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CAPITAL FORMATION WITH PARTICULAR REFERENCE TO VENTURE CAPITAL

A Thesis Presented to the Faculty of the Department of Economics University of Southern California

In Partial Fulfillment of the Requirements for the Degree Master of Arts

by Pete Zidnak June 19^0

UMI Number: EP44702

All rights reserved INFORMATION TO ALL USERS The quality of this reproduction is dependent upon the quality of the copy submitted. In the unlikely event that the author did not send a complete manuscript and there are missing pages, these will be noted. Also, if material had to be removed, a note will indicate the deletion.

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2:6^

£e. T h is thesis, w r itte n by

........... PETE_ZIDNAK........... u n d e r the g u id a n c e o f h%.iS.... F a c u lty C o m m itte e , a n d a p p ro v e d b y a l l its

m em b ers, has been

p re se n te d to a n d a cce p te d b y th e C o u n c il on G ra d u a te S tu d y a n d R e search in p a r t ia l f u l f i l l ­ m e n t o f th e re q u ire m e n ts f o r th e degree o f

MASTER OP ARTS

Date.

Faculty Committee

-

Gtwirman

.

To My Wife

TABLE OP CONTENTS CHAPTER I.

II.

PAGE 1

INTROD U C T I O N............................... The p roblem.............

2

The purpose and scope of thethesis . . . . .

I4.

Sources of d a t a .............. ...

£

Organization of the t h e s i s ................

6

CAPITAL FORMATION

...................

Significance of capital formation What is capital formation?

11 .

..........

12 ll}.

Capital formation and types of economic systems . ..............

III.

. . . . . . . . .

Capital formation and savings ..............

19

Source of capital

21

.........

The necessity for capital formation. . . . .

2I4.

C o n c l u s i o n ...........

26

VENTURE CAPITAL— THE LIFEBLOOD OF ADYNAMIC ECONOMY .........

2?

Nature of venture capital

28

Equity capital versus debt financing

IV.

l6

....

29

Dearth of equity c a p i t a l ..................

314-

Conclusion

39

................

. . . . . . . .

RETAINED EARNINGS AND DEPRECIATION

. . . . . .

1{.0

Retained earnings............ ............

I4.0

V

CHAPTER

PAGE Depreciation

Proposals for depreciation policy reform Conclusion

10

. . . . . . . . . . . . . . . .

............

. .

. . . . . . . . . .

52

V. TAXATION IN GENERAL AND VENTURE CAPITAL . . . . Conclusion

Ij.8

511-

...............

6l

VI. CAPITAL GAINS TAXATION AND VENTURE CAPITAL

. .

Past provisions regarding capital gains . . .

63 6ij.

Present treatment of capital gains and losses

...............................

6>Ij_

Revenue from capital gainstaxation .........

6?

Effects of capital gains taxation on venture capital . . . . . .

............



67

Proposals for reform of the capital gains tax structure

. . . . . . . .

73

C o n c l u s i o n ...............................

78

VII. SECTION 102 AND THE FORMATION OF EQUITY CAP I T A L...................................

79

The provisions of Section 102. . . . . . . .

79

Effects of Section 1 0 2 ....................

81

Proposals for the reform ofSection 102 . . .

83

C o n c l u s i o n ............... ................

8lj.

VIII. DOUBLE TAXATION AND VENTURE CAPITAL FORMATION..................................

86

Nature of double taxation

86

..........

Vi CHAPTER

PAGE Effects of double taxation

IX.

.

............

87

Proposals for r e f o r m ............ . . . . •

9^

C o n c l u s i o n ................................

95

THE CORPORATE INCOME TAX AND VENTURE CAPITAL

.

The ttbasisw for corporate taxes . . . . . . .

97 97

The provisions of the corporate income tax law . . . . . . . .

........

. . . . .

The receipts from corporate income taxes

X.

101

The effects of corporate income taxes . . . .

103

Proposals for r e f o r m .................

106

Conclusion

110

.........

PERSONAL INCOME TAXATION AND VENTURE CAPITAL FORMATION..........................

Ill

Provisions of present personal income tax . .

112

Effects of personal income taxation . . . . .

113

Reforms Conclusion XI.

. .

100

............. . . . . . . . . . . . . . . . . .

OTHER FACTORS AFFECTING VENTURE CAPITAL . . . .

119 12i{. 125

Fear and u n c e r t a i n t y ...........

125

Lack of knowledge..........................

132

Stockholder relations and managerial p o l i c i e s ......... C o n c l u s i o n ................... XII.

INSTITUTIONAL FUNDS AND VENTURE CAPITAL . . . .

136 139 lip.

vii CHAPTER

PAGE Life insurance companies. . . . . . . . . .

XIII.

lljlj.

Investment trusts . . . . . . . . . . . . . .

150

Conclusion

156

• • . • ......... .. ...........

GOVERNMENT AND ITS INFLUENCE UPON EQUITY CAPITAL FORMATION . . . .....................

158

Governmental lending

...............

158

Governmental spending .......................

l6l

Government and business.................. C o n c l u s i o n ................. ........... XIV.SUMMARY AND CONCLUSIONS..........................

163 166 l6?

Summary of findings...................... Recommendations Conclusion

169

..................

. . . . . . . . . . . .

175

.........

178

BIBLIOGRAPHY.........................................

180

L IS T OP TABLES

TABLE

PAGE

I. Capital Formation in Relation to Gross National Product . ..................

1?

II. Sources of Corporate Investment Funds,

19^6-191^9...............................

30

III. Estimated Taxes on Capital Gains and Losses of Individuals, 1 9 3 5 - 1 9 . . . . . .

68

IV. Corporate Income Tax Liability and Dividend Payments

.......................

102

V. Spending Units Owning Various Types of Assets, Early 19^-9

. . . . . . . . . . . . .

VI. Federal Individual Income Tax Receipts

115

....

122

. . . . . . . . . . . . .

130

VII. Reasons For and Against Holding Various Assets, Early 19^9

VIII. Distribution of Assets - U. S. Life Insurance Companies

11\$

CHAPTER I INTRODUCTION Progress and prosperity are two important factors in the phenomenal growth of the United States as a nation and in the achievements which have resulted in a high standard of living.

Without these two factors, the economy of the

United States would be unable to produce the results which have proven so beneficial to the country as a whole— In fact, to all civilization. It Is not denied that progress and prosperity in the United States were possible because of the great natural resources, the tremendous energy of the people, and the more or less equal opportunities prevalent in our democratic country.

However, one faetor stands out above them all— the

vigor of enterprise with all Its incentives, opportunities, genius, and innovations.

It was this vigor of enterprise

that made America, that created wealth for the masses, and that raised many large populations from the neolithic stage of civilization.

Moreover, this dynamic factor promises

incalculable benefits for the future.

On the other hand,

if this tremendously productive force is crippled, the mighty advance will stopj1 1 Carl Snyder, Capitalism the Creator (New York: The Macmillan Company, I9I4.O), pp. 93-97.

2 The problem.

The vigor of enterprise in the United

States is being crippled.

In truth, it is not being crippled

by any ruthless positive action designed solely and specifi­ cally to thwart desirable economic progress.

There are no

deliberate efforts made to sabotage the economic system so that progress and prosperity would be impossible.

Nor are

there any conscious attempts to pursue policies which lead down the road to economic stagnation and enervation. The vigor of enterprise is not being crippled by direct, positive action, but is being crippled— just as certainly and just as completely— by indirect means. being burdened with onerous conditions.

It is

Oppressive regula­

tions, supposedly designed for the benefit of the common good, tend to restrict freedom of operation.

Other numerous

and unnecessary obstructions are placed in the path of progress. Progress and prosperity are the direct results of a very complex economic system functioning in the unrestrictive atmosphere of a Democracy. . . . there is one way, and only one way, that any people, in all history, have ever risen from barbarism and poverty to affluence and culture; and that is by that concentrated and highly organized system of pro­ duction and exchange which we call Capitalistic . . . It is solely by the accumulation (and concentration) of this capital, and directly proportional to the amount of this accumulation, that the m o d e m industrial nations have arisen . . .2 2 Xbid.. p. Ij.*

Italics in the original.

This complicated and highly organized economic system so essential to progress, prosperity, and freedom is a strong mechanism.

Yet, at the same time, it is very delicate.

Any

unsound manipulation or interference will hinder its normal functioning. The system seems to he most vulnerable in that phase or aspect which accounts for the accumulation of capital so necessary for the introduction of new methods and equipment and the expansion and modernization of the old. It is this aspect of our economic system which is being crippled with a resulting paralysis and debilitation of the whole economy. The capital formation of our economy is being hindered.

And it is being hindered in its most significant

and essential aspect, in the lifeblood of the economic system— venture capital. Until recently, there has never been a general unwillingness on the part of people in this country to invest their savings in venture capital.

At times, there

was perhaps an actual shortage of savings to invest, but rarely was there a significant lack of interest in investing those savings that were available if there were prospects of an adequate return.

Such venture investing has long been an

American tradition which resulted in the rapid development of our resources, the expansion of production, and a steadily

k rising standard of* living.-^ Existing conditions are making it extremely difficult for venture capital to flow into the economic system.

And

as a consequence, the economy is not the vigorous, healthy system which had been the main force behind the progress and prosperity of the United States. The purpose and scope of the thesis.

The purpose of

this thesis is to investigate the conditions which influence the flow of vent tare capital in the economic system. Obstructions to the vital flow of venture investment are determined, and proposals for the removal of the crippling obstacles are set forth. Insofar as the equity problem as a whole is con­ sidered, previous investigations have not been adequate. (See pages 5>-6, infra.)

In fact, because of this inade­

quacy, the present study was undertaken with the aim of bringing together under one cover an exposition of the various factors which affect the flow of capital into venture investment, together with the reforms proposed to remove obstacles to the flow. This study must be considered as being somewhat 3 Thomas B. McCabe, wThe Equity Capital Situation,” statement submitted to the Subcommittee of the Committee on Banking and Currency of the United States Senate, August 19^9. p . l.

limited in objective in that it does not attempt to analyze in minute detail all of the various factors which affect venture capital.

Only the most significant forces which

have an Influence upon the flow of equity capital are dis­ cussed,

It is concentrated mainly on those factors which

directly affect the flow of funds into venture investment in American industry. Greater emphasis is given to the practical aspects of the flow of funds into venture investments.

Unnecessary

consideration is not given to any purely academic or theoretical problems Involved.

The everyday problems

encountered in obtaining risk capital are considered important, and it is the source of these problems which this thesis attempts to set forth. Sources of data.

Information regarding this study

was obtained mainly from recent periodicals.

Most of the

articles concerning the various phases of the problem have been published by business men from the securities industry as well as from other types of enterprises— men who are closely associated with the equity capital situation.

These

writers are intimately concerned with the problem, and con­ sequently, wrote of the practical aspects and proposed practical solutions.

Abstract theoretical considerations

concerning the flow of funds into venture investments were

also examined.

However, as mentioned previously, it was

intended to place greater stress on the practical aspects of the problem. The available sources of material directly concerning the equity capital problem are, in a sense, limited. Actually, the writers who are closely associated with the problem have written an adequate number of articles.

How­

ever, most of the articles are concerned only with a particular aspect of the problem, and in many cases, this particular aspect Is Included in a much broader study. Consequently, previous studies are deemed inadequate insofar as the complete venture capital problem is concerned. Organization of the thesis.

Specifically, Chapter II

is devoted to an analysis of the role of capital formation In an economic system with particular emphasis upon its functions In our democratic society.

The sources of capital

are considered, and the nature, significance, and the need for capital formation are discussed. Chapter III is a detailed introduction to the main element of the thesis Investigation— venture capital.

The

nature and significance of venture capital are analyzed. The effects of debt financing as opposed to equity capital financing are studied.

A very important aspect of this

study— the dearth of venture capital— Is examined in the

last section of this chapter. In Chapter IV, retained earnings and depreciation are discussed.

The retained earnings are considered in relation

to their effects upon the business organizations and invest­ ors.

The possibilities of future financing by means of

retained earnings are examined.

Depreciation is considered

in the second part of Chapter IV.

The present depreciation

policies for tax purposes are set forth, and problems arising from the present policies are discussed.

Suggestions for a

more realistic depreciation policy are proposed. A general study of taxation is provided in Chapter V. The general effects of the tax system upon the economy as a whole are set forth.

The deleterious consequences resulting

from an unwise tax structure are discussed, as well as the benefits possible from a sound tax system. The taxation of eapital gains and losses is treated in Chapter VI.

In this chapter, the present provisions of

the law regarding capital gains and losses are set forth, as well as statistical Information concerning the amount of revenue received from the tax.

The effects of capital gains

taxation on equity capital are discussed, and reforms are proposed. Chapter VII is devoted to the taxation provisions of Section 102 of the Internal Revenue Code.

The effects of

the tax are discussed, and suggestions for the reform of

Section 102 are proposed. The inequitable double tax is discussed in Chapter VIII.

The nature of double taxation is considered, and a

detailed examination is made of the effects which flow from the double tax.

Reforms are suggested so that the harmful

consequences resulting from double taxation can be alleviated and eventually eliminated. The corporate income tax and its effects upon venture capital are under examination In Chapter IX.

The provisions

of the present tax laws are discussed, revenues received from the tax are set forth, and desirable reforms are pro­ posed. Chapter X is devoted to the personal income tax. Discussed in this chapter are the provisions of the present personal income tax laws, the effects of personal income taxation upon equity capital, and proposed reforms. In Chapter XI, financial institutions and their relation to venture Investment are considered.

The first

part of the chapter deals with financial institutions in general.

In the second part, a detailed examination is made

of life Insurance companies In their role as a present and future source of equity eapital.

The last section of the

chapter deals with investment trusts. of the trusts is presented.

A general background

Emphasis, in this part of the

chapter, is put upon the possibility of investment trusts

furnishing a larger amount of venture capital and thus spreading ownership interest In American Industry throughout the country. Chapter XII deals with miscellaneous deterrents to the flow of equity capital into the economic system.

The

effects of fear and uncertainty upon the willingness to participate in venture investment are examined.

Desire for

security, mistrust, and false doctrines are other forces discussed.

The part played by the stock market crash of

1929 is considered.

The lack of knowledge regarding risk

capital is analyzed, and proposals to overcome this lack of knowledge are set forth.

The final section of this chapter

deals with management-stockholder relations and managerial policies which affect venture capital. The role of government is discussed in Chapter XIII. The effects of government lending and spending are examined. The positive governmental actions which are necessary for sound government and business relations are set forth In the last section of this chapter. The final chapter, XIV, summarizes the major conclu­ sions attained in the body of the work. There is no claim made for any original contribution. Uor is there any claim made for omniscience insofar as the venture capital problem is concerned.

Furthermore, the

proposals set forth in this thesis are not to be construed

10 as constituting a panacea which would remedy all the economic and social ills of the United States or the world. We do not pretend to have all the answers to all the difficulties facing the nation today. It is strongly felt, however, that in the following pages we have the realistic answer to a basic and urgent problem.*!-

K Jobs~and Taxes (New York: The New York Stock Exchange . T S W T T p T V T

CHAPTER I I

CAPITAL FORMATION Investment In the tools of production is an indis­ pensable process if an economy Is to prosper and progress. In fact, the process Is fundamental to economic survival Itself.

Without such investment, economic stagnation and *i decay are inevitable. Chapter II is devoted to this sine qua non process of investment in the productive facilities of an economy. A detailed exposition regarding the manner in which the Invested capital redounds to the benefit of civilization is set forth.

The significance of capital formation in any

type of economic system is analyzed, with special emphasis being given to the significance of this economic phenomenon in the free enterprise economy of the United States. Elements which constitute capital formation are determined, and processes Involved in the formation of capital are dis­ cussed.

For explanatory purposes, reference is made to the

simplest means of capital formation.

The relationship of

capital formation and savings is analyzed, as well as the 1 Hansen, Keynes, et al., agree regarding the importance of investment. Gf. Alvin H. Hansen, Fiscal Policy and Business Cycles (New York: W. W. Norton and Company, Inc., 19ip-)» PP« 3^1-365, and John M. Keynes, The General Theory of Employment. Interest and Money (New York: Harcourt, Brace and Company, Inc., 1936), pp. 27-31.

12 various sources of capital— individuals, institutions, and governments.

Statistical information regarding the amount

of capital formation in relation to the national product of the United States is presented.

The last part of the

chapter establishes the need for continued capital formation inasmuch as the process is essential to the maintenance of progress and prosperity. Significance of capital formation. All economic thinking starts with the vital need for high levels of production and employment.

The orthodox economists, the

Keynesians, the Socialists, and the National Association of Manufacturers are agreed on this point.

The common objective

is high, and progressively higher, standards of living, and as a means to this end, maximum opportunity to work and to engage in productive enterprise.

p

In certain aspects of the science of economics, there is some disagreement among economists.

However, most will

agree that increasing productivity was the basic force behind the spectacular and unprecedented progress of the United States. This increase is not due to any fabled gain in the '’efficiency” of the workers. There is little evidence that skilled workers are today any more skillful than 2 Harold M. Groves, Production. Jobs and Taxes (first edition; New York: McGraw-Hill Book Company, inc., 1 9 W , P* 9.

13 they were a hundred years ago. The increase in product seems due solely to invention, discovery, the creation of new processes, and the realization of them through largely automatic machinery. This in turn has required a vast expenditure of capital. The capital supply then is an ineluctable factor in high wages and a higher standard of living.3 Despite their various disagreements, most economists will further admit that increasing production is the only way to insure higher standards of living for the future and to avoid political, economic, and social chaos. Production can be increased in various ways.

Consider

the ancient fisherman catching slippery fish with only his bare hands, and also with only very limited success. he could catch more fish if he worked faster.

Maybe

Or, if he

fished more hours each day, perhaps the fisherman could increase his catch.

Also, by becoming more efficient in his

operations, he might be able to enlarge his fish supply. However, the fisherman could easily increase his catch by first producing a net to be used in his fishing endeavors. Our economy is not, of course, as simple as that of the ancient fisherman.

But irrespective of what system

prevails, the fact remains that production can be increased by the use of more effective tools. As long as man depended upon his bare hands alone, his life was very primitive--virtually at the level of brute 3 Carl Snyder, Capitalism the Creator (Hew York: The Macmillan Company, 19^0), p. Ip.2.

34 creation.

The construction and utilization of tools and

implements started mankind on the upward path in the struggle against nature and In the achievement of larger and more varied satisfactions.

The development of complex machines,

transportation and communication facilities, factories, and productive equipment generally made possible the tremendous material civilization of the modern age.

The growth of

capital has been an overwhelmingly important factor In mankind*s long struggle to conquer nature and make it yield its resources more abundantly.^" The growth of capital, it bears repeating, has served to multiply man's power over nature a thousand-fold; It has made possible our material civilization; without it we should still be living pretty much on the plane of Homo heldelbergensis.5 What is capital formation?

In this paper, capital

refers to the hand tools, power machines, all sorts of factories and industrial buildings, railroad tracks, and other produced goods which aid men in the process of production.

Capital is defined as consisting ”of commodi­

ties resulting from past production which are being directly utilized in the processes of further production— either of

L

consumers* goods or new tools of production.1*

Capital

If Harold G. Moulton, The Formation of Capital (Washington: The Brookings Institution, 193H?)» P* 7* 5 Ibid.. p. 8. 6 Ibid.. p. 9.

15 formation is the process whereby a part of present production is used to facilitate future production.

Capital formation

as such is not an end in itself but just a roundabout and very effective method of increasing the production of con­ sumers 1 good b J Capital formation is the process of creating plants and equipment which are later used to produce consumable goods and services.

This process is not a new phenomenon.

It has gone on in all stages of history.

In primitive

societies, capital formation was a very direct process.

A

fisherman applied his labor to fashioning a crude net with which to catch a greater supply of fish more easily.

The

formation of the product to utilize in further production was often an individual matter.

During the time spent upon

producing the net, the fisherman was unable to be out fish­ ing, and as a consequence, there was a decrease in the amount of his immediate catch.

By the creation of the

capital good, and the temporary sacrifice of a decreased catch, the fisherman was eventually able to realize a much greater Increase in the amount of fish caught. In the complex modern society, capital formation generally is not a direct, individual process.

The method

7 Clyde William Phelps, Outline of Economics. Economics 3>3a (revised edition; tos Angeles: University of Southern California, 19i}-8), Chap. IV, pp. 13-l6.

D of capital creation is much more roundabout pp. 19 ff.).

(Cf. infra.

However, the process is carried on and is

essential for continuing progress.

