It is frequently contended that the direct reinvestment of a large fraction of corporate earnings is essential to the expansion of corporate enterprise; and that the surtaxes imposed under the Revenue Act of 1936 will therefore operate to prevent or seriously to restrict such expansion.

Reference to the table on page 6 will show that a corporation with net income of $10 millions a year could, by increasing its total corporate income taxes from 15 percent to 16.6 percent of its net income, retain for expansion, after taxes and dividends, more than $1.5 millions a year; and that corporations with smaller net incomes could retain for expansion proportional amounts at smaller tax costs.

Apart, however, from the fact that the surtax rates are such as permit the retention of reasonable proportions or current earnings without prohibitive tax costs -- the rates being designed to yield the Treasury no more than would be collected in income taxes from the stockholders if all corporate net incomes were fully distributed --, the fact is that corporations are not required, in order to avoid the surtax completely, to pay out their earnings in cash. The dividends may be paid in the form of securities constituting taxable income to the stockholders, such as preferred and common stocks (provided such distribution changed the proportionate interests or the various classes of stockholders), and various classes of debt instruments.

In addition, for many decades, growing and successful corporations have been able to call upon their stockholders and others for additional capital through the offering of rights to the stockholders to subscribe for additional securities. Through the issuance of such rights, any medium-sized or large corporation whose stock is traded in the securities markets may obtain the reinvestment in its business of capital equal to all or any desired proportion of the current earnings that have been distributed in dividends; and, if need be, more.

Assume a corporation that desired to reinvest in its business its entire earnings of $5 a share, but that, nevertheless, decided to pay out the whole amount in dividends in order to avoid the corporate surtax. Such a corporation could usually obtain the reinvestment in its business of this $5 per share by offering to its stockholders rights to purchase additional capital stock at prices below the prevailing market values. The rights themselves would constitute a valuable marketable instrument which could be sold in the open market by any shareholder who was not disposed to reinvest his dividend check. It is equally apparent, of course, that the amount of money which can be obtained in this way is by no means limited to the amount of the earnings of the corporation, but that any reasonable increase in total capitalization can be effected by this means; not to mention the issue of preferred stocks and bonds.

During the period between 1921 and 1930, inclusive, the American Telephone and Telegraph Company paid regular dividends at the rate of $9 per share, the dividends aggregating about $854 millions during the ten years. But, during this same ten-year period, the corporation offered rights to purchase additional securities to its stockholders in 1921, 1922, 1924, 1926, 1928 and 1930, and in the aggregate raised about $950 millions of capital from its stockholders through the sale of such additional securities to them, or about $100 millions more than the aggregate dividends paid to them during the period.

The Travelers Insurance Company of Hartford, Connecticut, by successive offerings of rights to shareholders to subscribe to new stock at par in 1908, 1910, 1913, 19l6, 1920, 1923, 1925, 1926, 1928, and 1929, multiplied its outstanding amount of capital stock twenty times, from $1 million to $20 millions.

It may be objected that the issue of such rights is open only to extremely large corporations or that the practice or issuing them is infrequent. Neither of these objections is true. Using figures compiled by the Commercial and Financial Chronicle, the Bureau of Business Research of the University of Illinois estimated that more than $3 billions of capital was raised by corporations in 1929 through the offerings of securities to their stockholders. In discussing such stock offerings, Dewing, in his Financial Policy of Corporations, a standard work on this subject, says, "They occurred almost as frequently in 1922 and 1923 as they did in 1928 and 1929." The number of corporations, relatively small and unknown as well as large and well-known, that have been using this means of raising capital funds during the past twelve months is exceedingly large.

In addition to the funds which may thus be raised by nearly all profitable corporations, large and small, through the offering of new stock to their stockholders, large corporations, in particular, will continue to possess, as they always have, access to the organized capital markets for the direct flotation of securities to persons other than their existing security holders and so will be able to raise such additional funds as they may need through the offering of stocks and bonds for public subscription.

Nevertheless, there are some who argue as if capital funds obtained by direct reinvestment of earnings, and therefore credited to an account called surplus, have a special magic about them that makes them more valuable to a corporation than capital funds obtained through the sale of equity securities. Thus, it is contended that corporations with large accumulated surpluses are in a stronger competitive position than corporations with smaller or no surpluses. This contention does not stand examination. The item of surplus occurs on the liability side of a corporation's balance sheet and does not necessarily represent cash or marketable securities or inventories or any other type of liquid asset. In many cases, a corporation is born with a surplus as a result of the expedient of undervaluing its capital stock on its books and calling the rest of its paid-in capital "surplus." In other cases, the surplus is the result of giving a large and sometimes fictitious value to such intangible assets as good will or patent rights. In no case can it be truly stated that a non-financial corporation with an accumulated book surplus is in a better competitive position than another corporation with equal assets and similar liabilities and equally good management that has no book surplus. The latter corporation could create a book surplus at any time by a reduction in the par or book value of its capital stock.

It is sometimes argued that these considerations are more applicable to corporations engaged in stable than to those engaged in highly fluctuating industries because the latter corporations experience frequent and prolonged periods during which low earnings or actual deficits preclude successful appeals to stockholders for additional capital funds. The answer to this contention is that such corporations were previously able to obtain substantial amounts of capital funds through reinvested earnings only during prosperous years. Under the new law, they may continue to utilize prosperous years to accumulate capital funds by the sale of additional securities to their stockholders.

