[Previous]

Now, the most obvious fact bearing on this argument is that it simply did not work when, in 1929, the greatest depression this country has ever experienced came upon us. Not only do we now know that the corporate surpluses accumulated in the Twenties were not used to any great extent, in the aggregate, to maintain employment during the depression, but we also have some ground for suspecting that the very accumulation of these corporate surpluses assisted materially in causing the depression.

Thus, it has been argued by very respectable economic authorities, that among the causes of the depression was the starving of consumption through the withdrawal of too large a proportion of our national income for corporate capital expenditure. It is also held by many that one of the vicious influences contributing to the beat stock market boom of the late Twenties was the piling up of liquid corporate resources through excessive retention of corporate earnings. Stock market speculation, which had already been stimulated by the rapid growth in corporate earnings, was further stimulated by the volume of funds representing undistributed earnings that was poured into brokers' loans by corporations.

But let us examine specifically the contention that these accumulated surpluses were actually used during the depression to maintain employment, dividends, and other payments. The Department of Commerce figures are frequently cited to represent the aggregate losses of corporations during the depression. Either by direct statement or by implication, the contention is made that these losses represent the amounts which corporations have had to pay out, in excess of their receipts, to workers, suppliers of materials, bond holders, and the like; and that only their previously accumulated surpluses allowed them to do this without bankruptcy.

We have been at pains to examine the matter in detail on the basis of the actual income-tax returns filed by corporations, and we find that the figures reported each year to the Bureau of Internal Revenue are strikingly at variance with this contention or belief. Some of our findings are as follows:

If we consolidate the income accounts of all corporations for each of the three years 1931-1933, inclusive, we find that they reported an aggregate net deficit for this three-year period, after taxes, of $6.6 billions. We also find, however, that this aggregate net deficit was arrived at after deducting some $11.2 billions for depreciation, some $761 millions for depletion, some $3.7 billions for bad debts, and some $5.1 billions for loss on the sale of capital assets; deductions which, in the main, did not represent current cash outlays making for employment, dividends, etc. In other words, the aggregate net income of corporations before these valuation deductions, in the worst depression in history, was a little more than $14 billions, and their cash dividends a little more than $13 billions. for corporations as a whole, dividends, wages, and other payments, came out of current receipts, primarily, and not from accumulated liquid surpluses. The book surpluses of corporations were, indeed, reduced; but they were reduced in the aggregate, not by. actual cash disbursements, but by the writing down of assets on the books of corporations.

It may well be objected that these figures may be deceptive because they include financial as well as nonfinancial corporations. But the figures for nonfinancial corporations alone, which include all of our manufacturing, mining, merchandising, and similar business corporations, tell the same story. Nonfinancial corporations reported a net aggregate deficit after taxes for the three years 1931-1933, inclusive, of $3.9 billions. Their net income before valuation deductions, how,ever, amounted to $11.1 billions, and the dividends paid, to $10.6 billions. It is obvious that the previously accumulated surpluses of nonfinancial corporations, while reduced by valuation deductions, did not represent liquid resources that were drawn upon, in the aggregate, to pay wages or dividends.

Even if we confine our attention to deficit nonfinancial corporations, that is, nonfinancial corporations reporting no statutory net income, we find that valuation deductions, rather than cash operating losses, accounted for the largest part of their aggregate net losses during the depression. luring the three years 1931-1933, inclusive, the aggregate net losses after taxes of those nonfinancial corporations that reported no net income amounted to $12.1 billions; but $9.5 billions of this aggregate, or 78 percent, represented valuation deductions, primarily, rather than cash operating disbursements in excess of cash receipts. It should be borne in mind, moreover, that a corporation is included in the deficit group only in those years in which it reports no net income; so that the figures just cited INCLUDE the losses of all corporations during their worst years of the depression, AND DO NOT INCLUDE their net income, if any, in other years of the depression.

The figures cited above were obtained from the income-tax returns actually filed by corporations with the Bureau of Internal Revenue. It should be pointed out that there were other reductions in the book "surplus" of corporations besides losses allowed for income- tax purposes, and some of these represented cash outlays. It should also be made clear that the figures presented for all corporations, for all nonfinancial corporations, and for deficit non-financial corporations only, are aggregate figures, and are subject to the limitations of all aggregate and composite data. They are not necessarily representative of the experience or practices of any particular corporation. It is also true that in many cases corporations employed a portion of the receipts charged off as valuation items for necessary replacements of plant and machinery. Finally, it should be observed that most corporations are permitted to exercise a liberal range of discretion in the valuation of their assets on their own books and for their own purposes. Many of them revalue their assets upward during periods of prosperity, thereby creating direct additions to their surplus accounts, independently of their current income. Similarly, in periods of depression, many corporations make large write-downs in the valuation of their assets on their own books and they make corresponding reductions, in their book surplus accounts.

Although the accounting methods of corporations vary considerably, such variations do not affect the income and deficit figures presented above, because the regulations of the Bureau of Internal Revenue, as well as the statutes, lay down substantially uniform rules for the determination of taxable income. Only a limited use can be made of the balance sheet data submitted with corporation income-tax returns because, in contrast to the uniform rules for the determination of taxable income, the Bureau has not prescribed detailed regulations for balance sheet data. It should also be said that our Statistics of Income are not strictly comparable from year to year, because of changes in law, in affiliations for consolidated returns, and other factors.

Nevertheless, these limitations of the data obtained from corporation income-tax returns do not impair the general conclusions drawn above respecting the character of corporation deficits during the depression and the uses made, such as they were, of the accumulated corporate surpluses. It must be emphasized that reductions in book surpluses arising in the fashion just outlined do not represent funds paid out to employ labor, to purchase materials, or to pay interest or dividends.

In general, then, the figures reported to the Bureau of Internal Revenue clearly indicate, first, that for corporations as a whole, valuation deductions greatly exceeded the aggregate net losses reported during the depression; second, that valuation deductions, rather than net cash outlays, account for the largest part of the losses reported even by deficit nonfinancial corporations; and, third, that corporate surpluses in the aggregate have not been drawn down in fact to maintain employment, dividend payments, and other disbursements during the depression.