(See Table I, page

Immediately following, for statistical information regard­ ing the formation of capital.) Hew capital instruments of increased efficiency and improved industrial methods replace obsolete capital and organization, and these in turn give way to still newer technological advances. As such advances in productive techniques come to be universally applied and as the number or size of establishments increases, the aggregate productive capacity is greatly expanded— making possible an increased output of goods and services for the satisfaction of human wants.9 Capital formation and types of economic systems. Capital formation is carried on in all types of economic systems including socialism, communism, or free enterprise. Capital formation must necessarily be carried out in all types of political systems— totalitarian or democratic. nIn all ages and societies its purpose is the samej namely to increase the effectiveness of labor and thereby to raise the output of the goods and services people want.”^ 8 For examples, cf. Eugen V. Bohm-Bawerk, The Positive Theory of Capital (William Smart, translator, Hew York: G. E. Stechert and Company, 1923), pp. l?-23. 9 Harold G. Moulton, ejb al., Capital Expansion. Employment, and Economic Stability (Washington: The Brookings institution, 19l|X>')’, p. 177* Capital Formation Under Free Enterprise (Hew York: national Association of Manufacturers, 19^9)» P •

TABLE Ia CAPITAL FORMATION IN RELATION TO GROSS NATIONAL PRODUCT (Department of Commerce Definitions) In billions of dollars and percentages for selected years Gross national product

New construction

Producers durable equipment

Change in business inventories

#6.4

6.2$

#1.6

T"i

Total domestic investment 15.2$

1929

1103.8

17.8

1932

58.3

1.7

2.9

1.8

3.1

-2.6

-4.S

0 .9

1 .6

1933

55.8

1.1

2.0

1.8

3.2

-1.6

-2.9

1.3

2.3

1939

90.4

4*0

4*4

4.6

5.1

0 .4

0 .4

9 .0

10.0

19l£

159.6

3.2

2.0

4.7

2.9

1.4

0.9

9.3

5.8

19^6

203.6

8.5

4.2

12.4

6.1

3.7

1.9

24.6

12.1

19^8

262.4

17.9

6.8

20.7

8.0

6.5

2 .5

45.1

17.0

19^9

257.4

17.3

6.7

19.7

7.6

-2.3

-0.9

34.7

13.4

a National liable 2, XXX, No.

Adapted from Table 2, ’’Gross National Product or Expenditure; 1929^46 Income, supplement to Survey of Current Business (July, 194.7)» 19* and„ "National Income and Product 1948 and 194$*” Survey of Current Business. 2 (February, 1950) , ?8. V ^ ; .'.'."A • 7:'.77;:

7.5$

1.5$

#i5.8

b To be in line with the historical ’’norm” established between 1869 and 1929, total domestic investment should be about If? per cent of the gross national product.

18 Under a socialistic type of economic system, the process of allocating present production of the society to the creation of capital depends upon the decisions of the central authority.

The authority decides how much of the

productive power of the nation should be utilized for the formation of capital goods which will be used in future production, and how much of the producing capacity of a nation should be devoted to consumption goods.

The decision

is an arbitrary one imposed upon the ordinary citizen.

It

is rendered by an authoritative board rather than through the free market system. Under a free enterprise type of economic system, the allocation of energy between the creation of capital goods and consumer goods depends upon the market system and not upon an arbitrary board.

MIn our economy, with its emphasis

on freedom of individual choice, we leave the decisions for the most part to the individual members of the community. In a free enterprise society, the formation of capital depends upon two primary factors.

The first is the extent

to which the individual apportions his money income between savings and spending, and so sets aside funds for investment. The second factor is the possibility of the profits which are foreseen by the business enterpriser who translates the 11 Jobs and Taxes (Mew York: The Mew York Stock Exchange, 1 9 W ) , p. 11.

19 investment funds into actual plants, machinery, tools, and provides for the hiring of labor and purchasing of necessary materials.

The capital formation process is very complex

and roundabout.

Individual and business savers set aside a

portion of their money income for investment; business enterprisers float loans, bonds, and stocks in exchange for these funds.

The labor and materials which can be employed

with these funds are utilized in the construction of new capital equipment which, it is hoped, may yield profits in the future. Capital formation and savings.

In discussing the

formation of capital, the reference is not directly to money or money (nominal) savings.^

Capital formation Is not

merely a process of accumulating sums of money.

Capital

formation is the process of creating tangible plants, machinery, and tools which are used in the further production of consumer goods and services.

"Money accumulated is

worthless both to the owner and to society until it is put to work."^

"Stagnant capital markets inevitably involve

12 Moulton, The Formation of Capital. op. cit., pp. •li|.-l£. 13 Money savings simply consist of money income held back from expenditure. They become real savings through investment. Phelps, o£. cit.. p. £0 . llj. Emil Schram, President of the Hew York Stock Exchange, speech at Washington University, St. Louis, Missouri, March 22, 19^8.

20 ■unemployment; and unemployment means social and political i n s t a b i l i t y . T h e money and monetary savings must be put into motion--money in motion means men at work.

Monetary

savings— becoming ’’real” savings by a process of investment— are regarded as a source of capital formation in view of the fact that savings are necessary to finance capital goods. Capital ultimately comes from savings.^

In order to

have capital, it is necessary for someone not to consume all that is produced.

The simplest example of savings, invest­

ment, and capital formation is the farmer who puts aside a part of his year’s crop to use as seed for the following year.

When he sets aside the seed, it is ’’saving,” when he

uses— invests— the seed for future production, It then becomes "capital. Besides monetary savings, management vision is needed to see the necessity for new goods which are to be marketed. In connection with this phase, investment judgment is If? Moulton, et al., Capital Expansion. Employment. and Economic Stability, o p . cit.« p. 336. 16 Stahrl Edmunds, ’’Trends of Capital Formation,” The Commercial and Financial Chronicle. CLXX, Humber l\.o%0 TOctober 27, 19WT, 1717 Either voluntary, forced, direct, or Indirect, or any combination thereof. 18 The Economic Principles Commission of the national Association of Manufacturers, The American Individual Enterprise System (Hew York: McGraw-Hill Book Company, Inc., I9I4.6), I,

21 required to determine if the additional productive facilities can be profitable enough so as to insure a suitable return on their costs.

After all the initial decisions are made,

hard labor by a group of workers is also a requisite.

Con­

sequently, the process of capital formation has many various aspects, and it is closely allied with the character of the people.

Capital formation takes imagination and initiative

to think of a job which needs to be done. industry is necessary.

To do the job,

Honesty and a certain amount of

pride are required to do the task properly.

Also, self-

restraint to forego some present consumption is essential in order that savings may produce more goods in the future.^ Source of capital.

Savings and investment are the

ultimate sources for the formation of capital.

A nation

increases the number and variety of its instruments of pro­ duction through investment.

Over the period from 1869 to

1918, the gross output of the United States doubled about every twenty years.

The output of the nation again doubled

between 1919 and 19l|-8*

Such a phenomenal rise in the total

production in America would not have been possible without the steadily increasing flow of investment funds into new factories and machinery.^ 19 Edmunds, loc. cit. 20 E. Gordon Keith, "Tax Policy and Investment," The Annals of the American Academy of Political and Social Sciences. CCLXVI (Hovember, 19^9 !,“78T

22 The indisputable fact that is derived from the historical record, and that is supported by economic analysis, is that there must be a certain amount of saving and investment in capital formation if pro­ ductivity is to expand. Mere growth in the number of workers will not increase production. Without a parallel growth of capital, the increase of population results in greater poverty and declining living standards. Wages, the principal source of mass pur­ chasing power, are generated only by production, and the productivity of labor is directly related to the amount of capital available for the workers to u s e . 2 1 A nation can draw investment funds from individual savings--one 1s own or other people’s.

Converting one’s own

savings into capital under one’s own control— that is, "going into business for yourself" is one way a vast amount of capital is formed and maintained or expanded.^

Other

individuals’ savings can also be used for capital formation purposes.*^

These savings are so utilized by buying an

ownership interest— venture capital— or, by being loaned to the enterpriser.^Undistributed business earnings and depreciation 21 Harley L. Lutz, "The Budget and Private Enterprise," The Annals of the American Academy of Political and Social Sciences. CCLXVI (November, 19Tj-9'» ?!>♦ 22 This is also one way in which an enormous amount of savings is lost. 23 It should be pointed out that investment funds may be made available through foreign investors. A large amount of such investment funds were obtained during the so-called period of internal development in the United States in the nineteenth century. This source is, at present, not of great significance. 2if The Economic Principles Commission of the National Association of Manufacturers, op. cit.. p. 382.

23 reserves are an important source of investment funds for the expansion of business already in operation,

A more detailed

analysis of these sources is presented in Chapter IV, pp. 34.0-53. An expansion of bank loans to create funds for invest­ ment is another source of capital.

However, expansion of

bank credit to create investment funds is not an ideal or healthy condition.

An increase in the flow of money, as

exemplified by the funds created without having been preceded by money savings, has a tendency to bring about an inflation of prices.

"It diverts production from near-goods toward

remote-goods, thereby disturbing balance in both the vertical structure and the horizontal structure of industry• Government (see Chapter XIII, pp. 158-166.) is another immediate source of investment funds. 26 Throughout history, governments have played important roles in the development of capital.

The great Roman highways and aqueducts were

constructed under government auspices.

The part played by

the state in capital formation declined in importance with the introduction of the capitalistic organization based on private initiative.

In fact, in the heyday of the laissez

25 Phelps, loc. cit. 26 Ultimately, these government funds must come from the public through taxation or be "created" by the govern­ ment. The latter practice is dangerous, unwise, and reprehensible.

2k faire system, the role of government in the formation of capital was regarded negligible, and as confined mainly to structures of military significance.^ Governments everywhere continued nevertheless to participate in the financing of certain types of capital development. The construction of streets and roads, for example, has always been deemed an essential function of government, though to be sure many ”toll roads” were at one time built by private enterprise. In the United States a very extensive program of highway, canal, and even railroad, development was undertaken in the 1830’s under the auspices of state governments• Owing to disastrous financial results following the crisis of 1837s public opinion turned against state participation in such enterprises, and for many years thereafter the development of transportation was left to private Initiative. But since the beginning of the present century, governments, both federal and state, have again participated extensively in this field of capital development.28 The necessity for capital formation. States has grown as industry has grown.

The United

Industry has prog­

ressed only as funds have been made available for Its development— funds for the new plants, new methods, new tools and equipment that makes more production possible.

Tremen­

dous costs are Involved in such development. On the average it requires f>l8,jj>00 to make a job in the paper industry, #17,300 to make a job in a chemical plant, $6,900 in a printing establishment, f>6,600 in a rubber factory, $5,000 in the non-ferrous metal industry, #2,600 in the lumber business and about #2,14.00 in the leather or textile trades. 27 Moulton, The Formation of Capital, op. cit., pp. 119-120. 28 Loc. cit.

25 Roughly, each employee of Standard Oil of New Jersey is working with $25*000 of invested capital; each employee of International Paper with between $9>500 and #10,000; each employee of U. S. Steel with about $6,300 and each employee of General Motors with around $8,000. ? That is why investment— and a continuous investment— is vital to the continued prosperity of the United States and to the strengthening of the nation's industrial structure. The flow of capital into productive enterprises is essential to progress.

The enterprisers in the United States

have built immense factories and transportation systems. One hundred years ago, production arose almost solely from the energy of human labor and domestic animals.

In i860,

6 per cent of the work energy was applied by fuels and power.

There is twenty eight times as much work energy being

applied to production in m o d e m times, and 93 P©r cent of it is being supplied by fuels and power.

Today, the United

States, with but 7 per cent of the world's population, has more than one-half of the world's manufacturing capacity. The farsighted entrepreneurs instituted mass production methods which resulted in tremendous increases in productiv­ ity.

Concomitant with the increase in the productivity was

an equally amazing rise in the standard of living.

Today,

the people of the United States enjoy a standard of living 29 Schram, loc. cit. 30 Edmunds, op. cit.. p. 17.

26 which is the highest ever known in any place in the world or at any time in history* The benefits of such increases in productivity are apparent. Per capita real income has multiplied four­ fold since 185?0. The proportion of incomes which wage earning families have available to spend for goods, beyond their needs for food, clothing, and shelter, has almost tripled. This is a truly remarkable accomplishment when one reflects upon the slowness in the rate of economic progress in the centuries prior to 18^0.^1 To continue this amazing and desired increase in productivity and rise in the standard of living, the use of capital is absolutely essential. . . . the very justification for capital formation is the fact that labor ean produce more goods with a given amount of effort if part of that effort is first employed in producing capital goods which will later be used to assist in producing consumer goods.32 Conclusion.

Capital formation— the creation of goods

later used to produce more goods and services— is the founda­ tion of the economic strength of a nation.

It is an

indirect, roundabout process which necessarily involves savings and investment.

Capital formation is carried on in

all types of economic systems. system would become stagnant.

Without it, our economic With it, in sufficient

quantities, the future is unlimited.

31 Edmunds, loc. cit. 32 Capital Formation Under Free Enterprise, p. 26.

CHAPTER I I I

VENTURE CAPITAL— THE LIFEBLOOD OF A DYNAMIC ECONOMY Ownership ties a person in special ways into the affairs of his generation. Investment adds meaning and homefulness to living. There is color and zest in seeing the brick and mortar and steel of your invest­ ment, or reading an advertisement of your product, or getting a cash dividend check from the earnings of your own property.! Investment funds for the formation of capital can be obtained by the enterpriser through debt financing or through the supply of ownership capital— that is, venture capital, also known as equity or risk capital.

It Is this

venture capital which was instrumental in the fashioning and the functioning of an economic system which bestowed upon the United States and its citizens— and even upon the entire world— the prodigious benefactions which were so necessary for the advance of civilization.

It is this venture capital

which is the lifeblood of a productive free enterprise economy and a beneficent democracy. This chapter is devoted to a detailed analysis of this factor which is so essential to the free enterprise system— equity capital.

The nature and significance of

equity capital are discussed.

The effects which result from

the use of venture capital as opposed to debt financing are 1 Beardsley Ruml, ”The Little Capitalists Get Tog ether,tt Colliers (J amuary 21, 19^0), 26 .

28 analyzed.

Statistical information regarding the amount of

funds obtained by the process of debt financing in com­ parison to the amount accumulated through venture investment is presented.

The condition of the capital market in

respect to the amount of venture funds available is examined, and the need for capital by the American industrial machine is set forth. Nature of venture capital.

Venture capital refers to

those funds supplied to a business organization which do not involve any fixed lien or debt obligations, and on which there is no guarantee of a fixed return.

It is money in­

vested in an ownership interest of a corporation--usually in common stocks and in preferred stocks.

Venture capital

is ”seed money” which provides a dynamic vigor to our economic system.

Such capital is very essential to

business because it permits growth and risk taking without fear that a temporary period of poor earnings will mean hardship.^ In a dynamic free enterprise economy, ”risk capital is our self-starter, spark plug, and shock absorber.”^ 2 Thomas B. McCabe, ”The Equity Capital Situation,” statement submitted to the Subcommittee of the Committee on Banking and Currency of the United States Senate, August 5, 19^9, p- l.

3 Thomas W. Phelps, ”1929 Upside Down,” Fortune (November, I9I4-8), 98.

29

As mentioned above, risk money is "seed money" and ftarnishes the dynamic force which is so vital to otar economy. The economy is healthy and expanding when there is a constant and ample flow of venture capital.

Without an ample supply

of venture capital— the lifeblood of business— progress is halted and decay and stagnation follow.^Equity capital versus debt financing.

Debt financing

is the financing of enterprises through the process of obtaining funds by getting loans or selling bonds which involve a fixed lien or debt obligation and upon which there is guaranteed a fixed return* Since 19^-6, businesses have obtained funds for capital expenditures more from bank loans, insurance company loans, and new bond issues, rather than from the sale of stocks^ representing ownership interests.

In the interest of economic

stability, it is always better for businesses to finance more of their investment expenditures with equity and less with the borrowed capital of debt financing. Yet of the new capital raised for the capital expend­ itures of business in these past few years, a major portion— and a steadily Increasing one— has come from

K The First National Bank of Boston, New England Letter (August 31, 19^-9)# 2. 5> See Table II, page immediately following, for detailed statistics. 6 McCabe, loc. cit.

TABLE IIa SOURCES OP CORPORATE INVESTMENT FUNDS, 19^6 19^4*7 19149 (In billions of dollars)

19I46 19147 ; 19lf.8 I9I49 (Per cent of total)

EXTERNAL FINANCING Loans...........

3.3

2.6

1,2

-1.8

10

9

14

-7

Bonds. . . . . . .

1.0

3.1

14.8

3.8

5

10

17

16

Stocks .........

1*3 5.6

1.3

1.2

1.3

7

5

5

6.9

7.2

3.3

22

23

26

28

Retained profits0.

7.7

11.1}.

12.5

7.8

36

38

k$

33

Depreciation . . .

if..2

k*9

5.5

6.2

20

16

20

26

Other. . . . . . .

if..8

6.9

2.5

-3.1

22

23

9

-13

16.7

23*2

20.5

10.9

78

77

22.3

30.1

27.7

1I4.2

100

100

14

INTERNAL OPERATIONS

Totals . •

'

72 100" 100'

a Adapted from Table l6, ,fSource and Uses of Corporate Funds, 19^6 Survey of Current Business, XXX,,No. 2 (February, 1950), 27. b Data for 19^9 partially estimated. c Retained profits include depletion.

~

31 selling bonds and notes: I4.8 per cent in 19^-5J 58 P©3? cent in I9I4-0 ; 73 per cent in 19^7 . ®*id probably even more in 19^8. This means that businesses are going into debt for their needed outside capital instead of expanding their equity basis. Obviously, there is a limit to this method of procedure, as any business man who has ever found himself in a business slump with heavy fixed charges and loans to be met will agree,7 Capital formation through our commercial and savings banks, insurance companies, and similar institutions cannot go beyond a certain point in relation to the capital structure of the economy as a whole. cream of the risks.

Such financing merely takes the

However, the only way this cream can

possibly be created is by having others— the stockholders— provide the equity capital which serves as a buffer against Q losses to the bondholder. Venture capital is the shock absorber of enterprise which protects it during the periods when revenues decline. Payments for the use of risk capital are made out of the operating profits of a corporation, just as payments for the use of debt capital.

When revenues decline, the solvency of

a corporation is threatened sooner if it is working more on , debt capital.

The more a corporation is working on venture

capital, the more chance it has of nsweating it out11 and 7 Francis Adams Truslow, ’’Speculate or Stagnate!” Nation's Business. XXXVII, No. 3 (March, 19l*9), 30. 8 The Economic Principles Commission of the National Association of Manufacturers, The American Individual Enterprise System (New York: McGraw-Hill Book Company, Inc., 1946), I, 3B b T

32 continuing in business.^ The recent accentuation of the trend toward raising new corporate funds by floating debt securities has the unfortunate result of making corporate financial struc­ tures more vulnerable to business recession or depression. The necessity of meeting interest payments, amortization, and maturities pinches a debt-burdened company in periods of decreasing prices and production, and the discharging of employees, the reduction in general expenditures, and the forced liquidation of assets that result from financial stringency are important factors contributing to the intensity of deflationary spirals. Another aspect of the process of increasing debt without adding to equity investment is that debt instruments themselves become riskier investments. Debt securities can offer a reasonable degree of safety only when they are accom­ panied by a liberal cushion of equity financing. Debt financing should not be resorted to at the slightest provocation.

Such financing, in the average

industrial enterprises, should be used for emergencies only. In any bond financing, the principal eventually falls due. The inability to meet the principal is the usual cause of financial embarrassment. Also, bond financing is somewhat like a habit-forming drug--it is easy and pleasant at first, but the more an enterprise resorts to it, the more necessary it becomes to borrow more.

Equity financing under such circumstances

would soon become impractical, and the business would be 9 Emil Schram, "Taxation and Venture Capital," The Annals of the American Academy of Political and Social Sciences. CCLXVT (November, I9I4. 9T, 85• 10 Jobs and Taxes (New York: The New York Stock Exchange, 1 9 W ) , P* 37*

33 headed for the financial rocks.^ Heavy fixed (or floating) debt is obviously un­ desirable for the single enterprise in an unstable economy or industry. Any temporary adversity is likely to produce insolvency, with grave losses, not only for the stockholders but also for senior securities and the ^ enterprise as a whole, through the great costs of reorganization and the inevitable disturbances of operations and business relations which insolvency involves. Moreover, even if technical insolvency and reorganization are avoided, the enterprise and the whole economy may gravely be damaged by the practices necessary in avoiding it. Thus, physical properties may be abused merely to prolong technical, legal solvency, to avoid definitive squeezing out of shareholders, management, or ’’control11 in bankruptcy or reorganization, and thus to gamble (with nothing to lose!) on remotely favorable contingencies. The physical plant may thus be ”bled white” to meet current obligations, especially interest payment and bond maturities, in the pursuit of mere liquidity.12 Some of the bad effects resulting from excessive debt financing are not as easily understood— their action being somewhat roundabout, but their impact terrific. What is less clearly apprehended is the aggravated instability of the whole economy, and the obstacle to deliberate monetary stabilization, which corporate debt structures produce in their aggregate. It should be obvious what desperate and frantic struggles for corporate liquidity mean in total where the economy has slipped into general recession which, debt structures apart, might prove innocuous and short-lived. They may well mean the difference between a mild recession and a precipitous, catastrophic deflation.13 11 Clarence W. Fackler, ”A Four-Pronged Attack Upon Equity Capital Problem,” The Commercial and Financial Chronicle, CLXX, Number l|.86'8 (December 29# 19W ) » 9« 12 Memorandum to Harold M. Groves from Henry C. Simons. Harold M. Groves, Production. Jobs and Taxes (first edition; New York: McGraw-Hill Book Company, Xnc•, 1944), PP* 25>-26. 13 Ibid.. p. 26.

