U.S. and Argentine Federal Income Tax Treatment to Bank Deposits Interests. A policy study about the argentine interests exemption.

U.S. and Argentine Federal Income Tax Treatment to Bank Deposits Interests. A policy study about the argentine interests exemption.

By Guillermo Rubinetti, University of Texas at Austin (November, 2010)

I.- Introduction

This paper will be divided in three parts. In the first section I will analyze and compare the tax treatment that bank deposit interests receive under the argentine and U.S. federal income taxes. The main respective provisions and the key differences between both tax systems will be explained. Due extent limitations, unless necessary, the paper will limit the analysis to the bank interests treatment, but in some cases it would be necessary to provide a broader explanation of the differences between both taxes basic structure to provide better a understanding of the issue under study.

The second part of this paper will concentrate in the policy analysis of the exemption of bank interest provided by the argentine federal income tax. I will do a brief historical introduction to the provision, and the modifications that suffered since it has been enacted. After the historical review, I will focus on a policy analysis of the bank interest exemption contained in the argentine tax law. The exemption will be examined under the tax principles of economic efficiency, equity and simplicity.

Finally, the third part of this research will include some conclusions derived from the historical and policy analysis,  and will provide suggestions of what could be changed or improved to make it more consistent with the rationale of promoting private savings, and at the same time to address some of the fairness issues that have been pointed.

II.- Treatment of Bank Deposits Interests under U.S. and Argentine Federal Income Taxes

In this section I will introduce and compare the main regulations from both tax systems related to this research, and some key facts -that while they won´t be developed in detail on this paper- they will help to understand, compare and analyze the public policies implied by the discussed fiscal treatment.

From U.S. perspective, Section 61 of the IRC, defines “gross income means all income from whatever source derived, including (…) Interest”. [1]

An interesting point to mention in the comparison is that U.S. also uses tax policies to attract deposits to its financial system. The IRC Code excludes from gross income bank interests (and other portfolio investments) of non resident alien not connected with a U.S. trade or business. In the case of Argentina there would be argentine source as is the place where interests are paid in absence of an exemption.

In Argentina, “Ley de Impuesto a las Ganancias” (hereinafter LIG), provides in article 1 that: “All income obtained by individuals or corporations is subject to this emergency tax”[2]. Article 3 of LIG defines gross income, and requires, in the case of individuals, to exist a source of the earning or rent that is: a) periodical, b) permanent, c) habilitated (being able to make the source produce income). This concept of gross income is resembles to the one sketched by the U.S. Supreme Court in Eisner v. Macomber 252 U.S. 189 (1920).

In the case under study, individual bank deposit interests, they fulfill all the three conditions required by article 3 of LIG to be considered gross income, as they are paid periodically, they do not consume the capital or source as they are extracted, and the capital is able to produce them.

So both U.S. and argentine Federal Income Taxes consider bank interests gross income in the case of local residents, even in the more limited gross income concept of LIG. But the argentine law contains an exemption for bank deposit interests.

Article 20 of LIG provides: “Are exempt from tax: h) Interest arising from deposits made in the following institutions under the legal regime of financial institutions: 1. Savings, 2. Special savings accounts. 3. A certificate deposit. 4. Deposits of others or other forms of solicitation of public funds as determined by the CENTRAL BANK OF ARGENTINA according the established by the respective legislation. There are excluded of the previous paragraph, deposit interests with adjustment clauses. The provisions above shall not prejudice the full effect of the special laws which establish exemptions of equal or greater scope.”[3]

Two important issues should be taken in account, one is that the argentine income tax from individuals represents 3.1% of GDP (2008), while in US this number rises to 9.2% of GDP (2008).[4]

It also should be noted that individuals in Argentina are subject to 21% VAT for most goods and services they consume, subject to high Social Security and Payroll Taxes, and there is a progressive Wealth Tax for individuals with a net wealth over $300.000 pesos. The total tax pressure in 2009 reached 30% of the GDP[5] which is the second high for Latin America, and comparable to OECD tax levels. But this high pressure as numbers show is not mostly achieved through the argentine income tax.

