable year in which the corporation is a
Domestic International Sales Corporation (DISC), or in which it
owns any stock in a DISC or former DISC.

If taxable income is $100,000 when computed without regard to the
WHTC deduction, the WHTC deduction equals $100,OOOX(5 per-
cent/48 percent)--$10,416.67; taxable income is reduced to $89,583.33
and the tax liability on this amount is $29,500 (assuming a 20-percent
rate on the first $25,000 of taxable income, a 22-percent rate on the
I Under the present temporary corporate rate structure, the full 5 percentage point reduction applies to
all WHTC's with income in excess of $55,814. Corporations with less income obtain a deduction which will
reduce their tax rate by less than 5 percentage points. The full 2 percentage point reduction for 1979 will
apply to firms with income of $26,087 under the permanent tax rate structure.

next $25,000 and a 48-percent rate on the income in excess of $50,000).
Without this special deduction, the tax would have been $34,500.
Thus, the effective tax rate has been reduced by 5 percentage points.

For many companies, tax deferral through foreign incorporation
has been more advantageous than the WHTC provision. But, since
only domestic corporations may take percentage depletion, com-
panies with Western Hemisphere extractive industry operations out-
side the United States were traditionally organized as WHTC's.
Currently, however, the WHTC provision yields little or no tax
saving for such operations because the application of large foreign
tax credits completely or nearly completely offsets any U.S. tax
The WHTC provision also has been used by sales subsidiaries.
However, the more recent DISC legislation can be more valuable in
many cases, and the absence of growth in use of WHTC's may reflect
replacement of WHTC sales subsidiaries by DISC's.

The Revenue Act of 1942 enacted the WHTC provision to exempt
a few corporations then engaged in operations outside the United
States but within the Western Hemisphere from the high wartime
corporate surtaxes. The provision was continued in 1950 when the
tax structure was changed, and provided a 14-percent rate reduction.
It continued to be justified by some persons as necessary to maintain
the competitive position of corporations competing in the Western
Hemisphere with foreign corporations. The phaseout of the provision
was enacted in the Tax Reform Act of 1976. The reasons for the
elimination of the provision were multiple: a general tax equity
rationale, a recognition of the displacement of the provision by the
DISC legislation, a declining value due to higher foreign tax rates, and
tax simplification.
Selected Bibliography
AIlusgrave, Peggy. "Tax Preferences to Foreign Investment," in U.S.
Congress, Joint Economic Committee, The Economics of Federal Sub-
sidy Programs, Part 2-International Subsidies, July 15, 1972, p. 195.
Surrey, Stanley S. "Current Issues in the Taxation of Corporate
Foreign Investment," C(olbinbia Law Review, June 1956, pp. 830-38.
U.S. Congress. House. Committee on Ways andI Means. General Tax
Reform, Panel Discussions, Part II-Tax Treatment of Foreign In-
come, 93(1 Cong., 1st sess., Feb. 28, 197:3, pp. 1671-1888.
U.S. Congress. Joint Committee on Internal Revenue Taxation.
U.S. Taxation of Foreign Soirce Incone of Indizidnlals and Corporations
and the Domestic In tern national Sales Corporation Prorisions, Committee
Print, 94th Cong., 1st sess., Sept. 29, 1975.
U.S. Congress. Joint Committee on Taxation. General Explanation
of the Tax Reform Act of 1976, Dec. 29, 1976, pp. 278-80.


Estimated Revenue Loss
[In millions of dollars]
Fiscal year Individuals Corporations Total
1980 ..... 35 1,610 1,645
1979 ------ 30 1,520 1,550
1978 ------ 30 1,450 1,480

Section 174.
Taxpayers may elect to deduct costs for research and development
as incurred (i.e., these costs may be "expensed") even though such
costs may be associated with income that is earned over several years.
The cost then is deducted before the income it generates is realized.

The mismatching of costs and income operates, as accelerated de-
preciation does, to defer tax liability, and thereby provides the tax-
payer with an interest-free loan.
For example, if Corporation Z spends $1,000 on an R&D program
in a given taxable year, the entire sum is treated as a deduction from
taxable income, and represents a cash flow of $480 to the firm ($1,000
X48 percent marginal tax rate-$480). The value of the current ex-
pense treatment, however, is the amount by which the present value
of the immediate deduction exceeds the present value of periodic
deductions taken over the useful life of the expenditure.
The direct beneficiaries of this provision are firms that undertake
research and development. Mainly, these are large manufacturing
corporations. The scanty evidence available suggests that, of the total
amount claimed as research and experimental costs, about 10 percent
is basic research and 93 percent is product development.
Expensing of research and development costs for tax purposes is
consistent with the recent practice of a growing number of companies
that expense these costs for financial accounting purposes. This treat-
ment was approved by the Financial Accounting Standards Board in
October 1974.

Estimated Distribution of Individual Income Tax Expenditure by
Expanded Gross Income Class1
Expanded gross income class (thousands of dollars): distribution
0 to 10 -----------------------------------------------------0
10 to 20_- 3. 3
20 to 30 -------------------------------------------- 3.3
30 to 50 --------------- 13.3
50 and over_ 80. 0
I The distribution refers to the individual tax expenditure only. The corporate tax expenditure resulting
from this tax provision is not reflected in this distribution table.

This provision was added to the tax law in 1954. The general rule,
then as now, was that the cost of assets that benefit future years must
be capitalized and amortized over the assets' useful lives. Probably
because there was difficulty in determining the useful life of such
benefits, deduction was generally allowed for research and develop-
ment costs. The treatment in a specific case was determined by the
IRS administrative practice and court decisions. The purposes of the
1954 statute were to eliminate uncertainty in this area and to encour-
age expenditures for research and development.

Selected Bibliography
Cairns, Robert W. "Income Tax Provisions Regarding Research
and Development Expendittures," in U.S. Congress, House, Commit-
tee on Ways and Means, Tax Rerisioi Conpetdiurm, Committee Print,
1959, pp. 1115-23.


Estimated Revenue Loss
[In millions of dollars]
Fiscal year Individuals Corporations Total
1980 ------ 360 1,080 1,440
1979 ------ 300 965 1, 265
1978 ------ 300 885 1,185

Sections 263(c), 465, 616-617, 704(d), and 1254.
Except to the extent that the "at risk" rules described below apply,
taxpayers engaged n drilling for oil and gas, in general, may deduct in-
tangible drilling costs as incurred. Taxpayers engaged in other mining
activities may deduct exploration and development costs as incurred
(i.e., these costs may be "expensed").
Intangible drilling costs are certain expenses incurred in bringing
a well into production, such as labor, materials, supplies, and repairs.
Expenses for tangibles such as tanks and pipes are recovered through
Intangible drilling costs may not be deducted in excess of the amount
an individual or partnership has "at risk," or has actually invested, in
an oil or gas drilling venture. This rule is applied on a property-by-
property basis for individuals, and on all oil and gas properties in the
case of partnerships and small business corporations treated as
Amounts deducted as intangible drilling costs in excess of those
amounts which would have been deducted if the costs were capitalized
are recaptured as ordinary income upon the sale or other disposition of
the property.
Mining exploration costs are those for the purpose of ascertaining
the existence, location, extent, or quality of a deposit incurred before
the development stage, such as core drillings and testing of samples.
These expenses are limited in the case of foreign exploration. For-
eign exploration costs cannot be expensed after the taxpayer has total
foreign and domestic exploration costs of $400,000. Development
expenses include those incurred during the development stage of the
the mine, such as constructing shafts and tunnels, and in some cases
drilling and testing to obtain additional information for planning
operations. There are no limits on the current deductibility of such

costs. Although both intangible drilling costs and mine development
costs may be taken in addition to percentage depletion, mining ex-
ploration costs subsequently reduce percentage depletion deductions.
In the case of mines, as in the case of oil and gas intangible drilling
costs, there are "recapture" provisions under which capital gains from
the sale of the property are treated as ordinary income to the extent
of prior deductions for exploration expenses.

Generally, expendittures that improve assets yielding income over
several years must be capitalized and deducted over the period
in~which the assets produce income. The tax advantage of treating
these expenditures as current expenses is the same as any other
use of premature deductions; the taxpayer is allowed to defer cur-
rent tax liabilities; this treatment amounts to an interest-free loan
(see Appendix A).
These expensing provisions are additional benefits which supple-
ment the special percentage depletion allowances extended to the
mineral industry.' Although the expensing and depletion provisions
operate somewhat, independently, a firm or person may be eligible
for both and receive their combined benefits.

Estimated Distribution of Individual Income Tax Expenditure by
Expanded Gross Income Class'
ExpmInded gross income class (thousands of dollars) distribution
0 to 10 2.4
10to20-_ 3.8
20 to 30 ............. ...... 3.8
30 to 50 15.2
5 0 a n d o v er - - - -- -- - - - - - - -- -- -- - - - - - - -- - - 7 4. 8
The distribution refers to the individual tax expelditure only. The corporate tax expenditure resulting
from these tax provisions is not rellected in this distribution table.
The option to expense intangible drilling costs (as well as dry hole
costs) of oil and gas wells developed through regulations issued in
1917 (19 Treas. Dec., Int. Rev. 31 (1917)). These regulations reflected
the view that such costs were ordinary operating expenses. In 1942,
the Treasury Department recommended that the provisions be re-
moved, but Congress did not consider the suggestion. (Hearings on
Revenue Revision of 1942 before the Committee on Ways and Means,
p. 2996, vol. 3, 77th Cong., 2(1 sess.) In 1945, when a court decision
invalidated the regulations (F.I.E. Oil Co. v. Commissioner, 147 F.2d
1002, 5th Cir. 1945), Congress adopted a resolution (1-. Con. Res. 50,
79th Cong., 1st sess.) approving the treatment and later incorporated
it into law in the 1954 code. The legislative history of this resolution
indicates that it was intended to reduce uncertainty in mineral ex-
ploration and stimulate drilling for military and civilian purposes.
(H. Rept. No. 761, 79th Cong., 1st sess., pp. 1-2.) Expensing of
, Percentage depletion has been eliminated for larger producers of oil and gas, and is being reduced for
other producers; see pages 33 35, below.

mine development expenditures was enacted in 1951 to reduce am-
biguity in the then existing treatment and to encourage mining. The
provision for mine exploration was added in 1966.
Prior to the Tax Reform Act of 1969, a taxpayer could elect either
to deduct without dollar limitation exploration expenditures in the
United States, which subsequently reduced percentage depletion bene-
fits, or to deduct up to $100,000 a year with a total not to exceed
$400,000 of foreign and domestic exploration expenditures without the
application of the recapture rule. The 1969 Act subjected all post-1969
exploration expenditures to recapture.
The restriction of deductions to amounts "at risk" for intangible
drilling costs and the inclusion of intangible drilling costs in recapture
rules were added by the Tax Reform Act of 1976, primarily in response
to concerns about tax shelters in oil and gas drilling.

Selected Bibliography
Agria, Susan. "Special Tax Treatment of Mineral Industries," in
Arnold C. Harberger and Martin J. Bailey, eds., The Taxation of Income
From Capital, The Brookings Institution, Washington, D.C., 1969,
pp. 77-122.
U.S. Congress. Joint Committee on Taxation. General Explanation
of the Tax Reform Act of 1976, Dec. 29, 1976, pp. 62-67.
U.S. Congress. Senate. Committee on Interior and Insular Affairs.
An Analysis of the Federal Tax Treatment of Oil and Gas and Some
Policy Alternatives, Committee Print, 93d Cong., 2d sess., 1974.


Estimated Revenue Loss
[In millions of dollars]
Fiscal year Individuals Corporations Total
1980 ------ 405 1,310 1,715
1979--------370 1,210 1,580
1978 ------ 340 1, 120 1, 460

Section 613 and 613A.
Most firms engaged in oil, gas, and other mineral extraction are
permitted to deduct a "depletion" allowance for the exhaustion of the
mineral deposits. There are two methods of calculating depletion:
percentage depletion and cost depletion. Taxpayers who qualify for
percentage depletion must use it if it is greater than cost depletion.
Under percentage depletion, a taxpayer deducts a fixed percentage
of gross income from mining as a depletion allowance, regardless of the
amount invested in the deposit. The deduction for gas and oil (which
was 27.5 percent from 1926-69) is now set at 22 percent. However,
beginning in 1975 the percentage depletion allowance was repealed
for major oil and gas companies. Other companies (independents)
were exempted from repeal for 2,000 barrels a (lay for 1975. The
amount of this exempt portion is being phased down gradually to
1,000 barrels a day by 1980. In addition, beginning in 1981, the deple-
tion rate will be gradually phased down by 1984 to 15 percent for
qualifying producers.
Percentage depletion also applies to other mineral resources at
percentages currently ranging from 22 percent to 5 percent. Sulphur,
uranium, and most other metals mined in the United States qualify
for the 22 percent rate; however, domestic gold, silver, and iron ore
qualify for a 15-percent rate; most minerals mined outside the U.S.
qualify for a 14-percent rate; coal qualifies for a 10-percent rate; and
several forms of clay, gravel, and stone qualify for 5- and 71./-percent
Percentage depletion may not exceed 50 percent of the net income
from the property. This limitation is known as the "net income
limitation." The total cost which can be recovered by percentage
depletion is not limited to the cost of the property.
Cost depletion resembles depreciation based upon the number of
units produced. The share of the original cost deduction each year is

equal to the portion of the estimated total production (over the life-
time of the well or mine) which is produced in that year. Using cost
depletion, capital recovery cannot exceed the initial cost.
The value of the percentage depletion provision to the taxpayer is
the amount of tax savings on the excess of the percentage depletion
over cost depletion.

