Can Local Government Survive?


By HARLEY L. LUTZ, Professor of Public Finance, Princeton University

Delivered over Station WABC and C.B.S. Network, July 30, 1942

Vital Speeches of the Day, Vol. VIII, pp. 732-734.

I KNOW of no subject in our American system of public finance which has been and which continues to be so bedeviled with misinformation, half-truths, tricky and deceptive argument than the proposal to bring state and municipal obligations within the federal government's taxing powers. As the Mayor of New York recently said:

This is a most deceptive proposition, and one which the uninitiated and inexperienced legislator might readily fall for. I had the benefit of a term as a city official in between my first service in Congress and the time this came up, and had it not been for that experience, I can readily see how I might have been deceived by it."

When, however, in a recent radio address, a writer of so-called "philosophical-popularizations" attempted to drag a red, white and blue herring across the trail of this problem of economics and government, the subject reached its all-time low in cheap and prejudiced appeal. I shall endeavor tonight to get the subject back to reality. I shall discuss it with you simply as the problem of whether or not, under our present federal system, you are to continue to control the affairs of your own local government.

If you will walk with me this evening—figuratively, of course—down the Main Street of your community, I will show you why the proposal to tax the income from yourcity's bonds should receive your unqualified opposition. I will show you, too, why federal taxation of your local bonds is unanimously opposed by the states and cities, by all of the representatives of local government, and by such non-partisan groups as the American Federation of Labor, The National Educational Association and the American Bar Association.

As you walk down Main Street to the new Federal Post Office, or the new Federal Court Building, has it ever occurred to you that these buildings pay no local taxes? Or why? Go back to high school history and you will find the answer. Our system of government—the government that makes this the greatest country in the world, now, today, and tomorrow—is a double system of government. On the one hand we have a federal government which operates in certain necessary federal and inter-state fields. On the other— there is your local government through which you control directly the multitude of civic efforts which must always remain close to your heart and hand—schools, hospitals, police protection, streets, and local laws and regulations. The founding fathers of this great nation planned that dual system for the very reason that they wanted local affairs managed locally and not from Washington. Their experience with government by remote control taught them that local problems should be dealt with by the people of the locality. More than any other feature of the American formof government, this quality of federalism, of home rule and of independent local government is the shining triumph of our constitutional system. It was with this in mind that president Roosevelt said:

"We are safe from the danger (of oligarchy) just so long as home rule in the States is scrupulously preserved and fought for whenever it seems in danger."

The constitutional doctrine that neither of these two governments—federal or local—may tax the other, arose out of the determination of the founding fathers to preserve the independence of each branch. The power to tax involves the power to destroy. This determination to preserve a balance between federal and local powers and to prevent either from destroying the other, has remained firm in the minds of American statesmen for one hundred and fifty years. Only a week ago it was reaffirmed by the action of the Ways and Means Committee of the House in refusing to incorporate this tax in the 1942 Revenue Bill.

Now let us examine the doctrine of tax immunity a little bit closer at home. When your city, or mine, issues bonds to build a new school, a firehouse or a bridge, the interest which the investor receives from those bonds is also immune from federal taxation, just as the Post Office is immune from local taxation.

The proposal is now made to abolish one part of the century-old doctrine of tax immunity. But if the central government can tax your local bonds, the bond buyer will obviously add to the interest rate an amount sufficient to pay all foreseeable federal taxes on the transaction.

Through this tax the central government can exert pressure and control on your local fiscal powers, and it can eventually control the policies of local government itself. It is possible for such a tax to destroy the freedom of local action. But the proponents of this tax will tell you that it is necessary to tax the interest from municipal bonds in order that the federal tax collector may reach a vast body of millionaires who, they claim, have invested all of their money in state and municipal bonds to escape their just share of federal income taxes. The argument sounds plausible enough until it is subjected to the test of the facts.