Other tax to take in the analysis is the Tax on Bank Debts and Credits[6] which basically taxes every bank account at a rate of 0.6% each debit or credit. Workers saving accounts are exempt to the amount deposited by the employer. This tax gives depositors the complete opposite incentive than the exemption.

From the comparison, it results evident that Argentina and U.S. have adopted opposite provisions respect to bank deposit interests. While U.S. federal income tax has a broad concept of gross income and levies tax on interests without exceptions, the argentine system exempts automatically all interests on individual bank deposits, and other interests like public traded debt of companies.[7]  The argentine income tax excludes or exempts most returns on financial investments for individuals, which can be identified as a basic tax structural difference among both systems.

Established the substantial differences between both taxes, I will now evaluate the argentine exemption under the light of the tax principles of economic efficiency, fairness, and efficiency.

III.- The Argentine Federal Income Tax Exemption to Bank Interests.

1) Brief History of the exemption

After several attempts that were rejected by Congress, the first Income Tax law was approved in Argentina in 1933, and “it did not include in its article 4, relating to exemptions, any waiver pertaining to interest from deposits in bank accounts of any nature”.[8] The next year, Law 11.682 “Ley de Impuesto a los Réditos” replaced the previous tax that was instated by a provisional government, and solved many flaws of that law, and created for the first time an exemption for bank depositors for the first time.

The exemption experimented many changes being up to date 77 years in force. The first exemption was very limited, and conditioned that interests did not exceed one peso moneda nacional (M$n 1) per liquidation period. In 1946 with Perón in power, the cap was increased to a more generous 50 pesos moneda nacional.[9] In 1954, under the same government, but economically in decline, Congress decided to takes off the cap, and granted the exemption without limits.

In 1961 were included to the exemption “the amounts provided by the employers to their employees in deposits or loans”. [10] Again, a cap of $5.000 pesos was established in 1971[11], but it was shortly after, on December the same year, the cap is removed once again, on grounds of promoting internal savings[12].

Finally, article 20 of LIG replaced article 19 of Ley 11.682 in 1974. The exemption on employer’s loans deposits was eliminated in 1986, and the new article did not provide any maximum cap. It is interesting to note that some political groups are pressing actually in Congress to limit this exemption, reestablishing again a maximum cap, on grounds of fairness, along with the repeal of other exemptions on income from stocks, bonds, etc, (know as financial exemptions art. 20 inc h, n, k).

2) Policy analysis of the exemption

This section we will examine the policy behind the exemption of bank deposits that basically consists in using the tax system to promote the stability and growth of the financial system.

Atchabaian states that the exemption was “aimed to satisfy the need of not discouraging the formation of private savings, always essential in the effort to promote investment processes within the economy”[13].

While this may be truth in the origins of the law, and can be found in one of the extension decrees from 1980’s, the justification in the 90´s to extend the exemption while the financial system was healthy and the economy stable, was changed to “legal certainty of financial system reasons”, and the Congress did not say a word about the rationale when it made the exemption permanent in 2001.

Argentina has historical moderate domestic savings rates (compared to high growth countries), and it’s an upper-middle income country, which needs higher rates of growth to achieve full development. U.S. on the other side, setting aside times of crisis when it needs to stimulate demand, is the biggest economy in the World and has one of the highest baking rates in the world –as percentage of population-. Although domestic saving rates both actual and historical contradict this explanation. Argentina has 27% of GDP of domestic saving rate compared to U.S. 13 % of GDP. Rates would advise opposite tax legislation if the exemption and policy was as useful as proposed.

