then he operates his farm the same as any other farmer operates his farm.

He calculates his earnings or his losses the same as any other farmer does, and then when he determines how much he earns on that farm operation, he adds that to his outside income. That doesn't put him on an accrual basis.

Senator METCALF. It does not. Then the response that we gave you, both Mr. Koplan and I, would be correct.

Senator BYRD. Thank you very much, Senator. Thank you, Mr. Chairman.

The CHAIRMAN. Senator Hansen.

Senator HANSEN. Thank you, Mr. Chairman.

I am very pleased to welcome my colleague from Montana here this morning. I served with him on a few other occasions, and I have great respect for him.

I want to clarify, if I can, Senator Metcalf, the concerns that have
prompted your introducing the amendment that you have proposed.
I understand that there are roughly around 3 million taxpayers in the
farming business who report annually, and this figure has remained
fairly constant. Does this check with the figures you get? And I under-
stand from your testimony, your bill would affect about 14,000 indivi-
dual tax returns and would raise an additional $205 million a year in
tax revenue. Is that right?

Senator METCALF. According to the estimate that the staff of the
Joint Committee on Internal Revenue Taxation have given me.
Senator HANSEN. Oh, I see.

Senator METCALF. It is from the Joint Committee.

Senator HANSEN. Do you agree with that?

Senator METCALF. I don't have any reason to disagree with it. Senator HANSEN. What is the major purpose that you seek in proposing your amendment? Are you thinking about tax reform and tax relief?

Senator METCALF. I am thinking about tax equity.

Senator HANSEN. Tax equity.

Senator METCALF. And removal of unfair competition from the livestock and the farming industry, and removal of a serious distortion of farm prices which causes increased taxes and so forth of legitimate farmers above and beyond the productive capacity of those farms and ranches.

Senator HANSEN. You say a serious distortion of farm prices. Are you implying that the presence of this unfair competition has driven farm prices down?

Senator METCALF. No. It has driven the price of land in and around productive farms above the productive capacity of such a farm, so that if a young farmer, for example, wants to expand his farm, he has to pay sometimes twice as much for the land as it can produce, and so he can't go to a bank or an insurance company and say "Look, I would like to get a couple sections of land over here." He says, "Well, that land sold the other day to so and so from Texas, and how much am I going to have to pay for it?"

The banker says "Well, you will have to pay about the same amount

per acre."

The young farmer says "I can't produce that. I can't make a profit on that basis on that land." And then it is completely distorted. Then the tax assessor comes through and says "Look, this land sold here, this land sold there, we will have to double your tax." And so a serious distortion of land values results.

Senator HANSEN. When you speak of a serious distortion of land values, I guess you are aware, if my arithmetic is correct, that if this bill would affect some 14,000 individuals, out of around 3 million, this would be about one out of every 214 persons.

Senator METCALF. Your arithmetic I know is better than mine, so if you have made the computation, that is right.

Senator HANSEN. Wouldn't guarantee it, but as I figure it, it comes to about one out of every 214. Now I can share your concern over the young man who would like to get into the ranching business. Obviously he would like to get into a profitable business just as cheaply as he could having in mind the least amount of necessary capital outlay. What would be the attitude of the other 213 persons in the business! Do you think they would like to see their land increase or decrease in value?

Senator METCALF. Legitimate farmers trying to keep their farming business productive want to keep this distortion of land value out of the farm economy.

Senator HANSEN. How did you find that out?

Senator METCALF. Well, I am just guessing just as you are. May I finish?

Senator HANSEN. Yes.

Senator METCALF. Maybe 14 or 15 who have their land for sale immediately are anxious to sell to these industries that are going into the area for the tax benefits they can have. Some of the people who are immediately inheriting the land, and want to get out of their father's farming business are anxious to sell.

But the one who inherits the land and has to pay an inheritance tax on the basis of a distorted value next door doesn't like it. The one who is going out and trying to expand his farm doesn't like it. The man who has to pay taxes on this distorted value doesn't like it. It is only the man who is trying to liquidate his ranch that thinks that that is a pretty good idea.

Senaor HANSEN. I would question that the typical rancher, who has had to go to a bank and ask for credit would like to see the price of real estate lowered materially. I know I have talked with a good friend of mine who makes appraisals for one of the major life insurance companies, and he cites me a considerable instance of people in the Nebraska, Colorado and Wyoming area near Cheyenne, who have asked for appraisals on their land, and invariably have made an application for increased loan backed up by the appreciated land values.

Now, would you suspect that any of those people would like to see a depreciation in land values?

Senator METCALF. They don't like to see a depreciation in land values if it is a depreciation in the productive capacity of their land, but those farmers, at least it has been my experience from insurance companies and lending agencies in Montana, those farmers can't get an appraisal on the basis of the productive capacity. They have to com

Jete with substantial outside income so that they can convince others that they can pay off this extra amount of money that they are paying for others to enjoy a tax shelter.