Issues of principal concern are the extent to which percentage
depletion: (1) decreases the price of qualifying oil, gas, and other
minerals, and therefore encourages their consumption; (2) bids up
the price of drilling and mining rights; and (3) encourages the develop-
ment of new deposits and increases production.
Most analyses of percentage depletion have focused on the oil and
gas industry, which prior to 1975 accounted for the bulk of percentage
depletion. Since 1975 legislation repealed the percentage depletion
allowance for most oil and gas production, only one-quarter of oil
and gas production is estimated to be currently eligible for percent-
age depletion. Sales of all other mineral deposits were unaffected
by the 1975 legislation.
Because of the prior focus on oil and gas percentage depletion,
there has been relatively little analysis of the impact of percentage
depletion on other industries. The relative value of the percentage
depletion allowance in reducing the effective tax rate of mineral
producers is dependent on a number of factors, including the statutory
percentage depletion rate and the effect of the net income limitation.
In the past, the net income limitation kept the effective percentage
depletion rate for coal at around 6 percent although the statutory
rate is 10 percent. Because the rising price of imported oil has in-
creased the average price of all oil, coal has been substituted for oil,
resulting in dramatic increases in the price of coal. The price in-
creases will make the net income limitation inapplicable to much
coal production, so the effective depletion rate is likely to rise to nearly
the statutory rate.
Estimated Distribution of Individual Income Tax Expenditure by
Expanded Gross Income Class'
1 rce ntage
Expanded gross income class (thousands of dollars): distribution
0 to 10- 2.3
10 to 20 .-- -- 3. 6
20 to 30 ---- 3. 6
30 to 50 15. 1
50 and over ..... 75. 4
1 The distribution refers to the individual tax expenditure only. The corporate tax expenditure resulting
from these tax provisions is not reflected in this distribution table.
Deductions in excess of depletion based on cost were first allowed
in 1918 in the form of "discovery value depletion" which allowed
depletion on the market value of the deposit after discovery rather
than on its cost. The purpose was to stimulate exploration during
wartime and to relieve the tax burdens on small-scale prospectors.

However, the Treasury believed that under this system taxpayers
often established high discovery values, and thus claimed excessive
depletion. In 1926, to avoid the administrative problems raised by
the need to establish market value, Congress substituted percentage
depletion for oil and gas properties. Beginning in 1932, percentage
depletion was extended to most other minerals.
In 1950, President Truman recommended the reduction of percent-
age depletion to a maximum of 15 percent, but Congress failed to take
action on this recommendation. Only minor changes were made until
1969, when the depletion allowance for oil and gas was reduced from
27.5 percent to 22 percent, and "excess" depletion was made subject
to the minimum tax beginning in 1970.

Selected Bibliography
Agria, Susan. "Special Tax Treatment of Mineral Industries,"
in Arnold C. Harberger and Martin J. Bailey, eds., The Taxation of
Income From Capital, The Brookings Institution, Washington, D.C.,
1969, pp. 77-122.
U.S. Congress. Senate. Committee on Interior and Insular Affairs.
An Analysis of the Federal Tax Treatmerd of Oil arid Gas arid Some
Policy Alternatives, Committee Print, 93d Cong., 2d sess., 1974.


Estimated Revenue Loss
[In millions of dollars]
Individuals Corporations
year Coal Iron Total Coal Iron Total
1980--- 70 10 80 20 10 30
1979--- 60 10 70 15 10 25
1978--- 50 5 55 15 5 20

Section 631 (c).
Lessors of coal and iron ore deposits (which have been held more
than 1 year prior to disposition or lease) in which they retain an
economic interest may treat royalties as capital gains rather than as
ordinary income. Percentage depletion is not available in such cases.
This provision cannot be used by taxpayers obtaining iron ore
royalties from related individuals or corporations. No similar limita-
tion applies to coal royalties.

The extent to which this provision results in tax saving depends on
how the benefits compare with those from percentage depletion. In
past years, percentage depletion on coal often has been large enough
relative to profits to subject many firms to the "net income limitation"
which limits percentage depletion to 50 percent of net income. This
apparently has not been the case for iron ore where the percentage
depletion deduction is less likely to be subject to the net income
For corporations, a percentage depletion deduction equal to 50
percent of net income reduces the marginal tax rate to 24 percent (one-
half of 48 percent), whereas capital gains treatment results in a
30-percent tax rate. However, if the mine has a high basis for calcu-
lating cost depletion (which can be claimed ratably as an offset to
capital gains), the election of this provision may result in a lower
tax. Similarly, if the percentage depletion deduction is less than the
net income limitation, capital gains treatment may be preferred.
For individuals, the tax reduction from the capital gains deduction
is equivalent to that for percentage depletion when the net income
limitation is applicable-taxable income is re(luce(] by 50 percent. If
the net income limitation for percentage depletion does not apply, or
if the individual elects the alternative capital gains rate, capital gains
treatment will be more favorable.

In view of recently rising coal ricee, the percentage depletion
allowance will be less likely to reach the net income limitation, and
thus less likely to reduce tax rates by one-half. The value of newly
purchased coal deposits also will be likely to rise-thus increasing
the value of cost depletion. As a consequence, capital gains treat-
ment which reduces tax rates by one-half for individuals may become
relatively more valuable than percentage depletion for a larger number
of individuals.

Estimated Distributions of Individual Income Tax Expenditures
by Expanded Gross Income Class 1
Percentage distributions
Expanded gross income class (thousands of dollars): Coal Iron
0to 10_ 2.2 0
10 to 20 .- 6.6 0
20 to 30 .... 8. 9 0
30 to 50 ----------------------------------------15. 6 20
50 and over ------------------------------------- 66. 7 80
The distributions refer to the individual tax expenditures only. The corporate tax expenditures resulting
from these tax provisions are not reflected in these distribution tables.
Capital gains treatment for coal royalities was adopted in the Reve-
nue Act of 1951. The legislative history suggests it was adopted to:
(1) extend the same treatment to coal lessors as that allowed to timber
lessors (see p. 49); (2) provide benefits to long-term lessors with low
royalty rates who were unlikely to benefit significantly from the
percentage depletion deduction; and (3) encourage the leasing and
production of coal.
Capital gains treatment of iron ore royalties was added in the
Revenue Act of 1964 to make the treatment of iron ore generally
consistent with coal, and to encourage leasing and production of
iron ore deposits in response to foreign competition.

Selected Bibliography
Agria, Susan. "Special Tax Treatment of Mineral Industries,"
in Arnold C. Harberger and Martin J. Bailey, eds., The Taxation of
Income from Capital, The Brookings Institution, Washington, D.C.,
1969, pp. 77-122.
U.S. Congress. House. Committee on Ways and Means. General
Tax Reform, Hearings, testimony of E. V. Leisenring, National Coal
Assn., 93d Cong., 1st sess., Mar. 19-20, 1973, pp. 2223-30.

Estimated Revenue Loss
[In millions of dollars]
Fiscal year Individuals Corporations Total
1980 ------ 145 300 445
1979 ------ 130 265 395
1978 ------ 110 220 330

Section 103 (b) (4) (F).
Interest on industrial developmentt bonds used to finance the con-
struction or purchase of air and water pollution control facilities is
excludable from gross income. (For a description of industrial develop-
ment bonds generally, see pp. 61-63.)
As in the case of other industrial development bonds, a State or local
government issues pollution control bonds which the government
promises to pay only from rents received from facilities built with the
bond proceeds. The proceeds are used to construct or purchase
pollution control equipment which is leased to a private firm. This
firm then guarantees payment of the bonds. The promise to pay rent
by the private firm is sufficient to secure the bonds. The interest on
the bonds is tax exempt because in form, but not in substance, the
bonds are debt of a State or local government qualifying for exemp-
Tax-exempt pollution control bonds subsidize the cost of complying
with antipollution regulations. Because the interest is tax exempt, the
issuer can attract bond purchasers with lower interest rates than the
lessee of the pollution control equipment would pay if it issued taxable
bonds. In this manner, the exclusion from gross income of the interest
reduces the interest cost of private pollution control equipment.
Financing for electric utility pollution abatement facilities dom-
inates the pollution control bond market. In 1976 and 1977, issues
sold for this purpose constituted 50.2 percent and 65.3 percent of the
total dollar value of all pollution control issues, respectively. In 1976,
other principal users of these bonds were metal producers and proces-
sors (13.5 percent), oil companies (12.7 percent), chemical companies
(10.1 percent), and paper companies (5.9 percent). Most pollution
control bond issues are made to finance pollution control equipment for
large firms.

Reported pollution control bond sales rose from an estimated $93
million in 1971 to $2.98 billion in 1977. This constituted 6.6 percent
of total long-term municil)al debt and 8S.2 I)ercent of all industrial
develol)ment bond, issued in 1977. However, unreported pollution
control bond sales may be very substantial.
Outstanding pollution control debt in 1976 was estimated at $9.1
billion, and sales are projected to grow at an accelerating rate in the
next few years. High growth rates reflect increasingly comprehensive
and strin22ent antipollution requirements, and{ a greater willingness
to utilize these bonds after experience has proven them a viable
financial mechanism.
Projected rapid growth rates have led some bond market experts
to l)iedict strong pressure on all tax-exeml)t interest rates, a reduction
in the attractiveness of tax-exempt issues generally relative to taxable
issues, and a consequent dilution of the effectiveness of the exclusion.
Critics claim further that, as with the exclusion of interest on all
State and local debt, some of this foregone revenue flows into in-
vestors' I)ockets without reducing actual borrowing costs. For example,
it is estimated that every $.75 of interest saved by State and munic-
iptal governments because the interest on their bonds is not taxable,
costs the Treasury $1.00 of revenue foregone. In fiscal year 1977,
an estimated $4.8 billion in Federal revenue was foregone to save
State and local governments about $3.6 billion in interest costs.
The estimated difference of $1.2 billion was tax relief to investors.
The reasons for this difference are discussed in the section on exclusion
of interest on general purpose State and local debt, pp. 181-184.
Although many different types of investors buy )ollution control
bonds, fire and casualty insurance companies are the single largest
group of pollution control bondholders. These companies are attracted
to the high yields and long maturities of industrial revenue bonds
relative to general obligation issues. Their need for liquidity is low
relative to that of cominercial banks, the other major institutional
buyer of inuicipal obligations. According to one survey, 18 large fire
and casualty insurance companies with 57 )ercent of industry assets
purchased 55 percent of the volume of l)ollution control bonds sold in
1973. These purchases accounted for 30 )ercent of all tax-exempt
obligations acquired by these corn paies in 1973.
Since 1973, participation in their pollution control bond market
by these companies has decline(]. Part of the slack has been taken up
by the household sector through municipal bond investment funds.

Estimated Distribution of Individual Income Tax Expenditure by
Expanded Gross Income Class'
I'crc ntace
Expanded gross in tim class (thousands of dollars): distribution
0 to 10- 0
10 to 20 ....... .- 1.2
20 to 30------------------------------------------------------- 3. 5
30 to 50 ---- 8.2
50 and over_ 87. 1
I The dist ribut ion refers o the individual tax expenditure only. The corporate tax expenditure resulting
from this Itax provision is lot rellected ill this distribution table.

Congress lifted the constraints on tax-exempt pollution control
bonds in the Tax Reform Act of 1969 in anticipation of the passage of
antipollution regulatory legislation. Since the projected costs of
compliance were considered high, Congress created a vehicle through
which the Federal Government would share these costs with the
private sector.
Further Comment

As with other tax-exempt municipal debt, the proliferation of
pollution control bonds has elicited suggestions for alternative sub-
sidies to pollution control facilities. These include subsidized taxable
bond options and greater reliance on other tax incentives, such as
special investment tax credits and immediate deduction of the cost of
pollution control equipment.

Selected Bibliography
Criz, Maurice, and David Kellerman. "Unlisted Pollution Control
Debt Via IDB's Held Exaggerated," The Weekly Bond Buyer, Jan. 28,
1976, pp. 1, 8.
Forbes, Ronald W., and John E. Petersen. "Background Paper," in
Building a Broader Market: Report of the Twentieth Ceitury Fund Task
Force on the Municipal Bond market, McGraw-Hill, New York, 1976,
pp. 43-54, 77-88.
Fortune, Peter. "The Financial Impact of the Federal Water Pollu-
tion Control Act: The Case for Municipal Bond Reform," Harvard
Institute of Economic Research, Cambridge, Mass., 1975.
Lane, Leonard Lee. "Do Pollution Control Bonds Control Pollu-
tion?" Tax Notes, Mar. 29, 1976, pp. 22-23.
Petersen, John. "The Pollution Control Bond: A Costly Subsidy,"
Tax Notes, Mar. 29, 1976, pp. 16-21.
Peterson, George, and Harvey Galper. "Tax-Exempt Financing of
Private Industry's Pollution Control Investment," Public Policy,
Winter 1975, pp. 81-103.


Estimated Revenue Loss
[In millions of dollars]
Fiscal year Individuals Corporations Total

1980 ------ ------- 10 10
1979___ ------10 10
1978 ------ 10 10

Sections'l 18 (b)land 362(c).
"Contributions in aid of construction" to water and sewage disposal
utilities are not included in the utilities' gross income if the contribu-
tions are spent for the construction of certain facilities within 2 years
after receipt of the contributions. This treatment is extended only to
regulated utilities that provide water or sewage disposal services to
the general public in their service areas. In general, a qualifying con-
tribution in aid of construction is made by a builder or developer,
either as funds paid to a qualifying utility which uses them to build
water or sewage disposal facilities, or else as completed facilities trans-
ferred to the utility. Customer connection fees do not qualify as non-
taxable capital contributions. These connection fees include payments
made by customers for the cost of installing connections between their
property and a utility's main water or sewage line.
Qualifying contributions may not be included in the rate base for
ratemaking purposes by the regulatory body having ratemaking
jurisdiction. No depreciation may be claimed and no investment
credit may be taken with respect to any property acquired as the
result of a qualified expenditure.