This is what the Ways and Means Committee did a week or so ago, and they flatly rejected the proposal. On the basis of five good reasons, this Committee of House tax experts refused once again to permit federal tax interference with the affairs of your local government. Let us examine those five reasons:

First: A federal tax on future issues of your local bonds would not raise any substantial federal revenue for years to come, or until the present supply of local issues was replaced by taxable future issues. In 1939, an undersecretary of the Federal Treasury dismissed the revenues which the federal government would receive from such a tax as "unimportant,"

Second: Federal taxation of municipal bonds will move the control of local government from your home to Washington. The increased cost of local financing and of vitally necessary refunding will prevent local units from serving their citizens except by petitioning aid from Washington. He who controls the purse also controls policy. Just the other day, Congressman Disney of Oklahoma said: "If you want to take away the tax immunity of the local bonds, you must pay the price of losing your sovereignty of local government." Congressman Disney knows that if the federal government has the power to tax the states, the local governments will be controlled by one strong central authority far, far removed from the local scene. He knows that the central government is frequently subject to the pressure exertedby combinations from different sections of the country. These combinations may or may not respond to the particular interests, customs and beliefs of your local community.

Third: The appeal to popular prejudice that all tax exempt bonds are owned by a group of wealthy individuals who are escaping taxes is nothing more than an appeal to popular prejudice and the clever use of half-truths.

Those who urge this proposal know as well as we do that upwards of two-thirds of all state and local bonds are owned by banks, insurance companies, or government trust funds. The rich do not even own all of the remainder. The proponents of this proposal know as well as we do that during the fourteen years from 1926 to 1939, municipal bonds made up only 6.06 per cent of the total of all estates subject to federal estate taxes. They know, too, that the Treasury figures for 1940 showed a sharp drop from 1939 in the holdings of state and municipal securities in large estates. It is particularly noticeable in the estates of $1,000,000 or over where municipal holdings dropped more than 30 per cent.

Fourth: The federal taxation of municipal bonds will rob Peter to pay Paul. It will increase the cost of running your city and mine, and inevitably result in increased real estate taxes. Why?

Since municipal bonds are tax immune, the cities may now borrow at 2, 3 or 4 per cent depending on their credit. If the income from these bonds is taxed, however, all the experts and economists, including those employed by the Treasury Department itself, are agreed that the cities will have to pay higher interest rates. My studies show that a city which can presently borrow money at 3 per cent interest, will then have to pay 4 per cent, and so no. In terms of your local tax bill, the results are appalling. Real estate taxes in every city would rise sharply. For instance, in Chicago, real estate taxes would increase $2.42 per thousand dollars of assessed value; in Buffalo, $1.27; in Detroit, $1.06; in Philadelphia, $1.46; in Houston, Texas, $1.25; in Camden, New Jersey, $1.68; in Tulsa, Oklahoma, $1.05; and so on down the line.

Fifth: Federal taxation of your city's bonds will so paralyze and embarrass your city financially, that in many cases it will be impossible for it to render necessary services. Take the City of New York as an example. The Mayor of that city said that if its bonds had been taxed, the city would have been unable to acquire necessary subways, or build essential highways and bridges. Think of it—the City of New York being unable to furnish necessary municipal services—if its bonds are taxed. Think of that result in terms of your city.

I warn you that hardly a city, state or county will be financially able to engage in any public works construction if the income from its bonds is to be subject to federal tax. If municipal bonds are to be taxed, the small communities and school districts will be unable to make capital improvements at any time. Scores of larger cities will not be able to reorganize their present finances by refunding. The ability of the states and cities to take their proper place in a scheme of government built on the theory of local responsibility, will be challenged, if not totally destroyed, if municipal securities are taxed.

The most convincing test of the unsoundness of this federal proposal to tax municipal bonds is the flat unequivocal rejection of the plea by the House Ways and Means Committee. Every man and woman interested in the preservation of local government should congratulate the members of Congress who refused to listen to a purely demagogic appeal. In this instance, certainly they deserve your unstinted praise.

Finally, I want to tell you the truth behind one "grim" fairy tale. It has been said that we must tax municipal bonds in order to win the war. This has been called a "red, white and blue herring." I agree that it is. To win the war to engage in an all-out war effort, calls for more than tanks planes and munitions. It calls for more than railroad cars and ships. It calls for a full and sincere cooperation among the federal government, the states and the municipalities. The states and cities are besieged on all fronts to aid and assist and cooperate in the war effort. They are doing so cheerfully, willingly, and with a determination to win the war. I hope never to see the day whenthe people of the states and cities will refuse to make sacrifices. But by the same token, we should not sacrifice the very cornerstone of democracy—a free and untrammelled system of local government such as we now enjoy.

The courageous and able men who gave us the American Constitution learned the lesson of history. They knew that democracy could only survive in the little governments of the people back home. Above all things, they dedicated that Constitution to the preservation of those little governments. That is the stake in this attack on state and municipal financing.