It is no doubt true, however, that the existence of corporate surpluses facilitated or made legally possible the continuance of dividend payments in excess of current net earnings in many instances during the depression: and it is probable that one effect of the undistributed profits tax will be to make dividend payments less regular and less uninterrupted than they have been. Even this consideration, though meriting some weight, may easily be given exaggerated importance. For one thing, many corporations during the depression deliberately devalued the book or par value of their capital stocks in order to create or increase their book surpluses for the precise purpose of continuing dividendliberately devalued the book or par value of their capital stocks in order to create or increase their book surpluses for the precise purpose of continuing dividends. Moreover, the $13 billions of dividend payments made by all reporting American corporations during the three years 1931-1933, inclusive, included a very large volume of dividends on automative preferred stocks and dividends on stocks of companies in relatively stable lines of business, such as operating electric light and power companies. The general run of industrial and mercantile corporations eliminated or severely contracted their dividend disbursements, particularly on common stock, regardless of the site of their book surpluses.

It is doubtless true that the previously accumulated real capital of the country, consisting of buildings, machinery, etc., enabled us to operate curing the depression without full current maintenance thereof. This was true, however, regardless of the form in which ownership of this capital was held -- whether in the form of corporate debt instruments, common and preferred stocks, corporate surpluses, or individual ownership. But the bookkeeping recognition of unreplaced wear and tear, and of declines in values arising out of other causes, created no employment. To hold that such write-downs in value provided contributions by business to emergency relief would also require us to assert that the holders of stocks and bonds listed on the New York Stock Exchange contributed $86 billions of emergency relief between September 1929 and April 1933, this figure being the aggregate decline in the market value of their securities.

The record with respect to employment and payrolls is even less favorable than with respect to dividends. The Federal Reserve Board index of manufacturing output declined by 47 percent between 1929 and 1932; the decline in the index of factory employment was 37 percent; and the decline in the index of factory payrolls was 58 percent. Widespread part-tame employment, such as in the steel industry, where workers were retained on the payrolls though given only a day or two of work a week, prevented the employment index from reflecting fully the actual decline in the real volume of employment, such as could be measured by the number of man-hours worked. The index of factory payrolls not only declined much farther than the index of factory production -- 58 percent versus 47 percent --but it also dropped far more than the Bureau of Labor Statistics index of cost of living, which declined by only 21 percent, and the Bureau of Labor Statistics index of wholesale prices, which declined by only 32 percent in this period. These figures provide no supporting evidence whatever for the contention that the losses of corporations during the depression can be attributed in any substantial degree to the maintenance of employment or payrolls at levels higher than those justified by the reduced volume of business.

The fact of the matter is that, in general, though with wide- spread exceptions which, however, are unimportant in the aggregate, corporations cannot be expected, regardless of their book surpluses or even of their total liquid resources, to retain more workers nor to maintain larger aggregate payrolls than the minima required to maintain their plants and to conduct current operations. Depreciation of plant and equipment takes place irrespective of the volume of business done, very largely, and any current operations that yield more than their out-of-pocket costs reduce the aggregate net loss of a corporation. Hence, corporations find it profitable to continue operations and to retain the workers needed therefor even though after valuation deductions, a loss is recorded. The retention of portions of a working force under these conditions is no evidence of philanthropic activity on the part of corporations; and is altogether unrelated to the size of the book surplus account.

5. THE CONTENTION THAT THE TAX WILL PREVENT SMALL CORPORATIONS FROM GROWING INTO BIG ONES AND WILL THEREFORE OPERATE TO PROTECT ESTABLISHED CORPORATE ENTERPRISES WITH ACCUMULATED SURPLUSES FROM NEW COMPETITION:

This contention hardly merits formal analysis, but it represents a fairly widespread misconception.

It may be observed, first, that the Revenue Act of 1936 accorded preferential treatment to shall corporations in two ways. First, it provided for lower normal taxes; and, second, it limited to 7 percent the surtax applicable to the first $5,000 of undistributed net income of those corporations that report adjusted net incomes up to $50,000. In consequence, a corporation with net income of $20,000, for example, could retain $5,000 of its earnings undistributed and still be liable to total normal and surtaxes some $160 less than the normal tax liability alone on the same income for the, taxable year 1935.

The change in base between the present normal corporation income tax and the corporation privilege tax recommended, in an accompanying memorandum, and the corresponding change in the base and manner of application of the undistributed profits tax proposed elsewhere in this memorandum, make impossible an exact comparison of the total burden of Federal corporation taxation to which small corporations would be subjected under the terms of our proposals, taken as a whole, as compared with either the present law or the Revenue Act of 1935. It is clear, however, that our proposals would retain a very substantial tax advantage for the small corporation. In the first place, the privilege tax proposed to be substituted for the normal corporation income tax is itself graduated. Furthermore, it is proposed in another section of this memorandum that the specific credit of $5,000 allowed in section 14(c) of the present law be retained and, extended in its application to corporations with adjusted net income of up to $100,000, and that the rate of tax applicable to the portion of adjusted net income falling within the specific credit be reduced from 7 percent to 3 percent. The effect of these changes will be to reduce the total amount of undistributed profits tax paid by the great majority of small corporations.

But the capital funds available for profitable corporations, whether large or small, are not limited to the amounts that they can save directly from earnings. In the case of small corporations with a limited number of stockholders, it is almost as easy to,pay out earnings in dividends and have all or a part of them resubscribed by the stockholders for additional shares of the corporation's stock, as to reinvest them directly. Which method shall be followed is merely a matter of convenience and tax economy. Under the previous system of income taxation, these considerations tended to favor the process of direct reinvestment, and hence a body of examples taken from the growth of corporations over the period during which the previous system operated will naturally shod that numerous small corporations grew into large ones by this method. The method of resubscribing dividends, however, would be equally effective, except for that part of the dividends which is absorbed by the shareholders' individual income taxes.

We have already observed that small corporations are given preferential treatment in the Revenue Act of 1936, and will continue to be given preferential treatment under our present proposals, with respect to both the normal (or privilege) tax and the surtax on undistributed earnings. They also enjoy two advantages in the process of growing through resubscribed earnings. In the first place, the very compactness of most small corporations permits this process to be carried on with a directness and informality which is impossible for the larger corporations. The whole operation of declaring out the yearns profits as dividends and re subscribing all or a portion of such dividends for additional shares of the corporation's stock, either pro rata or in such proportions as might be mutually agreeable to the shareholders, can be completed In the course of a short stockholders' meeting.