If contributions in aid of construction were taxable currently,
utilities would: (1) pay tax on the contributions; (2) claim the invest-
ment credit on facilities constructed with the qualifying contributions;
and (3) depreciate the facilities over their appropriate useful lives.
Thus, if contributions were currently taxable, over time, utilities
would recover the resulting tax payments through depreciation
deductions. In effect, compared to the treatment of contributions in

aid of construction as taxable income, the treatment a-, non-taxable
contributions un(ler sections 118(b) an(l 362(c) constitutes a tax
(lererral rather than an exclusion.
Since amounts collecte(l as contributions to cal)ital are not included
in a utility's rate base, they cannot result in increased rates to con-
sumers or increase(l utility gross income. Absent the exclusion, the
costs of water or sewage (isIposal contributions in ai(l of construction
1)robably would be I)asse(l on by a utility to the developers and builders
who receive services directlyy related to these contributions. In turn,
the (levelol)ers an(l buihlers woulh pass on part or all of the costs to
their customers. Alternatively, to some degree, the increased utility
costs might be borne in the form of higher utility rates by ratepayers
generally, even though many of them do not, use the specific facilities
related to the contributions.
Prior to 1958, all public utilities had been permit ted to exclude from
gross income currently the contributions they had received in aid of
consruction of facilities. In 1958, under Rev. Rul. 58-555, the IRS
limite(l this favorable treatment to regulated utilities.
However, in 1975, in Rev. Rul. 75-557, the IRS held that amounts
l)ai(l by a home purchaser as a connection fee to obtain water service
were inclu(lable currently in a utility's income.
For many regulate( utilities, the issuance of Rev. Rul. 75-557 had
no tax effect as far as connection fees were concerned because these fees
ha(l historically been inclu(lei in gross income. The problem, however,
was that Rev. Rul. 75-557 might have been construe(d by the IRS
as applying to more than just connection fees, an( might have sub-
jected to tax for the first time contributions in aid of construction,
which previously had been exclude(I as non-shareholder contributions
to capital. It was unclear under the relevant case law whether various
types of contributions in aid of construction constitute(l taxable
income. The 1)resent statute was enacte(l in 1976 to clarify the ex-
clusion for regulated water and sewage utilities, subject to the limi-
tations describedd above.

Selected Bibliography
U.S. Congress. Joint Committee on Taxation. General Explanation
of the Tax Reform Act of 1976, Dec. 29, 1976, p). 635-38.


Estimated Revenue Loss
[In millions of dollars]
Fiscal year Individuals Corporations Total
1980 ------------ 40 40
1979- -45 -45
1978_ -- -130 -130

Sections 46(c) and 169.
In lieu of depreciation, pollution control facilities that have been
certified by both State and Federal agencies may be amortized ratably
over a 5-year period (i.e., 20 percent of the cost may be deducted each
year). Only the portion of the cost relating to the first 15 years of
useful life is eligible. This rapid amortization is currently available
only with respect to facilities added to plants in existence before 1976.
Certification requires that the new facility be a new identifiable treat-
ment facility that: (1) is used in connection with a plant or other
property to abate or control pollution; and (2) does not significantly
increase the output or capacity, reduce the operating costs, extend
the useful life of the plant, or alter the nature of the manufacturing
process or facility. The facility must comply with the Federal Water
Pollution Control Act and the Clean Air Act.
Taxpayers may take an investment credit on one-half of the cost of
property that is amortized under this provision, has a useful life of at
least 5 years, and otherwise would qualify for the credit.

Prior to the Tax Reform Act of 1976, the amortization provision was
used much less widely than it otherwise would have been because no
investment credit was allowed. The allowance of half the invest-
ment credit under the 1976 law makes the provision more attractive,
but its value is still reduced by the inability to use the full credit. To
the extent that it is used, 5-year amortization for assets with longer
useful lives benefits the taxpayer by effectively deferring tax liability.
(See Appendix A.)
Rather than functioning as an incentive, the 5-year amortization of
pollution control facilities subsidizes corporations that must comply
with Federal or State pollution laws. State pollution regulations vary,

and there are regional cost differences for a given facility; both may
account for geographical differences in the usage of the subsidy.

Section 169 was introduced for a 5-year period to ease the financial
burden of complying with environmental regulations when the Tax
Reform Act of 1969 repealed the investment tax credit. When the
investment tax credit was reinstated in 1971, rapid amortization was
retained as an option.
The availability of the provision was extended in 1974, but was
allowed to lapse. It was reinstated by the Tax Reform Act of 1976.
This Act also allowed an investment credit on one-half of the cost of
property for which rapid amortization is chosen. The purpose of this
liberalization was to relieve more of the burden imposed on producers
because of pollution control requirements. The 1976 Act also sub-
stantially broadened the defimition of pollution control equipment
eligible for the amortization.

Further Comment
The House voted in August 1978 to allow a full investment credit
on the cost of pollution control facilities for which rapid amortization
is elected, provided the property amortized under the provision has
an actual useful life of at least 5 years.

Selected Bibliography
McDaniel, Paul R., and Alan S. Kaplinsky. "The Use of the Federal
Income Tax To Combat Air and Water Pollution," Boston College
industrial and Comiercial Law Review, February 1971, pp. 351-86.
Moore, Michael L., and G. Fred Streuling. "Pollution Control De-
vices: Rapid Amortization Versus the Investment Tax Credit," Taxes,
January 1974, Ilpl. 25-30.
U.S. Congress. Joint Committee on Taxation. General Explanation of
the Tax Reform Act of 1976, Dec. 29, 1976, pp. 619-21.


Estimated Revenue Loss
[In millions of dollars]
Fiscal year Individuals Corporations Total
1980 ------ 5 5 10
1979______ 5 5 10
1978 ------ (1) (1)
I Less than $2,500,000.
Sections 167(n), 167(o), 191, and 280B.

Tax incentives and disincentives are provided to encourage the
preservation of historic structures. A taxpayer is permitted to elect
5-year amortization of capital expenditures (in lieu of claiming
allowable depreciation deductions) incurred in rehabilitation of a
certified historic structure. Amortization in excess of otherwise
allowable depreciation must be recaptured as ordinary income upon
sale of the property. These rules apply to improvements made before
June 15, 1981. Alternatively, a taxpayer may elect to be treated for
depreciation purposes as if he were the original user of a substantially
rehabilitated property and obtain the benefit of accelerated de-
preciation. This election applies to improvements made before July 1,
No deduction is allowed for amounts expended for, or losses sus-
tained as a result of, the demolition of a certified historic structure.
This rule applies to demolitions beginning before 1981. No acceler-
ated depreciation is permitted for real property constructe(l on a site
where a certified historic structure had been demolished. This rule
applies to construction costs incurred before June 15, 1981.

Prior to enactment of these provisions in 1976, the tax law- hlcked
incentives for preservation of historic structures. Current deductions
were allowed for demolition costs and for the remaining undepre-
ciated basis of a demolished structure. Accelerated depreciation was
permitted for new structures, but generally not for used ones. The
new incentive provisions permit the taxpayer to defer tax liability.

Since issuance of temporary regulations implementing these pro-
visions in arch 1977, the Department of the Interior has received
requests through mid-1978 for approval of some 470 rehabilitation
These tax provisions were adopted in 1976 to further the goal of
rehabilitating and preserving historic structures and neighborhoods.
Achievement of this goal was thought to be dependent upon the
enlist-ment of private funds in the preservation movement. Congress
believed tax considerations play an important role in determining
whether private interests will maintain and rehabilitate historic
Selected Bibliography
Lifton, Marcy A. "Historic Preservation and the Tax Reform Act
of 1976," U11iiier ity of San Iracico Lar Rerhc w, Spring 1977, pp.
"S ymposium: Perspectives on Historical Preservation," Connecticut
Law ,-vew, Winter 1975-76.
U.S. Conress. Joint Committee on Taxation. General Explanation
of the Tax l(foria Act of 1976, Dec. 29, 1976, pp. 643-45.
No istimat I distribution of the individual! tax expenditure h, expmded gross iscome class is provided
l, cause in 1 w7. the year covered by the distrihutions pepared 1y tbVe Trea sury Department, there was
very little usage of this provision by individuals, and no distribution was pieparel.


Estimated Revenue Loss
[In millions of dollars]
Fiscal year Individuals Corporations Total

1980_.... 70 250 320
1979 ----- 65 230 295
1978 ----- 60 205 265

Sections 631 (a) and (b), 1221 and 1231.

If a taxpayer has held standing timber or the right to cut it for more
than 1 year, the taxpayer may elect to treat the cutting of this timber
as the sale of a long-term capital asset at a price equal to its fair
market value on the first day of the taxable year. If an election is
made, gain or loss accruing before the first (lay of the year in which
the cutting occurs is treated as long-term capital gain or loss. Changes
in the value of the timber after the first of the year result in ordinary
income or loss, and not capital gain or loss. Capital gains treatment
also can apply to the sale of a stand of timber and the sale of timber as
it is cut by the buyer. Timber includes ornamental evergreens that
are 6 years of age or more when severed from the roots.
Some of a timber owner's costs which maintain or even arguably
improve his trees, such as disease control and thinning costs, can be
expensed currently (see Appendix A), even though their effects may
continue beyond the year in which they are made, and though they
are related to income which only will be recognized many years in the
future. Therefore, timber ownership offers opportunities for some tax-
payers to deduct current expenses associated with such ownership
against ordinary income from other sources.

The capital gains treatment of the cutting and sale of timber
constitutes a departure from the general rule that sale of a taxpayer's
inventory yields ordinary income. However, when timber is inventory,
it is usually held substantially longer than other types of inventory.
Both individual and corporate taxpayers are eligible for this treat-
ment. The graduated structure of the individual income tax rates

makes the provision more beneficial to individuals with high incomes
because the value of the deduction for capital gains increases with the
marginal income tax rate.
Two industries-paper and allied products and lumber and wood
products-clalin disproportionately lar-e amounts of corporate capital
gains. According to 1975 Preliminary Statistics of Income for Corpora-
tion,, 29 percent of taxable income of paper and allied products in-
distr'iesind 46 percent of taxable income of lumber ant wood prod-
ucts were long'-term 'capital gains. This proportion may be contrasted
with a proportion of 8.6 percent for all other corporations. These two
industries reported 29.5 percent or all corporate capital gains while
accounting for only 4.0 l)ercent of taxable income. Treasury Depart-
ment studies published in 1969 indicated that in these industries
five corporations accounted for about one-half of the capital gains
claimed, 16 firms accounted for about two-thirds, and 80 percent of
the gains were accounted for by approximately 60 corporations.
Estimated Distribution of Individual Income Tax Expenditure by
Expanded Gross Income Class'
Expanded gross incoine class (thousands of dollars): distribution
0to 10 ----------1.8
10to20 5.4
20 to 30 ---- 9. 0
30 to50 -- 16.4
50 and over 6---------------- -------------- 7. 3
1 The isiribution refers to the individual lax expenditure only. The corporate tax expenditure resulting
fron these tax provisions is not reflected in this distribution table.

The sale or a timber stand that had not been held in the course of
business was long considered the sale of a capital asset. The Revenue
Act of 1943 extended this capital gain treatment to all persons who
cut ind sell their tilber and to those who lease timber stands for
cutting. One reason for adopting this provision was to equalize treat-
ment between the taxpayer who sold timber as a stand outright, and
the taxpayer who cut timber for use in his business. It was also sug-
gested that this treatment would encourage ronservation or timber
through selective (cluttingi and that taxing the capital gain at ordinary
rates was an unfair practice because of the comparatively long de-
velopment time of timber.

Selected Bibliography
Brlg'.s', Charles W., antd Willian K. Condrell. Tax Treatment of
Tim ,ber, 5th ed.. Forest Industries Committee on Timber Valuation
and Taxation, Washington, D.C., 1969.
Sunley, Emil M., Jr. "The Federal Tax Subsidy of the Timber
hIndustrv," in U.S. Congress, Joint Economic Coinmittee, The Eco-
noiics of F deral Siibsidy Programs, Part 38-Tax Subsidies, July 15,
1972, ppl. 317-42.
U.S. Congress. House Committee on Ways and Means and Senate
Committee on Finance. Tax Reform Studies and Proposals: U.S.
Treasary Iepartm t, Committee Print, 91st Cong., 1st sess., Feb. 3.
1969, pp. 434-38.


Estimated Revenue Loss
[In millions of dollars]
Fiscal year Individuals Corporations Total
1980 ------ 480 80 560
1979_____.. 460 75 535
1978______ 445 70 515

Sections 162, 175, 180, 182, 278, 447, 464, 465, and 704(d), Regula-
tions 1.61-4, 1.162-12, and 1.471-6.

Certain farm businesses, generally individuals and family-owne I
corporations, may use the cash method of tax accounting to deduct
costs attributable to goods held for sale and in inventory at the end of
the tax year. These businesses also are allowed to expense (i.e. deduct
as they are incurred) some costs of developing assets that will I)roduce
income in future years. Both of these rules deviate from generally
applicable tax accounting rules, which do not l)ermit deduction of
inventory costs until the inventory is sold, and which require the cost
of income-producing assets to be deducted over their useful lives.
These rules thus allow deductions to be claimed before the income
associated with the deductions is realized.
Items that may be deducted before income from them is realized
include cattle feed, expenses of planting crops for the succeeding
year's harvest, and development costs such as those incurred in plant-
ing vineyards and fruit orchards. There are special rules that require
outlays for developing young citrus and almond groves to be cap-
In addition, certain costs that otherwise would be considered
capital expenditures may be deducted immediately by all farmers pur-
suant to specific sections of the Internal Revenue Code. These costs
include expenses for soil and water conservation (section 175), land
clearing (section 182), and fertilizer (section 180).
Certain restrictions primarily aimed at tax shelters apply to farming
deductions. Farm syndicates are restricted in their deductions of
pre-production expenses, and farm loss deductions allowable to
individual taxpayers are restricted to amounts "at risk," or actually in-
vested, in a farming venture.
The effect of deducting costs before the associated income is realized
is the understatement of income in the year of deduction followed by

an overstatement when the income is realized. The net result is that
tax liability is deferred from the tune the deduction is taken to the
asset's productive period. This affords the taxpayer an interest-free
loan in the amount of the deferred tax. When the income is finally
taxed, it may be taxed at preferential capital gains rates (see p. 53
The expensing of capital outlays provides a (eneral incentive for
farmingn investments that qualify for this treatment, and particularly
favors farming investments with long development periods (such as
orchards and vineyards).

