Because thrifts historically developed as the primary provider of home mortgages, federal policy in support of home ownership has operated in part by aiding thrifts. For many years, thrifts benefited from interest rate caps on deposits--set higher for thrift deposits than for bank deposits. They still benefit from access to low-cost funds from the Federal Home Loan Bank System, as well as from the tax benefit for bad debts. Moreover, other federal tax policies have supported homeowners more directly, such as deductions for mortgage interest (see REV04) and local property taxes (see REV-05), as well as certain exclusions of capital gains on home sales (see REV-23).

Over the past several decades, the development of the secondary market for mortgages and ongoing deregulation of the financial industry have helped to erode the unique role of thrifts in providing housing finance. The rapidly growing secondary market for mortgages, which efficiently links investors with borrowers, has pushed thrifts and other financial institutions into competition largely as originators of mortgages rather than as the primary long-term holders of them. In addition, certain aspects of deregulation, such as the removal of both the deposit interest caps and limits on the types of deposits that thrifts could accept, have fostered direct competition between thrifts and other financial institutions.

With thrifts and other financial institutions now competing directly, the tax preference for thrifts encourages more thrifts and fewer other financial insti

tutions to exist than would otherwise be the case. That result reduces economic efficiency when other financial institutions could otherwise provide the same mortgage services at lower cost. Some of those other institutions, such as mortgage companies, might have lower costs than thrifts because they do not need to provide the same services as thrifts, such as accepting deposits, which are subject to costly reserve requirements, deposit insurance premiums, and possibly higher administrative costs.

In recent months, the Congress has considered legislation to restructure the thrift industry. It has considered revoking the federal thrift charter and merging the thrift and bank deposit insurance funds. The Balanced Budget Act of 1995, vetoed by President Clinton, would have repealed the thrifts' tax preference for bad debts and required them instead to use the accounting methods that banks use. Thrifts with assets of less than $500 million, such as similarsized banks, could use the experience method, but all others would have to use the specific charge-off method. The provision would have recaptured a portion of past tax benefits by requiring thrifts to include in taxable income (over a six-year period) all post1987 additions to the bad-debt reserve in excess of bad debt under the accounting methods that banks use. The provision would have granted a two-year suspension of the tax increase for any thrift that maintained a substantial amount of its recent mortgage lending. The option estimated here reflects the version that the Congress passed in 1995.

Credit unions are nonprofit institutions that provide their members with financial services such as accepting deposits and making loans. The federal income tax treats credit unions more favorably than competing thrift institutions, such as savings and loan institutions and mutual savings banks, by exempting their retained earnings from tax. As a result, more credit unions and fewer taxable thrifts exist than would otherwise be the case. That situation reduces economic efficiency in that competing institutions might otherwise provide the same services but at a lower cost.

Credit unions, savings and loans, and mutual savings banks were originally all tax-exempt, but in 1951 the Congress removed the tax exemptions for savings and loans and mutual savings banks. It considered them to be more like profit-seeking corporations than nonprofit mutual associations.

Since 1951, credit unions have come to resemble those other thrift institutions in certain respects. Credit unions no longer limit membership to people sharing a common bond, which was usually employment. Since 1982, the regulators have allowed credit unions to extend their services to others, including members of other organizations. In addition, most credit unions allow members and their families to participate permanently, even after members have left the sponsoring organization. Credit union membership has grown from about 5 million in 1950 to almost 70 million today. That leap in numbers offers evidence that credit unions, like taxable thrifts, now

serve the general public. In addition, credit unions retain earnings like thrift institutions. Credit unions argue that they retain earnings as protection against unexpected events, but other thrift institutions argue that credit unions use the retained earnings to finance expansion. Moreover, credit unions are becoming more like savings and loans and mutual savings banks in the services they offer. A significant number of credit unions offer such services as first and second mortgages, direct deposit, access to automatic tellers, preauthorized payments, credit cards, safe deposit boxes, and discount brokerage services.

