Tax avoidance by savings and loan associ

Journal of Monetary Economics 1 (1975) 41-63. ONorth-Holland

Publishing Company

Edward J. KANE and John J. VALENTINI
The Ohio State University, Columbus, Ohio 43210, U.S.A.

1. Intmduction
Although recent events have made tax avoidance a household word, economists have only begun to wrestle with the microeconomics of paying income
taxes. It is not enough to suppose that the taxpayer minimizes, subject to
restraints imposed by the tax laws, the implicit and explicit tax liability associated
with the income he earns.’ Important tradeoffs exist between tax payments,
leisure, and after-tax income, and between these variables and penalties for
violating the tax law. Also, the taxpayer’s knowledge of the tax laws is inevitably
incomplete.
Each year, the tax law changes, either because of new legislation or because
of adjustments scheduled to occur gradually under existing law. Often these
changes are designed to accomplish specific social purposes. Almost as often,
the intended effects of such tax incentives are overwhelmed or frustrated by
tax avoidance.
Using regression methods and cross-section survey data collected in November 1972 from approximately 3400 insured S&Ls, this paper focuses on the

effects of the Tax Reform Act of 1969 on the savings-and-loan (S&L) industry.
We investigate how statutory changes in operative tax-payment restraints have
impinged on S&Ls’ tax-payment habits and portfolio decisions.
Our findings have important implications for the feasibility of the
Commission package of financial reforms. This package seeks to increase
*The authors are, respectively,
rett D. Reese Professor of Banking and Monetary EconoVice President, McKay-Shields Economics. They v’ijh to
mics, The Ohio State University,
thank the Federal Home Loan Bank Board for sponsoring this study and to acknowledge
helpful comments from Scott Beighley and SheI man Shapiro.
l Judge Lear ued Hand once ruled, ‘Any one .may so arrange his affairs that his taxes shall be
as low as possible; he is not bound to choose that pattern which will best pay the Treasury;
increase one’s taxes.’ The U.S. Supreme Court reaffirmed
there is not even a patriotic duty
this more prosaically in 1934, ho1 g that ‘the legal right of a taxpayer to decrease the amount
of what otherwise would be his taxes, or altogether to avoid them, cannot be doubted.’

42

E.J. zyxwvutsrqponmlkjihgfedcbaZYXWVUTSRQPONMLKJIHGFEDCBA

Kane and J.J. ValenthIi, Tax avoidance by S&L associations

competition among depository institutions by relaxing restrictions on the
types of securities they can hold and on the interest rates they can pay for
deposit funds. To reduce opposition to this plan, these reforms have been
packaged with proposals meant to protect mortgage markets, to establish tax
equality among depository institutions, and to enable mutuals to convert to
stock charters. Our research indicates that the 1969 Tax Reform Act has
contributed already to several of these goals. First, the act relaxed restrictions
on the proportion of S&L assets invested in residential mortgages, leading
these institutions to hold a more diversified portfolio. Second, the act succeeded
in increasing S&Ls’ effective federal tax rates. However, our research suggests
that facilitating conversions of mutual institutions to stock corporations would
push these tax rates lower again. We find that stock S&Ls - acd especially
holding-company affiliates -pay lower effective tax rates than mutuals. To
establish lasting tax equality among depository institutions, legislators would
have to anticipate the revenue effects of subsequent charter conversions.
2. Description of S&L tax-avoidanceopportunitiesandexperience
For S&Ls, tax avoidance has consisted tra.ditionally of transfes to bad-debt
reserves held against so-called ‘qualifying loans’ secured by real estate.2 To

qualify for favorable tax treatment of its reserve transfers, an association must
pass several IRS-impssed balance-sheet tests. An S&L that passes these tests
has its choice of three methods for calculating the maximum allowable increment
to its qualifying reserves:
(1) the experience method;
(2) the percentage-of-qualifying-loans method;
(3) the percentage-of-taxable-income method.
The first two methods limit an institution’s total reserve at yearend to a specifi:
percentage of its holdings of quaiifying loans. In the first method, the applicable
percentage is calculated as the ratio of two six-year moving-average figures:
the association’s losses (net of recoveries) on qualifying loans and the amount
of such loans outstanding. The second method parallels the non-experience
option available to commercial banks. It sets maximum qualifying reserves at
a predetermined ratio of qualifying loans, 3*0 percent in 1969 and 14 percent
from 1970 through 1975. Under both methods, an institution can make taxdeductible transfers to its bad-debt reserves only if, after deducting current
losses, its reserves fall below the relevant ceilings and only in amounts that
would not drive these reserves through the nearer of the two ceilings.
‘Deductible transfers to ‘non-qualifying loans’ not secured by real estate are relatively
unimportant, born because such assets hate represented a small fraction of total S&L assets
and because such transfers must be based on the six-year moving-average of losses actually

experienced on these loans.

E.J. Kane and J.J. Valentini, Tax avoidance by S&L associations

43

Three-quarters of survey respondents used the third method, supporting the
common presumption that (since it does not constrain accumulated reserves) it
typically generates larger deductions than the other methods. It allows new
transfers up to a maximum percentage of a specifically defined taxable-income
base. The allowable percentage, d, varies inversely with the institution’s ratio
of ‘qualifying assets’ to total assets. Qualifying assets consist of qualifying
loans, cash, government securities, passbook loans, and a few other miscellaneous
assets. The maximum percentage, dmax,is available to any S&L that has invested
82 percent or more of its funds in qualifying assets. Allowable maximum
percentages were 60 percent in 1969, 57 percent in 1970, and 54 percent in 1971.
Under current tax law, this maximum is scheduled to level off at 40 percent in
1979. For each 1 percent that qualifying assets fall below 82 percent, the allowable percentage is reduced by 0.75 percent.
Our survey indicates that S&Ls are rapidly reducing their relative holdings
of real-estate loans, an event with obvious consequences for morv.gage rates. in