Estimated Distribution of Individual Income Tax Expenditure by
Expanded Gross Income Class
Expanded gross income class (thousands of dollars): distribution
0 to 10 ----------------------------------------------------- 5. 3
10 to 20 .... 18.1
20 to 30 ---------------------------------------------------- 17. 1
30 to 50 ------------ 24.8
50 and over ---------------------------------- 34.7
1 The distribution refers to the individual tax expenditure only. The corporate tax expendi-
ture resulting from these tax provisions is not reflected in this distribution table.
The special rules with respect to development costs and cash ac-
counting were established in regulations issued very early in the de-
velopinent of the tax law. At that time, because accounting methods
were less sophisticated, tax rates were low, and the typical farming
operation was small, the regulations apparently were adopted to sim-
plify recordkeeping for the farmer. The statutory rules permitting
deductions for soil and water conservation, land clearing expenses,
and fertilizer costs were added between 1954 and 1962 to encourage
conservation practices. The special requirements for capitalizing out-
lays for citrus and almond growers were enacted in 1969.
The Tax Reform Act of 1976 required accrual accounting for some
farm corporations, and restricted deductions associated with tax
shelters, in recognition, respectively, of the more sophisticated account-
ing methods available to some corporate farmers, and the growth of
tax shelters.
The remaining use of cash basis accounting for individual and some
corporate farmers is still justified by its proponents as simpler, more
workable, and more consistent than the accrual method.

Selected Bibliography
U.S. Congress. House. Committee on Ways and Means. General
Tax RIform, Panel Discussions, Part 5-Farm ()perations, 93d Cong.,
1st sess., Feb. S, 1973, pp. 615-96.
Tax Rforat, Hearings, Part 2-Farmi Operations, 94th
Cong., 1st sess., July 15, 1975, pp. 1360-1402.
Tax Shelters: Farm Opratiowus, Committee Print, 94th
Coi-., 1st sess., Sept. 6, 1975.
U.S. Congress. ,Joint ('ommittee on Taxation. G(htieral Explalation
of the Tax Thform l ect of 1976, Dec. 29, 1976, pp. 40-62.


Estimated Revenue Loss
[In millions of dollars]
Fiscal year Individuals Corporations Total
1980 ------ 385 10 395
1979 ------ 365 10 375
1978______ 350 10 360

Sections 1201-1202, 1221-1223, 1231, 1245, and 1251-1252.
If gains from the sale or exchange of property used in a trade or
business exceed losses from such property in any year, the gain is
treated as a long-term capital gain. Real estate or depreciable property
used in farming operations and held for more than a year, but not
held for sale, generally qualifies as such property. However, horses
and cattle qualify only if they have been held more than 24 months.
In some cases, all or much of the cost of the farm property used in
the business has previously been deducted under the farm accounting
rules discussed on pages 51-52. Consequently, in 1969, Congress
enacted legislation to tax as ordinary income some gains previously
taxed as capital gain. These gains include those from the sale of land
held for less than 10 years, but only to the extent of previously
deducted soil and water conservation expenses. They also included
gains from other farm property to the extent of the amount in the tax-
payer's excess deduction account. The excess deduction account was
the cumulative total of farm losses which exceeded $25,000 in any
year when nonfarm income exceeded $50,000. The excess deductions
account was red uced bv net farm earnings and gains that were treated
as ordinary income. Under the 1976 Tax Reform Act, which restricted
farm loss deductions, additions to this excess deductions account for
1976 and later years were terminated. Recapture provisions will still
apply, however, to the extent of previously accumulated amounts in
excess deductions accounts.
Subject to these rules, taxpayers owning farm assets may obtain long-
term capital gains treatment on qualifying assets even though much of
the asset cost has been deducted against ordinary income. While this
favorable tax treatment is limited to property used in the farming


business, many farm assets have a dual potential of being held for
sale or for use in the business. Assets having this ambiguous nature
are often sold before the ambiguity is resolved, and the gain is treated
as capital gain. Over 90 percent of the tax saving is claimed by non-
corporate farmers. The tax benefit per dollar of capital gain increases
with the taxpayer's marginal tax rate.
In the past, the interaction between the deduction of costs and
capital gains treatment for the sale of such assets resulted in many
tax shelter operations in farming. However, restrictions on farm loss
deductions enacted in 1976 (discussed on pages 51-52), have limited
the attractiveness of farm tax shelters in general.
Estimated Distribution of Individual Income Tax Expenditure by
Expanded Gross Income Class'
Expanded gross income class (thousands of dollars): distribution
0to 10 ----------------------- 1.5
10 to 20 ------------------------------------------------------ 7.0
20 to 30 ----------------------------------------- 8.2
30 to 50 ------------------------------------------------------ 15.4
50 and over --------------------------------------------------- 67. 9
The distribution refers to the individual tax expenditure only. The corporate tax expenditure resulting
from these tax provisions is not reflected in this distribution table.
Preferential treatment for capital gains for individuals was intro-
d uced in 1921. 1towever, long-term capital gain treatment for property
used in a trade or business was not enacted until 1942. Between 1942
and 1951, there was a dispute whether livestock qualified as such
property, and legislation in 1951 gave livestock that status. The 1942
legislation was enacted to provide tax relief for war-related gains.
Restrictions on loss deductions were enacted in 1976 to limit the
use of farming tax shelters.

Selected Bibliography
Carlin, Thomas A., and Fred W. Woods. Tax Loss Farming,
ERS-546, U.S. Department of Agriculture, Economic Research
Service, April 1974.
U.S. Congress. House. Committee on Ways and Means. General
Tax Reform, Panel Discussions, Part 5-Farm Operations, 93(1 Cong.,
1st sess., Feb. 8, 197:3, pp. 615-96.
Tax Reform, Hearings, Part 2-Farm Operations, 94th
Cong., 1st sess., July 15, 1975, pp. 1360-1402.
Tax Shelters: Farm Operations, Committee Print, 94th
Cong., 1st sess., Sept. 6, 1975.
U.S. Congress. Joint Committee on Taxation. General Explanation
of the Tax Reform Act of 1976, Dec. 29, 1976, pp. 40-62.


Estimated Revenue Loss
[In millions of dollars]
Fiscal year Individuals Corporations Total
1980 ------ --190 560 370
1979 ------ -185 525 340
1978 ------ --175 490 315

Sections 1381-1388.
A cooperative is allowed to deduct earnings distributed to its cus-
tomers (or patrons) in the form of "patronage dividends" or "per unit
retain" allocations. Patronage dividends must be determined on the
basis of the quantity or value of business done with the patron, and by
reference to the cooperative's earnings from business with patrons.
Per unit retain allocations are based upon the quantity of products
marketed without reference to the cooperative's earnings.
The deduction applies to both cash dividends and non-cash divi-
dends in the form of certificates allocating amounts-retained by the
cooperative-to the patrons. In order for a cooperative to deduct the
non-cash patronage dividends: (1) at least 20 percent of the allocation
must be in cash; and (2) the allocation must be included in the patron's
income, unless it is related to personal, non-business expenses. Per
unit retains also may be deducted by the limited types of cooperatives
that can issue them, although the retains only represent allocations of
earnings to patrons and are not cash dividends. A patron must treat
all his patronage dividends and per unit retain allocations as taxable

The deduction of patronage dividends, and particularly non-cash
dividends, allows a cooperative effective exemption from the corporate
income tax, while the cooperative still retains its earnings for re-
investment through the use of certificates of allocation. For example,
if all dividends were paid in allocations, a cooperative could retain
80 percent of its earnings and incur no Federal income tax liability.
The most significant cooperatives qualifying for this treatment are
agricultural cooperatives, although substantial numbers of nonagri-

cultural cooperatives, such as consumer cooperatives, also benefit from
these provisions. Cooperative cre(lit institutions are not eliible for
this special treatment, although they do benefit from other tax
expenditures. Qualifying coo)eratives either may be purchasing or
marketing cooperatives, an(t may be involved in manufacturing
processes as well. Exemption from the Federal income tax provides a
coml)etit ive advantage for cooperatives, many of which are substantial
in size, over completing incorporated businesses.

The treatment of patronage dividends derives initially from rulings
issued early in the 1920's which allowed )atronage dividends to be
deducted by cooperatives. There was no explicit rationale for such
treatment, but apl)arently the rulings resulted from the requirement
that cooperatives make these dividend payments. It was argued these
p)aynents either were costs of goods sold or price reductions, and there-
fore should be de(luctible.
In 1951, when certain formerly exempt cooperatives were made
taxable, a requirement was added that patronage dividendss of exempt
and no-i-exeml)t cooperatives be treated in the same manner. The
legislative history indicates that the intent of Congress was to tax all
earnings or cooperatives either to the patron, stockholder, or coopera-
tive. Ilowever, when the TreasurT attempted to tax allocated patron-
age dividends to the patrons, a series of' court, decisions ending with
Long Poltry!l Farms, Inc. v. C'nmi.siotier 249 F. 2d 726 (4th Cir.
1957), held that allocation certificates were of contingent value and
were not to be included in income. Thus, such allocations were taxable
neither to the cool)erative nor the patron. As a consequence, sections
1381-1388 were added in 1962 to insure that such allocations were
taxable either to the patron or the cooperative.

Further Comment
Two theories are a(lvanced for allowing the deduction of patronage
dividends. The first is that such (lividen(ls actnallv constitute price
predictions to the patrons. The second is that all earnings of the
cool)erati\ e belong to its l)atrons, and( that the cooperative is an
agency of its members rather than a separate taxable enterprise.
()n the other hanI, current tax law treats cool)eratives as taxable
entities, and the deduction of patronage dividend(s results in effective
tax exemnrption. Allocated patronage dividends arguably do not con-
stitute l)rice redu(ctions, but rather are non-negotiable, non-interest-
bearing notes re(leei),ble by the )atron-, if ever, in the indefinite
future. One might question why patrons accept such allocations in
lieu of cash if the intent is a price reduction. The answer may be that
the interest of the patrons is that of investors. This response is par-
ticularly relevant since COOperatives are typically owned, either
through stock ownership or otherwise, by p)atroill_.
Persons arguing that patronage dividends are not comparable to
pri('e reduhctions note that price re(uhctions li a normal business have
a profit mot 1ve--expanding sales an( increasing 1wofit. So-called "price
reductions" for coop eratives in the form of' patronage dividends,
however, have the purpose of elirninating )rofit.

it is argued by some that even if the patronage dividends and per
unit retains are viewed as dividends, the tax rules governing coop-
eratives do not result in a tax expenditure because the patrons are
taxed on the dividends and retains they receive or have attributed
to them. In effect, the patrons are taxed as if they receive cash div-
idends and re-invest them in the cooperatives. However, the estimated
revenue foregone by allowing the cooperatives full deductions for these
dividends and retains far exceeds the estimated additional tax revenues
Iaid by patrons on their patronage dividends and per unit retains.

Selected Bibliography
Caplin, Mortimer M. "Taxing the Net Margins of Cooperatives,"
Georgeto'n Law Journal, October 1969, pp. 6-45.
Gelb, Bernard A. Tax Exempt Buisiness Enterprise, The Conference
Board, New York, 1971.
U.S. Congress. House. Committee on Ways and Means. General Tax
Reform, Hearings, 9:d( Cong., 1st sess., Mar. 16, 197:3, pp. 1691-1758.
U.S. Department of Agriculture. Legal Phases of Farmer (ioopera-
ies, Part It-Federal Income Taxes, Information Series 100, May

30 -560-78-5


Estimated Revenue Loss
[In millions of dollars]
Fiscal year Individuals Corporations Total
1980 ------ 530 530
1979- ----- 505 505
1978------ 475 475

Section 116.
An individual may-exclude up to $100 ($200 on a joint return) of
dividends received from domestic corporations.
Although this provision benefits all taxpayers who receive dividend
income and have tax liability, only a small percentage of total divi-
dends is affected by the provision because of the dollar limitation.
The tax saving per dollar of exclusion increases with the taxpayer's
marginal tax bracket. In the aggregate, the benefits tend to accrue
to middle- and high-income taxpayers because they are more likely to
own stock.
Estimated Distribution of Individual Income Tax Expenditure by
Expanded Gross Income Class
Expanded gross income class (thousands of dollars): distribution
0 to 10 -------------------9 1
10 to 20 -----------------------------------------------24.0
20 to 30 -----------------------------------------------24. 7
30 to 50 -----------------------------------------------23. 3
50 and over --------------------------------------------18. 9
In 1954 a dividend exclusion of $50 and a credit against tax liability
for 4 l)ercent of' dividends above that amount were a(lopte(I. The
stated l)urpose was to provide partial relief from the "double taxa-
tion" ol dividends (the corporate income tax and the inlividlal
income tax on dividends) which, it was argued, hampered the ability
of companies to raise capital. The exclusion was stated to be designed
to afford greater relief for the low-income investor.