3k Dearth of equity capital,

American industry is

expanding and becoming more modernized.

Increased mechani­

zation increases the productivity of labor, but it also increases the amount required for capital investment, Capital formation is the foundation of the economic strength of the nation, and it is faced with a great and growing shortage in its most critical element— venture capital.^ The refusal of so many Americans to risk their savings in business investments constitutes a problem which is recognized by Congress.

The Congress^-* is conducting public

hearings in order to determine the reasons for the serious •i^ lack of equity capital for business. "The private capitalistic system is being threatened by a lack of venture capital, and it cannot exist unless there is a steady flow of private capital Into the economy In terms of debt," declared Mr. ©♦Mahoney at the outset of the investigation. "The testimony of experienced men in the investment markets," he continued, "seems to indicate that the majority of people with savings are more desirous of security for those savings than they are for large profits from new ventures, or even from old ventures. They are therefore investing most of their savings in government bonds, in life insurance policies, and in savings banks. 3.7 lit Industry Believes (New York: National Association of Manufacturers, 19^9)» P* li|-« 15 Senate-House Economic Committee, Sehator Joseph C. 0 1Mahoney (D) , Wyoming, Chairman. 16 Associated Press dispatch, Los Angeles Times. December 5, 19^4-9 • 1? "Why the Dearth of Risk Capital?" Monthly Letter. National GIty Bank (January, 1950), 4 *

35

Risk taking has long been a tradition in American business and society..

Such risk taking has resulted in

tremendous progress in the processes of production and con­ sequently, a steadily increasing standard of living.

To

continue expansion and progress, risk taking in American business is necessary.

It has been estimated that for

continued progress and the maintenance of the free enterprise system, a sum of $5 billion "new” venture capital is needed annually for the next ten years.

This capital is essential

to finance new business ventures, to enable small businesses to expand, to make enough jobs for our growing population, and to provide a steadily growing tax base for the support of a steadily growing government.

This estimate is con­

sidered as being not too unrealistic.

The total volume of

business and employment has risen in the United States. Prices are higher.

It requires more capital to operate a

business, and it will take expanding amounts as the economy • l

O

*

continues to grow. Sourees of equity capital for new plants and equipment are drying up when they are needed most.. Postwar needs for funds in order to expand plants and equipment are unprecedentedly large.

The need for new production facilities

l8 S . L. Sholley, "Restore Equity Capital Flow by Lowering Tax on DividendsI" T h e Commercial and Financial Chronicle. CLXX, Number lj.866 (beeember 22, 1^9), 11.

36 continues great and urgent.

After fifteen years of under­

construction and tinder-maintenance of plants, there is a great void that must he filled if industry is to supply the goods required for ever-widening markets.

To the vast demand

for making up ground lost during the last depression and war must he added the requirements for material aid in the reconstruction of war-hattered countries abroad.

The war,

the doldrums of the thirties, and the ten million additional workers since 19^-0 mean an urgent need for new plants and equipment--whi eh in turn makes for an urgent demand for capital With savings of fij.00 million weekly, common stock offerings for new capital through the end of April 19^-9 were at the rate of only #5?0 million a month. The volume of trading on the Stock Exchange in relation to the number of shares listed is at a rate of only about one-seventh of that in 1926. Both of these are utterly inadequate trickles if we want to keep 66 million persons gainfully employed.20 People have become increasingly reluctant to contribute permanently to industrial capital. the necessary ownership interest.

They have not acquired The test of whether people

will voluntarily place their money in the ownership position is whether or not they do. speak for themselves!

The records in this connection

Further, the records against which

19 "Adjusting to the Value of the Dollar,” Policy Memorandum, Research Institute of America, October 20, 19i}-9, P. 13. 20 Schram, o£. cit.. pp. 89-9°.

37 this test may be made are not open to question.

The records

are of the sales of new securities and records of transaction in issued securities in the stock exchanges.

According to

the records, there is an increasing reluctance to purchase new common and preferred stock.

And there is a diminishing

Interest in either acquiring or disposing of stocks which have been issued in the past despite the low prices at which these shares are offered in relation to earnings. ?1 During the years 1945 through 194®# tiie percentage of new capital raised by selling common stock and preferred shares fell from about 52 per cent to about 20 per cent of the total.

During this same period, the annual volume of

stock transactions on all exchanges fell from about 800 to around 550 million shares.

In the first quarter of 1949# op transactions were at an even lower rate. & American industry is expanding, but not the number of stockholders owning it. • .10 ,769,4l3 have invested in the shares of 216 companies, an increase in 194® over 1947 of only insignificant in comparison with the growth of our economy. The drying-up of the flow of investor capital constitutes a menace crying , aloud for the most serious study— and remedial action. 4 21 Francis Adams Truslow, MCapital, Jobs and Taxes,” address before the Botary Club of Atlanta, Atlanta, Georgia, April 25, 1949, PP. 8-9. 22 Ibid., p. 9* 23 From 10,689,507 stockholders in 1947 to 10,769,413 in 194 ® — 3X1 increase of 79,9°®* 24 “Stock Analysis," Forbes. LXIV. Ho. 1 (Julv 1. 1949), 13.

38 A very noteworthy point is that during the period referred to above, the people have had record amounts of unused cash on deposit in the banks of the country.

The

accumulated savings of Americans total $200 billion.

Last

year (1914-8 ), the savings of the American people amounted to $12 billion.^

This amount of savings was more than twice

the estimated equity needs. ° Plenty of potential venture money is available. According to recent U. S. Treasury figures, individuals in the United States now hold liquid assets (not including life insurance) in the amount of about $200 billion.^

The liquid pQ assets are represented by the following type holdings:

Government Securities

Billion $68

Savings Accounts.

67

Cheeking Accounts

k3

Currency........

22

25 For 1914-8, gross savings were estimated to be $2ij. billion, and total dissaving $12 billion, leaving a net saving of $12 billion. ”1949 Survey of Consumer Finances, Part VIII, Distribution of Consumer Saving in 19lj-8,H reprinted from the Federal Reserve Bulletin (January, 1950)> 1* 26 Sholley, op. cit.. p. 11. 27 In 1939 » the liquid assets were estimated at $57 billion. 28 Edward Hopkinson, Jr., ’’The Equity Capital Problem,” The Commercial and Financial Chronicle. CLXX, Number I4.868 (December 29, I9I4. 9 ), 6.

Savings we are told are plentiful* The savings figures are brought up every time we bring up this question. The very size of aggregate savings, con­ trasted with the apathy for ownership, tells the story. Savingslike water, will not run uphill. The flow of savings is largely #in the direction of riskless invest­ ment, toward the attainment of a creditor or preferred position.29 In other words, the capital market IS STARVING IN THE PACE OP PLENTY.30 Conclusion.

The expansion and increased mechanization

of American industry requires an increasing amount of capital investment.

Venture capital— funds invested in an ownership

interest of a business organization— supplies the vital force so necessary to a free enterprise economy.

In recent years,

the amount of savings has been at record levels.

Yet, the

amount of funds flowing^ into venture investment has been significantly small. This study is to investigate the forces which have brought about this lack of equity investment.

Why is our

economic system suffering from a shortage of the element which it most critically needs? The following chapters will include detailed analysis of the various factors which affect the equity market.

29 Emil Schram, address before the General Management Conference of the American Management Association, New York City, June 9* 19^9*

CHAPTER I V

RETAINED EARRINGS AND DEPRECIATION The first part of this chapter is devoted to retained earnings.

Most enterprises have found retained earnings to

be an important source of investment funds.

Consequently,

the undistributed earnings are considered in relation to their effect upon the enterprise, the economy, and the investors.

The effects and the possibilities of more

extensive retained earning financing are also discussed. The second part of the chapter deals with depreciation. The present policies of the United States Treasury regarding depreciation are set forth.

Some of the problems concerning

depreciation— such as rate of depreciation allowed, the effects of a price rise, and the length of the depreciation period— are discussed.

Suggestions for the reform of the

present unrealistic depreciation policies are proposed. Retained earnings.

Since the end of World War II,

retained earnings have been a very attractive and a very important source of equity capital.

The business enter­

prisers very easily solved a large part of the problem of venture capital by plowing back earnings. Daring the years from 19I4.6 through I9I4.8 , corporations obtained the bulk of their capital funds from retained

Ip. earnings.

Internal financing operations during these years

accounted for about 75 P©** cent of the corporate investment funds ’’The fundamental reason for much internal financing, unquestionably, is the difficulty of raising money in the capital markets.”

Unfortunately, the very tendency toward

financing through retained earnings increases the diffi­ culty.

”It creates a vicious cycle.

When profits are plowed

back, dividends are just that much decreased."^ The larger corporations are temporarily solving the problem by plowing back earnings. These businesses normally pay 60$ to 70$ of their earnings as dividends. This year they are expecting to pay 30/& to ij.0$.hSuch practices do not find favor with the stock­ holders of the organizations.

The stockholders object to

plowing back earnings even if, with the plowed back capital, the corporation— and consequently, the stockholders— are in a better productive as well as financial position. Politicians and labor economists are also often opposed— though unjustly— to the plowing back of earnings. 1 See Table II, p. 30, and Table IV, p. 102, for detailed statistics. 2 Francis Adams Truslow, ’’Speculate or Stagnate,” Nation’s Business. XXXVII, No. 3 (March, 19^9), 29. 3 Loc. cit. Ij. S. L. Sholley, ’’Restore Equity Capital Flow by Lowering Tax on Dividends,” The Commercial and Financial Chronicle. CLXX, Number I4.866 (December 22, 19I49), 11.

k.2 Labor should welcome such plow-backs.

By an increase in

capital, productivity, and consequently the standard of living, will increase."^ The financing through retained earnings may solve the problem for a corporation which has sufficiently large earnings.

However, the smaller businesses are handicapped

in this respect.

Their present earnings are not sufficient

to finance expansion and progress.

Also, new firms would

not be able to finance desired and needed expansion since their earnings usually would be at a very low level. The establishment of new firms is unduly hampered by a lack of "outside” equity capital.

Mew enterprises

depend upon venture capital for their initial funds. firms play a very important role in our economy. leavening element of incalculable value.

Mew

They are a

Also, new firms

seek out new and promising opportunities, develop new pro£ duction techniques, and promote new or improved products.0 If the problem is left to the plowing back of retained earnings, big and established businesses must necessarily get bigger, the small businesses will find It difficult to survive, and the new firms will be unable to get into f> Robert E. Wilson, ".How to Solve the Equity Capital Problem." The Commercial and Financial Chronicle. CLXX, Mumber q.8£V'T November 10, 19IJ.9), 6. 6 Jobs and Taxes (Mew York: New York Stock Exchange, 19*1-9), P. 23*

to

operation.*^ Furthermore, undue reliance on retained earnings as a source of capital funds fosters a.tendency toward bigness and concentration of industrial control. Our best bulwark against such concentration is to make the establishment of new enterprises as easy and attractive as possible. If we fail to maintain a healthy competi­ tive order we will sacrifice the spurs to efficiency and self-regulating features of the market that go with competition and create a demand for broadening the scope of governmental intervention in economic affairs. The road to economic progress does not lie in that direction.o Retention of earnings for financing also results in keeping the stock prices down.

If the dividend disburse­

ments were larger, the ownership position would be more attractive, and more stock issues would be sold.

In this

connection, the statement made by Thomas B. McCabe is of value: Study of stock market behavior over the period I895-19I4.6 indicates the prices of stocks have fluctuated more closely in relation to dividends than to earnings. This suggests that investors attach more significance to dividends derived from stock ownership than to reported earnings.9 Another reason for the retention of a large part of earnings after taxes has been to make good the deficiency in depreciation allowances.

Conservative dividend policies

7 Sholley, loc. cit. 8 Jobs and Taxes, p. 23. 9 Thomas B. McCabe, MThe Equity Capital Situation,” statement submitted to the Subcommittee of the Committee on Banking and Currency of the United States Senate, August 194-9, p. 3.

l jT ? [I

have been dictated partly, therefore, by the necessity to provide adequate funds from present earnings to make up the difference between the depreciation allowed and the present cost of replacing existing equipment.^0 The further probable drop in earnings makes retainedearnings financing more difficult.

During the recent years

of high earnings, declared dividends were relatively low. However, because of stockholder pressure (in addition to that of the politician) and the desire of officials to attract more venture eapital, dividend payments are being increased.

This lessens the amount of earnings which can be

used for internal financing.

In this connection, once the

present liquid resources are expended, that process will come to an end. Furthermore, even if more earnings were available to corporations, the method of internal financing would not be sufficient for all the needs of business.

As mentioned

above (page Ij.2), small companies must look to outside capital for expansion, and new enterprises— the very yeast of our competitive system— could never get started without it* 11 Finally, too heavy reliance on retained earnings may lead to increased.economic Instability. In periods of .declining business activity when expenditures for plant and equipment are helpful in stabilizing the economy, 10 Infra, pp. l|J-£2. 11 Truslow, op. cit.. p. 30.

profits are likely to prove an inadequate source of funds. There will be little chance of funds forth­ coming at; such times if the sources of external capital .have been allowed to dry up through neglect and the removal of incentives to risk-taking.^ Depreciation. ^

The exhaustion of the existing

productive facilities of American industry is a very serious problem, and it is vitally essential that industry be able to replace the facilities continuously and adequately. The United States Treasury recognizes depreciation as a deduction from gross income for tax purposes.

The

recognized basis for computing depreciation being the original cost of the asset.

The annual depreciation charges

must be a ‘'reasonable allowance” for the exhaustion of property used in trade or business.^- The rate of deduction is not required to be uniform. matter of rough estimate.

Depreciation is at best a

In many cases, there is substantial

disagreement among competent judges as to what the deprecia­ tion allowance should be.

“The calculation involves so many

12 Jobs and Taxes, pp. 23-25. 13 Next to retained earnings, depreciation funds have been the most important source of corporate investment capital. See Table II, p. 30. llf Normal obsolescence— the Impairment of capital resulting from predictable improvements or changes introduced from time to time in the arts or industry generally— is considered as a part of depreciation. Harold M. Groves, Production. Jobs and Taxes (first edition; New York: McGrawHill Book Company, Inc., lgljij-), p. 63*

variables and imponderables that it may be closer to guess­ work than estimating. Even though no uniform method for computing deprecia­ tion is prescribed, a Treasury bulletin ("Depreciation Studies,” 1931) suggests a schedule of rates of depreciation which are to be applied to particular properties.

For

example, the

rate for tools is set at 20 to 2£ per cent.

The rate for

boiler engines is set at 5> to 10 per cent, while

that for brick buildings is are based on assets.

at 2 to 3 per cent.

These rates

a study of the estimated useful life of such

Taxpayers are urged to use the rates set forth by

the Treasury Department.

However, a Treasury regulation

(T.D. I4I4.22, February, 193if) sets up special rules for tax­ payers who wish to take depreciation deductions in excess of recognized amounts.^

Consequently, the "urging” takes

on the cloak of "required action” by a process of adminis­ trative action. The depreciation problem goes to the core of our present economic condition. In the tremendous expansion of war and postwar, corporations have had to acquire and pay for new plants and equipment at prices far above prewar costs, while depreciating old equipment at low rates on a prewar base. To accomplish this, they have been forced to retain an ever larger share of current earnings, to dip into their reserves and surpluses, and 15> Groves, loc. cit. l6 Morris Beck, "Capital Replacement, Depreciation and Taxes,” Taxes— The Tax Magazine. XXVI, Ho. 7 (July, 19^8)>

in many cases to borrow heavily from banks and insurance companies.17 In other words, because corporate tax credits are calculated on a minimum amount of depreciation based on a lower cost level, hidden depreciation costs are eating away more and more of corporate profits and capital.

T ft

It is frequently declared by many businessmen that low and inflexible rates of depreciation tend to discourage the replacement of worn and outmoded plant and equipment with new and improved productive facilities.^ Because original cost is used as the basis for com­ puting depreciation charges, during a period of rising prices, the depreciation charges thus computed tend to overstate profits and undervalue assets. 20

It appears, therefore, that

the present generation is enjoying the benefits of high­ valued equipment amortized at low costs, and that the consumer Is being asked to pay a lower price than he ought to be 17 John W. Hanes, "A Tax Policy for Enterprise,11 Tax Review. X, Ho. (May, 19^9)» 23-2i{-. 18 Loc. cit. 19 Alfred G. Buehler, "The Taxation of Small Business," American Economic Review. XXXVI. Ho. 2 (May, 19I4. 6 ), 263. Cf. Technological Stagnation in Great Britain (Chicago: Machinery and Allied Products Institute, 19^-8TT 20 Cf. Roy A. Poulke, The Theory of Corporate Net Profits (New York: Dun and Bradstreet, Inc., 19!$), and George Terborgh, Inflation and Postwar Profits (Chicago: Machinery and Allied Products Institute, 19I4-9)*

charged.

By following the traditional, and at present the

legal, accounting procedures, the businessman is apt to find himself without sufficient funds to replace the assets, and Pi

thus maintain his capital, at the end of their useful life. A Proposals for depreciation policy reform.

The chief

proposals for reform of present depreciation policy rest upon liberalization and realism.

A powerful impetus to

capital investment could be provided by a liberalization of the federal depreciation policy.

Such a procedure would

encourage business enterprises to maintain the nation1s pro­ duction mechanism at the peak of efficiency.

The swings of

the business cycle would be dampened, and consequently, bring about an increase in the national income and a rise in the standard of living.

PP

Wow the best answer . . . for all corporations struggling against high costs and restrictive tax policies, is a realistic depreciation policy. Corpora­ tions should be permitted to set their own depreciation rates, with two limitations: that the rates should be no higher than 20 per cent; and that corporations stick to their schedules, once these are established.23 MA more liberal administrative attitude does not demand anarchy in depreciation and obsolescence.

The methods

21 If the current cost of a new asset is double that of the original asset, the owner has recovered only half of the amount necessary to replace the old asset in kind. Beck, loc. cit. 22 Beck, o£. cit., p. 6^9* 23 Hanes, op. cit.. pp. 2ij.-25.

Italics in the original.

to

followed and the rates allowed should be logically con­ sistent.”^' By adopting such a broad principle for dealing fairly with depreciation charges, the economy as a whole would gain tremendously.

Management would be free to use Its own judg­

ment and Initiative In the expansion of productive facilities and ultimately the creation of more jobs.

pc?

In the long run, neither the taxpayer nor the Treasury would lose.

However, both would gain inasmuch as the ex­

pansion of production, creation of jobs, increase in produc­ tivity, and the rise in the standard of living benefit the entire nation.^ It certainly seems in order to suggest that, within a wide range of tolerance, businesses’ own judgment with reference to depreciation and obsolescence, as indicated by its books, might well be accepted in lieu of a more precise figure laboriously calculated by the Bureau of Internal Revenue.27 With a more liberal depreciation policy, the tax­ payers eould use those rates which are warranted by their own experience and that of their industry, rather than the arbitrary rates set down by the Treasury Department.

More

2i|- Buehler, loc. cit. 25 Loc. cit. 26 John W. Hanes, "A Businessman’s Viewpoint on Tax Policy,” The Annals of the American Academy of Political and Social Sciences. CCLXVII (November, 19^9)* 177. 27 Droves, op. cit.. p. 6lj-.

50

liberal policies would remove many of the existing inequali­ ties now possible in the application of the law.

Many small

businesses could obtain the depreciation rates they should have-~and which their competitors may actually receive. This would have a stimulating effect on competition.

Many

businesses, especially the larger competitors of the small enterprises, are more fortunately situated, financially and otherwise, for fighting out claims for depreciation.

As a

result, these businesses are not being unfairly treated depreciation-wise and have more favorable rates. An allowance of accelerated depreciation on new in­ vestments in machinery, plant, and equipment can be an effective stimulus to risk investment.

Many firms will not

purchase new equipment unless it appears that the newly bought equipment can pay for itself in three to five years. But, the ability of new equipment to pay for itself, as desired, is considerably impaired when depreciation must be spread over ten to twenty years.

This problem would be

alleviated by a shorter amortization period. 28 Buehler, op. cit.« p. 263. 29 E. Gordon Keith, "Tax Policy and Investment," The Annals of the American Academy of Political and Social Sciences. CCLXVT (November, 19WT, 83. Tn this connection, it should be pointed out that during the war, industry was given the privilege of amortizing certain new equipment over a period of five years. The accelerated amortization program was effective. Groves, o£. cit., p. 65.

51 Corporations replace old equipment and expand total equipment at irregular and varying rates . . . It can be said, however, that decisions as to replacements are more likely to he affirmative when assets are consider­ ably depreciated on a company's books. Decisions favorable to expansion are also encouraged by rapid depreciation because uncertainties are reduced if a large part of the cost of new equipment can be written off and the capital cost recovered in the early years of Its use.30 Current methods of depreciation accounting do not reflect the changes in the purchasing power of the dollar. Due to the effects of the recent inflation, depreciation charges understate the value of eapital consumption and fall short of replacement costs. Depreciation allowances should be put on a realistic basis.