1969, all but 14.3 percent of respondent S&Ls would have been entitled to
deduct the maximum percentage on the basis of qualifying loans alone. This
figure rose to 22.5 percent in 1970 and to 29.9 percent in 1971. Even associations
using the percentage-of-taxable-income
method for calculating allowable
reserve transfers have participated in this trend, in some cases at the cost of
transferring less than the maximal percentage of income to the bad-debtreserve shelter. This development suggests that the reduced benefits of bad-debt
transfers under the 1969 Tax Reform Act have led S&Ls to 1101~1
fewer mortgages
and to seek out non-traditional avenues of tax avoidance. In section 3 of this
paper, we investigate some of the avenues used. zyxwvutsrqponmlkjihgfedcbaZYXWVUTSRQPONM
Statutory rates wrsus effccti~~erates

-,

Corporations and mutual savings institutions are subject to a two-tiered
federal tax on net income. All income is subject to a basic ta:Lrate of 22 percent,
while amounts in excess of $25,000 in any year are subject to an additional or
‘surtax’ rate of 26 percent. Also, starting in 1970, these firms became subject
to the 10 percent Minimum Tax on Tax Preference Items.

This minimum tax on tax preference items is a new tax concept introduced
in the Tax Reform Act of 1969. It designates certain categories of income
taxed preferentially under the federal tax code as subject to a second round of
taxation at the flat rate of 10 percent. Among the designated types of preference
income are bad-debt deductions in excess of experience, accelerated depreciation
on real property in excess of straight-line allowances, and the ‘untaxed’ portion
of capital gains. However, generous deductions are allowed against this
preference-income-tax base. The tax is collected only on preference income in
excess of the sum of $30,000 and the taxpayer’s federal income-tax payments
less payments of penalty taxes levied on closely held corporations.

E.J. Kane and J.J. Valentini, Tax avoidance by S&L associations
44 zyxwvutsrqponmlkjihgfedcbaZYXWVUTSRQPONMLKJIHGFEDCBA

For S&Ls meeting all IRS tests, the percentage-of-taxable-income method
imposes maximum marginal rates of effective taxation on net operating income.
These rates are considerably lower shan statutory rates. Ceilings on effective
rates can be calculated roughly as the product of the applicable statutory rate
on each tier of taxable income (0*22 and 0.48) times [1 -d,,, (t)]. As table 1
shows, an S&L making bad-debt transfers equal to 60 percent of taxable income

in 1969 faced effective federal tax rates, before other deductions, of only 8*8
and 19.2 percent. For 1970 and 1971, the table also includes a column specifying
the asymptotic effective rate that would apply to a very large association whose
bad-debt transfers were subject to the 10 percent minimum tax. This calculation
is called ‘asymptotic’ because it ignores the lower first-tier corporate tax rate
and the basic $30,000 exemption from the minimum tax. As an association’s
income becomes very large, the ratio of these fixed items to income would
become negligible. Our calculations reduce the minimum-tax bastt for income
taxes paid on ordinary income, but to the extent that large S&Ls worked their
effective rates below the ceiling rates shown in the table, the applic; ble base for
the minimum tax would rise.
Although some S&Ls show effective federal tax rates on net operr.Gng income
approximating the ceilings shown in table 1, most institutions man; .zed to work
their rates to a lower level. Table 2 (which defines net operating income in a
footnote) indicates that, ignoring payments of minimum tax, average effective
tax rates for S&Ls subject to the corporate surtax ran between 15 and 16 percent.
Associations recording negative taxable incomes are not included in these
calculations.
Table 3 shows that stock S&Ls generally paid lower rates than mutuals,
and that holding-company affiliates frequently paid lower rates than other

types of associations. In each year, the calculations in table 3 ignore S&Ls
that showed a zero or negative value for net operating income. This is a much
smaller subsample than those with zero or negative taxable incomes. 170
associations showed negative taxable incomes in 1969, 187 in 1970, and 123 in
8971. Since mean net operating income at these institutions was sizeable in
each year ($314,000 in 1969, $153,000 in 1970, and $233,000 in 1971), it is
interesting to consider the specific deductions and exemptions by which these
institutions sheltered income from taxation. For these firms, transfers to baddebt reserves accounted for a substantial portion of their deductions only in
1969, while losses carried forward from prior years played a large and increasingly predominant role over the three sample years. Regressions summarized in
the next section indicate that losses carried forward are not important at most
other associations.
ean effective tax rates on net economic income (a U.S. Treasury Department
concept) provided a better measure of relative tax burdens. These rates show a
igher level but much the same qualitative pattern. It is interesting to note
QWmean tax rates vary with asset size. For mutual S

E.J. Kane and J.J. C/alentini,Ta;, avoidance by S&L associations

/
I

I
I

1

I

1

’
.I

e

!
I

I

I

I

I
/
I

I

I
/
,
1

I
I

45

Table 2
Ratio of mean federal income-tax payments and minimum-tax payments to mean net operating income at two classes of S&Ls, 1969 to 1971.
-_____-

--.

-

Minimum-tax
payments only
(in percent)

S&Ls with non-zero taxable incomes less than $25,000
_
Federal income-tax
Minimum-tax
payments other than
payments only
the minimum tax
(in percent)
(in percent)
No.

2.1
2.0

1002
1028
784

S&Ls subject to the corporate surtax

Year

No.

Tax payments other
than the minimum tax
(in percent)

1969

2134
2153
2493

15.0
15.5
16.1

1970
1971

-

-

_ -

--

6.3
6.4
6.0

0.2
0.2
_-

Notes: Net c wrntin_qrincome is taken from yenrend profit and loss statements filed with the FHLBB. It is constructed as the difference
between gross operating income and total opciating expenses (including interest payments of all kinds). Data on tax payments, taxable income,
and other tax variables were collected in our November, 1972 survey. Respondents were instructed to copy these figures from their federal tax
returns.