In 1964, although the Administration recommended repeal of both
the credit and exclusion, the credit was repealed and the exclusion
was doubled. The reasons offered were (1) that the provisions had not
achieved their objectives, (2) the change would remove the discrimina-
tion in favor of high-income taxpayers, (3) the change would en-
courage broader ownership of stock, and (4) the change would raise
revenues that could be used to reduce the individual taxes in general.
Further Comment
As indicated above, the issue that gave rise to the initial enactment
of the exclusion and credit is the "double taxation" of dividends or,
more generally, the burden of taxes on capital, and on corporate equity
capital in particular. While the exclusion survives, it does relatively
little to resolve this problem because of the low dollar ceiling. Many
proposals for partial and full integration of the corporate and indi-
vidual income taxes have been made. Partial integration proposals
were seriously considered, but not proposed, by the Carter Administra-
tion in 1977. Tliey have zilso been the subject ol Congressional hear-
in gs, an!d trve ben (discicssed in recent years in the IlHouse Ways and
Means ComnniIttee.
Selected Bibliography
Feldstein, MIartlin, and Daniel Frisch. "Corporate Tax Integration:
The Estimated Effects on Capital Accumulation and Tax Distribu-
tion of Two Integration Proposals,"! National Tax Jolirnal, March
1977, )l). 87-52.
Goode, Richard. Vic Indiridal Ihcoine Tax, Rev. ed., The Brook-
ings Institution, Washington, D.C., 1976, pp. 138-9.
Musgrave, Richard, and Peg-y Musgrave. t'llblic Finance in Theory
an~d Practice, McGraw-till, New York, 1973, )P. 267-97.
Pechnian, Joseph A. Federal Tax IPolicy, :d ed., The Brookings
Institution, Washington, D.C., 1977, pp. 169-80.
"The Taxation of Income Fron Corporate Shareholding," Sym-
posim sponsored by the National Tax Association-Tax Institute of
America and Fund for Public Policy Research, National Tax Journal,
September 1975.


Estimated Revenue Loss
[In millions of dollars]
Fiscal year Individuals Corporations Total

1980 ------- 155 315 470
1979 ------ 135 270 405
1978 ------ 115 235 350

Section 103(b).
The interest on industrial development bonds (IDB's) issued by
State and local governments to finance eight categories of investments
are excludable from gross income regardless of issue size. The eight
categories are: (A) residential family housing; (B) sports facilities; (C)
convention or trade show facilities; (D) airports, docks, wharves, mass
commuting facilities, and parking facilities; (E) sewage or solid waste
disposal facilities or facilities for the local furnishing of electric energy
or gas; (F) air or water pollution control facilities;' (G) facilities for
furnishing water made available to the public; and (H) the acquisition
or development of land for an industrial park.
The interest on IDB issues that finance other types of industrial
plant and equipment investments is generally not excludable from
gross income unless the issue has a face value of $1 million or less.
Under certain conditions, a State or local government can elect to
raise this limit to $5 million.
Unlike general obligation issues, industrial develol)ment bonds are
not backed by the issuing government. Rather, the bonds are guaran-
teed by a business. The issuer uses the proceeds of the bonds to finance
the investment in plant and equipment which the business intends to
utilize. The issuer typically leases the equipment back to the private
firm, including in the rent the interest costs of financing the bond issue.
Only the rent is available to secure the bonds.

Tax-exempt IDB's subsidize private investments. Since interest oil
IDB's is tax exempt, potential purchasers are willing to accept lower
before-tax rates of interest than on taxable securities. Consequently,
For discussion of the exclusion of interest on pollution control IDB's see pp. 39 41.

the issuing government can attract bondholders with lower interest
payments tban corporations selling comlmrable bonds in the taxable
market. By financing investment through IDB's, a private firm can
therefore lower its borrowing costs.
Benefits of the tax exeml)tion are conferred on both the holders of
IDB's and the )rivate firms using them as financing mechanisms. The
allocation of benefits between the holders and the businesses depends on
the sp)read in interest rates between the tax-exemi)t IDB market
and the taxable bond market. The smaller the slreai, the larger
the proI)ortion of benefits accruing to the IDB bondholders.
Firms which guarantee IDB's most extensively tend to be large.
Of all exemp)t I DB issues (other than for l)ollition control) listed in the
January 1977 issue of bloody's Bond Record, 62 l)ercent were issued on
behalf of 104 different members of the "Fortune 500." However large
firms tend to dominate IDB usage less now than they did before 1969.
Of all exeml)t I DB's (other than l)ollution control) issued prior to 1969,
71 l)ercent were on behalf of members of the "Fortune 500." Since 1969,
less than 60 percent of such issues have been on behalf of these firms.
This shift l)robably resulted from the fact that prior to 1969, interest
on all industrial revenue bonds, regardless of the matgnitude or 1)url)ose
of' the issue, was excludable from gross income.
In 1976, $357 million in tax-exeml)t non-pollution-control IDB's
were isued nationally. This constituted 11.8 t)ercent of all tax-exempt
JDB's issued.
As an exclusion, the value of this tax expenditure increases with
the marginal tax rate of the bondholder. Consequently, within the
household sector, IDB's tend to be held by high-income investors.
Fire and casualty insurance companies are attracted to IDB's because
of their relatively high yields an(l long maturities. Commercial banks,
the other major group of institutional investors in the municipals
market, have a greater need for liquidity than the insurance com-
panies. In general, they prefer bonds which are relatively short-lived
and serialized. General obligations tend to possess these characteristics
more than do IDB's.

Estimated Distribution of Individual Income Tax Expenditure by
Expanded Gross Income Class'
Expanded gross income class (thousands of dollars): distribution
0to 10- 0
10 to 20 ------------------------------------------------------ 2. 1
20 to 30 ------------------------------------------------------- 3.2
30 to 50 ---------------------- 8.4
50 and over ---------------------------------------------------- 86. 3
The distribution refers to the individual tax expenditure only. The corporate tax expenditure resulting
from this tax provision is not reflected in this distribution table.
The tax-exeml)t status of industrial revenue bonds was originally
established in the courts on the ground of State sovereignty. Mississippi
issued the first industrial revenue bonds as l)art of legislation to
"Balance Agriculture With Industry" (BAWI). The constitutionality
of Mississippi's BAW1 Act was upheld in 1938 by the Mississippi
Supreme Court. An al)l)eal was dismissed by the U.S. Supreme Court
for lack of a substantial Federal question.

Many early IDB issues were intended to promote industrial develop-
ment, particularly in agricultural labor surplus areas (luring the Great
Depression. IDB's continued to be used predominately for this purpose
through the 1940's and 1950's, mostly in the Southeast. The 1960's
saw an increase in the number and size of issues, and the proliferation
of 1DB-financed facilities into urban areas and other regions. Between
1959 and 1968, the number of reported issues rose from 88 to 212. The
dollar value of issues rose from $32.4 million to an estimated $1.8
billion. By 1968, 1DB's were in use in 40 States.
Dollar limitations were placed on the size of tax-exempt IDB issues
in 1969 for several reasons: the growing revenue loss to the Federal
Treasury; the intensification of financially debilitating competition
for industry among nunicilpalities through the extension of IDB
financing; the substantial use of IDB's by large corporations that
already had ample financial resources; and the pressure on interest
rates throughout the municipals market generated by IDB growth.

Further Comment
Several bills have been introduced recently in Congress to relax the
dollar limitations on the size of tax-exempt issues. In order to redirect
tax-exempt IDB's toward the purpose of promoting industrial develop-
ment in depressed areas, some have recommended that the dollar
limitations be eased only for facilities located in depressed regions.
The House voted in August 1978 to raise from $5 million to $10
million the limitation on the size of the small issue election for tax-
exempt industrial development bonds.

Selected Bibliography
Connelly, Francis J. "A Descriptive Analysis of the Use of Revenue
Bonds: 1966-1976," Institute of International Law and Economic
Development, October 1977.
Forbes, Ronald W., and John E. Petersen. "Background Paper," in
Building a Broader Market: Report of the Twentieth Century Fund Task
Force on the Municipal Bond market, McGraw-Hill, New York, 1976,
pp. 27-174.
Fortune, Peter. "Tax Exemption of State and Local Interest Pay-
ment: An Economic Analysis of the Issues and An Alternative," New
England Economic Review, May/June, 1973, pp. 3-31.
U.S. Congress. Congressional Budget Office. "The Tax Exemption
on State and Local Bonds," Report to the House Budget Committee,
Nov. 18, 1975.


Estimated Revenue Loss
[In millions of dollars]
Fiscal year Individuals Corporations Total
1980 ------------- 100 100
1979_ 90 90
1978 ------------ 80 80

Section 501 (c) (14).
Credit unions without capital stock, and organized and operated
for mutual purposes and without profit, are not subject to Federal
income tax.
Because their income is exempt from the income tax, credit unions
are treated more favorably than are competing financial institutions
whose income is taxed. On the other hand, credit unions are subject
to certain special constraints not required of their competitors, such
as limits on the interest rate charged on loans, on the duration of loans,
and on the types of investments that are allowed. In addition, credit
unions may lend only to members; however, only a small deposit may
be required for membership that qualifies the member for a loan
greatly in excess of the deposit.

Credit unions have never been subject to the Federal income tax.
Initially, they were included in the provision that exempted domestic
building and loan associations-whose business was at one time
confined to lending to members-and nonprofit cooperative banks
operated for mutual purposes. The exemption for mutual banks and
savings and loan institutions was removed in 1951, but credit unions
retained their exemption. No specific reason was given for continuing
the exemption of credit unions.
Further Comment
The Carter Administration proposed in 1978 that credit unions
no longer be exempt from the Federal income tax, but rather be treated
in the same manner as thrift institutions. The Treasury Department
indicated that the basis for this proposal was that many credit unions
are no longer truly mutual institutions with limited "common bonds,"
and are becoming virtually indistinguishable from other financial


Selected Bibliography
Croteau, John T. "Some Considerations on the Taxation of Credit
Unions," in U.S. Congress, House, Committee on Ways and 'Means,
Tax Revtsi*on Compendium, Committee Print, 1959, i)p. 183:3-66.
Gelb, Bernard A. Tax Exempt Busin~ess Eterprise, The Conference
Board, New York, 1971.
U.S. Department of the Treasury. The Presidldet'g 1978 Tax Pro-
gram: Detailed Descriptioos and SuJpportiltg Attalyses of the Proposals,
Jan. 30, 1978, )p.: 307-13.


Estimated Revenue Loss
[In millions of dollars]
Fiscal year Individuals Corporations Total
1980 ------------ 930 930
1979 ------------ 790 790
1978 705 705

Sections 585, 593, and 596; Revenue Rulings 65-92 (C.B. 1965-1,
112), 68-630 (C.B. 1968-2, 84).
In general, businesses are permitted to deduct as a current operating
expense a reasonable allowance for bad debts. The allowance usually
is based on the experience of prior years. However, the special formulae
used by financial institutions to compute bad debt reserves permit
deductions in excess of actual experience.
Prior to 1969, commercial banks were i)ermitted a bad debt deduc-
tion of 2.4 percent of outstanding loans. The 1969 Tax Reform Act
reduced this figure to 1.8 percent for years through 1975, 1.2 percent
from 1976-81, and 0.6 percent from 1982 through 1987. After 1987,
commercial banks will be limited in their loss reserve deductions to
actual recent loss experience.
As an alternative to this treatment available for commercial banks,
mutual savings banks and savings and loan associations have an
option, under certain circumstances, to deduct a specified percentage
of their taxable income. Under the provisions of the Tax Reform Act
of 1969, this percentage-of-net-income allowance is being reduced
from 60 to 40 percent by 1979. (The allowance for 1978 is 41 percent
of taxable income.) Thereafter, the percentage allowance will remain
at 40 percent. The total bad debt reserve of thrift institutions may
not exceed 6 percent of qualifying real property loans, or the
percentage-of-net-income bad debt deduction will be disallowed.
In addition, the annual bad debt deduction under this latter method
will be reduced if the thrift institution's investments do not coml)rise
specified proportions of certain "qualified" assets, which for "thrifts"
are essentially residential mortgages.

Bad debt reserve deductions in excess of actual experience lower the
effective tax rates of financial institutions, particularly thrift in-
stitutions, below the normal corporate tax rate of 48 percent. Apart
from any other means of reducing tax liability, the 60 percent bad
debt allowance resulted in a maximum effective tax rate for a thrift
institution prior to the 1969 Tax Reform Act of 19.2 percent.' With
full phase-in of the bad debt provisions of the 1969 Act, the maxi-
mum effective tax rate of a thrift institution qualifying for the full
bad debt allowance will be 28.8 percent.2 Therefore, to the extent the
bad debt deduction induced thrift institutions to hold qualified
assets, such as residential mortgages, before 1969, the provisions
of the 1969 Act have reduced the incentive effect of this tax
The tax treatment of commerical banks evolved separately from
that of thrift institutions. The allowance for special bad debt reserves
of commerical banks was first provided by IRS ruling in 1947, when
there was fear of a postwar economic (lownturn. [t was intended to
reflect the banking industry's experience (luring the depressionn
The special treatment of bad debt reserves for thrift institutions
was added by statute in 1951. Prior to that time, savings and loan
associations and mutual savings banks were exempt from taxation,
in most instances because they were viewed as mutual organizations
rather than corporations. Upon removal of this tax-exempt status,
special, and very favorable, treatment of bad debt reserves was
provided for savings and loan institutions and mutual savings banks,
which in effect left them virtually tax exempt for a number of years
thereafter. Some of the same factors which led to their tax exemption
probably account for the special allowance for bad debts, especially
the belief that these institution, fill an important role in providing
home mortgage funds.

Selected Bibliography
"Report on the Financial Institutions Act of 1973, A Section-by-
Section Analysis," Departneitt of the Treasary N its, Oct. 11, 1978.
U.S. Congress. House Committee on Ways and Means and Senate
Coninittee on Finance. Tax lheform Stadies and Proposals: U.S.
Tlreasr!/ Departmeuit, Comnmittee Print, Chapter IX-D- Tax Treat-
ment of Financial Institutions, 91st Cong., 1st sess., Feb. 8, 1969.