The other advantage which, generally speaking, small corporations have over large ones arises out of the relatively larder proportion of dividend receipts that their stockholders would have available, after payment of individual income taxes thereon, for subscription to additional securities, as compared with the important stockholders in larger corporations. It is generally true that the principal stockholders of small corporations are individuals of much smaller incomes than the principal stockholders of large, prosperous and well-established corporations. To the extent that both large and small corporations look to the dividends paid to their stockholders as sources of additional capital funds for ex pension, debt retirement, and the like, small corporations are in a relatively better position, by reason of our steeply graduated individual income taxes. Dividends which go to individuals reporting surtax net incomes between $10,000 and $12,000 are subject under present law to individual, income taxes aggregating only 11 percent; whereas dividends received by individuals reporting surtax net incomes between $100,000 and $150,000 are subject to income taxes aggregating 62 percent.

The considerations presented above apply with full force to corporations with a body of stockholders small or compact enough to act with an easy informality or a realization of their community of interest. Such corporations constitute the vast majority of all corporations -- not merely in the small, but even in the medium-size income brackets. Attention has already been called,constitute the vast majority of all corporations -- not merely in the small, but even in the medium-size income brackets. Attention has already been called, however, to the fact that not all of these considerations are equally applicable to medium-size corporations which have a relatively large number of stockholders, and, consequently, are unable to arrange for the reinvestment of corporate earnings through the medium of subscriptions to new corporate securities with the same ease. This type of corporation undoubtedly constitutes the most serious problem in the application of the undistributed profits tax. It is believed, however, that these problems can be solved through the media of taxable stock dividends and coercive or semi-coercive preferential subscription rights, as previously discussed. In the individual cases where the demand of the stockholders for a cash distribution renders the application of these means for the reinvestment of earnings impracticable, a grave question ought to be raised -- to say the least whether the corporation managements are justified in endeavoring to reinvest earnings in defiance of such demand.

6. MISCELLANEOUS OBJECTIONS:

In addition to the five primary objections to undistributed profits taxation just reviewed, a number of miscellaneous objections have been made. The more important of these are treated below:

(a) THE DANCER OF CAPITALIZING ALL CORPORATE EXPANSION

Expansion through the sale of additional securities, it is contended, leads to constantly increasing capitalization in good years, with the result that such losses as are suffered during bad years involve capital deficits. If a surplus account is built up during good years, such losses and, in addition, investments for expansion which has proved unwise, can be written off against that account without difficulty; but to write down capital, it is argued, is a more serious matter.

If the prevailing practice among American corporations were to maintain a consistent relationship between the carrying or par value of capital stock and the stockholders' investment, such value would have a definite and consistent meaning, though not one of primary significance. In actual practice, however, except for corporations under public regulation, there is no necessary or uniform relationship between the amount of the stockholders' investment and the par or carrying value of the capital stocks. Most corporations today are born with a surplus which is created at the outset by giving a smaller carrying or par value to the capital stock than the value of the assets presumably invested by the stockholders. Nearly every day one or more corporations is increasing its surplus account by reducing the par or carrying value of its common stock, or is reducing its surplus account by dividends payable in capital stock.

Whether expansion is financed directly from earnings or is financed by the sale of additional securities to stockholders, the corporation is, clearly, employing new capital funds -- and new capital funds provided by the stockholders. If the corporation does not desire to reflect the new capital funds in its formal capitalization, it is able in the one case, scarcely less than in the other, to reflect the additional capital funds by additions to its surplus account rather than by additions to the aggregate formal par or carrying value of its capital stock. It may reduce the latter virtually at will, with no perceptible effect upon the market value of its securities or upon its credit standing. A corporation which sold to its stockholders at $50 per share 100,000 shares of additional stock of $5 par or carrying value, would increase its surplus account by $4,500,000, and its capital stock account by only $500,000. It could then write off losses against this surplus account in the same way an against an earned surplus.

It is no doubt true that stockholders are apt to be somewhat more exacting with respect to the uses of the capital funds that they formally contribute than they are of capital funds which they contribute in no less degree, though less formally, through the direct corporate retention of earnings. Hence, an unwise use by corporate managements of funds contributed through the former, as contrasted-with the latter, method may involve greater embarrassment for corporate managements at stockholders' meetings. But it does not appear t hat any sound public purpose is served by disguising instance's of unwise use of stockholders' capital. Such losses may be reflected either by a charge to the surplus account created in the manner previously mentioned, or by a reduction in the carrying or par value of the capital stock, or even by an unvarnished deficit account, without important effect upon the credit of the corporation or upon the market values of its securities. The, United States Robber Company, with a balance sheet deficit of $17.3 millions on December 31, 1936. found on the see day its 5 percent bonds selling at 107, its non-dividend paying preferred stock selling at 97-1/2, and its common stock selling at 47-3/4.

(b) THE TAX PENALIZES CORPORATIONS WITH IMPAIRED CAPITAL

This objection takes two forms: First, that a corporation with impaired capital is in no position to pay dividends until its capital is replenished; and, second, that many State lawn prohibit the payment of dividends where such parent would impair or add to a previous impairment of a corporation's capital, and hence, a corporation is subjected to a tax penalty if it obeys the applicable Stage law.

The first objection rests on merely forms grounds. Virtually all corporations that have balance sheet deficits arc in a position to eliminate them by minor recapitalization, such as a reduction in the nominal or par value of the capital stock. To allow such corporations to retain earnings free from surtax until accumulated deficits have been removed by reinvestment of earnings would be to introduce tax discrimination in favor of a particular category of corporation losses, and moreover, of a category resulting from accidents of bookkeeping policies.