E.J. Kane and J.J. Vatentini, Tax avoidance by S&L associations

47

involves a gradual rise to a peak rate occurring somewhere in the range of $50
to $200 million in assets. For largei, institutions, the rate drops off mildly. A
parallel study, looking at approximately 850 of the nation’s largest commercial
banks in 1966 and 1967, observed a similar peaking and subsequent decline of
mean effective tax rates. 3 Holding-company S&Ls show peak rates in an
intermediate size range in 1969 and 1971, while stocks show this pattern only
in 1971. In the other three cases, effective rates for non-mutual S&Ls rose
irregularly with asset size. However, only three non-mutual S&Ls in our
sample had over $500 million in assets. These small sample sizes reduce the
reliability of inferences about the pattern of mean rates for stock and holdingcompany S&Ls.
Table 3
Mean effective federal tax rates by type of charter, 1969 to 1971.
_. --_--

__ _~_

- --

Ratio of federal tax
payments to net
operating income
1969
1970
1971

Ratio of federal tax
payments to net
economic income
1970 zyxwvutsrqponmlkjihgfedcb
1969
1971

14.1
11.0
12.0

18.1
13.9
13.1

~___

Mutuals
Stocks
Holding-company affiliates

16.9
16.6
17.3

17.9
15.7
14.3

20.8
20.0
21.1

21.4
19.6
18.9

-.--

Note: Net economic income is defined as the sum of taxable income reported to the Internal
Revenue Service and the following three items: (1) tax-exempt interest received ;
(2) bad-debt deductions in excess of recorded losses; and (3) loss carryovers used in
the current year. This variable is intended to provide a better measure of taxable
capacity. It was developed by the U.S. Treasury Department in: Tax reform studies
and proposals, Joint publication of the Committee on Ways and Means of the U.S.
Senate (U.S. Government Printing Office, Washington, Feb. 1969); see part 3, p. 460.

What is most important is the tendency for mean effective tax rates for stock
S&Ls to lie below those for mutuals of the same size and for the holdingcompany subset of stock associations to show lower rates still. This suggests
that the pattern of ownership affects both opportunities and incentives to
engage in tax-avoidance behavior. We investigate this question in more detail
in section 4.
Table 2’s average effective rates on ordinary income run approximatel).
75 percent of the hypothetical marginal rates presented in the second column
of table 1. This 25 percent ‘discount’ measures the additional tax savings
S&Ls generate through the application of the ::25,000 surtax exemption at
3Edward J. Kane, A cross-section study of tax avoidance by large commercial banks, in:
D.A. Belsley, E.J. Kane, P.A. Samuelson and R.M. Solow, eds., Inflation, trade, and taxes:
Essays in honor of Alice E. Bourneuf (Ohio S ate University Press) forthcoming-

4s

E,J. Kane and J.J. Valentini, Tax avoidance by S&L associations

surtaxed S&Ls and by avoidance activities other than straightforward percentage-of-taxable-income transfers to bad-debt reserves. That the discount is
only 25 percent suggests that, excepting transfers to bad-debt reserves, S&Ls
opportunities for tax avoidance are - especially for mutuals - relatively limited.
Using regression methods, the next section of this paper examines this hypothesis
more closely.
3. Regression models of individualS&Ls’ federal income-tax payments
S&Ls can lower their effective tax rates below the ceiling rates shown in
table 1 in four broad ways:
(1) by using the experience or percentage-of-qualifying-loans methods in
situations whenever these formulas yield larger deductions;
(2) by sheltering net income via deductions of other untaxed items (such as
state and local tax payments, coupon income from municipal securities,
losses carried forward from prior years, and contributior s to exempt
institutions) from their taxable income base;
(3) by taking advantage of opportunities to defer the due dat; of taxes on
current income to later years (e.g., by delaying the realiza*.ion of capital
gains while taking capital losses in the year that they occur, by writing off
as far as possible capital expenditures as current costs, and by using
possibilities for taking accelerated depreciation) ;
(4) by being aware of applicable tax credits (e.g., on investment in new equipment, on foreign income, and perhaps soon also on mortgage income).
Since the mean effective rates displayed in tables 2 and 3 are calculated
across the universe of S&Ls of all sizes, they cannot be compared directly
with table l’s ceiling rates. The effecteve rates shown in tables 2 and 3 emerge
as a weighted average of the 22 percent basic rate that applies to the first
$25,000 of any firm’s taxable income and the higher marginal rate that applies
to larger amounts. However, we can employ regression techniques to gain
perspective on the effectiveness of S&L tax-avoidance acAvity. We take up this
task in this section, building and estimating a model that explains the federal
income-tax payments made by an individual S&L in any year. Regression
estimates of this mo’del’s parameters provide direct measures of effective
marginal tax rates at various classes of SsCLs and otrer fresh insights into S&L
tax-payment and tax-avoidance behavior.
Family of models estimated

Our overall analytic framework is patterned on Kane’s study of tax avoid,u~ce
by large commercial banks. The underlying regression strategy can be justified
as a naive form of statistical ‘tax accounting’, designed to allocate (as far as