2 .48-.4(.48) =.288 (without taking the minimum tax into account).


Estimated Revenue Loss
[In millions of dollars]

Fiscal year Property Mortgage Corpo- Total
taxes interest rations

1980---- 5,750 6,140 --- 11,890
1979---- 5, 180 5,530 10, 710
1978---- 4,665 4,985 9,650

Sections 163 and 164.
A taxpayer may take an itemized deduction for mortgage interest
and property taxes paid on his owner-occupied home.

The deduction of nonbusiness mortgage interest and property
taxes allows homeowners to re(luce their housing costs; tenants have
no such opportunity because they cannot deduct rental payments.'
High income individuals receive greater proportional benefits than
low income persons, not only because of higher marginal tax rates,
but also because higher income taxpayers are more likely to own one
or more homes and to itemize deductions. Higher income people
also are likely to own higher priced homes with larger mortgages
and higher property taxes.
These provisions encourage home ownership by reducing its cost in
comparison to renting. Some observers believe that these deductions,
together with other favorable income tax provisions accorded to
homeowners, have been an important factor in the rapid rise of home-
ownership since World War 11. Other observers suggest that the hous-
ing market has adjusted for these deductions, and that home price
increases have compensated for the tax benefit.
To the extent that the deductibility of State and local property
taxes allows these taxes to be higher than they would otherwise be,
the provision has an effect similar to a revenue sharing program.
I hi contrast to the rental income paid to a landlord by a tenant, the rental value of an owner-occupied
home is not imputed-i.e., not included-in the income of the owner. Such income thus is tax exempt, but
the mortgage interest and property tax expense of earning it is allowed as a deduction from other taxable
income. These deductions favor investment in owner occupied homes over investments in residential rental
property or other assets such as securities.

Estimated Distributions of Individual Income Tax Expenditures
by Expanded Gross Income Class
Property Mortgage
Exl)ande(d gross income class (thousands of dollars) taxes interest
0to 10-- 1. 9 2.0
10 to 20 19. 4 24. 5
20 to 30 .... 28.4 36. 0
30 to 50 -- -- -- -- ---- ------ -- -- ---- ---- -- -- ----- 2 4. 6 2 5. 2
50 and over ....- 25. 7 12. 3
Generally, the deductibility of interest and of State and local taxes
has been a characteristic of the Federal income tax structure since the
Civil War income tax. An explicit rationale was never advanced, but
close examination of the legislative histories suggests that these pay-
ments were viewed as reductions of income. No distinction was made
between business and nonbusiness expenses. There is no evidence that
deductibility of these items was originally intended to encourage home
ownership or to stimulate the housing industry, which are the present
justifications offered for this treatment.
The code was revised in 1964 to specify the types of nonbusiness
taxes which could be deducted. The treatment for property taxes was
retained because removing the deduction would have )recipitated a
large shift in overall tax burdens.

Selected Bibliography
Aaron, Henry. "Federal Housing Subsidies," in U.S. Congress, Joint
Economic Committee, The Economics of Federal S?tbsidy Programs,
Part 5-Housing Subsidies, Oct. 9, 1972, pp. 571-96.
Who Pays the Property Tax? The Brookings Institution,
Washington, D.C., 1975.
Goode, Richard. The Indivihal Licome Tax, Rev. ed., The Brook-
ings Institution, Washington, D.C., 1976, pp. 117-25.
Helhnuth, William F. "Homeowner Preferences," in Joseph A.
Pechman, Comprehensive Income Taxation, The Brookings Institution,
Washington, D.C., 1977.
Laidler, David. "Income Tax Incentives for Owner-Occupied
Homes," in Arnold C. Harterger and Martin J. Bailey, eds., The Tax-
ation of Income From Capital, The Brookings Institution, Washington,
D.C., 1969, pp. 50-70.


Estimated Revenue Loss
[In millions of dollars)
Fiscal year Individuals Corporations Total
1980______ 2,610 2, 610
1979 ------ 2,350 2,350
1978 ---- 2, 120 2, 120

Section 163.
A taxpayerT'may.take an itemized deduction for interest paid or
accrued on nonbusiness indebtedness (for example, personal and auto
loans andcredit account purchases).

This provision reduces net interest charges, and thereby reduces
the price of consumer purchases financed by debt. Because higher
income taxpayers are more likely to itemize deductions, they are
more likely to benefit from this provision than are taxpayers in
lower brackets.
Under 1954 legislation, the deduction for carrying charges on most
consumer credit (unless explicitly denominated "interest") was
limited to about 6 percent on the declining balance of consumer debt.
In more recent years, bank charge cards have proliferated, and the
Internal Revenue Service has ruled that charges on those cards
generally can be fully deducted as interest. On the other hand, pur-
chases under deferred payment contracts usually remain subject to
the limitation previously mentioned. Thus, the theoretical treatment
of bank charge cards differs substantially from deferred payment, sales
where carrying charges are often not called "interest." Whether this
distinction is observed in practice is unknown.
Estimated Distribution of Individual Income Tax Expenditure by
Expanded Gross Income Class
Expanded gross income class (thousands of dollars): distribution
0 to 10 ------------------------------------------------------2.0
10 to 20 ----------------------------------------------------24. 5
20 to 30 ------------------------------- --------- 35.9
30 to 50 ----------------------------------------------------25.2
50 and over ------------------------------------------------- 12. 3

While the 1862 income tax statute (lid not contain a special provision
for the deduction of interest, it was allowed. When the income tax
was reinstituted in 1913, a special provision allowing the deduction of
interest was included, apparently because of concern that interest
might not be treated as a business expense and deducted under the
general business expense provision. At that time, no distinction was
drawn between business and nonbusiness interest expense, presumably
because the latter constituted a very sinall proportion of total interest
expense. However, today the nonbusiness interest cost is perceived as
a consumption item and hence different from busines-s interest.

Selected Bibliography
Goode, Richard. The In(l 6illal Inconie Tarx, Rev. cd., The Brook-
ings Institution, Washington, D.C., 1976, pp. 148-55.
Kahn, C. Harry. Personal Dedactions in the Federal Income Tax,
Princeton University Press for the National Bureau of Economic
Research, Princeton, N.J., 1960, pp. 109-24.
White, 'Melvin I., and Anne White. "Tax Deluctibitiy of Interest
on Consumer Debt," Piiblic Finance QO!arterly, Januiry 1977, pp. 3-7.


Estimated Revenue Loss
[In millions of dollars]
Fiscal year Individuals Corporations Total

1980 ------ 145 555 700
1979 ------ 90 525 615
1978 ------ 140 500 640

Sections 163-164, 189.
Interest and taxes incurred by a corl)orate taxpayer ,luring the con-
struction of a building either may be deductedd or may be capitalized
as a part of the de)reciable base of the building. A\n individual tax-
payer has the option of treating these costs either as a )art of the
depreciable base of the building, or as a separate capital cost to be
amortize(d over specified time l)eriods.
For nonresidential structures, the amortization period is 6 years for
expenses paid or incurred in 1978. This 6-year )eriol increases 1 year
in each subsequent year, until it, reaches 10 years in 198S2. For residen-
tial buildings other than low-income housing, the pat tern is the same
except that the period begins at 4 years for expenses )aid or iMcurred in
1978, and reaches 10 years in 1984. For low-income housing construc-
tion period interest and taxes, amounts paid or incurred before 1982
may be deducted fully in the year they are paid or incurred, subject to
limitations on pre)ayments; amounts paid or incurred in i1,8; may be
amortized over 4 years; and the amortization period increases 1 year
for each year thereafter until 1987, when it reaches 10 years.

The cost of interest an(l taxes paid or incurred during the construc-
tion period of a building is conceptually a cost of the constructed )rop-
erty. The allowance of such construction 1)eriod costs as deductions
when paid or incurred or over a )eriod of time shorter than the useful
life of the property results in a mismatching of income and expenses
by allowing the deduction of costs prior to the realization of income
related to the costs. In contrast, all other construction costs are re-
quired to be capitalized and depreciated over the useful life of the
building,. The effect of the construction period interest and taxes deduc-
tion is a deferral of income taxes in the nature of an interest free loan
(see Appendix A).

Estimated Distribution of Individual Income Tax Expenditure
by Expanded Gross Income Class 1
Expanded gross income class (thousands of dollars): distribution
0to 10_- 2.0
10 to 20- 3. 3
20 to 30 ---- 4.0
30 to 50 14. 7
50 and over -- 76.0
I The distribution refers to the individual tax expenditure only. The corporate tax expenditure resulting
from these tax provisions is not reflected in this distribution table.
The deduction for interest and taxes was provided in the original
income tax law in 1913. Although no specific rationale was stated, the
legislative history suggests that such payments were viewed as re-
ducing net income. In 1942, a provision was added to the law to allow
taxpayers to elect to capitalize such costs. The Tax Reform Act of
1976 required the phased-in 10-year amortization period for individ-
uals, which reflected a concern with the role this provision played in
individual tax shelters. When interest and taxes were currently de-
ducted, high income taxpayers could generate substantial immediate
tax losses which could be used to shelter income earned from other
Selected Bibliography
U.S. Congress. Congressional Budget Office. Real Estate Tax Shelter
Subsidies and Direct Subsidy Alternatives, May 1977.
U.S. Congress. Joint Committee on Taxation. General Explanation
of the Tax Reform Act of 1976, Dec. 29, 1976, pp. 25-29.


Estimated Revenue Loss
[In millions of dollars]
Fiscal year Individuals Corporations Total
1980--------165 50 215
1979--------155 50 205
1978 ------ 145 45 190

Section 179.
All taxpayers except trusts may elect to take a first-year deprecia-
tion deduction equal to 20 percent of the first $10,000 of investment
in tangible personal property ($20,000 in the case of a joint return)
having a useful life of 6 or more years. This first-year depreciation
reduces the basis of the asset. However, the remaining basis may be
depreciated under rates that are otherwise applicable. Real property
is not eligible for this treatment.
Assume a taxpayer purchases a $10,000 asset with a 10-year tax
life depreciated under the double declining balance method, and
with no salvage value. Without the first-year depreciation, his deduc-
tion in the first year would be $2,000 (200 percentX 'o X$10,000). In
the second year, his deduction would be $1,600 (200 percentX 'Io X
With the first-year depreciation allowance, his first-year deduction
would be $2,000 (20 percent of $10,000) pls $1,600 (200 percentX
}{o X$8,000) or $3,600. In the second year his deduction would be
$1,280 (200 percentX M//1o X$6,400).

This provision results in a deferral of tax liability and is similar
to an interest free loan (see Appendix A). Because it is a deduction,
the value is dependent on the taxpayer's marginal tax rate. It is
available to all taxpayers except trusts, but is of most significance to
small businesses because of the dollar limitations. As an incentive for
the acquisition of new assets by small businesses, it has broader
application than the corporate surtax exemption, since noncorporate
businesses can take advantage of it.

The provision is often cite(l as assistance to new and growing small
businesses which are likely to have limited access to capital markets,
and are thus more dependent on internal funds for financing invest-
nient. However, many such businesses, particularly new ones, may not
have sufficient taxable income to benefit from the provision.

Estimated Distribution of Individual Income Tax Expenditure by
Expanded Gross Income Class1
Expanded gross income class (thousands of dollars): distribution
0to 10-- 2.1
10 to 20 3.6
20 to 30 3.6
30 to 50- 15. 0
50 and ovr- 75.7
I The distribution refers to the individual tax expenditure only. The corporate tax expenditure resulting
frnio this tax provision is not refl cted in this distribution table.
The I)rov-ision was originally reported in the Small Business Tax
Revision Act of 195S, which with some mod ification was a(l(led in
conference to the Tecimical Amendments Act of 1958. The additional
first-year depreciation was inten(le(i to p)rov'idie relief for small busi-
nesses that are de)en(ent on internal finacini', ai to encourage
investment in small business.
Further Comment
A number of proposals bave been made to increase the dollar limits
of t his l)rovision to reflect the iiui)act of ilflation. Proj)o ,,ls have also
been made to shorten tie minimum life of qualifying assets in view of
tlie subsequent general re(tiction in asset useful lives. For example, the
tentative decisionss on tax reform adopted by the Ways an(l Means
committee e in 1974, though never reported as a bill. would have in-
c'ea,4f(l the dIollar limit to $15,000 ($:'O,)O() for a joint return), an(l
woul have reduced the minimum useful life to 4 years.
In Augulst 1978, the Htouse passed a )rovision that woub increase
tlie first-v eml diepreciat ion j)ercellt aize to 25 i)erceit, increase the dollar
linnit at ion on eligible p)roi)p)erty to $20,000 ($40,000 for mi(livi ifls filinr
joint returns), but ould allow a((litional first- year (!e)recit t!on only
to taxl)aers wN ith (lel)reciable assets w hose 11l*stetl basis is less than
$1 niillion.