The depreciation procedure should reflect the changes

in the price level. This could be accomplished by establishing an official procedure for the revaluation of business assets which were purchased before the great price rise of the past eight years. By this means, depreciation charges could be raised to a level consistent with current replacement costs, and business enterprises would no longer be obliged to pay taxes on that portion of alleged income which is actually required for replacement of existing assets.31 30 Groves, loc. cit. 31 H. W. Prentis, Jr., ”Taxation and Business Initia­ tive,” The Annals of the American Academy of Political and Social Sciences. GCLXVT (November, 19^-9)"* 7^* Reported profits overstate true profits by the amount depreciation charges understate the value of capital con­ sumption. Business pays taxes on the overstated profits. Consequently, in the short run, a loss in revenue to the Government would result. In the long run, these losses could be more than offset by an increase in production resulting in an increase in the tax bases upon which all types of taxes are paid.

52

The traditional function of depreciation charges is to insure the maintenance of capital.

Under present con­

ditions, depreciation charges are not performing that function.

Failure to take necessary action regarding

correction of present depreciation policies will result in unhealthy economic conditions.

More liberal and realistic

depreciation policies must be put into effect*

Without such

action, capital cannot be maintained and stagnation will be inevitable. Conclusion*

In recent years, retained earnings have

been an important source of investment funds.

However,

financing through retained earnings is not entirely satis­ factory.

It leads to a concentration and further growth of

big businesses, small firms find it difficult to survive, and new businesses are unable to finance needed and desirable expansion.

Furthermore, many stockholders object to plowing

back earnings— their main objective being higher dividends. Finally, retained-eamings financing, even under the most satisfactory conditions, would not be sufficient to meet all the capital needs of industry.

A depreciation allowance for the replacement of the productive facilities of American industry Is essential for economic well-being.

Present depreciation policies are

unrealistic, inflexible, and restrictive.

Proposals for

5 3

reforms are based upon liberalization and rea.lism.

These

include the provisions that corporations should be permitted to set their own depreciation rates and that the depreciation policy should be so formulated as to reflect changes in the price level*

CHAPTER V

TAXATION IN GENERAL AND VENTURE CAPITAL There is another exertion of political power, which wisely used will foster, and unwisely used will destroy, free enterprise. That is the power of taxation.! No tax system is ever completely neutral in its effects upon the economy.

This chapter treats of the general

over-all effects of taxation upon investment and the economy. 2 The bad effects flowing from a burdensome tax system are analyzed, and the benefits which would redound to the nation from a sound tax structure are discussed. Any tax program that is geared to the realities and the necessities of a highly dynamic free enterprise economy must make provisions for the needs of the future if that economy is to continue to progress or even to maintain its 1 Donald R. Richberg, Government and Business Tomorrow (New York: Harper and Brothers Publishers, 19^3), p. 151. 2 The chief cause of a burdensome tax structure is the vast amount of government expenditures in proportion to the national income. To pay the huge governmental debts, the tax burden is extremely heavy. Insofar as business Is concerned, the government is a voracious silent partner (see pages 101 If, infra). Tax reforms can provide a Hsolution” to the equity capital problem. However, to really solve the problem and to correct th© conditions leading to the difficulties, one requisite is that the proportionally huge governmental spending must be curtailed. (For a more detailed discussion of government spending, see footnote 19, p. 9^4-* footnote 23, p. 123, and Chapter XIII, Government and Its Influence Upon Equity Capital Formation, pp. 158-166.

5 S

present level and standard of living.^ Taxation is like dairy faming, not meat production; good husbandry builds up the herd. Taxation does milk the cows of private enterprise but it should draw the line at killing off the animals.4Taxation should be consistent with the economic and fiscal objectives of the community.

The maintenance of a

solvent and prosperous economy is the first desire of the people.

To be solvent, it is essential that the prosperity

goal be attained by the economy on a self-sustaining basis without resort to permanent public deficit financing.

In

order to be prosperous, it is necessary that production, employment, and consumption proceed at high levels."^ The tax system should not prevent the birth or halt the growth of new and small ventures. risk taking.

It should not penalize

Taxes should not deprive small business of the

funds which are so necessarily needed to finance production, marketing, and employment.

The incentives to working and

investing should not be dulled by an unwise taxation structure.

The tax policies should not be so formulated and

carried out as to invite monopoly or extreme concentration. 3 Harold M. Groves, Trouble Spots in Taxation (Princeton: Princeton University Press for the tJniversity of Cincinnati, 19^8), P» 9$« If Loc. cit. 5 The Gommittee on Postwar Tax Policy, A Tax Program for A Solvent America (Hew York: The Ronald Press Company, 19if5l, P. ll*-.

Also, taxation should not reduce the purchasing power of consumers so that demand will dangerously decline.

In order

to achieve all desired objectives,^ Mall tax impediments to investment and consumption along socially desirable lines, so far as it is feasible, should be removed.”^ For the preservation and continued expansion of the private enterprise system, three things are essential: (l) the creation of small businesses must be encouraged so that small business can become big business.

Small businesses

furnish an important source of the competition which is so necessary in a free enterprise economy.

Without competition,

and without the efficiency and economy of mass production brought about by big business, civilization could not be so far advancedj (2 ) more equitable distribution of the tax burden must be found; and (3 ), new workable methods for the Q encouragement of capital formation must be devised. Tax­ ation is inextricably associated with these three requisites. Nearly all real taxpaying ability in our economy is generated by private enterprise. We see this to be b However, for present stated objectives, cf. the Employment Act of 19^6--designed to ^declare a national policy on employment, production, purchasing power, and for other purposes.” 7 Alfred G. Buehler, ”The Taxation of Small Business,” American Economic Review. XXXVI, No. 2 (May, 19M >)t 250. 8 Godfrey N. Nelson, ”The Personal Income Tax and Business Enterprise,” The Annals of the American Academy of Political and Social Sciences. CGLXVFTNovember, 19^9), ll!>.

true whether we are considering taxes on individual enterprises, partnerships, corporations themselves or their owners, or taxes on the employees of any of the above forms of business organization. A tax system that hampers the operation and easpansion of existing business units or unduly discourages the initiation of new enter­ prises gradually destroys the sources on which it must rely for its revenue.9 The fact must be recognized that taxation can be used to promote or retard risk capital investments.

It Is

necessary to realize that high tax revenue— even at low rates— can be achieved by maintaining high production. Furthermore, it must be noted that financial stability and a healthy economy results from the expansion of national production"*-® and not from the imposition of excessive and burdensome tax rates*

Finally, what Is needed most of all

is the realization that the economic welfare of these United States can be best served by providing an ample supply of ownership capital.

11

The potential supply of investment funds can be affected by the impact of taxation and taxation policies on /

the incentives to invest.

In those situations where the

9 Jobs and Taxes (New York: The New York Stock Exchange, 19^9)V p . 30. 10 The labor force is constantly expanding. If employment is to be furnished to all those who seek It, the productive capacity of the nation must be continually increased. Enough ,fnewM Investment is needed to provide 700,000 to 1 ,000,000 additional jobs per year.

£8

risk factor is high, unsound taxation will tend to discourage investment by reducing the prospect for profits.

”The

investor, it has been pointed out, must bear the entire risk of any loss, but if the venture is successful, the government 12

will claim a large share in any profit.”

A common observation of business executives is that talented young men who would have started new enterprises of their own 25 years ago now prefer secure jobs with established concerns and that they also prefer secure investments. Many a young person faces a choice between security on the one hand and economic adventure on the other. The latter is attractive in many respects but carries with it a burden of responsibility, worry, and possible loss. That the financial prospects have some importance in the weighing of these alternatives is hardly open to doubt. It may not be possible nor desirable to recapture the spirit of high adventure that prevailed in our business world 50 years ago, but at least we should try to retain a dynamic economy.2-3 The taxation policies can exert a profound influence upon the flow of funds into investment channels.

The total

volume of tax collection affects the total supply of avail­ able investment money regardless of what kinds of taxes are levied.^

On the other hand, particular kinds of taxes,

irrespective of the amount of taxes as a whole, may either 12 E. Gordon Keith, ”Tax Policies and Investment,” The Annals of the American Academy of Political and Social Sciences. CCLXVI (November, 191+9)» 82. 13 Harold M. Groves, Postwar Taxation and Economic Progress (first edition; Hew York: McGraw-Hlill Book Company, 0 ), p. 6 . Inc., 194. llj. Harold G. Moulton, Capital Expansion. Employment, and Economic Stability (Washington: The Brookings Institution.

I9W . p. 270:

5 9

impede or foster the investment process.

i ^

When tax rates were relatively low, the impact of taxation upon investment decisions was of not too great importance.

However, with the exceedingly high rates that

are now in effect, the threat which the high taxes holds for future economic progress cannot be disregarded.^ This threat was not ignored by the Administration, for as Secretary Snyder stated: In his tax message to the Gongress on January 23, 1950, the President outlined a fiscal program designed to reduce the deficit and bring about budgetary balance as rapidly as possible. The policies embraced in this program were threefold, having to do with (1) reduced expenditures [sic] on the part of government, (2) measures aimed at encouraging and stimulating business expansion— which, of course would result in enlarging our revenue base— and (3 ) changes in the tax laws which would serve the double purpose of bringing in some net additional revenue and improving the equity of our tax system.3-7 Of great significance is the official recognition of the inter-relation of the phases outlined in the President’s tax speech.

HThe three policies outlined in the fiscal

program of the President . . . meshed.

are, as you will note, Inter­

The success of each one is bound up with the success

of the other two.M^® 13> Moulton, loc. cit. 16 Keith, loc. cit. 17 John W. Snyder, statement before the Committee on Ways and Means, House of Representatives, February 3* 1950, pp. 2-3. 18 Ibid.. p. 3.

6 o

In former times, taxation was ordinarily used only to raise the revenues required by government.

In recent

years, the taxes also have been levied for the purposes of regulation and control.

Taxation has been used as a method

of bringing about a redistribution of Income.

Taxes have

been utilized as a means of forcing modifications of certain types of corporate financial policies.

Taxation policies

have been so designed and carried out as to restrain, or to encourage, the expansion of plants and equipment, as well as to hamper certain types of businesses and to foster others.^ A tax program will facilitate production if it leaves busi­ ness decisions as much as possible to business discretion. At the present time, tax consequences enter heavily into many business decisions. 20 Federal tax and fiscal policies do have a very significant impact upon the volume and character of private investment.

The United States tax system is geared to ex­

tract more than

billion from the pockets and the bank

accounts of the American taxpayers. "

PI

Such an enormous tax

19 Moulton, loc. cit.

20 Harold M. Groves, Production. Jobs and Taxes (first edition; New York: McGraw-Hill Book Oompany^ Inc., 19*A)» P. 13. *■

21 In 19^1-8, the taxpayers paid fHlj.,500,000,000 in taxes, over a fourth of the national product, to federal, state, and local governments.- Associated Press dispatch, bos Angeles Times. February 26, 1950.

6i system will, irrespective of the types of taxes levied, have an important effect upon the flow of funds into private investment channels.

Furthermore, with its steeply pro­

gressive individual income and estate tax schedules and its high corporate rates, the present tax structure can hardly avoid having extremely significant effects on investment and production.

oo

The effects may be positive if— in the face of new taxation— taxpayers exert more initiative, energy, and inventiveness in order to maintain standards. Taxation may, however, by design or ineptitude, discourage initiative. Pew propositions in public finance have more often been cited than the one which tells us that wthe power to tax is the power to destroy.”23 Conclusion.

Venturesome economic undertakings are a

part of the American heritage. create this spirit.

Taxation can, in no way,

However, taxation which is badly devised

or imposed at heavy rates can limit or destroy a beneficent inclination which would otherwise continue to manifest itself throughout our society.^ In this chapter, we have seen that: (1) a tax system should be consistent with both the fiscal and economic objectives of a community; (2) risk taking should not be 22 Keith, o£. cit., p. 77. 23 Groves. Production, Jobs and Taxes, op. cit.. P. 10. p. 82.

2l|_ The Committee on Postwar Tax Policy, op. cit., “

penalized; (3 ) a more equitable distribution of the tax burden must be established; and (If), the operation of the economy should not be unduly hampered by unsound tax policies. In the following chapters, the various particular types of taxes and their effects on venture capital formation will be investigated.

CHAPTER V I

CAPITAL GAINS TAXATION AND VENTURE CAPITAL Sound results In taxation are not alway achieved in direct proportion to the number of words that are spoken and written on a particular subject. . . . Reams have been written about capital gains and losses • . . Today they still pose an unsolved problem. ^ In this chapter, the capital gains and losses tax provisions are considered.

The past provisions of the laws

regarding capital gains and losses are set forth.

The tax

treatment accorded capital gains and losses today are presented, as well as statistical information concerning the amount of revenue derived from the tax.

The effects of

capital gains taxation on venture Investment are discussed, along with Its effects upon established and new enterprises. The illusory aspects of capital gains are pointed out.

In

the last section of the chapter, recommendations are made for the reform of capital gains and losses taxation. The tax treatment of capital gains and losses is one of the most difficult and complex issues in taxation. Capital gains and losses can be realized from many different types of transactions and from many varying causes.

Many

of the people connected with the problem recognize the impossibility of achieving an ideal tax arrangement for the 1 Randolph E. Paul, Taxation for Prosperity (Indianapolis: The Bobbs-Merrill Company, 1947), p. 271.

treatment of capital gains and losses. ? Past provisions regarding capital gains.

Capital

gains were taxed fully as income between the years 1913 and 1921.

In 1921, Congress enacted laws which distinguished

between capital gains and other types of income.

A scheme

was adopted for taxing long-term capital gains at a special rate.

Since 1921, many various formulae have been used in

capital gains taxation.

The basic policy established in

1921 has been adhered to despite the various plans and procedures.

Long-term capital losses have also been subject

to various methods.

Between 1918 and 192l|., long-term losses

were deductible from income of any kind.

Since 1921}-, the

long-term losses have been deductible from other income, but only to a limited extent. Present treatment of capital gains and losses. Treatment of capital gains and losses is governed by the law enacted in 19i|-2*

In general, capital gains are profits

obtained from selling or exchanging any type of property, including securities, except certain kinds when they are 2 Jobs and Taxes (Hew York: The Hew York Stock Exchange,“ l9lj'9T7”p‘ri507 Cf. Paul, op. cit., pp. 271-276, Harold M. Groves, Postwar Taxation and Economic Progress (first edition; Hew York: McGraw-Hill Book Company, Inc•, I9I46) * PP» 206-223, and Capital Gains Taxation (Hew York: Tax Institute, Incor­ porated, 19^.6)» PP - 1-23. 3 Jobs and Taxes, p. 38*

used oi» held in trade or business.

More specifically, the

exceptions include property held for sale in a trade or business, real property and depreciable property used in business, and certain Federal, State, and municipal obli­ gations.^ Stocks and bonds are capital assets when held by individual taxpayers.

However, the same stocks and bonds

are not classed as capital assets when they are held for resale by securities dealers. sidered a capital asset.

A personal residence is con­

Houses held for sale by real estate

dealers are not classed as capital assets.

Likewise, an

automobile used for pleasure is a capital asset, but a truck used in a business is not.

Household furnishings, jewelry,

boats, airplanes, and almost all other kinds of property are usually classified as capital assets when owned or used for pleasure or personal investment.^ A six-month holding period was established to distin­ guish short-term from long-term capital gains and losses. The six-month holding period is a rough dividing line to separate the gains and losses of the traders or speculators / from those of the bona fide investors. The law provides It Your Federal Income Tax (19^4-9 edition; Washington: Treasury Department, Bureau of Internal Revenue, 19^4-9)> p. 63. £ Loc. cit. 6

and Taxes,loc. cit.

special rules for the taxation of gains derived from property held for more than six months. term.

Such gains are called long­

Only one-half of the profit is taxable, and the rate

of tax on this half cannot exceed

$0 per cent.

Combining

these two rules, the effective tax rate on the long-term gains never exceeds

2$ per cent.^

Gains made from capital assets which were held for less than the six-month period are called short-term gains, Q and are fully taxed at regular rates. The law also provides that the losses from the sale or exchange of capital assets held for more than six months shall be given special tax treatment.

These losses— called

long-term--are taken into account only to the extent of 50 per cent, as in the case of long-term gains.

Losses

sustained on capital assets held for six months or less— short-term losses— are taken into account 100 per cent. These short-term losses must first be used to reduce both long-term and short-term gains.

Any remaining excess of

such losses may be used to reduce ordinary income up to $1 ,000.

Furthermore, any excess remaining may be carried

over for use in the five subsequent years.9 7 How to Prepare Your U. S. Income Tax Return (Washington: Bureau of Internal Revenue, 19l|9)> p. 10.

6 7

Revenue from capital gains taxation.

Revenue received

from both short-term and long-term capital gains is not large in relation to total federal revenues.

The table on the page

immediately following is drawn up from figures released by the Secretary of Treasury showing the fiscal results of the capital gains and losses tax for the years from 1935 to 19l|5 * The largest amounts were received during the inflationary years 19^3*

and 19^5*

The amounts received represent

only ij-.O, 1 .9 * and 3.8 per cent of the total revenue from personal income taxes during those years, and only 1 .1 , 0 .8 , and 1.6 per cent of total federal receipts.'1'0 Effects of capital gains taxation on venture capital. Capital gains, along with dividends to the stockholders, are the principal form for the risk taking which is of so great n strategic importance in a dynamic economy. The present capital gains tax is a deterrent to risk taking.

It is a very great discouragement to venture

investing in new enterprises— without which progress will cease and our dynamic economy will stagnate.

New enterprises

have no retained earnings to rely on for funds and must raise their initial funds from outside sources.

The venturesome

investor Is the best source for these funds. 10 Jobs""and Taxes, p. lf.0 . 11 Groves, o£. cit.. p. 221.

These

68

TABLE III® ESTIMATED TAXES ON CAPITAL GAINS AND LOSSES OP INDIVIDUALS, 1935 - 19*1-5 (In millions of dollars) Year of liability

Total

1935

#72

1936

171

1937

*1-1

1938

12

1939

b

19*1.0

7

19*41

-86

19*1-2

68

19*43

266

19*4*419*4-5

.

35*4721

a Adapted from Jobs and Taxes (New York: The New York Stock Exchange, 19*4-9)> p. *4-0.

venturesome Investors are usually willing to put up the necessary funds in spite of the obvious hazards and the high degree of risk involved because they hope the venture will succeed and the increased value of their investment will accrue to them as a reward for assuming the risks of enter­ prise.

Because of the present capital gains tax system,

the venture investor hesitates to risk his savings, and consequently, the economy as a whole will eventually suffer. 1P The capital gains tax structure affects established enterprise as well as the new ones.

Investors who have

participated in a successful venture become reluctant to sell their securities even after they have been become sufficient­ ly seasoned to attract the average non-risk taking investor. This reluctance to sell comes about because the tax to be paid on the realized gain will reduce the principal, and if this reduced principal is reinvested, it Is unlikely to bring a return of equal size and security.

This results In a

"freezing*1 of capital, and also, In the reduction in the amount of venture capital available for new enterprises. Economic progress would receive a tremendous stimulus If the all too rare risk takers were encouraged, rather than dis­ couraged, to sell their seasoned securities to Investors who do not desire to, or cannot afford to, assume great risks, 12 Jobs~and Taxes, p. ip..

70 and then to reinvest the proceeds in new or small but promising enterprises.

J

Unfortunately, treatment of capital gains under the present system is discouraging, rather than encouraging and stimulating, to the vital economic function of risk taking. One of the principal reasons for buying equities is to realize a profit from their appreciation in value. Of course there is an accompanying risk of loss. In recent years the government has taxed the gains but would not allow the deduction of losses, except as an offset against gains, and to a limited amount. Thus such investments have been made less attractive.^4 The prospective risk taker is acutely conscious of the fact that if his venture should be prosperous, a sizeable share of any appreciation in the value of his assets will be taken in taxes when he sells his holdings.

If he suffers a

loss, he is allowed only a limited offset and carry-over against other income.^

Specifically,

If the Investment pans out successfully and yields a profit through capital appreciation, the Government takes a minimum of 2£ per cent of the gain. On the other hand, if the stock goes sour and the investor ’’loses his shirt,” he stands the loss himself, except for the $1,000 which he is permitted to deduct from other income in computing his overall tax. 13 Jobs and Taxes, pp. lj.1-lj.2. lit- Harold G. Moulton, et al., Capital Expansion. Employment. and Economic Stability (Washington: The Brookings Institution, l^O), p. 296. 15 Emil Sehram, ’’Taxation and Venture Capital,” The Annals of the American Academy of Political and Social Sciences. CCLXVI (November, 19I4-9T, 90•

71 In other words, for the large Investor at least, it is a good deal like "heads you win, tails I lose.” Barring the prospect of pretty sure appreciation, the game seems to many hardly worth the candle.1° "No system could be better devised to discourage risk taking at a time when personal Imeome taxes are crush­ ing in the upper brackets.11^ Another discouraging effect of the present capital gains tax should be pointed out.

Capital gains are apt to

be illusory In periods of generally rising prices or when prices in any Important sector of the economy are moving upward.

A man who sells his asset which has appreciated

because of a rise in the general price level finds that to replace his asset, a similarly inflated price must be paid. However, upon the sale of his original appreciated asset, a share of the proceeds are taken as capital gains taxes. It is obvious that he cannot purchase an equivalent asset without obtaining additional funds.