E.J. Kane and J.J. Valentini, Gx avoidance by S&L associations

49

collinearity with income permits a representative S&L'saggregate income-tax
bill across specifically identified statutory categories of tax liability and tax
relief. Formally, we focus on a family of tax-payment models (or tax ‘production
functions’), each member of which treats an S&L’s federal income-tax liability
T as the algebraic sum of a number of components, each of which is treated
specially under the law. These components consist of: (1) tax payments due on
net operating income, YoP, or tax-payment adjustments occasioned by any of
n other statutorily distinct categories of income or specific other categorical
sources of tax liability (viz., the surtax exemption on the first 825,000 of taxable
income, requirements for estimated tax payments, and the minimum tax on
tax-preference items), Yi; and (2) the tax relief provided by each of m specific
opportunities for tax reduction (viz., exclusions and deductions such as coupon
income from tax-exempt securities, losses carried forward from prior years,
state and local tax payments, and charitable contributions), 0ja4
Our general model is:
T = zyxwvutsrqponmlkjihgfedcbaZYXWVUTSRQPONMLKJIHGFEDCBA
a+b,Y,,+
i biYi_ f CjOj+U.
(1)
j=l

j=l

Eq. (1) is interpreted as follows:

(1) u represents the customary random-error term;

(2) b, represents the marginal effective rate of tax on net operating income; zyxwvutsrqponm
(3)

bi and cj represent the marginal effective rates of tax and tax relief associated

with Yi and 0,;
(4) the intercept a captures the average amount of sample institutions’ tax
payments not accounted for by the variables included in the model. As we
expand the categories of taxable income and tax relief, we introduce
corresponding dummy variables that allow a separate tax-schedule intercept
to be estimated for each type of income or class of institution.
The variance of the error term in eq. (1) may be expected to increase with
net operating income, YO,. Heteroskedasticity is customarily encountered in
cross-section regressions that combine data from firms of very different size.
To escape this problem, we estimate the parameters of the model only in a
transformed version, which is derived by dividing every term on both sides of
eq* (1) bY Yap*
T

rP==a

1
b yi-fcj!$..!m+.fw._
1-b,+
(2)
i r,,
F& zyxwvutsrqponmlkjihgfedcbaZYXWVUTSRQPONMLKJIHGFEDCBA
i-_1zyxwvutsrqponmlkjihgfedcbaZYXWVUTSRQPONMLKJIHGFE
j- 1
OP
OP

II 1

4To keep the size of our survey questionnaire within bounds, we collected data only on the
specific categories of rax liability and tax relief that promised to be particularly relevant for
S&Ls. We had planned to take data on depreciation allowances, equipment investment
eligible for the investment tax credit, and charitable contributions from yearend reports filed
with the FHLBB, but (with the exception of the value of contributions in 1971) these data had
ot been preserved by the F

E.s. Kane and J.J. Valentini, Tax avoidance LayS&L associations
50 zyxwvutsrqponmlkjihgfedcbaZYXWVUTSRQPONMLKJIHGFEDCBA

If o2 varies roughly as g2 (Y&) with a2 constant, this procedure would stabilize
the variance of the random error in (2). Using model. (2), the intercept a of
model (1) is found as the regression coefficient of the l/ YO, term, while the
effective tax rate on net operating income emerges as an intercept estimate. zyxwvutsrqponmlkji
We must emphasize that we divide model (1) by YOPfor statistical reasons,
not to focus on relative tax burdens. YOPis not inclusive enough to provide an
adequate measure of taxable capacity. We single out YO,from other sources
of income to recognize that variation in non-operating income is apt to be
dominated by tax considerations. zyxwvutsrqponmlkjihgfedcbaZYXWVUTSRQPONMLKJIHGFEDCBA
Regression strategy

Eqs. (1) and (2) each define a family (or general class) of t: x-accounting
models, the members of which differ: (1) by year, in the specific tax regulations
in effect and in industry awareness of avoidance opportunities available under
the law, and (2) across experiments, in the number and identity of Lhecategories
of tax liability and tax relief explicitly introduced into the analysis. Before we
can apply these models to our data set, we must decide on a strategy for choosing
among alternate Yi and Oj variables that might be included as explanatory
variables. Because most candidate variables are necessarily collinear with Yap,
we can be certain a priori that our data set is flawed by multicollinearity. Well
before we could build a model incorporating full tax-law detail, relations
between the various regressors and YO, would confound the effects of conceptually distinct provisions of the tax law.’
To maintain the interpretability of our coefficient estimates and to ensure
that we recognize distortions in estimates brought on by multicollinearity when
they arise, we adopt the ‘lean’ regression strategy of beginning from a model
incorporating only the most basic structural element of the federal tax code and
introducing, in a succession of regression runs or ‘experiments’, additional tax
distinctions and complications. We introduce these complications more or less
one at a time and in what we judge to be their rough oriler of importance. Our
goal is to incorporate as many relevant variables as we can before multicollinearitv. inevitably prevents us from assessing the relative influence of additional
variables. The degree of expansion that successive regression experiments can
accurately render is limited by the quality of the data set, much as the maximal
size of an acceptable photographic enlargement is limited by the resolution of
the negative being blown up. Although every increment in structural detail
allows us to attribute variation in tax rates to increasingly more-fundamental
causes, even our crudest model cannot be termed ‘wrong’. Adding explanatory
Tollineari t y is serious when the determinant of the X’X matrix formed from the regressors
approaches zero. In some of our structura!ly most-detailed regressions (in which we test for
differences between a number of a, 6, and c coefficients across several classes of S&&s), this
determinant proved less than lo- l 5.