Furthermore, any attempt to make the exemption rest upon a balance sheet deficit, which can be created by bookkeeping just as easily as a balance sheet surplus, would encourage evasion. A corporation can easily eliminate a balance sheet surplus by the declaration of a stock dividend; and it can create a balance sheet deficit by a downward revaluation of plants and equipment. The legal and administrative difficulties that have arisen in connection with the determination of taxable income should certainly discourage the proposal of a revenue provision which would entail equally difficult problems in the valuation of corporate assets and liabilities. The United States Rubber Company, previously cited as a corporation with a large balance sheet deficit, had net profits of $6.5 millions in 1935 and more than $10 millions in 1936, and wound up the latter year with net working capital of $57 millions.

The second form of the objection is that in many States dividends may not legally be declared if capital stock or capital would be impaired. This is the rule in about 35 States. This, also, in the vast majority of cases, presents only a formal difficulty, because most of these deficits could presumably be eliminated by reductions in the par or nominal values of the capital stock. Further, the Federal Government would be setting a precedent of extremely dubious merit if it permitted an important part of its tax structure, which was adopted for reasons of equity and other considerations of public policy, to be distorted by exemptions or special treatments in recognition of greatly varying formal restrictions obtaining in the different States. To do so would also involve the practical difficulty of a serious loss of revenue and of possible competition by the States to enact laws which would provide the maximum relief from the Federal surtax.

Most industrial and mercantile corporations are free to obtain their charters from the State offering the greatest tax economy, freedom from restrictions, or other inducements. To recognize the State law as controlling in this connection would be to introduce another element into the prevailing competition among a number of States for charter-granting. It would appear to be sounder policy to allow the State laws to accommodate themselves to the new Federal statute or to allow corporations to make the necessary adjustments in their capital structures or in their place of incorporation.

(c) CAPITAL GAINS AND LOSSES AND NET LOSS CARRY-OVER

Under the present law, capital losses suffered by corporations are permitted to be offset against capital gains enjoyed in the same year, but may be offset against other income to the extent of $2,000 only. No carry-over of net losses from one year to another is permitted either for net capital losses or for operating losses. These provisions apply equally for the normal corporation income tax and for the undistributed profits tax. Waiving any discussion of the propriety of these provisions with respect to either the present normal corporation income tax or the proposed privilege tax, it is urged that they present a peculiar hardship with respect to the undistributed profits tax. It is believed that this objection to the undistributed profits tax has greater merit than any other now currently urged. In the recommendations presented elsewhere in this memorandum, it is, therefore, proposed that a two-year carry-over for all types of losses be permitted for the purpose of the undistributed profits tax only, capital net losses being permitted tooposed that a two-year carry-over for all types of losses be permitted for the purpose of the undistributed profits tax only, capital net losses being permitted to be offset against operating profits and vice versa.

The disallowance of capital losses as deductions from income other than that realized from capital gains in the same year (except for $2,000) has never been seriously defended upon the basis of equity, but was inserted in the law with respect to the individual and normal corporation income taxes as a matter of revenue expediency only. This limitation, when extended to the undistributed profits tax, has a particularly harsh impact, since the disallowance of capital losses for the purpose of the undistributed profits tax tends to dissipate corporate capital resources. Corporations suffering net capital losses are, in effect, required to pay an undistributed profits tax, in order to MAINTAIN their capital intact, whereas such a tax is normally contemplated only when a corporation seeks to INCREASE its capital through the reinvestment of earnings.

The same type of situation is presented when corporations with widely fluctuating returns, which have just suffered heavy net losses, are, nevertheless, subjected to a large undistributed profits tax liability, unless they pay out practically their full net earnings during subsequent good years. The retention of earnings in such cases often represents merely a desire to maintain corporate capital intact rather than a desire to expand; and so, ex-hypothesis should not be subjected to undistributed profits taxation. The provision proposed would avert both types of injustice, within the limit of time provided by the net loss carry-over.

(d) TIMING OF DIVIDEND DISBURSEMENTS

It is contended that the requirement that current earnings be distributed within the taxable year in order to qualify for a dividend-paid credit is unduly stringent for virtually all corporations, and is especially severe upon certain types of industries and enterprises.

For corporations generally, it is held, the amount of corporate earnings cannot be closely estimated until some time after the end of the taxable year. In consequence, corporations are forced to determine dividend policies upon the basis of incomplete information. In some cases, this leads to a greater distribution of earnings than would have been made had the year-end results been accurately available; and in other cases, it may lead to a greater surtax liability than the corporation would have chosen to incur. It has therefore been proposed that corporations be allowed a dividend-paid credit against the adjusted net income of any taxable year for distributions made in the first sixty days following the end of that taxable year.

The decisive consideration that presumably dissuaded the, House Ways and Means Committee and the Senate Finance Committee from recommending such a provision was the large and permanent loss in revenue that it would entail. It would have meant that corporations could avoid 1936 surtax liability by distributing earnings in the first two months of the calendar year 1937 without making their shareholders subject to individual income taxes on the dividends incorporating these 1936 corporate earnings until the latter half of the fiscal year 1938 and the first half of the fiscal year 1939. Similarly, in the taxable year 1937, corporations could withhold all or an extremely large portion of their earnings, and yet avoid surtax liability to the extent that these were disbursed in the first two months of 1938. And their shareholders, though receiving dividends representing 1937 corporate earnings, by reason of the receipt in the first two months of 1938, would not pay individual income taxes thereon until the latter half of the fiscal year 1939 and the first half of the fiscal year 1940, and so on.

It is apparent, therefore, that the Treasury could lose forever one full year's tax revenues on that proportion of the corporate earnings which avoided corporate surtaxes by reason of distribution in the forepart of the ensuing year and which avoided individual income taxes until the next following calendar year. The loss in revenues would not consist of regular annual recurring losses, but would be of the character of a capital loss the loss would consist primarily of the first year's postponement of tax liability; but this loss would never be retrieved until the books where balanced on Judgment Day or the law altered. Such a provision would offer a very strong inducement to all corporations to concentrate a very large proportion of their dividend disbursements in the two months following the close of their taxable year.