Many injustices were,

and are still being, wrought by taxation of such Illusory capital gains during the highly Inflationary period of recent years.

Some people are forced, usually by circumstances

beyond their control, to change their place of employment and consequently, to sell their homes and purchase new residences.

In most cases, because of the inflationary

16 "Why the Dearth of Risk Capital?" Monthly Letter. National City Bank (January, 195>0), o. 17 Schram, loc. cit.

72 circumstances, the value of their original homes had appreciated*

A capital gains tax had to be paid on this . iO . appreciation* Unfortunately, the purchase of the new resi­ dence had to be accomplished in the same inflated market. Prom the point of view of persons in such a situation, the capital gains tax represents a levy on their capital. Capital gains taxation violates a deep-seated feeling on the part of the taxpayer that there is a fundamental distinction between occasional realized gains and income derived from wages, salaries or capital assets. As this form of taxation has been part of the tax structure for almost 30 years, entire elimination of capital gains taxation is too much to expect. Proper changes would help to reduce the degree to whieh the present tax is an embodiment of the spirit in the phrase "heads I win, tails you lose.” I cannot emphasize too much the restrictive effects of the present taxes on capital gains. They are making it almost impossible to obtain, a foothold in the economy, except for those who are born in unusually fortunate circumstances. Capital gains taxation does not help to establish those who display ability and e n e r g y . 20 The net effect of the present capital gains tax system is to create serious injustices among taxpayers.

It also

adds one more unfavorable element to a tax system vhich Is already heavily weighted against venture investment.

Every­

one who is interested in increased employment opportunities, 18 The taxpayer must pay a tax on profits, but he cannot deduct any losses he sustains. Sales or exchanges of any property not used for business or held for profitable sale fall under this general rule. 19 Jobs and Taxes, p. I4.3 . 20 Emil Schram, "Present Tax Structure Throttles Small Business!” The Commercial and Financial Chronicle. CLXX, Number i|.86o ”(Deceraber 1, 1 9 W ), 9*

73 in expansion and improvement of our industrial equipment, in better standards of living, and in the continued progress of civilization will be benefited by alterations in capital gains tax provisions designed to encourage risk taking.

21

Proposals for reform of the capital gains tax structure. A reform of the capital gains tax system no doubt would be a positive step in the establishment of conditions under which an ample flow of risk capital could be maintained. It Is realized that all obstructions to the formation of venture capital will not be removed by merely enacting different laws regarding one phase of enterprise.

However,

a more favorable tax atmosphere would certainly be beneficial to the enterprises of this country as well as to the economy and the people as a whole. The six-months holding period now used as a dividing line between trading or speculation and bona fide investment is an aspect of the capital gains tax structure that should be altered.

It Is not possible to draw an Iron curtain

around the various phases of the capital markets.

In fact,

it is believed that the application of the six-months rule under present conditions is very seriously impairing the vitality of the markets, and consequently, they are unable to effectively perform their vital function in the investment 21 Jobs~~and Taxes, p. I4. 0.

711-

process.

The present capital gains tax structure, as well as

the present international and domestic uncertainties, makes predictions difficult and deters savers from assuming risks. The factors responsible for both the high capital gains rates on short-term gains and the overall economic and political instability are likely to be operative for an indefinite time. For these reasons, it is believed that a shortening of the period dividing speculation from investment is in order. Consequently, savers would be more favorably disposed toward making equity investments.

Benefits would accrue to new as

well as existing enterprises.

Small, medium-sized, and large

business could attract funds more easily.

p"i

J

A reduction in the capital gains tax rate would encourage risk taking.

A decrease in the rate would increase

the possible reward an investor could hope to realize from his participation in any given venture.

The prospect of an

increased reward would make all investment opportunities appear more attractive.

It is recommended that long-term

22 There is little likelihood of a speculative wave• getting out of hand with all the existing regulatory and supervisory powers in control over the capital markets. The Securities Act of 1933 » the Securities Exchange Act of 193^, the regulation of margin requirements by the Federal Reserve Board, the authority of the Federal Reserve Board to fix percentage of loans secured by stock or bond collateral, and the strict self-policing of the security Industry itself are weapons against unwarranted and unwise speculation. Cf. Jobs and Taxes, p. i|J|.. 23 Jobs and Taxes, pp. 1|3—If-lj..

7 5

capital gains be taxed at a flat rate of 10 per c e n t . ^

If

the flat rate of 10 per cent were substituted for the present arrangement, the flow of venture capital would be stimulated, the sale of appreciated and seasoned assets would be encour­ aged, and less injustice would be done to the people who have had purely illusory gains that merely reflect the general and highly inflationary trend of recent years.^ Liberalized loss allowances should be established for capital gains taxation.

The extent to which losses can be

offset against ordinary income should be increased from the present $1,000 to $5*000.

Furthermore, this loss allowance

should be effective in each of the carry-over (and carry-back) years as well as for the year in which losses occur.

Such a

liberalization of loss allowances would do a great deal toward removing a most serious tax impediment to our industrial development and growth. The impact of present high taxes on venture invest­ ments might be further alleviated by more adequate capital loss offsets.

Longer loss carry-forwards would give the

enterprise with a fluctuating income a much better chance of 2ij. The present rates on short-term gains (supra pp. 6566) are considered adequate. However, for proposed changes affecting short-term gains see pp. 73-7i{-. 25 Schram, "Taxation and Venture Capital," op. cit., P. 92. 26 Ibid., p. 91.

76 spreading its losses over profitable years.

Such, a process

would enable the new firm to "break even" in its operations • before being subject to any tax.*^

The Secretary of the

Treasury of the United States, John W. Snyder, is acutely conscious of the need for reform in this connection.

In

his message to the Committee on Ways and Means of the House of Representatives, he said: I also recommend the extension of the period for off­ setting losses against profits of subsequent years. The need for giving business greater leeway to recover losses has been widely recognized in discussions of postwar tax revisions. Taking profits without adequate recognition of losses creates inequities and restrains risk-taking. A dynamic economy requires a continued stream of new ventures, which often result in losses for a series of years before they become profitably established. A longer period for carrying over loss will be especially beneficial to small and new business.2o "I recommend a five-year carryover with a one-year carryback.

This would provide a total period of seven years

in which losses might be offset against profits. provision would involve no immediate loss in

This

r e v e n u e . " ^

Randolph E. Paul, the tax expert and former General Consul for the Treasury Department, also recognized the 27 Gordon Keith, "Tax Policy and Investment," The Annals of the American Academy of Political and Social Sciences. CCLXVI (November, I9I4-9T, 83. 28 John W. Snyder, statement before the Committee on Ways and Means, House of Representatives, February 3» 19£0> p. 2l^. 29 Loc. cit.

77 various implications involved in the treatment of* capital gains.

He said:

The question of risk-taking" is relevant. It is quite possible that the gain to the economy to be derived from increased risk-taking would be worth more than the revenue loss involved in some reasonable averaging devices, the extension of the carry-forward period for losses, and a less discriminatory treatment of capital losses.30 Theoretical considerations regarding whether or not capital gains are true income and if the capital gains tax is a capital levy are not within the scope of this paper. Regardless of the stand taken in connection with this parti­ cular point, the eapital gains provisions are incorporated in the laws, and they are probably in the laws to stay. Complete repeal of the capital gains tax is not recommended at the present time.

Such a move appears to be politically

infeasible at this time.

Also, the insatiable requirement

for revenue by the Government makes complete repeal impracti­ cal.^^

It is, of course, realized that the Treasury is not

provided with large or dependable revenues under the present capital gains provisions.

However, until better sources of

revenue are available, complete repeal is not advocated. the other hand, since large or dependable revenues are not forthcoming under the present laws, the capital gains laws 30 Paul, o£. cit., p. 276. 31 See footnote 19# p. 9^4-# and pp. l6l-l63 for a detailed discussion of government spending.

On

must be judged on their economic effects and needed adjust­ ments must be made on that basis. Conclusion. be abolished.

Ultimately, the capital gains tax should

The tax under the capital gains provisions

is very complicated and inequitable. investment in American industry.

It discourages venture

Unfortunately, present

conditions make abolishment of the tax infeasible.

However,

until complete repeal can be affected, the present capital gains structure should be altered as suggested in this chapter.

32 C f . HWhy TaxesMust Be Cut," U. S. Hews and World Report (August 26. 19^9)* 3-3k, and "WhatT s Wrong With Prices of Stocks," U. S. Hews and World Report (May 13. 19li9).

25- 26.





CHAPTER V I I

SECTION 102 AND THE FORMATION OF EQUITY CAPITAL Next in a program of tax relief to encourage the flow of venture capital is the revision of Section 102 of the Internal Revenue Code*

This Section imposes penalties on

corporations found to have,accumulated reserves in excess of the ’’reasonable1* needs of their business.

Some relief

from Section 102 is a must item in any tax revision program. In this chapter, consideration is first given to the provisions of the present Section 102.

The effects of

Section 102 in relation to enterprises and the economy as a whole are then discussed.

In the last section of the chapter,

proposals for the reform of Section 102 are set forth. The provisions of Section 102.

At the beginning of

Income tax legislation in 1913, Congress recognized the possibility of using corporations as savings banks to avoid personal income surtaxes.

Corporations could avoid declar­

ing dividends beyond the consumption needs of their stock­ holders, and so the individuals would avoid the heavier taxes since management did the investing for them.

Stockholders

who control a corporation could allow the earnings to 1 John W. Hanes, ”A Tax Policy for Enterprise,” Tax Review. X, No. 5 (May, 19^9 ), 25.

.80 accumulate when they were not needed in the business, where­ as if they were paid out as dividends to the stockholders, most of the declared dividends would be paid over to the Treasury in taxes.

Special taxes were designed to prevent

such temporary avoidance of individual surtaxes.

At present,

these tax provisions are embodied in Section 102 of the p Internal Revenue Code. Section 102 of the revenue law makes accumulation of surplus beyond the reasonable needs of the business the equivalent of tax avoidance unless the corporation, by a clear preponderance of the evidence, proves the contrary. Investments in assets having no reasonable connection with the enterprise is usually considered grounds for applying Section 102.3 The Section 102 tax rate is 27i| per cent of the un­ distributed Section 102 net income not in excess of #100,000, plus 38^- per cent of that portion in excess of #100,000. There is no allowance for the capital loss carry-over or the net operating loss deduction.

The non-recognition of these

2 Harold M. Groves, Postwar Taxation and Economic Progress (first edition; Hew York: McGraw-Hill Book Company, inc., 19*4.6) , p. 2. 3 Ibid.. pp. !j.2-I|3. Groves reports the reaction of one competent critic to this provision to be as follows: ’’Through most of our history this approach has just been a farce and beginning in 1938 [Section 102 was considerably strengthened by the 1938 Revenue Ac6J it began to be an unmitigated nuisance.'

81 two items might have peculiar consequences with the result that, tinder certain conditions, even a deficit organization may have a Section 102 problem.^ Effects of Section 102.

The problem of protecting

governmental revenue without thwarting legitimate corporate expansion is a very delicate one.

Corporate reinvestment is

typically the result of mixed motives, and a plausible defense for any such reinvestment is usually not difficult to discover.

The administration of Section 102 may interfere

with the legitimate attempts of organizations to develop liquid corporate assets.

Prom the standpoint of all the

parties concerned, the uncertainties connected with the

cf whole procedure under Section 102 are thoroughly bad.-' Section 102 has especially unwholesome effects on the economy as a whole.

It imposes a large penalty on corpora­

tions found to have accumulated reserves in excess of the Reasonablert needs of their business.

Actually, the impor­

tance of Section 102 does not lie in its tax results but in its far-reaching influence upon business policies.

In

effect, this section places a burdensome penalty upon corporate thrift.

The enforcement of Section 102 leads to

if Clarence L. Turner, ’’Unreasonable Accumulation of Surplus . . . Section 102,” Taxes--The Tax Magazine. XXVI, No. 9 (September, 19if8 ), 82f0. f? G ro ve s, o £ . c i t . . p p . If2 -If3 *

8 2

a limitation of growth and expansion of private enterprise through the desirable medium of plowing earnings back into business.

Furthermore, the possible imposition of penalty

taxes under Section 102 keeps managements in a state of constant confusion, uncertainty, and turmoil concerning its own business policies. In making vital decisions, executives of such companies are burdened with the necessity of giving weight to the anticipated reactions of a revenue agent two or three years hence. Obviously, it is both absurd and unjust that the judgment of an outside entity, unfamiliar with the requirements of the business and not responsible for the consequences, should be free to make decisions regarding surplus accumulation. 7 If Section 102 were liberalized, more venture capital could be assured for larger enterprises because the fear of an assessment makes this section far more effective than any O revenue collected under it indicates. The plain fact Is that many corporate managements are In a constant turmoil over the uncertainty of a large penalty under Section 102 in case they are unable to prove to the satisfaction of the internal revenue agent the propriety of their current dividend policy. Many feel impelled to pay such heavy dividends that adequate reserves for future business needs are dissipated.V ”This deters many managements, particularly of small 6 Turner, op. cit., p. 810. 7 Loc. cit. 8 Clarence W. Fackler, ”A Four-Pronged Attack Upon Equity Capital Problem,” The Commercial and Financial Chronicle. CLXX, Humber (December 29, 19i|9), 2ij.. 9 Hanes, o£. cit., p. 2£.

83 and growing businesses, from proceeding with justifiable expansion .and rehabilitation programs. Proposals for the reform of Section 102,

The tax

policies of Section 102 should be changed so as to accept the decisions of management regarding the proportion of earnings which are to be retained.

In any event, the

Internal Revenue Commissioner should have the burden of establishing an unreasonable accumulation under the pro­ visions of Section 102. ^ A seeond needed change In the provisions of this section would allow corporations, in computing Income for the purposes of Section 102, to deduct dividends paid with­ in in seventy-five days after the end of the tax year* Another amendment to the present law should be made so as to permit capital gains, now included as income for purposes of Section 102, to be exempt from the 102 penalty tax if they are long-term gains.

11

J

Furthermore, the tax should apply only to that part l O ^ T ^ i d n e y Houston, "Taxation and Corporate Enter­ prise,” The Annals of the Amerlcan Academy of Political and Social Sciences. CCLXV:TTNo v ember, 19^9), 99. H Industry Believes (New York: National Association of Manufacturers, 19^-9)» P • 20. 12 Hanes, loc. cit. 13 Loc. cit.

of tli© undistributed Section 102 net income which is un­ reasonably accumulated. Section 102 of the Revenue Act should be amended so as to provide that the tax Imposed thereunder would not apply to sums set aside as a reserve for the ”exclusive purpose” of paying dividends upon stock in later years at the same rates prevailing at the time the reserves were created. This proposal would help insure the maintenance of regular dividends rather than excessively fluctuating dividends over a period of years.

This provision is of importance for the

reason that investors in common stocks are showing an in­ creasing interest in current dividend yields.^ Finally, the tax laws should be amended so as to provide that the tax imposed under Section 102 would not apply to a corporation that invests its retained earnings in fixed tangible assets, whether in its own or in another enterprise.^ Conclusion.

The proposals mentioned above must neces­

sarily be adopted if the provisions of Section 102 are not to continue to be a deterrent to sound business policies. The amendments suggested would overcome the uncertainty and confusion produced by the present Section 102 provisions and li*. Fa'ckler, op. cit.. pp. 2l}.-25>.

85 administration.

A sound tax policy under Section 102 is an

essential step for continued economic progress.

CHAPTER V I I I

DOUBLE TAXATION AND VENTURE'CAPITAL FORMATION Chapter VIII deals with double taxation.

The nature

of double taxation Is discussed, and some mention made of its historical background.

The effects of double taxation

upon the initiative to partake of venture investments, as well as upon the economy as a whole, are set forth.

In

order to mitigate the bad effects of the double tax, reforms are suggested. Nature of double taxation. Double taxation of corporate income occurs when corporate income Is taxed once as income to the corporation and again as Income to the stockholder.

The first tax is on the corporation at the

prevailing corporate income tax rates.

The second tax is on

the stockholder in the form of an individual tax upon the dividends he receives. In 1913> the first modern income tax law recognized the inequity involved in double taxation.

Consequently, the

dividend income was not taxed at the personal normal rate.

The personal normal rate was 1 per cent— the same as the corporate rate.

Under these conditions, the corporate income

tax was largely a device for collecting personal income taxes on dividends at the source.

Although dividend income

continued to be exempt from the personal normal tax, beginning in 1918» corporate rate was higher than the personal normal rate.

Thus the corporate income tax could

be justified no longer entirely on the claim that it was a means of collecting personal taxes at the souree. of double taxation was introduced.

A measure

Double taxation was made

complete by the Revenue Act of 1936 which provided that dividend receipts to stockholders were to be fully taxed at both normal and surtax rates.

Corporate earnings distributed

as dividends have been subject to high double taxes since then.^" The discrimination of double taxation must be appreciably alleviated if risk taking and investment in equity securities are to be encouraged.

It is necessary that

the best possible solution, considering the economic, politi­ cal, psychological, and revenue factors involved, should be sought and soon adopted. Effects of double taxation.

The effect upon our

economy of the double taxation of dividends takes many forms. For one thing, of grave significance now, the double taxation 1 Jobs and Taxes (New York: The New York Stock Exchange, 19^-9)» PP. 35>-36. 2 Alfred G. Buehler, ”The Taxation of Small Business,” American Economic Review. XXXVI, No. 2 (May, I9J4.6), 261.

8 8

promotes undue debt financing in place of healthy owner­ ship interest.

Funds seeking the shelter of debt securities

are not merely the savings of each year.

Old capital, whose

owners are becoming less active, flees into this debt sanctuary or tends to move into the hands of trustees.

As

a result equity financing is not as prevalent as it should be. ^ • • • there is little doubt that it effects a distortion of the capital structure of many corporations. Stockholders cannot foreclose if dividends are not paid. But debt commitments require that fixed interest charges must be paid to bondholders. Undoubtedly the rigidity of debt contracts increases risks. To the extent that debt financing is encouraged and equity financing discouraged, the resulting corporate capital structure may be. too flimsy to withstand the stresses of bad times.4 For a more detailed consideration of the effects of debt financing see Chapter III, pp. 27-39, supra. The double tax is considered unfair because it results in a heavier tax on income derived from dividends than on other income.

On grounds of equity and justice,

^there is no justification for taxing dividend income twice whereas income from interest, rents, royalties, and the like is taxed but once."^ 3 Emil Schram, ’’Ueeded Measures for Tax Relief, Exchange, IX, No. 2 (February, 19^8)$ 2. If Randolph E. Paul, Taxation for Prosperity (Indianapolis: The Bobbs-Merrill Company, 194-7), p . 3f?0. 5 Jobs and Taxes, p. 36.

The

89 Another serious indictment against double taxation is that it intensifies the deterrent to risk taking that already exists in the economy as a result of our steeply progressive income tax.

Since the owners' profits from

corporate enterprises are taxed at high rates, the incentive to assume the risk involved in corporate equity investments is drastically reduced. 6 An illustration, however, will help emphasize the seriousness of this point. Suppose a man invests §100,000 in either a new or an existing corporate enter­ prise the total capital stock of which is $2 million. Let us suppose further that the company makes a profit of $200,000 or 10 per cent on its capital and is in the position of being able to distribute to stockholders the entire earnings after taxes. Total corporate tax liabilities would be about lj.0 percent or #80,000, leaving #120,000 for dividends. The share of our investor who purchased 5 percent of the stock is #6,000. If this addition to the investor's income falls in a 30 percent tax bracket, his tax on the dividends will be #1 ,800, and the #Ij.,200 he retains represents only a I}..2 percent return on his investment. The results are even more unsatisfactory for investors in higher income groups. An investor whose income is taxed at a Lj.0 percent rate would realize a return of only 3*6 percent; one whose income is taxed at 60 percent would realize only a 2 .1|. percent return.7 The significant point is that a stockholder's return is reduced drastically by double taxation.

The income of

investors, especially those in middle and upper income groups who are best able to buy ownership interest, is seriously affected.

Because of double taxation, stockholders may

6 Jobs "and Taxes, p. 38 .

7 Loc. cit.

90 realize a very little more than relatively riskless taxexempt bonds would afford them even if the corporation they invested in had a successful operating experience.

With the

possible rewards for the essential service of risk taking so thoroughly whittled away and with the prospects of uncom­ pensated losses looming so large, savers seek refuge in well-seasoned debt securities, in institutional investments, or in government bonds.

With a prolonged continuation of

such inequitable and punitive tax provisions, no saver will supply the necessary venture capital to new or growing Q corporations• Admitting that a large portion of corporate dividends is received by individuals in high income tax brackets, the heavy taxes levied against those dividends are slowly but surely eausing these individuals to withdraw from venturing. It is the conviction of this author that no other single force Is so effective today in drying up the free flow of capital and forcing this country into a socialistic state than the inordinately high tax rates imposed on individuals with large Incomes. Furthermore, these rates are almost entirely political. They produce a relatively small amount of revenue for the Federal Treasury, and, as the Individuals switch their Investments from venturing to tax-exempt securities because they obtain more net yield, the lifeblood of new capital is gradually drying up.9 To do business under a corporate form of organization is in no wise a luxury that should be subject to a penalty 8 Jobs"and Taxes, loc. cit. As a result, it becomes easy (but incorrect) to claim that private investment is insufficient, and therefore government must invest. 9 G. Sidney Houston, “Taxation and Corporate Enter­ prise,” The Annals of the American Academy of Political and Social Sciences. CCLXVI (November, 19^4-9) » 9^*"

91 tax in addition to the various franchise imposts charged upon this mode of business.