E.J. Kane and J.J. Valentini, Tax avoidance by S&L associations zyxwvutsrqponmlkjihgfedc
51

variables increases our ability to interpret (to ‘resolve’) the results of leaner
runs, but it does not shift the overall focus of the research.
Successive regression experiments incorporate (albeit in a rough way) various
subtleties in the Internal Revenue Code, but focus consistently on the marginal
rates of effective taxation and tax relief applicable to S&Ls whose circumstances
differ in specified ways. Effective marginal tax and benefit rates are measured
by the estimated values of the coefficient, bi and Cj. These coefficient estimates
could be used by legislators to predict the impact of proposed tax reforms
(including the proposed mortgage-income tax credit) on S&Ls’ tax rates and
portfolio decisions. 6 zyxwvutsrqponmlkjihgfedcbaZYXWVUTSRQPONMLKJIHGFEDCBA
First regression experiment: M odelling the tw o- tkrcd tax structure, panel 1 of
table 4

The first panel of table 4 incorporates only one class of taxable income (net
operating income, YOJ and a single tax-law complication (the statutory jump
in marginal rates that occurs after an S&L’s first $25,000 in taxable income).
D,, is a ‘surtax-exemption’ dummy variable that takes on the value of unity for
S&Ls whose taxable income in the sample year does not exceed $25,000. For
the surtax-exempt S&Ls, the estimated marginal rate of effective federal income
tax on YoPemerges as the sum of the intercept b, and the coefficient of D,, 7% in 1969 and 1970 and 8 % in 1971, rates that lie between the ceilings on
effective rates calculated in table 1 and the average rates shown in table 2. The
sum of the coefficients of l/ V,, and D,, (l/ Y,,) provides the estimated intercept
of these S&Ls’ tax schedule, which (in line with the statutory schedule) rounds
to zero in every equation estimated.
For S&Ls whose taxable incomes rise into the surtax range, the estimatecl
linear tax schedule usually has a non-zero intercept: the coefficient of l/ YoP.
Each such institution has made tax payments on its first $25,000 of taxable
income at the first-bracket rate of 22 percent. Therefore, a partial test of whether
additional net sources of tax liability or tax relief belong in the equation is
given by the distance between this coefficient and (0.22) (25) = 5*50. Since our
estimates lie uniformly below 5.50, the evidence suggests that we should seek
to model additional avoidance opportunities.
Finally, t-values are presented for the excluded variable YO, to indicate

The number of valid observations available for use in any particular regression is less than
the 3439 survey responses we received. This drop-off occurs brimnrily because of (double-entry
accounting) validity checks employed to eliminate faulty input data. Some additional observations were dropped to keep negative and zero Yap values out of our regression samples. This
excision helps to reduce the potential bias associated tvith the tax law’s many-one mapping of
zero and negative taxable incomes into zero federal tax payments, by removing cases where tax
completely outside the parameters investigated
avoidance either is
in our study.

Table 4
Cross-section regressions relying on the two tiers of the corporate tax schedule to explain the ratio of federal income=iax payments to net
operating income at approximately 3300 S&Ls.
_-~__I

Year

_-

---

Intercept

D,t

l/K,

Tm,nlYap

R2

Standard error
of estimate
N

-

0.24

0.073

3361

excluded

0.28

0.070

3315

excluded

0.3 1

0.062

3297

0.31

0.069

3315

-

0.069

3315

0.35

0.060

3297

Panel I zyxwvutsrqponmlkjihgfedcbaZYXWVUTSRQPONMLKJIHGFEDCBA
0.15

- 0.08

(24.1)

0.56
(1.6)

- 0.52
(1.5)

(70.4)
0.19
(97.8)

(30.3)
-0.1 I
(37.3)

(1.9)
- 2.80
(10.8)

(2.0)
2.83
(11.0)

0.16
(54.7)
0.15
(62.0)
0.17
(65.0)

- 0.08
(24.0)
- 0.08
(24.2)
--3.09
(27.4)

0.21
(0.7)
8.53
(1.8)
- 1.39
(5.1)

-0.18
(0.6)
- 0.49
(1.7)
1.42
(5.3)

excluded
(-0.5)
- 0.55
-0.10
0.17
1970 zyxwvutsrqponmlkjihgfedcbaZYXWVUTSRQPONMLKJIHGFEDCBA
excluded
0.59
1969

1971

(56.0)

(-0.4)

excluded
(- 1.4)

Panel 2
1970
1970
1971

excluded
(0.3)
excluded
excluded
(- 1.4)

0.71
(10.4)
1.00
C)
1.06
(13.9)

Notes: Figures in parentheses are coefficient t-values. Input data in thousands of dollars. Introducing the Y@r,
term has virtually no effect
on the other coefficients in the model.

E.J. Kane arid J.J. Valentini, Tax avoidance by S&L associations

53

that the effective tax schedule for S&Ls shows a statistically insignificant
tendency toward regressivity. zyxwvutsrqponmlkjihgfedcbaZYXWVUTSRQPONMLKJIHGFEDCBA
Panel 2 of table 4: IIltroducingthe minimum tax on tax- preference items

The second panel of table 4 introduces an additional tax-law complication
operative in 1970 and 1971 only: the amount of tax paid as a minimum tax on
tax-preference items, rmin* By construction, the coefficient of Tmin should be
unity. It is a direct component of federal tax payments. Using this knowledge,
we can interpret significant departures from this value (as occur in 1970) to be
indicative of either collinearity with other explanatory variables or errors of
measurement in the input data. On the hypothesis that errors of measurement
are zero, we re-estimate the 1970 equation under the constramt that the coefficient Of r*lin equals exactly unity. This second 1970 equation should, of
course, be preferred over its predecessor.
Combining the information in both panels of table 4, we can derive an
estimated schedule of effective minimum-tax rates in each year. All we have to
do is to subtract each of the last two equations in the bottom panel from the
corresponding equation in the upper panel. For surtax-exempt S&Ls, the
estimated schedules have a zero rate and a zero intercept. For S&Ls subject
to the corporate surtax, the marginal effective rate is 2 percent in each year and
allowable deductions from the minimum-tax base provide something in excess
of $1000 in average relief from the tax.
Second regression experiment : M odel/ing the influence of IRS surt~eillance on
S&b required zyxwvutsrqponmlkjihgfedcbaZYXWVUTSRQPONMLKJIHGFEDCBA
tofile
zyxwvutsrqponmlkjihgfedcbaZYXWVUTSRQPONMLKJIHGFEDCBA
estimated tax pa)wents