Argentina economy, as a primary goods exporter, is more vulnerable to external shocks, and international crises, often reverberate in its financial system. Depositors had been expropriated their deposits by hyperinflation and devaluation in the 70´s, 80´s, and in 1989 CD´s were converted to public debt bonds. In 2001 bank crisis, U$S deposits that had insurance from Central Bank were defaulted and converted 1 dollar to 1,40 pesos (when dollar market price was $3.40). There are probably other tools more effective than a tax exemption to boost depositor savings, and to create trust in the public, by assuring stability of rules, and Courts reassuring property rights of depositors.

It can also be said that since 2000 in Argentina imposed 0,006% gross emergency tax, to any credit or debit to any bank account, and transfers between accounts between banks. This tax still exists, but is very controversial, and raises the double of the funds for the treasure than what the exemption is speculated by the Treasury to cost.

I would analyze the exemption under the three classical policy principles: economic efficiency, simplicity, and fairness.

2.1. Economic Efficiency

The weakness of the financial system and the distrust of the general public to banks could be a good rationale to establish an exemption in order to attract depositors that otherwise would invest their money in most lucrative but taxed activities. But this raises many questions if this change of behavior promoted by tax incentive is efficient at all from an economical perspective.

Notwithstanding, the exemption, as most exemptions, introduces a distortion in the incentives of the economic agents. This is what the Congress intends, to change some specific conduct that -always according to Congress- would not happen in absence of the exemption. According to Congress good intentions, the economic agents, which ex ante, would decide to spend their money, or just place it under the mattress, with the enactment of the exemption, will change their behavior and constitute a deposit in the argentine financial system.

This distortion of economic agent’s behavior would be justified if the Congress and Government policies respecting bank depositor’s property rights would be consistent with the public policy of the exemption. On the contrary the recent prorogated –not so emergency- bank credits and debits tax shows that Congress has less interest in promoting the health of the financial system than raising revenue for the Treasury.

Another aspect that should be studied, because this is a tax on interests on deposits, is the temporal neutrality of the exemption, if the exemption affects the decisions of taxpayers to consume or defer consumption for the future.

An intuitive economic consideration would suggest that taxing bank interests would reduce its after-tax return on investment decreasing the incentives of the economic agents to save, or at least to funnel saving through the financial system if all other financial exemptions are not repealed also. The exemption (with other exemptions to return on capital) would in theory add inter-temporal neutrality to the tax, which in its absence would result in a distortion of the decision to consume or save.

Slemrod exemplifies: “a tax of 20 percent on interest income reduces the reward to saving that income. If the before-tax interest rate is 10 percent, you get only an 8 percent return after tax. Another feature of our tax system can exacerbate this distortion: it fails to adjust the measurement of capital income for inflation.[14]

While the creation by an exemption of an incentive to save is undeniable, economists don`t agree and there is no conclusive empirical proof that there is a correlation between the incentives to save and the real private saving rates observed in the economy. Most probably, the save or consume decision is influenced by other more decisive factors (personal expectations, family needs, job and career expectations, cultural, economy outlook, etc) being tax only one of them and not the most significant.

Slemrod states that: “A large number of studies have (…) generally come to the conclusion that saving is not very responsive to incentives. It is probably not appropriate to call this conclusion a consensus (…) Still, given the state of the evidence, any claim that reducing or eliminating the tax on the return to saving would lead to large increases in saving must be viewed with skepticism.”[15]

The uncertainty about the economical effects on savings of the exemption weakens one point that could be argued in its favor, and was that if it had really an effect on the level of savings, it would have contributed also to a more neutral tax, by not distorting the decision to save or consume, the first which would be penalized by taxing interests.

A last note on efficiency, if the exemption is repealed, all the other financial exemptions should be repealed also, in order to avoid the creation of new distortions favoring the non repealed exemptions.

2.2. Simplicity

In general any exemption added to the Law, adds complexity, and litigation whether the taxpayer´s income is the type the Congress intended when enacted the exemption.