A further disadvantage of such a provision would be the inducement offered to evasion of both the corporate and individual surtaxes by the use of a chain of holding companies. Company A received dividend income in 1936 which it distributes to Company 3 in February 1937, which company B Distributes to Company C in February 1938, which Company C distributes to Company D in February 1939, which Company D distributes to Company E in February 1940. In each of these cases the corporation has avoided surtax liability by full distribution of its income without making any shareholder subject to individual income tax liability. The principal deterrent under present law to the use of a device of this character for the substantial postponement, at least, of income tax liability, is the corporate normal tax applicable to 15 percent of dividends received by corporations. This tax amounts' to something legs than 2.25 percent of dividend income, An individual eight find it more profitable to pay this tax ten times over on the same income during a series of years than to receive the income himself In a year when he was subject to high surtaxes. This deterrent factor would be much more important, however, should the proposed privilege tax be adopted with the provision that intercorporate receipts of dividends, as well as of interest, rents and royalties would be subject to the full force of the tax.

Although it is doubtless true that some risk of over- or under- estimating earnings is involved by the requirement that distributions must be made before the end of the taxable year to enjoy the, dividends-paid credit, it muse be remembered that more than eleven months of the taxable year elapse before a corporate management faces this problem of estimating, and that the twelfth month's business is already well in hand. Moreover it is recommended in this memorandum that the first bracket of 5 percent of adjusted net income remaining undistributed be taxed at the rate of only 3 percent. Finally, a dividends-paid credit is allowed for any dividends paid in excess of earnings during the two preceding taxable years.

A different but somewhat related objection to the required timing of dividend disbursements is made on behalf of corporations whose taxable incomes often consist in substantial measure of additions to their inventories of raw materials, as is frequently the case with leather and metal companies; or of additions to their holdings of promissory notes or installment payment contracts, as is frequently the case with farm equipment companies; it being realized in these cases that the distribution of such earnings is impossible within a limited period without serious curtailment of their business.

As against this objection, however, it might be said that such corporations have the clear option of paying out their earnings in the form of additional securities -- securities that would represent the additions to their inventories in value and quantity, or the additions to their accounts and notes receivable. To grant a special exemption from the surtax for portions of corporate earnings used to increase inventories or holdings of receivables would not only invite widespread tax avoidance, but would also be exceeding arbitrary and inequitable as between different enterprises engaged in the same or similar lines of business.

Decre and Company may show an increase of $12 millions in its holdings of farmers' promissory notes and this increase may represent virtually all of its earnings in a single good year. Another farm equipment manufacturer sells its farmers' paper to an installment finance company and its earnings may therefore take the form of an equivalent increase in cash. Shall Decre and Company be accorded preferential tax treatment because it chooses to engage in the banking business as an adjunct of farm equipment manufacturing?

Kennecott Copper has a far smaller refining and fabricating capacity in relation to its copper output then has Anaconda Copper. In consequence, Anaconda must maintain far larger inventories of copper metal than Annacott. Shall Anaconds, be given preferential tax treatment because it chooses to integrate its operations more fully than does Kennecott?

In these and similar cases, earnings taking the form of increased inventories or increased portfolios of receivables may be distributed to stockholders in the form of securities without reducing the resources of the corporation available for maintained or increased operations.

IV. RECOMMENDATIONS

The fun-mental principle of the undistributed profits tax is sound and should be retained. It will be necessary, however, to alter its manner of application considerably, in order to coordinate it with the corporation privilege tax proposed in an accompanying memorandum. It is believed that the adoption of the privilege tax and the method of coordinating it with the undistributed profits tax herein proposed accompanying memorandum. It is believed that the adoption of the privilege tax and the method of coordinating it with the undistributed profits tax herein proposed will in themselves result in substantially increasing the equity of both types of corporation taxation. In addition, we are also recommending certain changes in the undistributed profits tax itself, designed to increase the effectiveness and diminish the hardships of this tax as such. These recommendations would stand in broad outline even should the imposition of the privilege tax and the proposed coordination of the undistributed profits tax therewith be abandoned.

1. COORDINATION WITH THE PRIVILEGE TAX.

It is recommended that adjusted net income should be redefined to consist of privilege-tax net income less the privilege tax paid. Under such a definition, adjusted net income would be income before the deduction of interest, rents and royalties, as well as of dividends paid, and it is recommended that undistributed net income should consist of adjusted net income less all such payments. Credit would, of course, be allowed only for interest, rents and royalties actually paid during the taxable year; but, aside from this shift from an accrual to a cash basis with respect to these deductions, undistributed net income would be the same as at present defined. Adjusted net income, however, would be larger for all corporations having prIor charges; and, therefore -- assuming that the brackets and rates of tax remained unchanged -- the absolute amount of undistributed profits tax upon the retention of any given amount of income by any such corporation would be reduced and the reduction would be very substantial in the case of corporations having a large amount of prior charges.

The difference in the effect of the application of the undistributed profits tax upon the new base, as compared with the present base, in the case of a corporation with heavy prior charges can be illustrated by the following example:

                                        Corporation    Corporation

                                            A              B

Net income after corporation 
  privilege tax (or normal income 
  tax), but before provision for 
  interest, rents and royalties         $1,000,000     $1,000,000

Interest, rents and royalties                    -        800,000
                                        __________     __________
Income available for dividends          $1,000,000     $  200,000

Dividends paid                             800,000              -
                                        __________     __________
Undistributed net income                $ 200,000      $ 200,000

Percent considered undistributed, 
  present basis                               20%           100%

Percent considered undistributed, 
  proposed basis                              20%            20%

Undistributed profits tax (present 
  rates), present basis                 $  19,000      $  41,000 

Undistributed profits tax (present 
  rates), proposed basis                $  19,000      $  19,000

Corporation A in the abode example has no prior charges whats- year, while Corporation B has prior charges so heavy that it earned the only 1.25 times during the year in question. The example is meant to be extreme, but is by no means unrepresentative. Corporation B may be "debt-ridden", but it has a great deal of company. Time was when a railroad or public utility bond earning its charges 1.5 times was considered of good quality. The Northern Pacific Railroad Company earned its fixed charges 1.13 times during 1936, and its 4-1/2 percent bonds sold at 105 on the last day of that year.