Table 5 introduces a further tax wrinkle - requirements to make estimated
tax payments - into the preferred models of table 4. During the sample years,
S&Ls were required to file estimated tax paymenrs if their total tax bill could
‘reasonably’ be expected to exceed $100,000. These estimated payments were
supposed to equal 100 percent of the estimated final tax liability. We expect
S&Ls required to file estimated tax payment:, to pay higher effective taxes than
other S&Ls on the hypothesis that they should feel themselves more closely
monitored by the IRS and less free to cut rebuttable tax corners as closely as
they might wish.’
IRS enforcement practices suggest that S&Ls incurring federal tax bins of
$100,000 or more in the preceding year would be well-advised to consider themselves in the estimated-payment class. Nine percent of sample S&Es met this
condition in 1970 and 1 I percent in 1971.
‘Tables analyzed in The Wall Street Journal’s ‘Tax Report’ of February 28, 1973 indicate, as
economic theory would suggest, that the IRS audits an increasing proportion of returns in
evotes more manhours to big returns than to small ones.
higher-income classes a

Table 5
Regression estimates of our so-called basic model, incorporating the erTects of IRS surveillance associated with requirements to file estimatedtax payments.
-- ~_-I___

Year
-1969
1970
1971

----

_-____

-- _--

Standard error
Intercept zyxwvutsrqponmlkjihgfedcbaZYXWVUTSRQPONMLKJIHGFEDCBA
Dst
of estimate
N
D cst
Dst W Ep
Des, 1I Yap Tnd Yap
R2
W&3
-0.13
- 0.06
- 0.03
2 ag
- 2.36
83.99
0.33
0.069
3361
(42.8)
(17.3)
(15.3)
(6:;)
(3.7)
(6.6)
0.14
- 0.07
0.02
1.46
- 1.43
9.97 zyxwvutsrqponmlkjihgfedcbaZYXWVUTSRQPONMLKJIHGFEDCBA
1.00
0.@58
3315
(49.6)
(19.3)
(3.7)
(3.1)
(I)
(4.6)
(4.5)
0.16
- 0.08
0.004
- 0.70
0.74
24.03
1.05
0.37
0.060
3297
(57.7)
(24.1)
(14.0)
(0.8)
(2.4)
(2.6)
(6.1)
l

-

Notes: Figures in parentheses are coefficient I-vaks.

Input data in thousands of dollars.

---

E.J. Kane and J.J. Valentini, Tax avoidance by S&L associations

55

In 1970 and 1971, the dummy variable Dest equals unity for institutions
meeting this condition and is zero otherwise. Lacking data on 1968 tax payments,
in 1969 Qst is less satisfactorily proxied by zyxwvutsrqponmlkjihgfedcbaZYXWVUTSRQPONMLKJ
D,,, (1970). (D,,, . l/ YO,)shows a
consistently positive and significant coefficient. This supports both the notion
of a difference in the effective tax schedule facing these S&Ls and the hypothesis
that these S&Ls pay higher taxes. Further support is provided by the positive
coefficients of zyxwvutsrqponmlkjihgfedcbaZYXWVUTSRQPONMLKJIHGFEDCBA
Dest in 1970 (significant) and 1971 (not significant)?
Tltird regression experiment:
opportunities

Introducing rouglr proxies for S&L tax- deferral

To dig into the phenomenon of tax deferral, table 6 estimates a model that
introduces, insofar as our data permit, lag terms in YO,and T into our basic
eq. (1). A tax deferral can be defined as any actual or accounting transaction
undertaken to convert future costs into tax-deductible current expenses (e.g.,
current writeoffs of what are, from the point of view of economic theory,
properly capital expenses) or to postpone the formal realization of taxable
current revenue to a future tax year. Deferral is an avenue of tax avoidance to
the extent that it reduces the present value of the cumulative tax liability incurred
on current economic income, where current economic income is defined as
explicit and implicit net additions to taxpayer wealth.
In the lag model, the slope coefficients, bi and cj, of current variables must
be interpreted anew. In the presence of lag terms, these coefficients represent
effective ‘impact’ or first-round marginal rates of tax and tax relief, respectively.
Since tax disbursements (and some tax savings as well) accrue gradually through
time, these coefficients should lie below both statutory rates and effective
stationary-state rates.’
Ignoring b estimates that round to OGO, 1970 and 1971 stationary-state
marginal rates for S&Ls never exceed the current rates contained in table 5
bq more than one percentage point. Kane’s study of tax avoidance by commer- zyxwvutsrqponmlk

8Only the ncg ative D,,, coescient found in zyxwvutsrqponmlkjihgfedcbaZYXWVUTSRQPONMLKJIHGF
1969 fails to support the hypothesis. However,
the 1969 estimates are biased because Dcs(is calculated contemporaneously with T. If estimatedtax status had no effect at all on tax-payment hablts, the 1969 coefficient of D,,,/ YoPwould
approach 100, with the coefficient of D,,, forced compcnsatingly low enough to give the same
explained average tax rate for these S&Ls as the table 4 model.
“Stationary-state marginal rates of effective taxation can be calculated from any equation t?j
first setting the ratio of ( Y& ,)/ to YoPat unity and T/ YOpequal to the same value in all years.
Next, WCgroup the T/ YOpterms on the left-hand side to derive a ‘net’ coefficknt for that
equation: 0.61 for the preferred 1970 estimate and 0.69 in 1971. We can then convert any
‘impact’ coefficient to its stationary-state value by dividing it by the ‘net’ coefficient of the
equation in which it appears. For example, the marginal stationary-state rate of ordinary
taxation of net operating income for surtax S&Ls is [(0.09-0.002)/0.61] = 0.14 in 1970 and
0.12/0.69 = 0.17 in 1971; for surtax-exempt S&Ls, these rates are reduced by 0.05/0.61 = 0.08
in 1970 and by 0.07/0.69 = 0.10 in 1971; and for estimated-tax payment S&Ls, these rates must
be raised by 0.01/0.61 = 0.02 in 1970 and 0.002/0.69 = 0.003 in 1971.