There is a key difference between U.S. and Argentine Supreme Court related to the treatment of exemptions. The Supreme Court of Argentina has changed for many years the traditional doctrine that exemptions should be interpreted in a restrictive way -which U.S. Court supports-, but instead they state that exemptions have to be given all the extent Congress wanted to give it. This is more neutral approach, but can get to more complex interpretations of what the Congressmen meant when enacted the provision.

The exemption hasn´t caused in 77 years in force much litigation, or complications of interpretation, so it shouldn´t be repealed or limited on grounds of simplicity.

On the contrary, the exemption has made the lives of millions of argentines easier, as they had never to report income from their bank accounts, nor get withholdings, or fill any type of forms. Many employees receive their salaries in a saving account, and as it is exempted, they don´t have to file taxes for the interests on those accounts. The same could be said for most people who have a saving account, a checking account, or a certificate deposit. If the exemption would be repealed, the banks will have to withhold the tax from the interest, and that would make a lot of people to file tax returns.

Most employees in Argentina get their taxes both income and social security withheld, and don’t file taxes unless they have another activity. The repeal of the exemption will add more complexity, especially for small taxpayers that now do not have to file taxes, or fill any form.

2.3. Fairness

The exemption of interest income from bank accounts has been recently attacked on grounds of fairness. In fact there is a project in Congress to put a maximum cap of $30.000 pesos, and repeal other financial exempted income from stocks, bonds, etc, (know as financial exemptions art. 20 inc h, n, k).

Fairness could be formulated by the statement that all people should equal contribute to the maintenance of public charges. From there derives the application of two principles: horizontal equity (equal treatment for those who are in similar circumstances) and vertical equity (adequately different treatment to those who are unequal in different circumstances) In this sense, the principle of equity could be used to synthesize in a way, the principles political-social or ethical issues that concerned Neumark in his famous work, “Principles of taxation “, i.e. the generality, equality, proportionality and redistribution. [16]

From a horizontal equity analysis, is unfair that someone who constitutes a CD for $400.000, does not get taxed on the 15% average interest he will get, while someone who uses that same amount in a risk business, and supposing a same level of return 15%. The return of the second will be taxed, at the progressive rate which maximum is 35%.

To be fair two points have to be conceded. From an historical perspective, the risk of not getting the money back from an argentine bank may not be completely reflected in the interest the depositor is getting paid. A business with 15% ROI is a very low risk business, and probably not the perfect comparable.

Anyhow, one taxpayer does not pay any tax compared to the other whichever the risk is, the marginal rate for the income of the second is 35%. In my view, the provision does not stand a fairness analysis.

At this point I would like to add, the actual 12% interest rates from the example are negative compared to 25% annual inflation that Argentina has suffered the last 2 years, which cannot be adjusted in LIG both for individuals or corporations up to date.[17] While the exemption is unfair, in this -hopefully temporary- inflationary scenario, taxing a negative interest (which is clearly not income, but recovering some part of the unrecognized loss from inflation) would lead to significant cases of unfairness.

As vertical equity comparison, we may compare the case of Amalita Fortabat, a billionaire and the richest woman of Argentina, who may have 4 million pesos in certificate deposits in a bank of Argentina –almost 1 million dollars-. For that sum she can probably get 20% interest, so in one year the Congress will agree her to make $800.000 pesos tax free. Amalita will be waived of top marginal rate which is 35%., the tax exempted in this case would be $ 266.500 pesos.

On the other hand most low/middle income workers will spend most of their salaries during the month in their saving accounts. Let´s suppose, Federico, starting at a law firm junior lawyer, who earns $3.500 pesos per month, and , he saves $5.000 pesos and constitutes a certificate deposit at 12% rate. After a year, he will have $ 600 pesos free of tax ($150 dollars approximately).