It will be noted that both Corporation A and Corporation B had identical amounts of net earnings available for the persons equitably entitled to participate therein, irrespective of the technical form of instrument by which this right of participation was evidenced; and, consequently, had the same privilege tax net income and paid the same privilege tax. In both cases also, the amount, disbursed to such equitable owners was the same and the amount remaining undistributed was the same. In each case, $1,000,000 of potential individual income was created through the activities of the corporation, and $800,000 was sent on its way to the individual income tax mill, while $200,000 was retained --perhaps as seed corn -- but, in any event, was not available for processing under the individual income tax.

It would appear, therefore, that the two corporations ought to receive the same treatment with respect to the undistributed profits tax. The only argument advanced to the contrary is that the corporation is already under compulsion to disburse its interest, rents and royalties, while dividend disbursements are voluntary; and, therefore, pressure need be applied to that income segment alone. Assuming, however, that it is the FACT of distribution which is important, it would seem an inadequate concept of the nature and purpose of the undistributed profits tax to deny credit to a corporation for disbursements made under contractual coercion (originally self-imposed, in most cases), while allowing credit only for disbursements made voluntarily or under governmental coercion.

The proposed manner of coordination of the undistributed profits tax with the corporation privilege tax would be fair and equitable for the reasons just stated, even if (a) the income of every corporation could be determined with accuracy, (b) such incomes were sufficiently constant so that corporations with heavy prior charges could count upon earning such charges in future years with confidence, and (c) interest, rents and royalties had always been included in the base for the corporation privilege (or normal) tax, and so presented no transitional problem. None of these hypothesis is true, however, and the untruth of each constitutes an important collateral argument for the adoption of the plan of coordination herein proposed.

(a) All corporation income is subject to a considerable margin of error of estimate. The situation of most corporations in this respect is greatly dissimilar from that of most individuals, who report their incomes on a cash basis. Most corporations, on the other hand, report their incomes upon an accrual basis, many of the accruals being estimates subject to a large margin of error and with many years to run before any final check can be made upon their accuracy. Taxable net income, in particular, may vary rather widely from true economic net income, not merely because of the difficulty inherent in the determination of true economic income in any event, but because the rigid application of uniform rules and definitions necessary in the computation of income for tax purposes makes difficult or impossible proper allowance for bona fide variations in conditions between industries, localities, and individual firms. A more important source of error in the determination of taxable income is that each taxpayer is attempting to report as little income as possible and the Government, which is well aware of this, has leaned the other way in the formulation of its own rules and regulations. Statutory income, therefore, as contrasted with ECONOMIC income, is determined, not by a painstaking search for truth, but by a competitive tug of war in which sometimes the taxpayer and sometimes the Government gets the better of it.

The base to which the margin of error of estimate should properly be applied is net income available to all of the equitable owners of a corporation rather than that available to the stockholders only. To revert to our example, the margin of error of estimate expressed in dollars is the same for both Corporation A band Corporation 3, other things being equal. It is the million dollar figure in both cases which is subject to error of estimate the $800,000 of prior charges of Corporation B are no guess, but a hard fact. If true income in each case should be 10 percent less than the million dollar estimate, it would result in a diminution of only the same percentage in the income available for the stockholders of Corporation A, but would result in a decrease of 50 percent in the amount available for the stockholders of Corporation B. Since the scale of graduation hereinafter proposed for the undistributed profits tax is based more upon the margin of error of estimate in net income than upon any other single factor, it seems only reasonable that it be applied to the same base as that to which the error applies.

The matter of margin of error of estimate is of far beater importance for the undistributed profits tax than for the normal or privilege taxes. If income is over-estimated for the purpose of the normal tax, it merely results in the individual concern paying a higher rate of tax upon its real economic income than that overtly stated in the law. If all incomes are equally overstated for the purpose of this tax, there is no injustice at all, and such injustice as there is in actual practice comes only from different degrees of over or underestimation of income. The case is entirely different with respect to the undistributed profits tax, however, for here a general overestimation of economic income and the consequent distribution of larger amounts than really earned will cause a general dissipation of capital and the over-estimation of the nomic income and the consequent distribution of larger amounts than really earned will cause a general dissipation of capital and the over-estimation of the income of a particular firm will, in most cases, result in a dissipation of its capital.

(b) The distribution of a given proportion of its total income available for all classes of participants places a greater strain upon a corporation with a large amount of prior charges than it does upon a corporation with a small amount of such charges, or none at all. Referring again to our example, Corporation A can pay our all or substantially all of its million dollar earnings to its stockholders with a light heart, since it knobs that if it earns nothing next year it is under no obligation to make any payments to its security holders; and even should it suffer a loss, its sound capital structure will always enable it to raise additional funds. Corporation 3, on the other hand, if it pays out In dividends any of the $200,000 it has earned for its stockholders, must do so with trepidation, since it knows not only that next year there will recur another $800,000 in charges which it must meet -- income or no income -- or else be taken over by its creditors; but also that its top- heavy capital stricture will make it difficult to raise additional funds. It is true that Corporation B's present capital structure may not be involuntary, but rather the result of the eagerness of its owners to trade on their equity to the maximum extent possible; and, consequently, it is entitled to no tax favoritism. Nevertheless, its plea for equal consideration with Corporation A for having passed on $800,000 of its million dollars of "income toward the tax, mill ought to receive our respectful attention.

(c) The change in the base of the normal or privilege tax from income available to stockholders only, to income available to all persons entitled equitably to participate in the earnings of the corporation, bile eminently fair from the longer-term point of view, places a heavy transitional strain upon corporations with substantial amounts of prior charges. Referring again to our example, if we suppose that a 15 percent "normal" corporation income tax is replaced by an 8 percent "privilege" tax, the tax upon Corporation A would be reduced from about $177,000 to about $87,000, while the tax upon Corporation 3 would, be increased from about $35,000 to about $87,000, the new tax being-the same upon both corporations. These figures, of course, include only the "normal" or "privilege" taxes. This heavy transitional strain placed upon corporations with substantial amounts of prior charges makes it particularly urgent that these corporations receive their full measure of equity in the coordination of the undistributed profits tax with the new privilege tax.