E.J. Kane and J.J. Vakntini, Tax avoidance by S&L associations

57

cial banks (cited in footnote 3) found stationary-state tax rates considerably in
excess of direct estimates of effective marginal rates. Assuming that both
banks and S&Ls economize tax payments, the difference in estimates indicates
that S&Ls (except for holding-company affiliates as we show later) have limited
opportunities for deferring taxes on current income.
‘T’hepattern of coefficient differences between table 5 estimates and the
stationary-state coefficients implicit in table 6 is an encouraging one: the
only marked departure is a substantially lower value for the stationary-state
coefficient of &ml/ YoP= - 1*87 in 1970 and lo-96 in 1971. Although the
1970 estimate is negative and not significantly different from zero, the 1970
coefficient of Dest is both positive and significant, indicating a one-percent
IRS ‘extraction’ rate. The 1971, D,,,*(l/ Y,,) coefficient suggests that the 1?71
in
level of IRS surveillance of estimated-tax payment S&Ls wo ld produce
the stationary state an average of $11,000 a year in extra government revenue
from each S&L.
This pattern is encouraging because extensive differences in coeficient
estimates would reduce confidence in our approach. The identity of the atjrected
coefficients is also encouraging, but for philosophical reasons rather than statistical ones. The lower estimated-tax coefficients indicate that the average amount
of extra taxes extracted by close IRS monitoring of S&Ls is considerably less
than table 5 would lead us to believe. Since the U.S. income-tax system depends
critically on accurate self-reporting, high IRS extraction rates would indicate
either substantial tax cheating or unfair IRS pressure on estimated-tax firms.
lzyxwvutsrqponmlkjihgfedcbaZYXWVUTSRQPONMLKJIHGFEDCBA
riC- Iregression experiments.* Introducing spec$c categories qf exentptiojts and
deductions
pl.,”

For 1970 and 1971, we tried to expand the unlagged model of table 5 to
include the effects of several ca.tegories of exempt income and deductible
expenses: LC, loss carryovers charged against current income; 7’s*,concurrent
state and local tax payments; Yt,, coupon income from tax-exempt securities;
d,,, net changes in qualifying reserves; and C, tax-deductible contributions
(reported in 1971 only). Common coefficients and overall fit changed only
slightly from those s lown in table 5. The principal effect was to raise effective
marginal rates on n t operating income by one percentage point. The pattern
of coefficient signs proved sensible for most variables, but some coefficient
magnitudes proved suspiciously large, suggesting multicollinearity.
Other experiments were conducted, allowing the coefficients of LC, T,1,
Yre and C (in 1971) to vary between surtax-exempt, estimated-tax, and other
S&Ls. By and large, thes ttempts to incorporate additional structural detail
lticollinearity proved high and coefficient estimates
must be adjudged failures.
unstable.

58

E.J. Kane and J.J. Valentini, Tax avoidance by S&L associations

4. Difference in tax-payment parameters across mutual, StOC

In this section, we disaggregate sample S&Ls into three subsamples: mutual
associations (whose behavior dominates the aggregate regressions presented in
section 3); stock associations; and the subset of stock associations that are
holding-company affiliates (HCs). Our goal is to investigate whether and how
differences in the pattern of S&L ownership affect management’s pursuit of
tax-avoidance opportunities.
Our strategy is to re-apply the regression models developed in section 3 to
each of the three subsample groups. Our analysis focuses both on differerces in
estimated coefficients across the three data sets and on covariance analysis
tests of the significance of the differences we observe.
The pattern of coefficient differences that emerges is strikinglv. consistent
across the three years and constitutes this paper’s most important finding.
Our statistical tests establish that surtax-exempt stock associations and HCs
face lower marginal rates of effective taxation. Also, in runs of the table 6
model, HCs show substantially higher coefficiems for the lagged zyxwvutsrqponmlkjihgfedcba
Ti Y variables,
indicating that, much as commercial banks, these firms exploit tax-deferral
opportunities far more energetically than do mutual or non-HC stock S&Ls.
This keener pursuit of the benefits of tax deferral is responsible for a sizeable
portion of HCs’ more favorable current tax situation, but even these firms’
stationary-state effective tax rates remain well be ow those of other S&Ls. We
hypothesize that these firms’ principal avenue of tax avoidance lies in their
ability to shelter S&L income with losses generated elsewhere in the holding
company, although HCs also hold greater amounts of tax-exempt securities.
Stock associations (whether or not affiliated with a holding company) are all
state-chartered firms. Different state &arters place diKerent degrees of restriction on the composition of S&L portfolios, a condition that may allow stocks
on average to hold a larger proportion of their assets in tax-subsidized investments. Greater portfolio flexibility should increase opportunities for tax
avoidance, perhaps through substantial investments in low-grade tax-exempts
issued by political subdivisions in which they are domiciled,’ o
Since many mutual associations are pressing for freedom to convert to a
stock charter and since stock associations have shown a tendency to become
absorbed into holding companies, these findings should be considered by
Congress in estimating the revenue costs of freer conversion, of relaxing restrictions on S&L investment ratios, and zyxwvutsrqponmlkjihgfedcbaZYXWVUTSRQPONMLKJIHGFE
of the various other structural reforms
proposed in the Financial Institutions Ball of October, 1973.
“°FederaZZychartered S&Ls can hold state and local securities as long as these securities rank
in the highest four investment grades. They ‘zan even count these holdings in their ‘liquidity’

reserve if the term-to-maturity remaining on these securities is less than two years. Finally,
federal S&Ls can invest up to 1’7; of their assets in any low-grade tax exempt as long as their
ome office is located in the political subdivision issuing the security.

