income (and perhaps converts later to capital gains, but not as sec. 521 is now written). However, deductions disallowed are lost forever. Therefore, deductions disallowed on account of excess real estate depreciation should be added back to basis cost for purposes of later determining capital gain. (This treatment would correspond to the treatment of that part of excess depreciation which is itself disallowed under LTP).

Provisions of the Bill directly affecting nonresidential construction, and their effects

In addition to all the provisions adversely affecting both housing and other real estate investment, there is one very important provision in the current Bill which applies only to nonresidential construction. This provision, in sec. 521, would limit the use of accelerated depreciation by the original owner of new nonresidential structures to the 150 percent declining balance method, instead of the presently allowed double declining balance method. The 150 percent method is substantially slower than the 200 percent (double declining balance) method, and it therefore reduces very substantially the incentives for investment in nonresidential construction.

The reason given for treating housing and nonresidential construction differently is that "Congress has expressed its desire to stimulate construction in lowand middle-income housing to eliminate the shortage in this area" (Ways and Means Report No. 91-413, Part 1, p. 166).

However, as I have developed in detail earlier

in my testimony, it is entirely unrealistic to posit that better housing in a better environment can be achieved by stimulating residential construction alone. Proper community development requires the blending and integration of housing, appurtenant community facilities, and commercial structures. Without the latter, developers may be unable to open up new areas for housing, because no one wants to live

where there are no stores, amusements, or other attractions.

This is especially

true of low-income persons, because they are known to be much less mobile than

persons with higher incomes (the two-car family can live where it pleases; the onecar or no-car family cannot).

Within the cities, it is especially desirable to encourage the development of commercial structures, because such buildings increase the tax base and provide the cities with sorely needed revenues. These revenues are obtained without placing

additional tax burdens on urban residents, and they may thus help to stem or reverse the flow of middle-income families away from the cities, allowing a better mixture of income groups in all residential loci.

It should be clear, therefore, that there is no sound basis for limiting the tax advantages of the double declining balance method only to new housing, because proper and full development of the nation's housing requires a correlative stimulus

conresidential construction.

The need for favorable tax treatment of new nonresidential construction can

also be developed from a more general approach, comparing commercial construction with other sectors of the econory (commercial construction is the largest component of nonresidential, nonfarm buildings, and it is the one on which the Bill in its current form concentrates). As my earlier discussion indicates (see again Charts 22 and 23), investment in both housing and commercial structures has been growing much less rapidly than other forms of investment, although sound national economic and social policy requires that both of these sectors grow much more rapidly than they have been growing, and also more rapidly than GNP and other major components

thereof.

The deficiency in the pace of housing investment is clearly much greater than in the pace of investment in commercial structures, but that is no reason for remov

ing tax advantages from the latter.

The present tax advantages for commercial construction are inadequate in terms of our national needs, and they should be strength

ened rather than weakened.

In this connection, it should be observed that the

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current Bill places as great an additional burden on investment in nonresidential real estate as it does on investment in producers' durables. The repeal of the investment tax credit, the only provision directly affecting investment in producer durables, is expected to yield 3.3 billion dollars in 1979, when fully effective (projections based on current volume of activity see H.R. Report 91-413, Pt. 1, p. 16). This is only 5.6 percent of the 1968 investment in this category. In contrast, the reduction in accelerated depreciation on new nonresidential buildings alone is expected to yield 960 million dollars, or 5.1 percent of the 1968 investment in such buildings, and the other tax provisions affecting real estate will certainly increase substantially the tax effect on new construction in this field, although the Committee Report does not give revenue estimates in sufficient detail to letermine these effects exactly.

The immediately preceding discourse implicitly assumes that there is merit in the proposition that commercial buildings (if not housing) depreciate (in an economic or value sense) less rapidly that straight line. For reasons already stated,

this proposition has nowhere to my knowledge been vindicated, nor do I agree with

it.

A recent study by Taubman and Rasche,* made available to the U.S. Treasury, may well have attained some influence in directions contrary to those I recommend. My analysis of this study, showing its shortcomings, is attached as Appendix Two.

The foregoing indicates that the current tax treatment of all real estate invest

P. Taubman and R.H. Resche, "Economic and Tax Depreciation of Office Buildings" (University of Pennsylvania, Wharton School of Finance and Commerce, Department of Economics, Discussion Paper No.111, January 1969).

ment, both housing and nonresidential, is desirable on the general grounds of public

economic policy.

However, the current Bill is directed more narrowly to the

question of tax equity, and it is important that the tax equity arguments be faced on their own grounds, even though I feel that these grounds are not the best grounds for resolving the basic issues of our national needs for accelerated investment in

these sectors.

Equitable considerations

It must be emphasized that tax concessions to the real estate industry do not "enrich" real estate investors generally, as shown on my earlier Chart 27.

Thus, the current tax concessions available to real estate enable lower rents than would othervise obtain, and stimulate construction, but they do not provide real estate investors generally with inordinate gains. This indicates that the equity issue may be somewhat specious: investors in real estate generally are no better off after

paying their (allegedly) reduced taxes than other investors paying (allegedly) higher

taxes.

tion

The question of equity is thus transformed into a question of resource alloca

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is it proper that real estate continue to receive the economic stimulus

they now receive from current tax provisions?

I feel that the materials I have

incorporated in this testimony provide an affirmative answer to this question.

Additional considerations

The increasing burden of State and local property taxes weighs most heavily upon residential and commercial construction, and indeed upon the owners and renters of such properties, including average business people and, most importantly, families of low and lower-middle income. Federal tax concessions for real estate thus serve in part to redress the balance, not disturb it (and they are also a way for the

Federal Government to ease the plight of the States and localities).

Second, as already discussed, high interest rates are more burdensome to housing

and other aspects of real estate investment than to other industries, because these endeavors are much more dependent upon external financing (rather than retained earnings) and upon debt financing (see again Chart 27); These high interest rates, however, are not necessarily a true measure of either the scarcity or the value of capital for investment, but rather they are contrived by Government policy. It is therefore extremely appropriate that tax concessions to real estate be used to offset some of the distortions caused by artificially high interest rates.

Third, most other forms of investment will retain the advantages of shortened guideline lives and accelerated depreciation, and similar treatment of real estate is again a balancing force rather than a disturbing one.

Consideration of these three factors is an application of what is called the

theory of second-best.

As a general principle, subsidy for one industry leads to inefficient allocation of resources; but this principle applies only when there are no taxes or subsidies for any other industries.

1

Viewed against the background of

an established tax structure, containing many different types of taxes imposed by many different Jurisdictions, the simple rule that subsidies cause inefficiency can no longer be applied (if it has any large validity in principle). Given the present tax structure, it seems clear that continued Federal income tax concessions for real estate are appropriate. Of course, major changes in other parts of the structure might be desirable, and it might then become desirable also to modify the tax treatment of housing and other aspects of real estate investment, but that is not a controlling factor at this time.

Another broad class of reasons for applying only with caution the general rule that subsidies, including those in the form of tax concessions, are inefficient is