Senator HANSEN. It has been proposed that for estate taxation purposes, evaluations be made on the basis of productive capacity rather than on real value. What is your feeling in this instance?

Senator METCALF. I think that it should be based on productive capacity; yes, sir.

Senator HANSEN. And not on actual value.

Senator METCALF. Not on a distorted value as a result of sales to taxdodge farmers.

Senator HANSEN. May not a distorted value become actual value? Senator METCALF. If it is on a productive capacity. Of course if it is in subdivisions or something like that, that is another matter. That is not a matter that enters into the proposition of this bill. This bill applies only to those people who are taking advantage of the special tax situation that the farmer has, and abuses it by covering substantial high nonfarm income, as this ad I have for high income people suggests, with a tax shelter.

Senator HANSEN. Thank you, Senator Metcalf.

My time is up.

Senator GORE. Since Senator Byrd responded to a request, I had a young man from a neighboring State the other day ask me to submit to you his problem and ask your reaction.

He has a farm which he obtained from his father. He made quite an investment, in brood mares, and some cows. He expects to losemoney for the next 3 or 4 years. Hopefully eventually it will be profitable. He has fallen in love with a young lady who had inherited a building from her father that provides considerable rent; also sheteaches. Her income is something in excess of $15,000, and he wants to know of you whether they should go ahead and get married or live in sin.

Senator METCALF. I would say that that young man, who is a very smart young man, will nail down that proposition right now and get married.

Senator GORE. Will you provide an amendment in your bill for him? Senator METCALF. He will have the income anyway.

Senator GORE. I will not argue with you, Senator. There is a problem of tax shelter here with which the Congress must deal, but I think your contribution this morning and the questions indicate that we haven't found the proper and full answer yet. I thank you very much. Senator METCALF. I do want to say, that every single farm organization is in favor of my bill. I hope, Mr. Chairman, that my other colleagues that follow me in support of other types of legislation will be treated better by the audience than I have been treated just in the last

response.

(Senator Lee Metcalf's prepared statement and the text of his amendment follow:)

STATEMENT OF HON. LEE METCALF, A U.S. SENATOR FROM THE STATE OF MONTANA. ON BEHALF OF HIS PROPOSAL TO ELIMINATE "TAX-DODGE" FARMING

SUMMARY

My bill, S. 500, would eliminate existing distortions in the farm economy by limiting to $15,000 or to the amount of "special deductions" listed in my bill, whichever is higher, the amount by which a "farm loss" may offset nonfarm

income. Special deductions are those that would be allowed to someone whether or not he was in farming or because it is the type of deduction clearly beyond a taxpayer's control. I am referring to such things as taxes, interest, abandonment or theft of farm property, fire, storm, or other casualty, losses and expenses from drought, and recognized losses from sales, exchanges, and involuntary conversions of farm property. Neither the House-passed bill nor the Administration's proposal contain a comparable provision to protect the legitimate farmer and rancher from being penalized for having incurred an economic agricultural farm loss in a given year. My bill also provides safeguards to protect those just starting out in farming as well as those who might find themselves in a loss situation in a given year, not by design for tax purposes but rather by chance. This is accomplished by a provision that allows any disallowed loss to be carried back three years and forward five years against past or future farm income. The problem with the approach recommended by the Administration and now contained in the House-passed bill except for different dollar exclusions is that it allows the tax-dodge farmer to defer any recognized capital gains while at the same time he is allowed to continue using the full amount of his artificial losses as an offset against nonfarm income year after year. By attempting to convert capital gains into ordinary income rather than nip the losses in the bud before the tax-dodge farmer can use them, both the House bill and the Administration allow offenders an easy out with just the proper amount of tax planning.

Revenue figures provide some insight into the comparative effectiveness of the House bill, the Administration's proposal, and S. 500. My bill would affect about 14,000 individual tax returns and would raise an additional $205 million a year from these individuals. The House bill would affect about 3,000 returns and when fully operative raise an additional $25 million annually. These revenue estimates do not include comparative figures for corporations. I can only imagine the amount by which the gap between the two bills would widen even further. The Administration estimated its 4 September proposal would apply to 9,300 individuals and raise $50 million annually. The Administration has already admitted that although the House bill adopts the same approach, the dollar exclusions contained in the House bill are so high as to render it ineffective.

Here is a unique opportunity to combine substantial revenue increases with substantial equity by restoring healthy competition to our farm economy. The House-passed bill can be reshaped to serve as a meaningful vehicle for equitable and effective reform in this area.

STATEMENT

I appreciate the opportunity to testify for legislation that would remove in- * equities between legitimate farm operators and tax dodge farmers-people who engage in farming for the purpose of creating artificial losses which can be used to offset substantial amounts of their nonfarm income.