Selected Bibliography
UT.S. ('ongre.s;. Ittoue. Smll Ta. ; 7 Tx IAcro .t ,!f 1058,
11. Rep)t. No. 2198, Julv 6, 195S.
U.S. (oiiress. Senate. Small ih.,;,. 7s Tax 'rlm, Joint hearings
before tle Select Coiiiittee on Siall Business and the subcommitteee
o)n Financiail Markt- of the ('omittee on Fiance, 94th C(. ong., 1st
1es. 975.
U.S. (C'ongres- Senate. Select ('oluluittee on Small Business.
Small Bu.o.iu*, 1" .r T \'Ji/s, Iearini-+, 94ti Cong., l ,t e February

ON BUILDINGS (Other Than Rental Housing) IN

Estimated Revenue Loss
[In millions of dollars]

Depreciation on Deprecial ion on
rental housing other buildings
Indi- Cor- Indi- Cor-
Fi-cal year vid- pora- Total rid- pora- Total
uals tions uals tion'

1980 ------ 290 70 360 105 115 220
1979 ------ 290 70 360 115 130 245
1978 _____ 300 70 370 125 140 265

Section 167(b) antd (j).
Taxpayers are allowed to recover the cost of their durable income
producing assets that wear out or become obsolete by deducting from
gross income an allocable portion of the cost of the assets. Normally
these depreciaticn deductions are spread over the useful life of the
asset, and the total amount equals the asset's cost less salvage value.
Taxpayers are generally offered the choice of using the straight-line
method (in which an equal amount of depreciation is deducted each
year of the asset's life) or accelerated methods of depreciation (in
which greater amounts are deducted in the early years). A taxpayer
can switch from the declining balance or the sum of the years-digits
methods of accelerated depreciation to straight-line depreciation when
it becomes advantageous to do so as the asset grows older.
The use of accelerated depreciation on structures is limited as
(1) New construction may be depreciated under any method
allowed by the Internal Revenue Code.
(2) Used buildings having at least a 20-year life when acquired
may be depreciated inder the declining balance method using a
rate not In excess of 125 percent of the straight-line rate.

(1) New construction may be depreciated by any accelerated
method which does not yield depreciation greater than the
declining balance method using a rate not exceeding 150 percent of
the straight-line rate.
(2) Used buildings may be depreciated on the straight-line
method or any other reasonable method that is neither a declining
balance or sum of the years digits method.
If a building is sold at a gain, some of the accelerated depreciation
will be recaptured as ordinary income. Without recapture rules, all of
the gain would be taxed as capital gain. However, the recapture
concept is not fully applied to low-income housing.
Assume a used residential structure with a basis of $10,000, an
expected remaining life of 25 years, and no salvage value. If the straight-
line method were used, the deduction would be $400 each year. Under
accelerated depreciation, the first-year depreciation allowance can be
cornputed as follows:

Depreciation allowance 125% X 1/25 X $10,000 $500
In the second year, the depreciation allowance is computed in the
same way except the original basis of $10,000 is now reduced by
the amount previously depreciated. Hence, the new basis equals
$9,500. The second year computation is:

Depreciation allowance-- 125% X 1/25 X $9,500 $475

Thus, in each succeeding year, there is a decrease in the amount of
depreciation claimed for tax purposes, and therefore an increase in
tax liability compared to what it would be otherwise.

Because accelerated depreciation allows for larger deductions in
the early years of the asset's life and smaller depreciation deductions
in the later years, accelerated depreciation results in a deferral of
tax liability. It is a tax expenditure to the extent it is faster than
economic (i.e. actual) depreciation. It is widely believed to be con-
sistent with actual experience to allow accelerated depreciation for
some machinery and equipment which, in many cases, decline in value
more rapidly in their early years than later years. However, similar
treatment for buildings is generally believed inconsistent with their
rates of eonomic decline in value which are generally much slower
than those of machinery and equipment.
The direct benefits of accelerated depreciation for structures
accrue to owners of business buildings and rental housing. The benefit
is estimated as the tax saving resulting from the depreciation deduc-
tions in excess of straight-line depreciation. About 81 percent of the

tax saving from rental housing and 47 percent of the tax saving from
nonresidential buildings are estimated to accrue to individual owners
in FY 1978. The remaining portion of each class of benefit goes to
corporate owners.
Efforts to repeal accelerated depreciation for real estate have been
opposed on the ground that without this treatment, real estate invest-
ments would be so unattractive relative to other forms of investment
that drastic cutbacks in building would result. On the other hand,
it is argued that the tax benefits increase the production of new building
only to the extent that demand for new buildings responds to small
price changes, and that this response is relatively small. The impact of
accelerated depreciation on rental housing is generally estimated to be
greater than for nonresidential buildings since the demand for housing
is more price elastic.
Estimated Distributions of Individual Income Tax Expenditures
by Expanded Gross Income Class 1
Prccntaoc distributions
Expanded gross income class (thousands of dollars) : Iltal housinig building,
0 to 10--- 2.2 2.1
10 to 20__ 3.4 3. G
20 to 30 37. 6
30 to 50-_ 15.(0 15.0
50 and over 75. 6 75. 7
tThe distributions refer to the individual tax expenditure- oniv. The corporate tax expenditures
resulting from these tax provisions are not reflected in these distribution tables.
Prior to 1954, depreciation policy had developed through adlninis-
trative practices and rulings. The straight-line method was favored
by IRS and generally used. A ruling issued in 1946 authorized the use
of the 150 percent declining balance method. Authorization for it and
other accelerated depreciation methods first al)pearedl in legislation in
1954 when the double declining balance and other methods were
enacted. The discussionn at that time focused primiarily on whether
the value of machinery and equipment declined faster in their earlier
years. However, when the accelerated methods were adopted, real
property was included as well, even though it (lid not decline more
rapidly in value in its first years.
By the 1960's, most commentators agreed that accelerated deprecia-
tion resulted in excessive allowances for buihling.,. In 1964, a provision
was enacted which "recaptured" accelerated (le)reciation as ordinary
income in varying amounts when a building was sold, depending on the
length of time the property was held. However, recapture was not
required for straight-line depreciation upon the transfer of real estate.
In 1969, the "recapture" provision was strengthened, more in the case
of commercial real estate which became subject to full recapture, but
also to some degree in the case of rental housing. The Tax Reform Act
of 1976 provided for complete recapture of subsequent accelerate(
depreciation for all residential real estate except low-income housing
which continues to receive more liberal treatment.


Selected Bibliography
Surrey, Stanley S. I'athways to Tax Reform, Chapter VII-Three
Special Tax Expenditure Items: Support to State and Local Govern-
ients, to Philanthropy, an to Housing, Harvard University Press,
Cambridge, Mass., 1978.
Taubman, Paul, an( Robert Rasche. "Subsidies, Tax Law, and Real
Estate Investment," in U.S. Congress, Joint Economic Committee,
The Economics of FeIderal Subsidy Programs, Part 3-Tax Subsidies,
July 15, 1972, pl. :348-69.
U.S. Congress. Congressional Budget Office. Real Estate Tax Shelter
Subsi(dies and Direct Suibsidy Alternatives, May, 1977.
U.S. Congress. House. Committee on Ways and Means. General Tax
Reform, Panel Discussions, Part 4-Tax Treatment of Real Estate,
93(1 Cong., 1st sess., Feb. 8, 1973, pp. 507-611.
Tax Reform, Hearings, Part 2, Panel Nos. 1 and 2,
"Tax Shelters and Minimum Tax," July 16, 1975, pp. 1403-1607.


Estimated Revenue Loss
[In millions of dollars]
Fiscal year Individuals Corporations Total
1980_..... 165 3, 120 3, 285
1979______ 135 2, 640 2, 775
1978______ 115 2,245 2,360

Section 167(m); Regulation 1.167(a)-11; Rev. Proc. 72-10.

The Internal Revenue Service has established useful lives for classes
of depreciable assets. The asset depreciation range (ADR) system
permits taxpayers to choose any useful life within a range of 20 percent
more or less than the class life otherwise established by the IRS for a
particular asset. It ADR is chosen, the taxpayer is not required to
justify retirement and rel)lacement policies, nor to show that the useful
lives selected for the assets are consistent with their actual useful lives.

Assume that a taxpayer has a $1,500 asset for which the class life
established by the Internal Revenue Service is 10 years. Using (ouble
declining balance depreciation without ADR, the deduction in the
first year would be 200 percentX.10X$1,500= $200. After deduction
of this depreciation charge, the adjusted basis of the asset is $1,200
($1,500-$300). In the second year, the deduction would be 200 per-
cent X. 10 X $1,200 = $240.
Undei the asset depreciation range, a useful life of between 8 and 12
years may be selected. If the taxpayer chooses 8 years, the first-year
deduction would be 200 percent, XV8 X$1,500=$:75. In the second
year, the deduction wOUl be 200 percent X1sX$1,125= $281.25.
Therefore, the use of ADR would result in additional deductions of $75
the first year ($375-$300) and $41.25 the second year ($281.25-
The ADR system, as accelerated depreciation (see Appendix A)
reduces taxes early in the life of depreciable assets and thus increases
cash flow (luring that time. The subsidy value of ADR is the tax saving
from the allowance of a tax depreciation life shorter than the guideline
life of the asset. Capital intensive businesses such as manufacturing
firms and utilities necessarily can benefit most from ADR.

Securities an(l Exchange Commission data indicate significant use
of ADR by railroads, utilities, airline coml)anies, and truck and
equil)lent companies. Treasury Department data indicate that the
use of ADR is more probable the larger the size of a corporation. In
1974, 64 percent of all (leI)reciable corporate assets were held by cor-
)orations that electe(l ADR. Nearly 92 )ercent of corporate tax-
I)ayers with (lel)recialble assets of $1 billion or more elected ADR, and
a little more than half of corporations with dej)reciable assets of $100
million or more elected ADR. In contrast, only 0.36 percent of corpo-
rate taxj)ayers with $500,000 or less in del)reciable assets elected ADR.

Estimated Distribution of Individual Income Tax Expenditure
by Expanded Gross Income Class'
Expanded gross inc, )ne cliss (thousands of dollars): distribution
0 to 10 -_- 3.0
10to20-- 9.0
20 to 30 8.0
30 to 50__ 20.0
50 ard owvr ----- 60. 0
Tihe distribtion reers to lie individual tax expenditure only. The corporate tax expenditure resulting
rti un these tax provisiwis is not reflected in this distribution table.

The ADR system was enacted in 1971 )rinci)ally to stimulate in-
vestment and econoliic growth by deferring taxes through the ac-
celeration of del)reciation deductions. In addition, it was asserte(l the
system woil(l simplify the administration of the existing depreciation
Selected Bibliography
Braiinon, G,arzil I. "The Effects of Tax Incentives for Business
hivestiiinVt: A S',iyev of the Economic Evideece," in U.S. Congress,
Joint Economic Committee, The EcotIoimics of Fcderal Subsidy Pro-
(Jr/ins, Part : -ax Silbsidies, July 15, 1972, pp. 245-68.
Levine, Ilowarl J. "An Analysis of the Plannin Ot)portunities
Existing Unler the Current ADR System," The Jowrval of Taxation,
March 1978, p)). 1:80-:84.
U.S. Con tiss. Ilotise. Committee on Ways atid'\ eans. General Tax
It',form, Panel Di,;cussions, Part :8)-Tax Treatment of (at)ital Re-
covry, ('on., 1st sess., Feb. 7, 1978, l)p. 845-504.
U.S. Library of (on-ress. (ongressional Research Service. "An
Analysis o nix Provisions Affectin Business hivestment: Delwecia-
lion an(l the Investrment Tax Credit," by Jane Gravelle, Multilith
74-151E, Auu. 14, 1975.

CAPITAL GAINS (Other Than Farming, Timber,
Iron Ore, and Coal)

Estimated Revenue Loss
[in millions of dollars]
Fiscal year Individuals Corporations Total
1980 ------ 8, 585 635 9,220
1979 - 7, 990 575 8, 565
1978 ____ 7, 430 540 7, 970

Sections 1201-1254.
Gains on the sale of capital assets held for more than I year
are subject to preferentially lower tax rates (see Appendix B). Ak,;o,
gain on the sale of property used in a trade or business is treated as
long-term capital gain if all gains for the year on such property exceed
all losses for the year on such property. Qualifying property used in a
trade or business generally is de)reciable p)rop)erty or real estate that
is held more than 1 year, but not inventory.
For individual taxpayers, only one-half of long-term capital gains
is included in income; or alternatively, on the first $50,000 of capital
gain, the taxpayer may elect to pay a tax of 25 percent.
For corporate taxpayers, long-term capital gains generally require
a dual tax computation. They are first included in income, and a tax
on the total income, including the capital gain, is computed using the
regular rates. In the "alternative" computation, a tax on all income
other than long-term capital gain is computed at regular rates. The
long-term capital gain is taxed at a 30-percent rate, and the two result-
mg taxes are added together to yield the "alternative" tax. The lower
of the tax computed the regular way or the "alternative" tax is the
tax liability. Thus, a corporation must include the full amount of net
long-term capital gains in taxable income, but may apply the special
30-percent alternative capital gain tax rate on the gain.
Gain on most depreciable tangible personal property used in a
trade or business will be treated as ordinary income to the extent it
arises from depreciation that has been allowed after 1961, i.e., the
depreciation is "recaptured" ; but only some depreciation on real estate
is "recaptured."
The untaxed portion of capital gains is the principal tax expendi-
ture subject to the minimum tax for tax preferences. This additional
tax may offset a portion of the benefits of capital gains taxation for
individuals and corporations with substantial annual capital gains.