It is argued by some that stockholders may be reluctant or even unwilling to reinvest in any given enterprise any large fraction of the earnings distributed to them in dividends. But this argument assumes that corporate managements may justly reinvest earnings in a particular enterprise against the desire of the stockholders. In the last analysis, however, the earnings of a corporation belong to its stockholders; and stockholders are entitled to exercise a choice, which, under the present corporate practices they do not always possess, with respect to the disposition of these earnings. Insofar as one effect of the undistributed profits tax will be to encourage corporate managements to obtain the consent of their stockholders for capital expansion, and to give to stockholders -- the real owners of the corporation -- a greater control over the disposition of their earnings, this effect is altogether desirable. It has often been remarked that corporate managements are far more prudent in the use of capital funds obtained through formal financing with the aid of investment bankers than in the use of capital funds arising out of reinvested earnings. A more disciplined use of the latter source or capital is no less desirable.


Critics of all forms of undistributed profits taxation have attempted to rest much or most of their case on this contention. It has been widely charged that one of the principal results of the tax will be to make future depressions far more severe because the accumulated corporate surpluses that in the past have cushioned corporations, their creditors, their stockholders, and their employees from the full effects of a declining or low level of industrial activity, will, by reason of the new tax, be available in much smaller volume. Hence, the tax has been called a tax on thrift, a penalty upon prudence, a factor that will make for numerous corporate bankruptcies at the first sign of bad times. Such contentions possess a surface plausibility, but they do not withstand analysis.

In the first place, much of the plausibility of these contentions arises out of a very widespread misapprehension of the nature of corporate surpluses. A corporate surplus appears on the liability side of a corporate balance sheet and not on the asset side. The account does not represent a pool of liquid assets, cash and the like, which corporations keep available for use in emergencies. It very commonly represents fixed assets in large part, such as plant and machinery; or intangible assets, such as good will, patent rights, contracts, et cetera, none of which can be "spent" to meet depression needs or to repair damages caused by floods, or for any other emergency. Corporations with capital deficits are quite frequently far better situated, so far as liquid assets are concerned, than corporations that publish balance sheets containing large surplus figures.

In recent years particularly, the size and character or corporate surpluses, as the expression is used in corporate accounting, have been profoundly influenced by considerations of convenience, taxation, and financing; and the size of a corporate surplus today bears no necessary relationship to the amount of accumulated earnings nor to the liquid resources of a corporation. Stock transfer and similar taxes, for example, often make it advantageous for a new corporation to place a small book or par value on its stocks, or for an established corporation to revalue its existing capital stocks in this direction, and in both cases to transfer the remainder of the stockholders' equity to the surplus account. Aside from the taxation and similar advantages involved, this change is purely one of bookkeeping. It does not affect the corporation's ability to withstand depressions or to undertake new expenditures.

The case is not much different for corporations whose surplus accounts actually represent accumulated earnings. If these earnings have been invested in the construction or purchase of additional plants and machinery, the large surplus account offers no measure of the corporation's ability to meet financial difficulties. If an investment banker or an investor examines the balance sheet of a corporation to determine whether the stockholders' equity provides an adequate margin of safety for a bond issue, he looks to the whole stockholders' equity, part of which will be found in the capital stock account and the rest of which will be found in the surplus account. It makes very little, if any, difference to him whether the surplus account is large and the capital stock account is small or vice versa, provided only that the book figures accurately measure the value of the stockholders' equity.

It is not the size of a bookkeeping figure called "surplus" that determines the ability of a corporation to meet a depression or other contingency. It is the amount of the total assets of the corporation as compared with its obligations (particularly its short-term obligations), and the proportion of its assets which it keeps in liquid form, that are significant in this connection. Corporations with relatively large amounts of liquid assets, whether derived from previous earnings or from previous issues of securities, are in a position to meet unusual financial needs, irrespective of the size of the balance sheet item called "surplus."

There is no doubt that a corporation MAY increase the volume of its liquid resources by withholding current earnings from its stockholders. When it does so, however, it is obtaining new capital funds from them. It could equally increase its liquid resources by distributing all of its current earnings in dividends and offering its stockholders rights to purchase additional stock with a portion or all of their dividend receipts. The undistributed profits tax places no limit upon the aggregate volume of a corporation's resources nor upon the proportion of these resources that it may keep in relatively liquid form.

There are some who, though admitting the inequities of the previous system of corporation taxes, nevertheless defend it on the ground that the corporate surpluses that are built up free from surtaxes serve a public function by enabling corporations to maintain employment at a higher level than would otherwise be possible in periods of depression. 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. Is it not quite possible that in some instances, important in the aggregate, over-expansion of plant capacity was stimulated by the desire of the controlling stockholders in corporations to have the corporate earnings directly reinvested, in order that they might avoid liability for individual income taxes on the added dividends? It is also held by many that one of the vicious influences contributing to the great 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. Large 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, et cetera. 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 $1 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, however, 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. The cash and investments of all nonfinancial corporations submitting balance sheets amounted to $32.7 billions at the end of 1929; at the end of 1933, they amounted to $33.5 billions.

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. During 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 nonfinancial 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 information 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, in contradiction to certain misleading statements that have gained considerable currency, 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 entirely possible that one effect of the undistributed profits tax may 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 dividends. Moreover, the $13 billions of dividend payments made by all reporting American corporations during the three years 1931-1933, inclusive, an amount $1 billion less than their net cash receipts, included a very large volume of dividends on cumulative 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 size of their book surpluses.

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-time 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 19 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 widespread 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.