Corporate forms are essential in

order to amass the large amounts of capital that modern methods of production make necessary in many branches of industry.

Therefore, any measures that make it more

difficult for corporations to raise venture capital thus do not discriminate merely against this particular form of organization, but also impede the growth and development of whole sectors of industry. Proposals for reform.

Unquestionably, the double tax

on corporate dividends has materially helped to destroy the attractiveness of equity investments.

This policy of tax

discrimination has had a most discouraging effect on the •i n

attitude of investors of venture capital. x By reason of this double tax, equity capital in our economic structure now assumes an unwarranted and much greater risk of loss than any other form of capital invest­ ment.

This order certainly should be reversed.

Instead of

placing a penalty on the fruits of venture investments, inducements should be made so as to compensate more liberally those who are willing to risk their savings in productive 10 Jobs"*and Taxes, p. 39* 11 Godfrey N. Nelson, wThe Personal-Income Tax and Business Enterprise, *’ The Annals of the American Academy of Political and Social Sciences. CCUXVI (November, 19^-9)»lift.

92 enterprise.

If private enterprise is to be fairly and

equitably served, the income therefrom should be taxed just once— not twice. & Elimination of the double taxation of dividends is by far the most important of all possible tax revisions which might encourage equity capital formation. Canadian Minister of Finance Douglas Abbott could have been speaking for and to the United States, as well as Canada, when he told the Canadian Parliament on March 22: Today we find governments in this country, as well as In most other countries, taxing away at least a third of corporate profits. In addition, the personal income-tax rates apply in full to what Is distributed out of the remaining two-thirds. The tax may be as high as 80 per cent upon distributions to shareholders. It seems to me that under a system of private enterprise, which depends for Its existence on a steady flow of venture capital, we cannot afford to neglect the implication of this defect in our tax system, which has been accentuated by the increase In both corporate and personal income-tax rates. . . , It is a matter of concern for the future under a system where we depend, and must depend, for full employment and the creation of new wealth on the willing­ ness of our people to risk their money in constructive enterprises. J-3 The most satisfactory method for the elimination of the double tax on dividends would be to free the corporation from income tax entirely.

(Cf. post, pp. 106 ff.)

However, as

mentioned in Chapter IX, the possibilities of a tax structure 12 Nelson, loc. clt. 13 John W. Hanes, MA Tax Policy for Enterprise,” Tax Review. X, No. 3 (May, 19^9), 25-26.

9 3

with no corporation income tax are very remote.

The next

most satisfactory arrangement for the elimination of the double tax would follow the proposal of Senator Walter P. George*

He said, ’’Ultimately, we should exempt dividends

from taxation completely.’’^

It is realized that because of

the tremendous revenue needs,^ neither of these proposals can be readily adopted.

However,- because of its injurious

effects upon the economy, double taxation should at least be promptly and adequately moderated. The most effective method by which to moderate the double tax is by a dividend received credit.

The tax law

should be revised so as to permit individuals to deduct from their personal income tax liability an amount equal to 20 per centx

of the dividends they have received.

Under such a plan a corporation would make its tax return and pay its tax just as it does today. The individual would include all dividends received with lif “'Why Taxes Must Be Cut,” U. S. Hews and World Report (August 26, 19lj-9)> 32. ~” 15 See pp. 16I-I63 regarding government spending. 16 According to Sholley, the 20 per cent dividend received credit figure is neither accidental nor arbitrary. He says that a 193o mix-up between the House and Senate versions of the tax bill resulted in the present law under which corporate earnings are taxed twice. Since our first individual tax bracket is now 20 per cent, a dividend received credit of 20 per cent will, in effect, restore the status that existed prior to the oversight in 1936. S. L. Sholley, ’’Restore Equity Capital Plow by Lowering Tax on Dividends!” The Commercial and Financial Chronicle. CLXX, Number lj.866 (December 22, -19W ) , 11.

914other Income and compute his tax exactly as he does today. Then there would be one more line on the tax return which would be labeled Dividend Received Credit. It would Instruct the taxpayer to compute an amount equal to 20% of the dividends included In the return and claim it as a credit to be deducted from the tax due.3-7 This plan would, in effect, reduce the federal tax rate on dividend income by 20 per cent for taxpayers in all tax brackets.

Under the dividend received credit plan, the

person who Is subject to the present rate of 77 per cent would pay £7 per cent on dividend income.

The taxpayer

with a small Income who now pays a 20 per cent tax would pay no 'tax on dividend income.

The benefits of the dividend

received credit plan are greatest to lower bracket tax* 1A payers.xo Irrespective of what particular group gets the greatest amount of calculable benefit, the important fact is that the entire economy gains by the removal of a serious impediment to venture Investment. The theoretical c o s t ^ of the dividend received credit plan may actually turn out to be a profit so far as 17 Sholley, loc. cit. 18 Loc. cit. 19 The Treasury Department estimated that a 20 per cent dividend received credit would reduce individual taxes, and consequently revenue, $1.1}. billion annually. Sholley points out the Hoover Commission Report Indicates that $>3 to f>3> billion annually could be saved through the elimina­ tion of waste and Increase In efficiency without impairing any of the functions of the Federal Government. This is two to three times the amount needed to make up the supposed loss of revenue. Loc. cit.

the Treasury is concerned.

on

The restoration of a more

normal and desirable flow of savings and other funds into equity capital will expand many small enterprises and create many new businesses with a consequent increase in employment and in total payrolls.

Furthermore, it will

greatly broaden and strengthen the base from which future corporate and individual taxes must necessarily come. 21 "But above all else, it will do much to maintain the American system of capitalism and free enterprise and thus insure the continued growth and prosperity of our country."22 Conclusion.

Double taxation is discriminatory,

unfair, and punitive.

It deters risk taking and has detri­

mental effects upon the economy as a whole. The real solution to the difficulties is the comple te elimination of the double tax structure.

But, abolishment

20 In March 1949 » Canada undertook bold measures of tax relief. Minister of Finance Douglas Abbott later reported: "Events have, I submit, justified that boldness.. It gave a stimulus to the economy at a crucial time . . . Lest anyone should think that these tax reductions must have put the Canadian Government into the red, let me hasten to add that . . . every month since the beginning of this fiscal year I have been required to explain why revenues exceed expenditures by more than had been predicted Douglas Abbott, "The Economic Wisdom of Tax Relief. Vital Speeches of the Day. XVI, No. 5 (December 15, 19495, 15B.

seems unlikely because of the huge revenue needs by the government.

However, the double tax should be adequately

moderated as quickly as possible.

Effective reforms

would have a salutary effect upon the entire economy as well as upon the Incentive to invest.

CHAPTER I X

THE CORPORATE INCOME TAX AND VENTURE CAPITAL In this chapter, the corporate income tax and its effects upon equity capital are investigated.

The

"basis” for levying a corporate income tax is analyzed, and the provisions of the present corporate income tax and the revenue received from the tax are set forth.

The

effects of the corporate income tax, with a view toward its influence on equity capital financing, are discussed, and suggestions for desirable reforms are proposed. The "basis” for corporate taxes.

A plausible case

for corporate taxes is made by many writers on the subject. They believe that the corporate taxes are an appropriate return for benefits received by corporations from govern­ ment and for the special privileges that corporations enjoy.

Governmental services are classified as a factor

of production, and business should pay for this factor as it does for others.

Also, these writers argue that

I T . S. Adams, "The Taxation of Business," Pro­ ceedings of the National Tax Association (1917)* 18^-19^. Gerhard Colm, "Conflicting Theories of Corporate Income Taxation," Law and Contemporary Problems. VII, No. 2 (19^0), 281-290. Paul Studenski, "Toward a Theory of Business Tax­ ation." Journal of Political Economv. XLVII. No. £ (19I1.0 J, 521=555.--------------

98 corporations have the ability to pay which is separate from that of the stockholder.

Furthermore, corporate

taxation is looked upon as affording a needed instrument of social control --the corporate tax to be used as a /

means to prevent monopoly and to recapture "unjust” en­ richment arising from monopoly or other action.^ The position taken in this paper is that there is no logical excuse for the corporate levy.^"

Duplication,

confusion, and discrimination results from the combi­ nation of a federal corporate income tax and taxation of dividends to stockholders.

Business entities as such

have no taxpaying significance. ations of individuals.

They are merely associ­

The benefit received theory is

of no significance in this respect because most benefits of government are provided in the common interest and are not subject to apportionment.

It is true that business

could not thrive in the anarchy that would prevail without government power, but neither could the laborer, the professional man, or any other taxpayer.

There is no

2 Harold M. Groves, Postwar Taxation and Economic Progress (first edition; New York: McGraw-Hill Book dompany, Inc., 19^6 ), pp. 21-22. 3 Harold M. Groves, "Personal Versus Corporate Income Taxes," American Economic Review, XXXVI, Ho. 2 (May, 19M>)» 2lp.. Ij. Cf. Roswell Magill, The Impact of Federal Taxes (Hew York: Columbia University tress, 19^J) •

convincing evidence that corporate taxes for social control have been successful.

There are many other ways

of aiding small and new businesses.

And in general, to

overtax competitive business on the off-chance of catching some monopoly profits is not a very enlightened policy.

There are cases of special benefit, but such cases

are usually financed by special assessments.

In general,

there is no measure by which the cost or the benefit of government can be justly attributed to each taxpayer. ttIt is impossible to say in what degree various taxpayers benefit from a battleship.”^

In the last analysis, all

taxes come out of the actual or potential capital or income of individuals. 6 inanimate objects.

Tax burdens cannot be borne by

These considerations lead to the conclusion that there is little, If any, rational basis for an inde­ pendent corporate Income tax; that its Incidence is uncertain and confusing; that its effects are discriminatory and probably repressive. The strong­ est case for it rests on the ground that it yields well and that certain possible substitutes are worse. If for administrative and political reasons the tax system cannot be entirely rationalized, a capricious tax on stockholders may be less undesirable than a capricious tax on consumers.7 Despite the fact that there appears to be no 5 Groves, Postwar Taxation and Economic Progress. O^. iiiji* f P • 23 . 6 Ibid., pp. 22-30. 7 Ibid.. p. 37.

logical reasons for a corporation income tax, the abolishment of corporate taxes would be impractical at the present time.

The present needs of the Government

are such that it would hardly be expedient to meet practically all of our revenue requirements from the individual income tax.

Furthermore, from the standpoint

of our economic goals of high employment and high national income, a corporation tax is distinctly prefer-

o able to an increased reliance upon excise taxes*

It

appears as if the corporate income tax is here to stay. However, if abolishment is not forthcoming, the tax should be amended so as to get rid of its undesirable features. The provisions of the corporate income tax law. Under the present income tax laws, corporations with in­ comes of less than $50,000 pay taxes under a bracket arrangement ranging in effect from 21 to 38 per cent of their total incomes.

Corporations with incomes of over

$50,000 pay taxes at the flat rate of 38 per cent of their total incomes.

Specifically, corporations with incomes

of less than $5*000 pay a 21 per cent tax rate, those with incomes ranging from $5*000 to $15*000 pay 23 per cent, and those with $15,000 to $25,000 incomes pay 25 8 Randolph E. Paul, Taxation for Prosperity (Indianapolis: The Bobbs-Merrill Company, 19q-7 )* P« 358.

1 0 1

per cent.

Corporations with income between #25*000 and

#50,000 pay a tax at the flat rate of 53 per cent on that part of their income exceeding #25*000, and up to #50,000. The reason for such a provision in the tax laws was stated by Treasury Secretary Snyder to be as follows: During most of its history the corporation income tax law has accorded preferential tax treatment to small business. To preserve such treatment when the wartime rates were imposed, an excessively high rate of 53 per cent was applied to corporations with in­ comes between #25,000 and #50,000. This so-called "notch11 rate provided the transition from the low rates on small corporations to the generally applicable higher rates.9 The receipts from corporate income t a x e s . U n d e r the present corporation income tax provisions, the Govern­ ment is a partner in business--in fact, a preferred partner. The Governments "take" as a 38 per cent partner in business is reaching great proportions.^^

The profits for

9 John W. Snyder, statement before the Committee on Ways and Means, House of Representatives, February 3* 1950, p. 23. 10 See Table IV on page immediately following. 11 In their search for more revenue, the Executive and Treasury Departments are proposing an increase in the corporate income tax rates. The Secretary of the Treasury suggests that the present 38 per cent general corporate rate be raised to \\2 per cent. Snyder, loc. cit. The effect of such a raise on enterprise is extremely important. Would higher rates of tax than those prevailing tend to cause corporations to pull back from expansion, to lower dividends, and to think in smaller terms? If so, the Government, al­ ready drawing great amounts of cash from big business, might find itself drawing less even with higher tax rates.

TABLE IVa CORPORATE INCOME TAX LIABILITY AND DIVIDEND PAYMENTS (In millions of dollars) Corporate income after taxes

Corporate income before taxes

Corporate tax liability

1942

121,098

111,665

X943

25,052

14,406

10, 6)4.6

4,493

X944

24,333

13,525

10,808

4,680

19kS

19,717

11,215

8,502

4,699

X946

23,560

9,620

13,94-0

5,808

X947

31,602

12,511

19,091

7,018

1948

34,793

13,619

21,174

7,932

w to 15

27,600

10,900

16,700

8,000

#9,433

Corporate dividend payments 14,297

a Adapted from Tables 17. 18, 19; and 20; Survey of Current'Business• ' XXIX, Ho. .7 (July, 19k.9), 16-17. ' a •" b Estimates for 1949 from the Connell of Economic Advisers."The Annual Economic Review," TJ. S. News and World Report (January 13, 1950), 68, 102

1 0 3

191$ will yield nearly 10 billion dollars in taxes to the Gov eminent.1^ Out of each dollar that any corporation in the United States earns, the Treasury generally takes about 38 cents as its direct contribution.

In addition, each

dollar of dividends paid by corporations out of earnings yields at least 21*5 cents to the Treasury.

On the share

of earnings paid out as dividends, the Treasury takes about 59.5 cents per dollar— 38 from the corporation and on an average of 21*5 from the individual getting the dividend.13 The effects of corporate income taxes.

The effeets

of the corporate income tax are considered to be bad effects.

The public purposes to be served by taxation

are not well served by the corporate income tax structure. The tax is uncertain in Its effects with respect to the stabilization of the dollar, and it is Inequitable as a part of a progressive levy on Individual income.

Further­

more, the tax reduces the yield on Investment and obstructs the flow of savings into business enterprises.1^" 12 ^Government *Take' As 38$ Partner in Business,” U. S. Hews and World Report (November 2I4., 19!$), 21. 13 Loc. cit. llj. Beardsley Ruml, ”Tax Policies for Prosperity,” American Economic Review. XXXVI, No. 2 (May, 19l}.o), 270.

lOlj.

The tax tends to raise the prices of goods and services.

Managements of the most efficient enterprises

in an industry, when the longer-term outlook for business is considered favorable, ordinarily seek to compensate for the burden of the tax on profits by quoting prices at a level that transfers the impact of such taxes to the consumer.

Consequently, it becomes necessary for the

managers of the less efficient companies to set substan­ tially the same prices as their more efficient competitors (at least no higher) if they want to sell enough goods to stay in business. ^

This reaction will not invariably

result from the corporate income tax.

However, the corp­

orate net income tax applies to items of imputed rent and interest--items deductible as costs when the management employs the factors on a contractual basis.

Thus the

tax does reach certain costs, as well as surplus, and would be reflected in prices.^

’’Insofar as the tax is

shifted forward it becomes a sales tax in disguise, having all the regressive features usually associated with the sales tax family.”"^ 15? H. W. Prentis, Jr., ’’Taxation and Business Initiative,” The Annals of the American Academy of Political and Social Sciences. CCLXVI (November, 19^4-9}» 72. 16 Groves, Postwar Taxation and Economic Progress. op. cit.. p. 28, 17 Groves, ’’Personal Versus Corporate Income Taxes,” op. cit.. p. 2i|.l.

105 Suffice it to say that no definite conclusion as to the incidence of the corporate income tax is possible and that not improbably the burden is divided between at least stockholders and consumers.^.” Since the corporate tax is at least partially borne by the stockholder, it follows that two taxes are imposed on the profit element in income, whereas only one is imposed on most other income.

Although there is no

definite proof that the corporate tax does have repressive effects upon incentive, it should be evident that two taxes on enterprise income, while other income bears only one, imposes a special penalty at a particularly strategic spot in the economic process.^

(For a more detailed

consideration of double taxation, see Chapter VIII, pp. 86-9^, supra.) The corporate income tax is as unsatisfactory to those who are chiefly interested in the fairness of the tax system as to those who are mainly concerned with incentives. As mentioned before (see p. lOij., supra). an unknown portion of this tax becomes an element in prices and is paid by the consumers In haphazard amounts and proportions.

Also, the

tax is necessarily impersonal In character and makes no differentiation among stockholders according to their l6 Groves, Postwar Taxation and Economic Progress. op. cit.. p. 28. 19 Ibid.. pp. 30-31.

i o 6

income status.

The small stockholder, sometimes completely

dependent upon a small income from stocks, is subjected to the same treatment as the wealthy investor. 20 However, the main issue is not whether taxes at the corporate level are more of a deterrent than taxes at the personal level. The issue is whether singling out the profit element in income, regardless of distribution, for especially heavy taxation is a deterrent to risktaking investment. The question, put this way, seems almost to answer itself.21 Proposals for reform.

The abolishment of the

corporate income tax from the tax structure should be the ultimate goal for a sound revision of the tax system.

”It

would be better for all concerned were all income to run the gantlet of the tax system only once and at the personal level

At the personal level, the income could be taxed

as severely as the needs of the government might require.^ 20 Groves, Postwar Taxation and Economic Progress. op. cit.. p. 36. 21 Groves, ’’Personal Versus Corporate Income Taxes,” QP. cit.. p. 2i|i|., 22 Groves, Postwar Taxation and Economic Progress. loc. cit. 23 Such a system would have salutary effects on govern­ ment as well as on the economy as a whole. The ”one-biten system of taxation would stimulate greater interest on the part of citizens with respect to government spending. There would be no ’’hidden” taxes through which the government could raise additional revenue for any unnecessary or unwise spend­ ing. Through the tax system, the citizens would become more aware of excessive governmental spending, and they might act to cut out such unwise policies.

107 The elimination of the corporation income tax from the tax system will increase the effectiveness of our fiscal and monetary policies and, by broadening markets for goods and services, will strengthen business for its task of producing goods, providing employment, and giving the. people a place where their savings can be invested. However, if and when the corporation income tax is abolished, measures must be adopted in order to insure that the corporate form of business will not be used as a device to avoid payment of individual income taxes.

Also, pro­

visions should be passed so that the corporate form of doing business will not be used as a means to build up unneeded and unused corporate surpluses, or to secure any tax advan­ tages over unincorporated businesses.^ A strong theoretical case may be advanced in favor of a drastic reduction, perhaps complete elimination, of the tax on corporation income, providing adequate safe­ guards are established to prevent undistributed earnings from escaping taxation entirely. Investment of venture­ some capital would likely be encouraged and a stimulus given to business expansion if income tax relief should be granted to corporations. Laborers and consumers who are adversely affected by any measure, such as a tax law which restricts productive activity, would stand to benefit from an enlivened and more prosperous economy. Despite the preponderance of theoretical evidence in favor of complete abolishment of the corporate income tax, 2)4. RublL7 loc. cit. 2£ Ibid.. p. 269.