In the first session of the 90th Congress, I introduced S. 2613, to amend the Internal Revenue Code of 1954 to provide that farming losses incurred by persons who are not bona fide farmers may not be used to offset nonfarm income. When I ultimately decided upon the loss limitation approach as the best way to get at this problem, one of the sources of information I considered was an article written by Hendrik S. Houthakker, now a member of the Council of Economic Advisors. At the time that he wrote the article, Mr. Houthakker was engaged as a professor of Economics at Harvard. He concluded his article, which appeared in the January-February 1967 issue of Challenge, with the observation that "if this sacred cow is to be finally eliminated, the Internal Revenue Service may need some help from the Congress."

I found Mr. Houthakker's discussion of possible methods to get at this problem particularly stimulating. He stated as follows:

"If the tax laws are to be effective in this area, a more sophisticated definition of farmers is needed, or, alternatively, the offsetting of farm losses against other income should be restricted. But this restriction has to be introduced with due regard to the interests of genuine farmers.

"The best possibility would be to limit the farm loss deduction to, say, $10,000 in any one year, with provisions to carry larger losses backward or forward to be offset against earlier or later farm profits, but not against nonfarm income. In 1962 the taxpayers who claimed over $10,000 in farm losses had an average nonfarm income of about $50,000.

"Another possibility would be to treat as farmers only those who have derived a specified fraction of their income from farming during the past five years.

༧.

"Still another (similar to the Treasury proposal of 1963 which was rejected by Congress) would be to allow capital gains treatment only for the amount by which sales exceed deductions for farm losses in prior years. This proposal, however, would not deter those who do not take capital gains at all."

The 1963 Treasury proposal referred to by Mr. Houthakker is basically the same proposal as that suggested by Administration officials in their testimony before the House Ways and Means Committee on 22 April of this year and restated again but with higher dollar figures before this Committee on 4 September. This proposal which has come to be known as the Excess Deductions Account approach is now contained in the tax reform bill under review by this Committee. In July of last year, both the Departments of Treasury and Agriculture issued highly favorable reports on S. 2613, the predecessor to my bill, S. 500, which I reintroduced with substantial bipartisan support in January of this year. Both of those reports endorsed the principle of my original bill but at the same time suggested constructive modifications which I incorporated in the bill which was introduced last Fall for discussion purposes and then reintroduced early this session.

In order for the record to be complete on this matter here are the constructive suggestions made by the Treasury Department in its report of 11 July 1968: "As an alternative, we suggest placing a ceiling on the amount of nonfarm income which could be offset by farm losses in any one year. If there were excess farm losses, they could be carried backward and forward to offset farm income, but no other income, of other years. If part of a taxpayer's income for a year consists of capital gains, his carryover of excess farm deductions arising from the special farm accounting rules would not be permitted to offset it. On the other hand, the ordinary farmer incurring a loss would be protected under this approach in two ways: First, by allowing a limited deduction for farm losses, an ordinary farmer who must take part-time or seasonal employment to supplement his income in a poor year in his farm operations would not be deprived of his farm loss deductions. Second, the carryover and carryback provisions would be available to absorb large one-time losses. In other words, the provision would, in operation, only affect taxpayers with relatively large amounts of nonfarm income, that is, individuals who do not have to depend on their farm income for their livelihood.

"It is suggested that . . . corporations could be covered in the same manner as individual farmers and farms run by a partnership."

The Treasury Department concluded by suggesting that some kinds of farm expenses should be excepted from the disallowance provisions. Here is the reason for that suggestion:

"One category of farm expenses would include taxes and interest which are generally deductible whether or not they are attributable to an income producing activity. A second category would include casualty and abandonment losses and expenses and losses arising from drought. These events are generally not in the taxpayer's control and disallowance of the loss or expense could create an undue hardship to the taxpayer since they may be catastrophic. These same expenses and losses are now excluded from the operation of section 270 which excludes losses in connection with a hobby operation."

One additional suggestion made in the report was to provide "for an adjustment that would limit the measure of allowable farm deductions to the taxable one-half of capital gains." The reason for this suggestion was to prevent the taxpayer from receiving a double deduction against his capital gain farm income. The suggestions contained in last year's Treasury and Agriculture reports together with those contained in Mr. Houthakker's article made a great deal of sense. For example, it was clear that all concerned agreed the most equitable and effective way to get at this problem is to limit the amount of farm losses that can be used as an offset against nonfarm income in any one year.

The problem which now exists is that liberal tax accounting rules designed for the benefit of the ordinary farmer are being manipulated by nonfarmers. These nonfarmers engage in farming for the purpose of creating artificial losses that they can use to reduce the taxes they would otherwise have to pay on highbracket nonfarm income. The tax losses which these tax-dodge farmers show are not true economic losses. These so-called "tax losses" arise from deductions taken because of capital costs or inventory costs and thus usually represent an investment in farm assets rather than amounts actually lost. Usually, the investment is ultimately sold and taxed only at lower capital gains rates.

The deductions are set off against ordinary income, while the sale price of the resulting assets represents capital gain. The gain is then usually the entire sales