2. RATE SCHEDULE

The proposed schedule of surtax rates applicable to stated percentages of adjusted net income remaining undistributed is presented and compared with the present schedule in the following table:

     Present Schedule                   Proposed Schedule
Percent undis-      Percent        Percent undis-    Percent
  tributed            tax            tributed          tax

 0    to   10          7           0    to     5       3
10  + to   20         12           5  + to    15      15
20  + to   40         17          15 +  to    50      40
60  + to  100         27

The following table and the accompanying chart compare the relative severity of these two schedules in terms of effective totality rates:

  Percent undis-   :          Effective totality rate, percent
     tributed      :          Present /1/           Proposed /2/
        10                        7.0                   9.0
        20                        9.5                  18.3
        30                       12.0                  25.5
        40                       13.3                  29.1
        50                       15.0                  31.3
        60                       16.2                  36.1
        70                       17.7                  39.5
        80                       18.9                  42.1
        90                       19.8                  45.7

FOOTNOTE TO TABLE

/1/ Applies to corporations with adjusted net incomes over $50,000.

/2/ Applies to corporations with adjusted net incomes over $100,000.

          EFFECTIVE TOTALITY RATES FOR SELECTED PERCENTAGES
                     OF UNDISTRIBUTED NET INCOME
      Corporations with Adjusted Net Income of $100,000 or More

                            CHART OMITTED

     NOTE: -- THE TOTALITY RATES ARE NOT DIRECTLY COMPARABLE SINCE 
              THE PROPOSED SYSTEM WOULD INCLUDE IN "ADJUSTED NET 
              INCOME" ALL PAYMENTS OF INTEREST, RENTS, AND ROYALTIES, 
              AND WOULD GRANT CREDIT FOR SUCH PAYMENTS IN DETERMINING 
              THE PERCENTAGE OF ADJUSTED NET INCOME REMAINING 
              UNDISTRIBUTED.

It should, of course, be noted that the comparison made by the tables and the chart is formal only; and they must be used with extreme caution in comparing to effective rats of the present and proposed schedules, since, as discussed at some length in the preceding section, the base and manner of application of the proposed schedule are very different from those used in the present law. In general, the proposed rates are much less severe, in comparison with the present ones, for corporations with prior charges than would appear from the tables, -- and the greater the count of prior charges, the greater is the disparity between the real and apparent severity of the two schedules.

The proposed schedule has been trained with the following three fundamental factors in mind:

(a) The rate in the first bracket has been set at only 3 percent. It is believed, particularly in view of the margin of error of estimate applicable to all income figures, chat corporation managements should be allowed to retain a moderate proportion of adjusted net income if they feel that this is necessary to maintain their capital intact over a period of years. This allowance in also of some assistance in lessening such hardship as is incident to the requirement that dividends be paid in the same taxable year in which earned -- a requirement which is believed necessary on other grounds. In general, the removal of a small segment of adjusted net income from the impact of the tax may properly be compared with the removal of a small amount of water from a tank under high pressure the reduction in pressure is far more than proportional to the amount of fluid removed.

(b) It is felt that rates of intermediate severity are an evil which should be avoided as far as possible. Such rates -- ranging perhaps from 10 percent to 30 percent -- may not be sufficiently high to induce distribution of earnings; yet, if paid by corporations, impose an inequitable burden upon stockholders in the lower individual income tax brackets. The tax of 15 percent actually proposed is, for example, higher than the individual income tax on all amounts of surtax net income of less than $16,000. While it is felt impracticable to eliminate which intermediate rates altogether, the proposed schedule confines itself to one such rate -- 15 percent on amounts of earnings retained between 5 and 15 percent of adjusted net income.

(c) Over the remainder of the scale constituting 85 percent of total adjusted net income it is felt that the tax ought to be high enough to induce distribution of the amount of adjusted net income falling in such brackets in substantially all cases. The present rates of undistributed profits tax are quite inadequate to do this when earnings are withheld for tax purposes, as is clearly indicated by the comparison between the rates of the undistributed profits tax and the lower limits of surtax net income, upon which an equal or a higher rate of individual income tax (normal tax and surtax combined) would be levied than of undistributed profits tax shown in the following table:

___________________________________________________________________
  Percent of ad- :    Rate of undis-   :     Lower limit of surtax
justed net income:   tributed profits  :     net income taxable at
 undistributed   :        tax          :      same or hiker rate
___________________________________________________________________

 0    to   10%               7%                   $ 4,000
10  + to   20               12                     12,000
20  + to   40               17                     18,000
40  + to   60               22                     26,000
60  + to  100               27                     38,000
__________________________________________________________________

It is true that it is inaccurate to make a direct comparison between the rates of the undistributed profits tax and the rates of the individual income tax since, if income upon which an undistributed profits tax has been paid in one year is distributed in a subsequent year, it is subject to the full rates of the individual income tax, notwithstanding the prior payment of the undistributed profits tax. Since such a subsequent distribution is alwaysto the full rates of the individual income tax, notwithstanding the prior payment of the undistributed profits tax. Since such a subsequent distribution is always possible, the payment of the undistributed profits tax never gives complete assurance that no further taxation will be exacted, whereas the payment of the individual income tax does --at least within the limits of the ability of any tax payment to give such assurance. To put it in another way, MONEY CAN ALWAYS BE TRANSFERRED TAX-FREE FROM THE INDIVIDUAL POCKET TO THE CORPORATE POCKET WHEREAS THE REVERSE IS NOT TRUE.

It seems reasonable to infer, therefore, that a rate of undistributed profits tax substantially lower than that of the individual income tax to which a distribution would be subjected, will be sufficient to induce distribution, in so far as this is determined by tax considerations.

It is with this consideration in mind that it has been estimated that the top rate of 60 percent, applying to the bracket of between 50 and 100 percent of adjusted net income undistributed, will be sufficient to induce distribution even in closely held corporations. It should-be noted, however, that for individuals in the highest individual income tax bracket -- 79 percent --the net amount remaining after the payment of the individual income tax is only a little over half that remaining after paying an undistributed profits tax of 60 percent. It is therefore believe that a maximum bracket of 60 percent is necessary. The 40 percent bracket applying to amounts of adjusted net income between 15 and 50 percent ought, of course, to be sufficient to induce distribution in the vast majority of cases.