26 C. Ward Macy, "Incidence or Effects of the Corpora­ tion Income Tax?" American Economic Review. XXXVI, Ho. 5> (December, I9I4-6}, 90— allowing for common stock investment by trusts. Section 21 (1) of the Personal Property law now states: ”Jt fiduciary holding funds for investment may invest the same in the kinds and classes of securities described in the succeeding paragraphs of this subdivision, provided that investment is made only in such securities as would be acquired by prudent men of discretion and intelligence in such matters who are seeking a reasonable income and the preservation of their capital . . The securities described include “other securities of corporations organized and existing under the laws of the United States or of the District of Columbia or of any state of the United States including, but not by way of limitation, . . . shares of common and preferred stocks of such corporations . . . ” However, ”no investment shall be made . . . which . * . will cause the aggregate market value of the investments not made eligible by the preceding paragraphs of this subdivision to exceed thirty-five per cent of the aggregate market value at that time of all of the property of the fund held by such fiduciary . . . ” Furthermore, ”no common or preferred stocks, other than bank and Insurance company stocks, shall be purchased • • • unless currently fully listed and registered upon an exchange registered with the securities and exchange commission as a national securities exchange.”

lt|3

A significant step toward the solution of the equity capital problem would be the broadening of the market for venture capital among bur existing financial institutions.^ The institutions have become the custodians of much of the larger part of the liquid savings of the nation.^"

These

vast sums collected by the institutions are invested almost entirely in debt investments. Out of approximately $2? billion personally saved in the years 1946-I9M)* about #22 billion went into insti­ tutional saving, that is, into life insurance, saving accounts in mutual savings banks, savings and loan associations, and time accounts of commercial banks. "While this form of saving satisfies the desire for fixed-sum saving, the #22 billion, or the bulk of it, does not become available for investment in equities be­ cause of the laws regulating insurance companies, banks, and savings and loan associations. These institutions are not permitted to invest in equities with only minor exceptions. As a result corporations seeking outside capital have had to shape their financial policies to meet the requirements of the chief suppliers of capital, 3 It is believed that the present existing insti­ tutions are adequate to meet equity capital needs if necessary reforms are made. The plan proposed by Senator Joseph C. 0*Mahoney for a private system of capital banks under the Federal Reserve System is considered a wasteful duplication. Existing institutions could fill the needs adequately if some of the present obstacles were removed. Cf. "Private System of Capital Banks to Help Small Business Proposed by 0*Mahoney; U. S. Aid Excluded." Wall Street Journal, Pacific Coast Edition, XLII, No. 24 (February 3, 19£>0), 3, and "For Easier Raising of Business Funds," IT. S. News and World Report (February 10, 1950)*

1^ .8.

I4. Furthermore, an increase in the amount of funds is probable in view of the fact that most of the industries1 new pension plan will be handled by banks, as trustees of pension funds, or by insurance companies, as the insurers of pensions.

a requirement which involved issuing bonds instead of equities.5 Too great an amount of debt financing is uriwholesome for a private enterprise economy. 6 If personal savings are to continue to flow predominantly into the financial institutions--and a reverse to this phenomena seems unlikely, the institutions must be looked to as a source of equity funds for capital formation. Life insurance companies.

Life insurance companie

are extremely Important factors in the economy.

Next to

the commercial banks, the Insurance companies hold the biggest block of Investment money in the United States.^ The life insurance industry*s assets amounted, at the end of 1949 > bo the enormous total of #£9*3 billion-the biggest single liquid piece of American wealth.

Life

insurance in force at the end of 1949 was #213.4 billion, up #62 billion from 194®.

Life insurance now accounts

for about one-third of all personal savings.

There is no

wlack of business” problem in the insurance industry. Actually, the problem of the 5>5>0 legal reserve insurance 5> n!nvestment Companies— A Neglected Source of Equity Capital?” The Conference Board Business Record. VI, Nos. 11-12 (November-Deeember, 1949)/ 4^^» 6 Supra. pp. 29 ff. 7 See Table VIII, page immediately following.

TABLE VIIia DISTRIBUTION OP ASSETS - U. S. LIFE INSURANCE COMPANIES (In billions of dollars and percentages for selected years) Total assets

Stocks

Government securities

Bonds*5

$

Otherd

i

1903

# 2.2

* *16

1910

3.8

.13

3.3

1921

7.9

.06

.9

1.9

23.6

1.5

19.1

1930

18.8

•I4.6

24

t.9

25.9

14

7.8

12.0

63.9

19140

30.8

.55

1.8

8.6

28.0

84

27.1

13.2

I43.I

1914.6

I48.I

1.2

2.6

11.8

2I4.6

23.5

148.8

11.6

2I4.0

19V 7

51.7

l4

2.7

4.7

28.5

22.0

M.5

13.6

26.3

19148

55.6

14

2.6

18.9

3*4.0

19.1

3I4 4

16.2

29.O

7.3$

*

#

...... i

14*14 5 6 4

a Adapted from Life Insurance Pact Book (New York: Institute of Life Insurance, 19^9)* PP* 1^6-68.

;: :

b Includes railroad, public utility, industrial, and miscellaneous bonds. c Includes federal, state,local, and foreign government bonds. d Includes mortgages, real estate, policy loans, and miscellaneous assets.

llj.6

companies is to find suitable investments fop the premiums they receive*® To channel portions of this vast amount of personal savings into equity investments, the present legislation should be changed to permit more venture financing through the medium of common stocks. One of the objections against allowing insurance companies wider participation in common stocks is that the companies have fixed dollar liabilities.

They attempt

to carry on their business on an assumption of steady and eertain minimum rate of earnings.

However, equities

fluctuate in price, and the ineome from them is uncertain. Consequently, equities are not considered as appropriate assets for insurance companies.^ Actually, the Ineome necessities of insurance companies are not absolutely fixed.

Through alterations

of their dividend payments, the companies could adjust to substantial fluctuations in income.

Further, the chances

of net withdrawals of funds from an insurance company are very slight, and a possibility of a mildly fluctuating in­ come should not interfere with equity investments.

However,

8 Associated Press dispatch, Los Angeles Times. January 3, 195>0. 9 Homer Jones, ’’Should Life Insurance Companies In­ vest in Equities,” The Commercial and Financial Chronicle. CLXXI, Number I4.87O («Ianuary 5, 1950), 18.

Ikl even if net withdrawals are experienced in the future, companies would certainly be able to meet the withdrawals even though they hold substantial equities.

The companies

own large amounts of governments, and their market will be well maintained in time of a depression when the possibili­ ties of net withdrawals are greatest.

In fact, it makes no

difference whether insurance companies invest in equities or not because in the final analysis, their liquidity depends upon the government in time of depression.

Also,

since the insurance companies will only invest a part of their funds in equities, they can depend upon the remainder of their assets to provide liquidity and earned income.^ Another objection to equities as assets for life insurance is the possibility that they will decline in value. Since liabilities of life insurance companies are a large percentage of their assets, It is believed that a rather small percentage decline in the value of its equity assets would render the typical Insurance company insolvent.11 This objection seems to be unwarranted since by following sound principles, either on the companies own initiative or on the insistence of the government, equity assets would not be acquired entirely at the peak of the 10 JbidT. pp. 18-19. 11 Ibid.. p. 19.

ll*£ market.

By reasonable Investment policies, no drop in

equity values would be necessarily involved.

Furthermore,

the companies would hold a cross-section of all the equity in the economic system rather than just a few specific stocks.

This diversification will bring about a condition

whereby the risks will offset each other. If there is extensive investment in equities by insurance companies, they will have to look upon these commitments as more or less permanent.

The companies would

have to look to the productivity of the enterprises in which equities are held, and not to profits to be gained from trading in securities.

If the institutional holders tried

to make sales in great blocks, the market could very easily be completely disrupted.

Legislative action and government

and Industry supervision could very easily and adequately limit speculation.

This could be accomplished in part by

limiting the gross amount of equities which might be acquired in a year.

Also, companies could be required not to dis­

pose of equities for at least a year after the date of acquisition.^ Actually, if common stock holdings by life insurance companies, as well as other institutions, are to be permitted, 12 Ibid., pp. 18 ff. 3-3 Ibid.. p. 31.

lfy -9

some limitation concerning the total amount of stock in­ vestments must be made.

Furthermore, limitations should

also be put on the amount of holdings in any single issue. Involved in these considerations is the question of the alleged eontrol of corporations by institutions through the ownership of voting stock.^ In order to prevent domination by the life insurance companies of individual companies or industries, or unwarranted risks of investment loss through common stock ownership, such investment should be carefully prescribed by appropriate legislation. Some such formula as the following might be employed, e. g.» investment of any one life insurance company in the common stock of a business enterprise might be limited to one per cent of the outstanding voting shares or $1,000,000, whichever is larger.^5 It Is admitted that there are a few obstacles in achieving a sound program of Institutional investments in equities.

However, it is believed that these obstacles can

be overcome, and more extensive institutional equity invest­ ing will redound to the benefit of all. If a certain small proportion of insurance company funds were invested in high grade equities such as most trust companies recommend for Individual estates, the interest in high grade equities would increase, because people in general would begin to have greater confidence In equities and little by little, having once crawled, llj. Sherwin C. Badger, "Equity Investment and Life Insurance," The Commercial and Financial Chronicle. CLXX, Humber lj-852 {November 3, 19W ) * 20. 15 Thomas B. McCabe, "The Equity Capital Situation,” statement submitted to the Subcommittee of the Committee on Banking and Currency of the United States Senate, August 5>» 19^9» P. 5.

i5 o individuals, and some of the investment trusts, would soon walk into venture capital, the capital that builds ideas and that built America. Investment trusts.^7

Investment companies are

organized for the purpose of investing in securities of business concerns.

The investment companies obtain their

capital funds from the sale of their own securities.

Of the

various types of investment companies in existence, only two are of Importance— the closed-end and the open-end (Mutual Funds). The closed-end companies have a fixed capitalization, and their shares are bought and sold in the open market like most stock shares for whatever price the buyer and seller agree.

This type is of little significance for the purposes

of this paper. The open-end investment company shares are bought and sold by the investment company itself at a price determined 16 Allan M. Pope, ,fMore Confidence in Business Needed for More Equity Capital,” The Commercial and Financial .Chronicle. CEXX, Number ^866 (December 22, 19^9 ), 77* 17 This paper considers investment trusts mainly after the passage of the Investment Act of 19^0 • Prior to that time, many Investment trusts, without any "outside” regulation and very little self control, participated In abusive and unsound financial practices. For a more detailed discussion of investment trusts and a more critical evaluation of their practices before 19Jj-0, see Roy L. Garis, Principles of Money, Credit. and Banking (New York: The Macmillan Company, 193^)» pp. 965972.

151 each day by the value of the securities owned by the invest­ ment company.

". . * they are constantly in the market for

new funds and the securities they issue are

redeemable. The

holders can, at any time, withdraw by presenting their shares "•Q

to the company for repayment.'* the main topic of discussion

The mutual funds will be in this paper.

The mutual investment fund, entirely of American origin,3-9 represents a rather sweeping modification of the original investment trusts. It is in a sense an investment cooperative in that investors may partici­ pate in any amount and may withdraw their participation in full or in part at any time without disturbing the diversification of the fund’s Investments. Mutual fund shares are acquired by the investor at their current net asset value (the total current value of all securities and cash held by the fund, less liabilities, divided by the number of fund shares outstanding), plus a premium to cover costs of distribution. They represent his proportionate ownership In the securities held by the fund, and he shares the expenses, income, and profits on a pro-rata basis with all other Investors. He can sell his equity back to the Issuing company on any business day at the current net asset value per share. All money which is received by the fund, and for which participating shares are issued, may be held in cash or entirely invested in s e c u r i t i e s . 20 18 "Investment Companies— A Neglected Source of Equity Capital?" oj>. cit.. p. lj.58* 19 The Boston Personal Property Trust was the first company founded In America (1893), and it is still in ex­ istence. However, It was not until the decade of 1920 to 1930 that American Investment trusts were started in size­ able numbers. William D. Carter, "Mutual Investment Funds," Harvard Business Review. XXVII. Number 6 (November. 19k9). 719-720. For a more thorough treatment of the origin and development of investment trusts, see Garis, op. cit.. PP. 965-988.

20 Carter, o£. cit.. p. 720.

lf>2 The mutual funds make investment a reasonable and economical possibility for people with small sums to in­ vest,^ and consequently, serve a large number of people who have previously been unable to partake in the ownership interest of American industry. sort of co-operative.

The investment company is a

It joins together in a common invest­

ment program many individual investors with a common interest, and provides in common what no single individual would be able or likely to provide for himself.^ The investment company provides important advantages that the ordinary individual cannot provide for himself, or at best can provide only imperfectly.

These advantages are:

(l) diversification of investments among different industries and Individual companies.

Such action spreads the risk and

cannot be undertaken by the small investor If he invested by himself; (2 ) expert and continuous supervision and manage­ ment regarding investments; (3 ) liquidity— the marketability of the shares is readily assured; (Ij.) the Investment company provides a convenient medium for the small Investor— all the little “chores” required by investing are done by the 21 However, It is rightfully pointed out that persons with small means have no business “investing” in the stock market. ” . . . their dollars could and should be more safely and wisely deposited in savings banks or invested in life insurance.” Garis, op. cit., p. 968. 22 Beardsley Ruml, "The Little Capitalists Get Together,” Collier* s (January 21, 195>0),

153 company; (5>) regulation tinder the Securities Act of 1933* the Securities and Exchange Act of 1 9 3 W aul the Investment Act of 19i|-0, as well as the various state laws, makes the investor feel reasonably certain that he is being protected from the more obvious frauds and abuses; and (6 ) the invest­ ment companies have an advantage over insurance companies and savings banks in that they are not compelled to Invest in overpriced ’’legals.”

The investment companies are able

to follow a flexible investment policy.^

With all these

various advantages go rates of return substantially higher than an Individual can ordinarily obtain for himself without assuming risks with which he may be unfamiliar. The small Investor of today Is justifiably fearful of throwing all his eggs in one vulnerable basket, so he favors the trust which scatters his savings in many baskets and pays him an assured income (about 5*3 P©** cent). Psychologically, such investments are ’’geared to the times,” since they prosper on today’s mass fetish— the quest for security.^ As of September 30, 19^-9* the nearly 130 mutual funds had total net assets of #l,755»l60,000.

The number of

— 23 ’’Investment Companies— A Neglected Source of Equity Capital?” op. cit .. pp. lj.5>9-j|.6o.

2k ’’The Trend to Trusts.” Forbes. LXIII. No. 2 (June 1, 1914-9), 11*

l$k shareholders amounted to about 775*000.

The growth of the

funds is impressive in view of the fact that in 19^4-0 , total assets were only fljlj.8 million and the shareholders numbered only 296,056.

Equity securities of perhaps 500 or more

business corporations are now held in mutual funds, and this number increases steadily with the growth and "seasoning” of other corporations.^ By and large, new business is not the business of the investment companies. It is not suggested that the mutual investment com­ panies will furnish venture capital in any substantial amount to untried and unseasoned enterprises, but that by broadening the base of public ownership of equity securities and increasing generally the size of the market for such securities, a highly constructive pur­ pose will be served with immeasurable benefit to both our industries and investors therein. . . . By providing a greatly increased number of investors with a strong backlog of diversified and supervised equity invest­ ments, this process places these Individuals in a safer nite portion of their funds Investment companies direct the small savings of many people Into ownership interest in American business on a prudent, economical, and supervised basis.

In doing so,

they tend to restore to the equity markets, in part, capital that had been withdrawn as savings.

They make it again

25 0. Glenn Saxon, Mutual Funds and The People *s Savings (New York: Floyd L. Carlisle, Inc., I9I4.9 ), pp. 11-12. 26 Loc. cit.

15# available to take the risks and rewards of ownership.

As

they perform this service with respect to the savings of individuals, so in the future, the investment companies may do the same for endowments and pension funds.

In fact, there

are already instances where endowments and pension funds have invested some portion of their funds in the securities of investment companies.^ There have been justified objections set forth against the mutual funds.

Their ability to weather a period

of drastic economic change has been questioned, as has the quality of their management.

It is also held they have

grown so large that they have become a dominating and potentially dangerous voice in corporate management affairs through their large holdings of voting stock. two objections are closely inter-related.

pfi

The first

Managerial

efficiency could do much toward helping the funds to weather a storm of depression.

In this regard, ordinary business

prudence would be an effective preventative measure.

Inso­

far as the last objection is concerned, it is admitted that the potential dangers are great.

However, adequate regula­

tion and supervision should provide sufficient safeguards. Also, it might be feasible to employ some formula 27 Ruml, o|>. cit.. p. 55* 28 Carter, o£. cit.. p. 716.

156 by which common stock ownership of any one investment trust in any one company could b.e limited to a certain amount. The powerful force represented by institutional investment should never be permitted to disrupt the economy or bring about undesirable social changes. On the other hand, mutual investment funds can pro­ vide a reasonable solution to the equity capital problem. It appears to be one method of awakening mass interest in the securities of American industry.

It is contended that

the investment trusts are creating thousands of new capitalists among the broader segments of the public who now hold the bulk of the investible savings and who previously were not Investors in securities.29 Mutual Funds are gradually becoming one of the more important but indirect sources of equity capital, so essential to the continuation and improvement of the living standards of the United States. At the same time, on a steadily Increasing scale, they are proving to be the most effective means of creating hundreds of thousands of new capitalists, each owning a share in the fortunes of American business and industry— a growing bulwark against the tide of State Socialism now sweeping over large areas of the world. 30 Conclusion.

Institutional funds could be utilized

to alleviate the venture capital problem.

Personal savings

29 Ibid.. p. 715. 30 Paul A. Johnston, "Mutual Fund Articles Re-state Policies, Aims," Barron* a National Business and Financial Weekly. XXIX, No. I4.9 (November lij., 19ij-9), 25.

are flowing predominantly into institutional accounts, such as life insurance, mutual savings hanks, savings and loan associations, etc*

Life insurance companies hold huge

amounts of personal savings and investment money*

A greater

participation in.venture investment by these institutions would solve, to a degree, the investment problem of the companies and increase the amount of venture funds available to American industry.

Investment trusts are a steadily

increasing factor in the securities Industry and the financial system of the nation*

Investment companies that

are reasonably regulated and supervised as well as properly and competently managed can be of real service in "mobilizing” small contributions of capital which can be committed to equity investment.

CHAPTER X I I I

GOVERNMENT AND ITS INFLUENCE UPON EQUITY CAPITAL FORMATION In the preceding chapters, desirable specific actions by the government have been outlined in order that various obstacles to the flow of venture capital may be removed.

Actually, the proposals set forth prev­

iously are extremely important if the equity investment problem is to be solved.

However, there are other

governmental policies which influence the willingness and the ability of people to place their funds into venture Investments, This present chapter is devoted to other govern­ mental policies which influence the equity capital market. The effects of governmental lending and spending policies are discussed. examined.

Government and business relations are

General proposals for the reformation of the

various aspects discussed are set forth. Governmental lending.

If the existing obstacles

to the flow of venture savings into business enterprises are not removed, the government will be looked upon as the principal source of investment funds.

An ironical conse­

quence of governmental policies that result in shutting off the flow of venture funds is to make it appear that the government itself is the only source of the spirit of

1 5 9

enterprise and jobs, as well as capital.^

But, ”if

government risk capital were to succeed private risk capital . . . it would mean the beginning of the end of O our capitalistic era.” If the government must provide venture capital to keep up our rate of capital formation, then the nationalization of industries in the European fashion is to be expected. A private capital market is the very heart of a private economy. If we have a govern­ ment capital market, we will have a government operated economy. The government will decide what kind of business to foster, how it shall be managed, what it shall sell, at what price to sell it. These will all be the conditions of providing the venture capital. 3 Actually, the furnishing of capital to business enterprise by the Government has not been very significant in volume.

However, such action has exerted a tremendous

influence upon the attitude of prospective investors. Through its many and varied agencies, the Government has not furnished business with equity capital in the strict sense in which we use the term.

But, loans made by such

agencies as the Reconstruction Finance Corporation and the Federal Reserve Banks have served somewhat the same general 1 Jobs and Taxes (New York: The New York Stock Exchange, 19U-9)» pp. 6 and 5^4-. 2 E. A. Krauss, ”How Federal Regulation Has Changed Structure of American Capitalism,,f The Magazine of Wall Street and Business Analyst. LXXXV, No•' 7 (Dec ember 31.

195577 3lS-

3 Stahrl Edmunds, ’’Trends of Capital Formation,” The Commercial and Financial Chronicle. CLXX. Number a850 T o S t o b e F 2 7 ; i 9W , “

--------------------

i 6 o

purpose.

The Reconstruction Finance Corporation

accomplished its original purpose somewhat effectively. At present, the' policies and objectives of the Corp­ oration are not conducive to a free economy.

The RFC has

been gradually extending its operations over a larger area.^

Through this organization, the government has been

increasing its influence over private business.

The bigger

role of government in business adversely affects a free enterprise system.

The bigger role of government as a

supplier of capital lessens the attractiveness of equity securities and disrupts the capital market.^ RFC business lending at present serves only to discourage commercial and investment bankers, to create dissatisfaction among businessmen who fail to obtain loans, and to sponsor a group of preferred businessmen existing by virtue of distribution of government funds. At best, a vaguely defined lend­ ing policy to business by a public corporation with large available capital invites political pressure, difficult to resist. The whole policy is unsound.® Ij. The RFC has made an astounding infiltration into American business life. The Agency's business loans out­ standing amount to f>!|.l6 million. More than £,14.00 business concerns owe money to the RFC. New applications, are being received at the rate of 1,200 a month. In August, 192+9# the RFC received 1,26£ applications for #ll+l million in business loans and authorized tj-70 of them for $76 million* "RFC: Haven For Businessmen in Need,” U. S. News and World Report (October 21, 19i|-9), 22. 5 Lewis A. Froman, "Can Individual Investment Be Stimulated," The Commercial and Financial Chronicle. CLXXI, Number l}-870- (January £, 195>0T»~30. 6 Emil Schram, "Stimulating Capital Markets," The Commercial and Financial Chronicle, CLXX, Number I+.851+. (November 10, 191+9), 2+1.

l 6

i

Active governmental participation in the capital markets is an unwise and undesirable policy if the free enterprise economy and democracy are to be preserved. The government would be vested with a formidable power if it is put into the vital and strategic role of principal supplier of investment funds.