Due the progressive rate, the tax that which would apply to Federico in absence of the exemption is 9%, and the tax levied would be $ 54 pesos. The progressivity of the tax rate makes the exemption more regressive and vertically unfair, as taxpayers in higher brackets receive greater if not most of the benefits of the exemption. Does Amalita need more help than Federico?

But the vertical fairness does not end there. Argentina has VAT at 21% rate, and a reduced rate of 10.5% to some basic products.  There are many poor people, who are not as lucky as Federico to have a formal job, or job at all, and doesn´t have and never knew anyone who have a bank account. It´s not only that, the loans this exemption wants to promote, by the formation of a bulk of deposits, will never reach this low segment of the market, as the banks mostly target middle and higher income.

The multiplier effect that banking and financial system could offset at some degree, the inequalities that were pointed, as the loans, even for the rich, could create jobs, and consumption, and more jobs, etc. But, as was pointed earlier, and will be addressed in the conclusions, to overcome the secondary effects of this public policy –in this case clear unfairness- and to achieve the goal set, it is necessary that other non-tax policies are followed consistency. In absence of them, the policy is ineffective, and the unfair consequences of it arise.

Inflation recognition problems should be solved allowing temporarily inflation adjustments as this is not the only field were there taxation of inexistent income because of inflation leads to unfairness. This will lead to complexity issues. That´s life. A struggle between efficiency, simplicity and fairness…

The fairness analysis is conclusive this is an exemption that mostly favors the well-to-do, it is a scandal that an indigent person pays 10.5% VAT for milk and bread, but billionaires are not taxed on their interests on deposits or stocks. On exclusive fairness grounds I would support the repeal of the exemption.

3) A cap on grounds of fairness and simplification

The history of the exemption is also the story of the cap, coming and going. I think that reenacting of a cap has sense both in fairness and simplicity aspects, and will be better policy than just repealing the exemption.

A cap set at a reasonable amount like the minimum non taxed salary. The cap could be set in a specified number of minimal salaries also. But it should be set above the level of salaries that including deductions are not required to file taxes. If not the Government should have to implement a system to refund tax, that people won´t trust or accept peacefully. Simplicity issues advice that the cap will not be lower than $ 6.662 pesos which is the salary of a married worker with two children which does not pay the tax.

The project in the Congress suggested the amount of $30.000. To my mind, in a country where the minimal salary $1.740 pesos, that amount is excessive. One thing can be wise about the amount, Congresses more usually get late than early updating monetary caps (Section 861(a)(3) of IRC cap of $3000 is a good example). This could be aggravated if Argentina continues suffering annual high 0inflation.

According to the Argentine Supreme Court, the negligence of the Congress cannot be presumed, so I would suggest a cap of $7.000 pesos, trusting that Congress will timely update it each time the minimum taxable and deductibles are updated also.

This cap will cut the windfall for the rich, but will still benefit most middle class and some low earners. It will cut some of the unfairness, but not completely as lower classes will continue not to have access to banking or loans, but at least will not be subsidizing the wealthiest free tax income with their dairies purchases.

IV.- Conclusions

Argentine Congress cannot rely exclusively on the tax system to promote the deposits in the banking system, when all other policies for the last 60 years have discouraged them. In this scenario the use of the tax system to promote public policies doesn´t have any strength as a public policy tool. Economic agents, who´s property rights in the banking had been disrespected on several occasions will mostly not follow the economic incentive that is given.

The exemption is economically inefficient as economic agents are making decisions based on tax considerations, instead of business ones. The inefficiency would be offset if the goal of achieving a stronger financial system, and more loans available to the public would be achieved.

In theory the exemption –with other exemptions- would achieve temporal neutrality of the tax, and incentives to save, but there is no empirical proof to demonstrate that these incentives reflect in the conduct of the economical agents. There is no conclusive data to ascertain that the exemption has any real effect on consumption decisions, or even that it promotes the growth of the financial system at all. Given this uncertainty, it is not possible to give a judgment if the exemption contributes to tax neutrality, and to economic efficiency.