E.J. Kane and J.J. Valentini, Tax avoidance by S&L associations

59 zyxwvutsrqpon

Modelhg the two tiers of the corporate-tax structure

Table 7 arrays the results of fitting the model of table 4 to our three subsamples. l l The HC intercept (our estimate of b,, the effective lmarginal tax rate
on net operating income) proves significantly lower than that for other S&Ls in
all 1969 and 1971 runs, and also in any 1970 run in which the l/Y,, variable
(which does not differ significantly across groups) is constrained to have the
groups. The coefficient. for the surtax-exempt dummy
same coefficient for al zyxwvutsrqponmlkjihgfedcbaZYXWVUTSRQPONMLKJIHGFEDCBA
variable is significantly more negative for stock S&Ls in the 1969 and 1971
runs. In 1970, the coefficient assigned the surtax-exempt dummy variable for
HCs proves significantly more negative than that found for other S&Ls, while
the difference in this coefficient approaches significance for the subset of all
stock S&Ls.
These significant coefficient differences indicate dissimilarities in opportunities for, and/or proclivities toward, tax-avoiding behavior. Even in our
most-detailed regression experiments, these differences are only panly accounted
for. We hypothesize :

(1) that HCs’ base-rate tax advantage traces to their unique ability to shelter
net income from S&L operations with losses and accounting deductions
generated by non-S&L affiliates;
(2) that surtax-exempt stock S&Ls are subject to special stockholder pressures
to minimize taxes, pressures which we attribute in turn to their being (we
suppose) more closely held than stock S&Ls that generate larger taxable
incomes.
Modellirlg requirements to file es tha ted-tax pa}wen ts

To keep the paper within bounds, we merely summarize the results of expanding the model to take account of IRS surveillance of S&Ls required to
file estimated-tax payments in 1970 and 1971. It should be remembered that
data limitations prevent us from proxying this condition adequately in 1969
runs. In 1970 and 1971, the intercept again proves significantly lower for HCs
than for other associations. However, the greater estimated effect of IRS
surveillance at HCs required to make estimated-tax payments (significant in
1970 and almost significant in 1971) recaptures a good portion of this advantage.
* ‘hlulticollincarity proves a larger problem in our subsample regressions than it did in the
aggrcgatc-snmplc runs. Every subsample rcgrcssion incorporating 7’,,,J YoPshows a significant
departure from this variable’s a priori known value of unity. As a result, for 1970 and 1971,
we only present runs which include this a priori constraint.
In these disaggregate runs, the number of mutual and stock associations included in eack
year’s data sets should add up to the number of cases in the aggregate samples of tables 4 and 5.
A minor variation in the formulation of a conditional tape-read statement prevented this
equality from being realized. However, the ditrerences are small and all significance tests
summarized in the text crivc from regressions in which the read-in conditions were properly
stated.

60

E.J. Kane and J.J. Valentini, Tax avoidance by S&L associations

E.J. Kane and J.J. Valentini, Tax avoidance by S&L associations

61

62

E.J. Xme and J.J.

ValentiA, Tax avoidance by S&L associations

In 1970, the only other significant departure from common parameter values
occurs in a large negative value estimated for the coefficient of (D,,,*l/ YO,>at
stock associations. The 1971 equations show the same two significant differences
that emerged in table 7 plus a few others not worth detailing. Taken together,
these results suggest that the lower average tax rates of stock associations
portrayed in able 3 r+iv:;: slmost entirely from the efforts of surtax-exempt
stocks and of HCs.
M odelling deferral opportunities

Table 8 presents evidence (patterned on the models of table 6) that considerably more tax deferral takes place at HCs than at other S&Ls. Covarianceanalysis tests indicate that the coefficients of the lagged 1969 T/ YO1)term found
for HCs are significantly higher than those for other S&Ls and that the higher
values of HC lag coefficients are entirely responsible for the deviation of stockassociation lag coefficients from the values found for mutuals. Stationary-state
effective tax rates on HCs’ net operating income are O-03/0*34= OaO9in 1970
and 0*05/O+! = O-11 in 1971. Even though the effect of estimated-tax payments
variables would raise these basic rates considerably, both values lie about 5-3:
percentage points below the parallel estimates for other S&Ls.
nd conclusions
Our regression models explain between 30 and 40 percent of observed
variation in S&L effective rates of federal taxation. By the goodness-of-fit
standards that apply in cross-section research, this is a creditable performance.
More important, estimated marginal 1 dtes of tax relief or tax capture associated
with specific provisions of the U.S. internal revenue sQde obtain plausible signs
and magnitudes.
The Minimum Tax on Preference Income Items enacted in 1969 appears to
have increased S&Ls’ effective marginal rates of federal taxation by 2 percent
both in 1970 and 1971. However, this tax has reinforce the direct erosion of
tax incentives for S&Ls to invest in mortgages establis d in the Tax Reform
of 1369. In combination with the annually diminishing tax-free percentage of
taxa’ble income that can be transferred to bad-debt reserves, the minimum tax
has led - and should continue to lead - S&Ls to reduce the proportion of their
funds placed in residential mortgage laans. This trend should accentuate upward movements in mortgage rates. The legislated downward trend in the
effective tax benefits of mortgage holdings for S&Ls combined with the downward trend in the tax bracket of the marginal investor in tax-exempt securities
Ls to reach out increasingly for municipal bonds.
remarkable findings concern estin:ated differences in tax-avoidance
arameters across mutual, stock, and holding-company associations.
olding-

E.J. Kane and J.J. Valentini, Tax avoidance by S&L associations

63

company affiliates and surtax-exempt stock associations are seen to be more
effective tax minimizers than other S&Ls. This observation forges a link between
expected Treasury tax receipts and Hunt Commission recommendations to
grant mutual S&L authority to convert to stock charters, underscoring a
neglected secondary d imension of the conversion problem.