Many smaller credit unions, however, retain the characteristics of nonprofit mutual organizations and perhaps should not be subject to taxation. For instance, only volunteers from the membership manage and staff some of those credit unions. Moreover, many of those smaller credit unions do not expand their membership beyond their immediate common bond or provide services comparable to competing thrift institutions. To protect those smaller credit unions, the Congress could choose to exempt from taxation those credit unions with assets below $10 million. Such an action would exempt about twothirds of all credit unions from taxation, although they hold only about 8 percent of all assets in the credit union industry.

Taxing all credit unions like other thrift institutions would raise $5.3 billion in 1997 through 2002. Taxing only credit unions with assets above $10 million would raise about $0.6 billion less.

The current tax system favors extractive industries (oil, gas, and minerals producers) over most other industries through two types of tax preferences. First, certain exploration and development costs incurred by extractive producers may be immediately deducted ("expensed") rather than recovered more slowly through deductions for depreciation. Second, certain types of extractive companies (independent producers and royalty owners) may elect to use the "percentage depletion" method to recover costs rather than the standard "cost depletion" method. Under percentage depletion, cumulative depletion deductions may exceed actual costs of investment. As a result, the tax system subsidizes production.

Eliminating those two tax preferences would improve the allocation of resources while raising significant revenue. Repealing the expensing of exploration and development costs would raise $4.4 billion in 1997 through 2002, assuming that firms could still expense costs from unproductive holes and mines. Repealing the percentage depletion would raise $2.4 billion over the same six-year period.

Repeal Expensing. Certain types of oil and gas producers and producers of hard minerals may deduct some exploration and development costs at the time such costs are incurred rather than over time as the resulting income is generated. That immediate deduction of costs contrasts with the normal tax treatment facing other industries, in which costs are deducted more slowly according to prescribed rates of depreciation or depletion. The Tax Reform Act of

1986 established uniform capitalization rules that require certain direct and indirect costs allocatable to property to be either deducted when inventory is sold or recovered over several years as depreciation deductions (so that any deduction of costs is postponed to the future). However, intangible drilling and development costs and mine development and exploration costs are exempt from those rules. Thus, the expensing of such costs results in a tax preference for extractive industries that does not exist for most other industries.

Expensible exploration and development costs include costs for excavating mines and drilling wells. They also include prospecting costs for hard minerals but not for oil and gas. Although current law allows full expensing for independent oil and gas producers and noncorporate mineral producers, it limits expensing to 70 percent of costs for "integrated" oil and gas producers (companies involved in substantial retailing or refining activities) and corporate mineral producers. Firms subject to the 70 percent limit must deduct the remaining 30 percent of costs over a 60month period.

Repeal Percentage Depletion. The percentage depletion method of cost recovery allows certain types of extractive companies (independent producers and royalty owners, or "nonintegrated" companies) to deduct a certain percentage of a property's gross income in each taxable year, regardless of the actual capitalized costs. In contrast, other industries (and since 1975, integrated oil companies as well) use the

cost depletion method. Under cost depletion, the costs recovered cannot exceed the taxpayer's expenses in acquiring and developing the property. But under percentage depletion, they may. Thus, the percentage depletion method results in a tax preference for certain types of extractive companies that does not exist for other companies. Unlike the expensing of exploration and development costs, however, percentage depletion applies only to a small subset of total oil, gas, and minerals production because it excludes the large integrated producers.

Current law typically allows nonintegrated oil and gas companies to deduct 15 percent of the gross income from oil and gas production up to 1,000 barrels per day. The Omnibus Budget Reconciliation Act of 1990 made percentage depletion even more generous, however, for those nonintegrated companies that are considered to be "marginal" producers (those with very low total production or production that is entirely made up of heavy oil). The deduction for marginal properties can be up to 25 percent of gross income if the market price of oil drops low enough.