To illustrate the calculation of capital gains taxation for corpora-
tions, assume a corporation has, for the taxable year 1978, taxable
income of $250,000, which includes net long-term capital gains of
Tax (omputed in Regular Manner:
Taxable income ....- $250, 000
(20 percent X $25,000) --- 5, 000
(22 percent X$25,000) --- 5,500
(48 percent X $200,000) ----- 96, 000
T otal -- ------------------ -- -------- ----- -------- 106, 500
Alternative Tax:
Partial tax on $190,000 ($250,000-$60,000):
(20 percent X $25,000)- 5, 000
(22 percent X $25,000) --- 5, 500
(48 percent X $140,000) --_-- 67 200
30 percent of $60,000 18, 000
Alternative tax -- -- -- 95, 700
The alternative tax is $10,800 less than the regular tax, and in this
example, the tax expenditure is the tax savings attributable to the
alternative tax computation.
For individuals, the deduction from gross income of half of capital
gains results in tax rates half the normal rates. The alternative (25
l)ercent) tax benefits only those individuals whose marginal tax rate
is above 50 l)ercent. The tax treatment of capital gains increases the
aIfter-tax earnings on assets, and thereby may encourage individuals
to invest in assets which may appreciate in value. Furthermore, the
tax preference may reduce the inhibiting effects of taxation on the
sale of assets.
The benefits of this provision are concentrated among high income
individuals, with approximately two-thirds of the benefit received by
those with expanded gross incomes of $50,000 or more. The tax saving
l)per dollar of cal)ital gain increases with the tax bracket of the tax-
Corporations with taxable income over the surtax exemption that
realize income from the sale of long-term capital assets are the direct
corl)orate beneficiaries of the general capital gains rules.
According to 1975 tax return data, capital grains taxed at alternative
rates averaged 5 percent of taxable income for all corporations. Aside
from farming and timber, iron ore, and coal to which special capital
gains rules apply, industries which had a high ratio of capital gains to
ordinary income were general building contractors, real estate com-
panies, hotels, and investment companies.
In cases in which the inilinimm tax a)p)lies to offset some of the
benefitss of, capital gains taxation, it generally will increase the maxi-
mum rate on cal)ital gains by slightly less than 5 percentage points for
in lividtials and by slightly more than 1 percent for corporations.

Estimated Distribution of Individual Income Tax Expenditure by
Expanded Gross Income Class'
Expanded gross income class (thousands of dollars): distribution
0 to 10 ------------------------------------------------------1.7
10 to 20 -----------------------------------------------------6. 9
20 to 30 -----------------------------------------------------8. 1
30 to 50 ----------------------------------------------------15. 6
50 and over -------------------------------------------------67. 7
1 The distribution refers to the individual tax expenditure only. The corporate tax expenditure resulting
ron these tax provisions is not reflected in this distribution table.
Although the original 1913 income tax law taxed capital gains at
ordinary rates, the 1921 law provided for an alternative flat rate tax
for individuals of 12.5 percent. This treatment, was to minimize the
influence of the high progressive rates on market transactions. The
Committee Report noted that these gains are earned over a )eriod of
years, but are nevertheless taxed as a lum) sul. Over the years many
revisions in this treatment have been made, including the temporary
adoption of a sliding scale treatment (where lower rates applied the
longer the asset was held). The current basic approach for taxing
capital gains of individuals was adopted as part of the Revenue Act of
1942. The alternative maximum 25 percent rate was limited to $50,000
of gains annually by the Tax Reform Act of 1969. Both the minimum
tax on preference income and the maximum tax offset, which raise the
capital gains rate for a limited number of taxpayers with capital gains,
were first enacted in 1969 and then strengthened in 1976.
Prior to 1942, corporate capital gains were taxed in the same manner
as ordinary corporate income. The 1942 Act also introduced the
alternative tax for corporations at a 25-percent rate, the alternative
tax rate then in effect for individuals. This tax relief was premised
on the belief that many wartime sales were involuntary conversions
which could not be replaced during wartime, and that resulting gains
should not be taxed at the greatly escalated wartime rates. The Tax
Reform Act of 1969 increased the alternative rate to 30 percent.
This increase was based on several considerations, including the
adoption of the limitation of the alternative capital gains tax for in-
dividuals to the first $50,000 of capital gains, and the absence of a
major "bunching" )roblem (i.e., income earned over several years is
recognized in a single year) which occurs more commonly in the
individual tax because of graduated rates.
Further Comment
Many reasons have been advanced for preferential treatment of
capital gains income of individuals, with the major ones being: (1)
capital gains are accrued over a long period of time, and should not be
subject to tax under progressive rates as a lump sum; (2) capital gains
reflect inflation to a substantial extent and are thus not real income;
and (3) because an asset owner has discretion as to when to realize
gains, the application of ordinary tax would act as a barrier to transac-
tions in the capital market and lead to "lock-in" effects (asset, owners
refrain from selling because of the tax), with attendant distorting
effects on savings, investment, and economic efficiency.

On the other han(1, the following arguments have been ad vance(l
a-ainst the preferential treatment of capital gains: (1) even if capital
gains were taxed as ordinary income, the advantage remains of the
(leferra l of tax on nnrealizeNl gains; (2) inflation affects returns on
assets i i general, not. jIst capital gains transactions; (3) the "lock-in"
problemm might be resolve(l in other ways, such as taxing gains trans-
ferre I at leath (11s removing the Op)!ortunity to avoi(l capital
gains taxes entirely ) ; am l (4) the "bunching" problemm can be met by a
sp)e ial averaging provision.
The effect of the difference in tax rates on ordinary income versus
ca pital gains is different for corporations and idi vi( l ls for a number
of reasons. More of the capital gain for corporations results from sales
in the normal course of bus-iness. Further, the ability to exempt gains
froim tax by leath transfers is not, available for corlporations. Finally,
there is less of a "lunching' problem for corporations since the
corporate rate is generally not a gra(luated rate.
In August 1978, the House voted to eliminate capital gains as an
item o1 tax l)reference subject to the minimum tax. The House also
aoree(il to repeal the 25 percent alternative tax on the first $50,000 of
a noncorporate taxpayer's net long-term capital gain. In addition, the
Iiouse agreed to exclu(le from tax the l)ortion of capital gains that
reflects the effects of inflation on the value of common stock, real
l)ro)perty, anl tangible personal property.
Selected Bibliography
Bailey, Martin J. "Capital Gains and Income Taxation," in Arnoll
(. Ilarberger ami Martin J. Bailey, es., The a.raton of Income
]Kin ('apital, The Brookings Institution, Washington, D.C., pp.
David, Martin. Alterniative Approaches to Capital Gains Taxation,
The Brookings Institution, Washington, D.C., 1968.
David, Martin, and Roger Miller. "The Lifetime Distribution of
Realized Capital Gains," in U.S. Congress, Joint Economic Com-
mittee, The Econwnics of Federal Siibsidy Progratis, Part 3-Tax
Subsidies, July 15, 1972, pp. 269-85.
Seltzer, Lawrence H. The Natbre an(l Tax Treatnaut of ('apital
G'ains and Losses, National Bureau of Economic Research, Newv York,
Smith, Dan Throop. "Tax Treatment of Capital Gains," in U.S.
Congress, House, Committee on Ways and Means, Tax Revision
C'onpendiitm, Committee Print, 1959, pp. 1233-41.
U.S. Congress. House. Committee on Ways and Means. General
Tax Reforn, Panel Discussions, Part 2-Capital Gains and Losses,
Feb. 6, 1973, pp. 245-841.
Wetzler, James W. "Capital Gains and Losses," in Joseph A.
Pechinan, ed., Compreheinsive Income Taxation, The Brookings Institu-
tion, Washington, D.C., 1977, pp. 115-62.


Estimated Revenue Loss
[In millions of dollars]
Fiscal year Individuals Corporations Total

1980 ------ 1,030 1,030
1979 ...... 980 980
1978 ------ 935 935

Section 1034.
Gain from selling a residence is not taxed if the taxi),ver purchasess
another residence with a cost at least equal to the sale price of the old
residence within 18 months before or after the sale of the o11 residence.
This treatment also applies if the seller constructs a new hiome of equal
or greater value, if construction begins within 18 month- of the sale,
and if the taxpayer occul)ies the new residence within 2 years of the
If the new residence costs less than the sale price of the ol, the
ditference in )rice is subject to tax.
The tax basis of the new residence is reduced by the amount of the
tlntaxed gain on the sale of the ol residence. Therefore, the gain on
the sale of the first home will be recognized, if at all, at the tline of the
sale of the second home. However, the tax may again be deferred on
the gain from the sale of both holes if another home is l)urchased by
a taxpayer meeting the requirements of section 1084. The interaction
of section 1034 and section 121 which benefits those over 65 (see p. 163)
will result in ultimate exeml)tion from tax of t)art or all of the l)re-
viously unrecognized gain if the taxpayer sells his second or subsequent
home with a carryover basis after he is 65.

As with any tax deferral, the taxl)aver receives the equivalent of an
interest-free loan. This )rovision benefits primarily middle and upper
income taxpayers. Ninety-six percent of the benefit accrues to those
in the $10,000$50,000 exl)anded gross income (lass. This subsidy
facilitates the ownership of increasingly expensive homes, of which
much of the increase in value in many cases is attributable to inflation.

Estimated Distribution of Individual Income Tax Expenditure by
Expanded Gross Income Class
Lxpand(d gross inIeorl(o (las-s (thousal(s of dollars) : distribution
0 to l10 ..10 ----- -- -- -- -- -- --.--- -. 4. 0
1 0 to 2 0 - - - - - - - - - - - - - - - - - - - - - - - - --- 4 2 8
20 to 30_ -- 33. 7
30 to 50 _----- 14. 6
50 and over -- -- 4. 8

Tile l)rovision was a(lopte(1 in 1951 to relieve financial hardship
when a personal residence is sold, particularly when the sale is neces-
sitate(d by such circumstances as an increase in family size or chang-e
in the place of employment. The Finance Committee Report noted
that sales in these circumstances are particularly numerous in periods
of rapid change such as mobilization or reconversion (presumably
referring to wartime conditions).

Further Comment
Many have questioned the taxation of any gain from the sale of a
personal residence, particularly since the tax law does not allow the
deduction of l)ersonal capital losses, an([ because the )urchase of a per-
sonal residence is less of a profit motivate(l investment than many
other types of investment. On the other hand, tax deferral of gain
from home sales does favor investment in homes as compared to
other types of investment and, along with other features of the tax
law, contributes to the generally favorable tax treatment afforded
Selected Bibliography
U.S. Congress. House. Committee on Ways and Means. General Tax
Reform, Panel Discussions, Part 2-Capital Gains an(l Losses, 93(l
Cong., 1st sess., Feb. 6, 1973 (note, particularly statement of Kenneth
B. Sanden, 1). 254).


Estimated Revenue Loss
[In millions of dollars]
Fiscal year Individuals Corporations Total
1980------ -9,910 9,910
1979------ -8,975 8,975
1978------ -8, 120 8, 120

Sections 1001, 1002, 1014, 1015, 1023, 1040, 1221, and 1222.

A capital gains tax generally is imposed on the increased value of a
capital asset when the asset is sold or exchanged. However, this tax is
not imposed on the appreciation in value when ownership of the
property is transferred as a result of the death of the owner or as a
gift during the lifetime of the owner. Only in certain circumstances
when the property subsequently is sold by the heir or donee is the
appreciation taxedi that occurred when the asset was owned by the
transferor. The heir and donee are thereby able to defer or avoid
entirely the payment of income taxes on this appreciation.
All previously untaxed appreciation of capital assets will be taxed
as a capital gain subject to adjustments when a donee sells property
received as a gift from a living donor. However, only appreciation
which occurred after December 31, 1976, will be taxed as a capital
gain subject to adjustments when an asset is sold by an heir who
received the property as the result of death. The gain in the former
case may be reduced for State and Federal gift taxes, while the gain
in the later case may be reduced for State and Federal death taxes.
Gain on the first $60,000 in value of property is exempt under the
death transfer rules. In addition, the executor of the estate may elect
to exempt from income taxation up to $10,000 of appreciation in the
value of household and personal effects.
Assets transferred at death or by inter vivos gift are subject to the
Federal estate and gift taxes, respectively, based upon their value at
the time of transfer.
The exclusion of capital gains at death is most advantageous to
individuals who need not dispose of their assets to achieve financial
liquidity. Generally speaking, these tend to be wealthier individuals.

The deferral of tax on the appreciation involved comlbined with the
exemption for the appreciation before death is a significant benefit
for these investors and their heirs.
Failure to tax capital gains at death encourages "lock in" of assets,
which in turn means less turnover of funds available for investment.
In deciding whether to change hi- portfolio, an investor takes into
account the higher pre-tax rate of return ie might obtain from the
new investment, the capital gains tax he might have to pay if he changes
his )ortfolio, and the capital gains tax his heirs might have to pay in
the future if lie decides not to change his portfolio. Often an investor
in this position decides that, since the capital gains tax his heirs
might incur is so distant and pos,ilbly avoidable, he should transfer
his portfolio unchanged to the next generation. The lack of a tax on
capital gains transferred at death or by gift provides a further
incentive to this ol)tion. ro the extent this option is takenl, taxpayers
are said to be "locked in" to investments.

Estimated Distribution of Individual Income Tax Expenditure by
Expanded Gross Income Class
Pe ra taqe
Expanded gross income class (thousands of dollars): distribution
( to 10 --- 1.8
10 to 20 .. .- 6. 8
20 to 30 --- 8. 1
30 to 50 -- 15. 6)
50 and over ....- 67.7

The rationale for this treatment is not indicated in the legislative
history of aii of the several interrelated applicable provisions. How-
ever', one current justification given for the treatment is that death and
winter c iv~'o,,gifts ae considered as inal)lrol)riate events to result in the
reco-niti1on of income.
The exclusion of appreciation occurring prior to December 31, 1976,
on assets transferred by death is to ease the transition from "step up"
basis to "carryover" basis, which was included as part of the Tax
Reform Act of 1976. Prior to this Act, all capital gains accruing during
the il'etiime of a decedent escaped income taxation entirely in the case
of assets transferred by leath. The basis of the property was "stepped
ill)" or steepedd (lown" in the hands of the heir to its fair market
value at the (lecelent's death. The Tax Reform Act of 1976 required
that, in general, the basis of inherited property be the same in the
han(ls of the (ecedent, i.e., that the basis be "carried over" from
decedent to heir.
Further Comment
Taxation of capital gains at death would cause liquidity problems
for some taxpayers, such as owners of small farms an(I businesses.
Therefore, most )roposals for taxing, capital gains at death would
combine substantial averaging d)rovlslOns, leferredI tax liaymnent
schedules, anti a substantial deduct ible floor ill determining the amount
of gain to be taxed.