3. SMALL CORPORATIONS

It is not believed that the contention frequently made that the undistributed profits tax places small corporations at a disadvantage has merit, but the contrary is rather believed to be true. Nevertheless, in line with our consistent policy of granting preferential treatment to small corporations in any event, it is recommended that the specific credit provided in Section 14(c) of the Act be continued at $5,000, that the rate of tax thereon be lowered from 7 percent to 3 percent to conform wIth the lower rate suggested for the first bracket of the regular tax, and that it be extended in its application to corporations with adjusted net incomes of up to $100,000 (rather than $50,000).

This extension is necessary principally In order to maintain the effect of the present specific credit, which is that the first should in every case have a width of an absolute amount of $5,000, or of the whole adjusted net income if less than that amount. In view of the decrease in the percentage width of the first bracket from 10 percent to 5 percent, it is necessary to increase the application of the credit from $50,000 to $100,000 if this rule is to be maintained, and if the effect of the credit is to fade out gradually rather than ending abruptly. An additional reason for the upward extension of tic application of the credit is the change in the base of adjusted net income, since a corporation with an adjusted net income of $100,000 on the new base might easily have an adjusted net income of $50,000 or less on the present base.

It is further recommended that whatever Income remains undistributed beyond the amount included in the specific credit be taxed at the rates applicable if the specific credit had not been granted. At present the specific credit has the effect of taking income off the top bracket and transferring it to the first bracket. Under the proposed modification it would merely have the effect of transferring income to the first bracket from the immediately adjacent brackets.

4. ALLOWANCE OF NET CAPITAL LOSSES.

It is recommended that an unlimited offset of capital losses be permitted, for the purpose of the undistributed profits tax only, against other income.

5. NET LOSS CARRY-OVER.

It is recommended that a two-year carry-over should be allowed for all losses (including capital losses as merged with other losses by the preceding recommendation) for the purpose of the undistributed profits tax.

It is believed that recommendations 4 and 5 taken in conjunction will meet the legitimate complaint that it is often necessary for a corporation incurring substantial capital losses, or engaged in a fluctuating business, to pay an undistributed profits tax, in order to retain its capital intact; whereas, in the contemplation of the law, such a tax should be paid only when it is desired to increase the capital employed in a business by reinvestment of earnings free from the individual income tax. This complaint is directed primarily not against the undistributed profits tax itself, but rather against the underlying tax structure upon which it is superimposed; and, consequently, the principal discussion of the points Involved is in the memoranda upon the corporation privilege and capital gains taxes. Nevertheless, it must be recognized that the impact of the disallowance of net capital losses and of net loss carry- over is particularly harsh when applied to the undistributed profits tax. Consequently, if only a limited amount of relief is to be given in these respects, the Undistributed profits tax should receive first consideration.

6. OPTIONAL SETTLEMENT OF SUBSEQUENTLY FOUND DEFICIENCIES.

It is recommended that if audit of a corporation return reveals that net income from a previous year should have been reported at a higher figure than that appearing upon the face of the return, and no question of bad faith is involved, the taxpayer should have the option of paying the undistributed profits tax liability thereby created, with interest, or of paying a special tax of 5 percent of the undistributed profits newly determined by the Commissioner, and adding the remainder of such newly determined profits to adjusted net income in the current year.

It often happens that the Commissioner finds that the net income reported upon the face of a return has been understated. While this may be due to bad faith on the part of the taxpayer, it is more often due to other causes, ranging from totally innocent bookkeeping errors or misunderstandings of the law, up to the taxpayer giving himself the advantage of the doubt on all possible issues, but falling short, nevertheless, of the legal concept of fraud or bad faith.

Such delays in the final determination of tax liability were relatively harmless prior to the introduction of the undistributed profits tax, since any additional amounts of tax which were found to be due would have had to be paid by the taxpayer in any event. In such a case it rendered substantial justice to both parties for the Commissioner to levy such additional tax with interest, the latter being at a sufficiently high rate both to compensate the Government for the delay in the collection of the tax and to discourage taxpayers from being overly generous to themselves in their interpretation of doubtful points of law or accounting. A totally new difficulty is introduced by the undistributed profits tax, however, since the corporation might have avoided the tax altogether by a timely distribution of earnings had it known that such a liability existed. To require the corporation to pay a back undistributed profits tax with interest because of subsequently determined net income would appear to be inequitable if the corporation had made its original return in good faith and had always stood ready to distribute &11 or a large portion of its adjusted net income. The inequity of such procedure, moreover, would be greatly increased by the application of the new surtax rates suggested in this memorandum.

7. SPECIAL TAX ON EARNINGS EXEMPTED FROM THE UNDISTRIBUTED PROFITS TAX BY BE REASON OF CONTRACTS PROHIBITING THE PAYMENT OF DIVIDENDS, ETC.

It is recommended That a tax of 10 percent be levied upon earnings exempted from the undistributed profits tax under Section 26(c) of the Act, because of contracts prohibiting the payment of dividends, etc., and that such tax be levied in lieu of the lowest brackets of the undistributed profits tax in which the amounts so exempted would otherwise have fallen, provided that the total undistributed profits tax liability should never be increased by the operation of this provision.

The present relief granted by Section 26(c) seems to be based upon the hypothesis that the undistributed profits tax is a penalty, and that, therefore, corporations which are unable to distribute their earnings and profits in taxable dividends, because of contractual restrictions, should not be penalized. This conception is incorrect. The tax on undistributed profits is not a penalty applied to a morally opprobrious act, but is a compensation to the Government for the non-taxation of the undistributed income under the individual income tax. If current income remains undistributed as a result of prior contractual obligations, it results in as much revenue loss to the Government as if it had remained undistributed as the result of a currently made decision of the Board of Directors of the corporation. It would appear, therefore, that if relief is to be extended to any special cases of this character the appropriate form thereof is not a complete exemption from the undistributed profits tax, but rather the substitution of a moderate flat rate of undistributed profits tax upon the relevant segment oot a complete exemption from the undistributed profits tax, but rather the substitution of a moderate flat rate of undistributed profits tax upon the relevant segment of income in lieu of the sharply graduated rates that would otherwise apply. This principle was recognized in the House Bill in which most of such "relief" provisions carried a 22-1/2 percent flat tax (it should noted in this connection that the House Bill did not provide for any normal tax).