In the special case of Argentina, because of its recurring banking crisis, it is easier to sustain that there is no relation between the incentive created and the actual savings. If there is no real impact on the level of deposits, then the unfair implications of the exemption have a more difficult justification.

The exemption proves to be unfair both under horizontal and vertical analysis. It is a privilege that benefits mostly wealthier people, while most taxpayers receive no or a minimal part of the tax expenditure. This unfairness is not offset by the simplicity achievements. The inflationary issues that the repeal would create, may arise new cases unfairness, those issues should be solved by Congress by allowing some type of recognition of inflation. As not recognition of inflation is revenue raising, and also indexation may accelerate inflation, this solution may prove not to be politically possible.

Bank Interests is a simple exemption, as it is not necessary to fill any form to obtain it, and it is provided to all individuals automatically. It complies with simplicity principle, and its repeal would result in an increase of complexity for taxpayers, tax administration, and banks.

The complexity concerns of the repeal do not offset the fairness issues that the exemption arises. In order to avoid the increase in complexity, while addressing the fairness concerns, I propose the reenactment of the cap, which will balance fairness and simplicity concerns

This cap will cut the free lunch for the wealthy, while still covering middle class and some low earners. It will cut some of the unfairness, but not completely as lower classes will continue not to have access to banking or loans, but we cannot ask Rawlsian justice to a federal income tax, which maybe better achieved though public direct expenditure.

Being that is not possible to demonstrate that the exemption has any real effect, and given the serious unfairness issues pointed in this work, at least the undesired consequences of the exemption should be removed by reenacting a cap.

[1] 26 USC Sec. 61

[2] Law 20.628, (T.O. Decreto 649/97 y modificatorios).

[3] Law. 25.402, Article 3, subsection a), B.O. 12/1/2001 entered in Force on 01/12/2001 making this exemption permanent for interests received after 1 January 2001, inclusive. Before this enactment, Congress allowed on yearly to the Executive to maintain or not the exemption since 1986.

[4] Juan Pablo Jiménez & Jesús Ruiz-Huerta, Política fiscal y equidad: una mirada cruzada entre Europa y América Latina, LC/R.2153, 2009, U.N., Comisión Económica para América Latina y el Caribe (CEPAL).

[5]U.N., Comisión Económica para América Latina y el Caribe (CEPAL), Estudio económico de América Latina y el Caribe • 2009-2010, LC/G.2458-P , 97.

[6] “Impuesto sobre los Débitos y Créditos Bancarios” enacted by Law 25.453 B.O. July, 31, 2001.

[7] “Obligaciones Negociables” is a type of public traded debt emitted by companies which interests are also exempt for individuals by art. 36 bis, inc. 4 of Law 23.576.

[8] Adolfo Atchabahian, Exención del impuesto a las ganancias sobre intereses de depósitos en cuentas bancarias: proyecto de ley para derogarla, PET 2010 (junio-444), 11/06/2010, 9.

[9] Law 14.338, B.O., May, 20, 1946.

[10] Law 15.798, B.O., January, 10, 1961.

[11] Law 19.127, B.O. July 16, 1971.

[12] Law 19.409, B.O., December, 31, 1971.

[13] Atchabaian, supra.

[14]Joel Slemrod & Jon Bakija, Taxing Ourselves. A Citizen’s Guide to the Debate over Taxes, The MIT Press 127, (fourth edition).

[15] Supra, 130.

[16] Juan Pablo Jiménez & Jesús Ruiz-Huerta, supra at 9.

[17] The Supreme Court favorably decided only one case of confiscation of capital, because of the prohibition to adjust by inflation for year 2002. Confiscation has to be proved case by case and is very difficult to prove in Courts (Corte Suprema de Justicia de la Nacion, “Candy S.A. c/ AFIP y otro s/ acción de amparo”. C. 866. XLII              03-07-2009).