Producers of hard minerals may also use percentage depletion, but the statutory percentages vary. Minerals eligible for percentage depletion include, but are not limited to, sand (5 percent), coal (10 percent), rock asphalt (14 percent), iron ore (15 percent), oil shale (15 percent), gold (15 percent), and uranium (22 percent). Tax law limits the amount of percentage depletion to 100 percent of the net income from an oil and gas property and 50 percent of the net income from a property with hard minerals.

Economic Inefficiency Associated with the Preferences. Both expensing and percentage depletion were established in the early part of this century. Although the original rationale for expensing was that the costs of exploration and development were considered ordinary operating expenses, continuing both types of preferences has been justified on the grounds that oil and gas are "strategic minerals," essential to national energy security.

However, expensing and percentage depletion distort the efficient allocation of resources in several ways. First, the preferences cause resources to be overallocated to drilling and mining, when some of those resources might be used more productively elsewhere in the economy. Second, although the preferences might reduce dependence on imported oil in the short run, they encourage current extraction, perhaps at the cost of reduced future extraction and greater future reliance on foreign production. Third, the preferences may result in an inefficient allocation of production within those extractive industries, since the subsidies are not systematically related to the economic productivity of investments. For example, percentage depletion is a subsidy according to gross income and not according to investment. Thus, it encourages developing existing properties over exploring for new ones. As another example, producers who pay the alternative minimum tax must defer or even forgo both types of preferences, regardless of the economic productivity of their investments.

The current tax system allows timber producers to deduct immediately ("expense") most of the production costs of maintaining a timber stand. That tax treatment contrasts with the uniform capitalization rules applied to most other industries. Established under the Tax Reform Act of 1986, such rules require that production costs not be deducted until the sale of the produced goods or services. When businesses do not account for costs properly, business income is not measured correctly because the costs of producing goods and services are not matched with the sale of the goods and services.

Although the costs of planting a timber stand are in fact subject to capitalization rules, subsequent maintenance and production costs are not. Timber producers can expense indirect carrying costs, such as property taxes, interest, insurance costs, and administrative overhead, as well as the costs of labor and materials to remove unwanted trees and to control fire, disease, and insects. By allowing timber producers to deduct such production costs before the timber is harvested or sold, the tax code in effect subsidizes timber production by deferring tax that producers otherwise would owe on their income. (Under certain circumstances, however, the deferral granted to noncorporate producers of timber may be greatly curtailed by the limits of the tax code on losses from passive business activities.)

The original rationale for expensing timber production costs was a general perception that such costs were maintenance costs and thus deductible as ordinary costs of a trade or business. When the Tax Reform Act of 1986 established uniform capitalization rules, the costs of producing timber were exempted, as were the exploration and development costs asso

ciated with oil, gas, and minerals production (see REV-34). The general reason given for those exemptions was that applying the rules to those industries might have been unduly burdensome.

Expensing timber production costs distorts investment behavior in two ways: more private land is devoted to timber production, and trees are allowed to grow longer before they are cut. Unless timber growing offers spillover benefits to society that are not captured by market prices, the tax preference leads to an inefficient allocation of resources and an inefficient harvesting rate.

Whether or not timber production offers important spillover benefits is unclear. Standing timber provides some spillover benefits by deterring soil erosion and absorbing carbon dioxide (a gas linked to global warming), but cutting timber can lead to soil erosion. In addition, producing and disposing of wood and paper products contribute to pollution.

Capitalizing the costs of timber production incurred after December 31, 1996, would raise $2.6 billion in revenue from 1997 through 2002 by accelerating tax payments from timber producers. In the long run, capitalizing timber production costs would raise the price of domestic timber and lower the value of land used to grow timber. Moreover, lease payments to private landowners by timber growers would probably fall, causing some land that historically has been devoted to growing timber to be used in other ways. In the short run, however, capitalizing timber production costs might lower the price of domestic timber because producers would have an incentive to harvest timber earlier.