Under such conditions, the

government would necessarily direct the flow of capital among the various industries.

In fact, governmental

control would inevitably increase throughout the whole economic system.

Such a course is not consistent with the

maintenance of the system of free enterprise.7 Governmental spending. We must wish to maintain a dynamic and progressive people. But dynamic progress Is not made with.dynamite. And that dynamite today is the geometrical increase in the spending of our government— both [[sic*} Federal, state, municipal and county.” Total federal expenditures of all kinds— federal, state, and local— now aggregate around #60 billion annually and represent approximately 27 per cent of the national in­ come.

This constitutes a very dangerous diversion of money

from private enterprise— a diversion which siphons into government coffers money which should be used for the pur­ 7 Jobs “and Taxes, p. 6. 8 Herbert Hoover, "Taxes and Spending— Double Danger," Tax Review. X, No. 8 (August, 19^9), 39.

.

162 chase of tools, equipment, and facilities that expand pro­ duction and create jobs.^ The large governmental expenditures and the huge national deficits have created a psychology that has found expression, to some extent, in the equity market.

These

governmental actions have the effect of depressing business and consequently, do not encourage potential investors to put their funds into venture securities. Grandiose new spending schemes involving vast amounts of money are being proposed daily.

Such schemes,

if enacted, would impose a crushing burden of additional taxation on an already onerous tax structure. What all this really comes down to is that we are spending and taxing too much. Here we see the seamy side of programs that call for the spending of billions of dollars in subsidies, bonuses, and ambitious social welfare schemes • • .10 A strong private economy is a most essential foun­ dation for a strong nation.

Moreover, the smooth operation

of the strong private economy is necessary in order that high levels of employment, production, and income can be maintained.

Deliberate and continuous deficit financing

does not have salutary effects upon a private economy. 9 The First National Bank of Boston, NewEngland Letter (August 31 > 19^9)» 3* 10 f,Why the Dearth ofRisk Capital?” Monthly Letter, National City Bank (January, 1950), 6.

163 Burdensome and confiscatory taxes applied to provide revenue to carry on extravagant spending schemes are not conducive to a prosperous economic system. It is, of course, true that the American free enter­ prise system has unlimited possibilities if no restrictive measures are applied.

However, it is just as true that no

economy can ever be rich enough to afford public spending for unnecessary activities or in a wasteful manner.

In

order to insure the existence of a free enterprise system, public spending should be strictly controlled and every possible waste eliminated.^'*' Government and Business,.

The state is best fitted

to serve social ends such as education, conservation, and protection.

On the other hand, the state is ill fitted to

serve social ends where local differences are involved, risks need to be taken, freedom of choice is wanted, and P liberty is to prevail. 1 ^

Since the government has assumed a much more important - role in our economy than in the past, it can do much, along 11 industry Believes (Hew York: National Association of Manufacturers, l^i|9), P» l£* 12 The Economic Principles Commission of the National Association of Manufacturers, The American Individual Enterprise System (New York: McGraw-Hill Book Company, Inc., 19^-6), I, Chapter I, pp. l-l£.

with the investment companies, institutional investors, and corporate managements, to promote the development of a vigorous and adequate market for equity securities,^

One

of the ways in which the government can contribute is by encouraging business.

It Is realised that healthy attitudes

toward business, optimistic expectations, and an encourag­ ing atmosphere cannot be attained by just an act of Congress. The chief method by which government can encourage business is to stop discouraging business.

Positive governmental

action should be taken in order to alleviate the discourag­ ing effects of unsound government taxation, regulation, and competition. . . . Government should accept the fact that we cannot have full employment and freedom of enterprise unless business is fostered and encouraged, instead of being persecuted and annoyed to death. A factor that causes concern and influences the willingness of people to participate in ownership interest is an anti-business attitude on the part of government. Corporations and business in general must receive better acceptance and support of the government before the public will become substantially interested in investment in equity 13 Clarence W. Fackler, WA Four-Pronged Attack Upon Equity Capital Problem,” The Commercial and Financial Chronicle. CLXX, Number (December 29* 19V?)> 2J4.. 1I4. Benjamin Graham, ’’Business and Government Must Compromise,11 The Commercial and Financial Chronicle. CLXX, Number ij.852 .(November 3, 19V?), lfp.

165 securities. Actually, a more sympathetic governmental attitude towards profits is necessary.

There should be less

propaganda about "exorbitant profits."

The idea that it

is a crime to make profits should be discarded. not socially harmful.

Profits are

The government and the public should

recognize that adequate profits are essential in order to maintain a business. A change in the political-economic thinking of the government and the public is required.

The apprehensions

and uncertainties that now afflict business should be dispelled.

A measure of confidence should be restored in

order to revive initiative and willingness to venture funds into private enterprise.

It is necessary to encourage

business leaders and the public so that American industry and the free enterprise system can be expanded through the healthy medium of ownership interest.

Debilitation and

decay are inherent in governmental handouts, subsidies, or ownership. If venturesome funds are not to be encouraged by creating greater confidence in business than has been created in the past, and if such funds are wanting and are essential, then they will be run b£ the Govern­ ment for the Government but with our own money just the same.^5 15> Allan M. Pope, "More Confidence in Business Needed for More Equity Capital," The Commercial and Financial Chronicle. CLXX, Number I4.866 (December 22, I9I4. 9 ), 77. Italics in the original.

166 Conclusion,

The most certain road to economic

progress is through the time-tested American system of private enterprise.

Moreover, this system is compatible

with freedom of individual action and democracy.

Programs

of government lending and spending should be conducted in a manner which is consistent with democracy and free enter­ prise.

The governmental attitude toward business should be

such as to instill confidence in the community.

The private

enterprise system— and with it, the American people— should be given a fair chance to prosper by mitigating the handi­ caps and removing the obstacles that certain features of legislation and governmental action place upon it, and which threatens to destroy the sources of its vitality.-*-^

lo Emil Schram, "Taxation and Venture Capital," The Annals of the American Academy of Political and Social Sciences, CCLXVI (November, I9I4.9 )» 92•

CHAPTER X IV

SUMMARY AND CONCLUSIONS "No other method could be devised which brings home more forcibly the soundness of capitalism than to have the people of the country OWN STOCKS IN AMERICAN ENTERPRISE."1 A person considers the economic, political, and social affairs of his generation in a different manner when he has an ownership Interest in the productive facilities of his community.

Investment adds a different meaning to living--

when a person owns something, he feels differently about it. There Is color and zest In seeing the brick and mortar of one’s own investment.^

A confident feeling of accomplish­

ment is imparted to the Investor when he reads an advertise­ ment of his own product.

Moreover, getting a cash dividend

check from the earnings of one’s own property instills con­ fidence and faith in the American economic system and the American way of life. The influence of ownership capital in American 1 Humphrey B. Neill, "What Path Ahead for Investment Trusts," Financial World. XCII, No. 7 (August 17, 19^9). 3. 2 A great insurance against Socialism or Communism would be to have every person a part-owner in our system of private enterprise. Even a Communist would hesitate to share that which he himself owns. 3 Beardsley Ruml, "The Little Capitalists Get Together," Collier*s (January 21, 195>0), 26.

p

industry is exerted upon more than just the personal aspects of economic enterprise.

Ownership interest is a powerful

force which pervades all phases of economic activity. An adequate supply of equity capital is absolutely essential if the standard of living is to be improved, and if the strength of the nation is to be increased.

Without

sufficient venture capital, economic decay will be inevit­ able— the economic machine will cease to expand, and it will be unable to provide the new job opportunities demanded by a rapidly growing labor force.^ Equity capital also makes possible the development of new products, affords the means to finance the adoption of new industrial techniques that increase the productivity of labor, and keeps alive the competition which acts as a spur to efficiency and lower prices and continued progress.^ The presence of an adequate supply of venture capital is not accompanied by clarion-like announcements proclaim­ ing an immediate burst of economic growth and tremendous achievements.

Usually, the resulting benefits are not

dramatic or instantaneous. Unfortunately, neither is the drying up of the supply and the restriction of the flow of venture capital generally It Jobs "and Taxes (Mew York: The Mew York Stock Exchange, 19*1-9), p. 5>2.

169 accompanied by spectacular danger signals that arouse people to corrective action.

The resulting deterioration in pro­

ductivity and living standards is not dramatic or immediate. It comes slowly and imperceptibly, and there is no specific way to compare the performance of the economy wi.th what it might have been if equity investment had not been impeded.^ Summary of findings.

In a dynamic economy, many

factors affect the functioning of the various aspects of the system.

Some specific findings regarding venture capital

formation and its relation to the operation of the economic system are: (1) Economic stagnation and decay are inevitable with­ out investment in the tools of production.

Capital formation

is carried on in any type of economic system and is funda­ mental to economic survival itself.

Today, the people of

the United States enjoy a standard of living which is the highest ever known in the world.

To continue this high

standard of living, the use of capital is absolutely necessary. (2) Venture capital is the factor which provides the vigor to a dynamic, free economy.

Without it, progress is

halted, and economic deterioration .will follow.

Unfortunate­

ly, despite the fact that plenty of potential venture money 6 Ibid.7 p. 5*1-.

1 7 0

is available, people have been reluctant to contribute permanently to American enterprise.

They have not acquired

the necessary and extremely desirable ownership interest. In the equity capital market, there is starvation in the midst of plenty. (3)

Financing by retained earnings has been a very

important source of equity funds in recent years.

The very

tendency toward financing through retained earnings increases the difficulty.

Stockholders object to plowing back earnings

since it decreases the amount available for dividends.

Large

businesses with larger earnings have an advantage in this respect over small businesses.

In the case of new businesses,

retained earnings are at best at a low level, and without equity capital, desired and needed expansion is hampered. Finally, the further probable drop in earnings will make future retained earnings financing very difficult. {!(.) The exhaustion of existing productive facilities Is a serious problem.

Depreciation policy--which can help

solve the problem— is at present unsatisfactory. inflexible rates of depreciation are in effect.

Low and Depreciation

charges are computed on an original cost basis and do not reflect any changes in prices.

The entire depreciation

policy is unrealistic. (5>) The existing federal tax structure is causing a creeping paralysis in-the economy that has alarming

171 Implications for the future expansion, productiveness, and resilience of business enterprises..

It Is having this■

undesirable effect by impeding the creation and flow of venture capital-~the lifeblood of a progressive economy. Five particular features of the present tax system are primarily responsible for this unfortunate result.

They are

the capital gains tax, the taxation under Section 102, double taxation, the corporate Income tax, and the personal income tax. (6) The treatment of capital gains and losses under the present tax structure is unsatisfactory. serious injustices among taxpayers.

It creates

Capital gains are apt

to be illusory in inflationary periods, and payment for illusory gains is unjust.

Capital gains taxation dis­

courages risk taking with resulting bad effects upon the economy as a whole. (7) Under the provisions of Section 102 of the tax laws, any accumulation of surplus beyond the '’reasonable” needs of business is taxable.

What constitutes ’’reasonable”

needs is determined by the revenue agents.

In order to

escape being penalized under this section, the corporation must prove, by a preponderance of evidence, that the amount accumulated is not beyond the ’’reasonable” needs of business. Such taxation terms have unwholesome effects upon the ex­ pansion of industry, and consequently, upon the economy as

1 7 2

a whole, (8) Under the existing tax structure, corporate income is taxed twice— first as income to the corporation at the prevailing corporate income tax rates, and then again as income to the stockholder in the form of an individual income tax upon the dividends he receives. discriminatory and unfair.

This double taxation is

Moreover, the double tax unsatis­

factorily affects the initiative and incentive to the venture investment which is so necessary for a progressive economy. (9) The corporate income tax is an unsatisfactory method of raising revenue.

Its effects are discriminatory,

repressive, and inequitable.

The tax reduces yields on

investment and consequently, obstructs the flow of savings into business enterprises. (10) The high personal income tax rates have dele­ terious effects upon the economy.

The existing confiscatory

rates destroy or dull the ambition, the initiative, and the inventiveness of the people. invest are suppressed.

The incentive to work and to

The present highly progressive

personal income tax structure adversely affects those very qualities and forces which made America great. (11) Pear and uncertainty regarding economic, politi­ cal, and social happenings are a great barrier to the formation of venture capital.

False doctrines concerning

the economic system and mistrust and suspicion towards

173 business enterprisers influence the attitude of the people about venture investing.

A very important aspect of this

fear and uncertainty is-the almost pathological desire of individuals for security and safety. (12) The stock market collapse of 1929-1932 has erected a very great psychological obstacle to venture in­ vestment.

The influence of this event upon common stock

investing has been broadly encompassing and not confined solely to Immediate participants. (13) hack of knowledge regarding stock investment is another aspect of the venture capital problem.

The con­

fiscatory and redistributional taxation policies in addition to the other Hequalitariann actions by the government and pressure groups have created new holders of surplus funds.^ These new holders of excess funds generally have no know­ ledge of the common stock investment opportunities. (llf) Managerial policies are being formulated with the objective of obtaining more equity investors in American industry.

Employee stock acquisition plans have been put

into operation by many corporations.

Furthermore, relations

with existing stockholders are being constantly improved. (15) Next to commercial banks, the insurance companies 7 Usually, only at the expense of other individuals and the economy as a whole, and not by the highly desirable method of increased productivity.

174 hold the biggest block of investment money in the United States.

Insurance company assets could be effectively used

to furnish American industry with a-larger portion of the required equity capital. (16) Mutual investment trusts are playing an increas­ ingly greater role in the economy.

They serve many people

who have previously been unable to acquire an ownership interest in American industry.

Reasonably regulated and

competently managed mutual investment funds can aid in the "mobilization11 of capital for venture investment. (17) Many governmental actions are closely related to the venture capital problem.

Government lending— through

its various agencies— has a tremendous influence upon business activity and outlook.

Large governmental expendi­

tures adversely affect the equity market through psychologi­ cal discouragement as well as through the burdensome tax structure caused by the huge spending. (18) Positive government action is essential in order to arrive at an adequate solution* of the venture capital problem.

The government has assumed a very important role

in our economy.

This role should be used to encourage the

development of a vigorous economy. If economic and social progress are to continue and a free society is to exist, the free enterprise economic system must be given a chance to survive and prosper.

The cause

175 of* maintenance of a progressive economy and a free society can best be served by mitigating the handicaps which certain features of our tax laws, legislative policies, governmental attitude toward profits, etc., place upon them and which threaten to destroy the sources of their vitality. Recommendations.

In order to preserve the democratic

capitalistic society, to avoid economic stagnation and decay, and to provide for the continued improvement in the welfare of civilization, it is of the utmost importance to restore the free flow of venture capital into American enterprise and to insure that a sufficient quantity of it is available to American industry. The free flow of funds into venture capital will be re-established and the supply of equity capital will again appear in abundance when the restrictions previously set forth have been removed and the recommended positive pro­ posals followed.

Specific suggestions for reform are:

(1) Depreciation policies should be made more liberal and more realistic.

Corporations should be per­

mitted to set their own depreciation rates.

Changes in

price level should be taken into consideration for deprec­ iation charges. (2) The capital gains tax structure should be reformed. The tax rate should be reduced, and the six-month holding

1?6 period dividing investment from speculation should be shortened.

Liberalized loss allowances— the offset against

ordinary income should be increased to $>j?,000--over longer loss carry-forwards and carry-backs should be established for capital gains taxation. (3)

Section 102 should be changed so as to accept

the decisions of management regarding the proportion of earnings which are to be retained.

The burden of proof

concerning unreasonable accumulation should be with the Internal Revenue Commissioner and not the corporations.

(I4.) The double taxation of corporate income should ultimately be eliminated, but it should be immediately and adequately moderated.

Moderation could be accomplished by

allowing individuals to deduct from their personal income tax liability a 20 per cent dividend received credit. (5) There is little, If any, rational basis for a corporate income levy, and it should be abolished. conditions make this action somewhat infeasible. a revision is deemed necessary.

Present However,

The corporate income tax

rate should be lowered, and the so-called ”notch rate” eliminated.

To avoid much overlapping and confusion, a

uniform, non-duplieating system for taxation should be adopted by each state. (6) The present confiscatory personal income tax rates should be reduced.

An immediate reduction throughout

177 all brackets is necessary.

For maximum rates, the indivi­

dual income tax should range from about l£ per cent in the lower brackets to no more than

per cent in the top

brackets, (7) False and insidious doctrines regarding the free enterprise system should be cleared away, (8) The general suspicions of the people regarding the businessman should be eradicated, (9) Education is necessary to erase the psychologi­ cal apathy toward venture investment and to interest the holders of savings in the acquisition of an equity interest in business, (10) Relations with existing stockholders should be improved, (11) The workingman should be influenced toward ob­ taining an ownership interest in American industry— the workers should have a stake in the free enterprise system. Employee stock acquisition plans are a desirable means of accomplishing this objective, (12) Life insurance companies should be permitted a greater participation in the venture financing of American enterprise, (13) Mutual investment funds can mobilize small contributions of equity capital for industry.

In fact,

mutual funds appear to be one method of awakening mass

1 7 8

interest in the securities of American enterprise.

Suffi­

cient safeguards against unsound and abusive practices is deemed necessary. (ll|.) Government lending policies should not be so formulated and carried out as to discourage private initia­ tive or unduly restrict and hamper enterprise.

Active

government participation in the capital market is considered unwi se and undesirable• (15) The government should take positive action to encourage business.

This can be most effectively accom­

plished by having the government stop advocating and following policies which discourage business. (16) Governmental spending should be strictly con­ trolled and every possible waste eliminated. spending and taxing too much.

We are now

THE NATION MUST LIVE WITHIN

ITS MEANS If a strong free enterprise economy and a strong democracy are to be maintained* Conclusion.

The American system of private enter­

prise has been thoroughly tested throughout its existence. The accomplishments of the system, reflecting its tremen­ dous productiveness, lead to the conclusion that it is the surest means to economic and social progress.

Furthermore,

it Is believed that the American system of enterprise is the most compatible with freedom of individual action and

179 democracy. Freedom of enterprise is actually the keystone of all freedoms.

This freedom enables the individual to develop

according to his inherent capacities.

Also, it enables him

to receive rewards under competitive conditions which are commensurate with his contribution to society.

The release

of individual energy, initiative, and inventiveness under such a constructive stimulus is the secret of the unparallel­ ed American progress.

It is highly significant that almost

all modern progress has been initiated under private enterO prise in liberal democracies. VENTURE CAPITAL— THE LIFEBLOOD OF A DYNAMIC FREE ENTERPRISE ECONOMY— HAS PLAYED A VITAL ROLE IN THIS DEVELOPMENT. The proposals for the solution of the venture capital problem made In this thesis, if adopted promptly, could provide the stimulus for an era of desirable economic, political, and social growth and individual economic pro­ gress even greater than any we have thus far achieved.^ . . . the triumphant march of Technology will go on, unchecked, and therewith the increase of wealth and wages, comforts and enjoyments; and human toil will be steadily lightened. . . . We can set no limits upon human ingenuity and inventiveness.^-0 8 Jobs~and Taxes, p. 9 The First National Bank of Boston. New England Letter (March 31, 195°), 2. 10 Carl Snyder, Capitalism the Creator (New York: The Macmillan Company, 194-0), p. if20.

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1 8 2

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Hew York: The

Technological Stagnation in Great Britain.Chicago:Machinery and Allied Products Institute, 195-8. 89 pp.

183 Terborgh, Georg© W . , The Bogey of Economic Maturity. Chicago: Machinery and. Allied Products Institute, 194£* 263 pp. , Inflation and Postwar Profits. Chicago: Machinery and Allied Products Institute, 1^49* Your Federal Income Tax. 1949 edition; Washington: Treasury Department, Bureau of Internal Revenue, 1949* 138 pp. Zelomek, A. W., Here Comes Tomorrow. Chicago: Ziff-Davis Publi shing C ompany, 1944* 131 PP• B.

PERIODICAL LITERATURE

Abbott, Douglas, "The Economic Wisdom of Tax Relief,” Vital Speeches of the Day. XVI, Ho. 5 (December 15, 194-97# 157-159* Adams, T. S., ”The Taxation of Business,” Proceedings of the National Tax Association (1917), 185-194-. Armitage, Albert T., ”Securities Industry Must Unite in Striving for Better Public Relations,” The Commercial and Financial Chronicle. CLXX, Humber 4-86b (December 22, 1§49), 17 ff. Badger, Sherwin G., "Equity Investment and Life Insurance," The Commercial and Financial Chronicle. CLXX, Number 4-852 (November 3# 194-9 )» 20-21. Balmer, Thomas, "Broader Interest in Employe Stock Purchase Plans," The Exchange. IX, Number 10 (October, 194-8)# 4-5* Beck, Morris, "Capital Replacement, Depreciation and Taxes," Taxes--The Tax Magazine. XXVII, No. 7 (July, 1948), 658-663. Bell, Haughton, "Does Direct Placement of Securities Lead to Corporation Control?" The Commercial and Financial Chronicle. CLXX, Number 4886 (December 22, 1949)» 9 ^ • Bleiberg, Robert M., "Washington Wakes to Equity Capital Needs," Barron*s National Business and Financial Weekly. Volume XXIX, No. 33 (August 15, 1949)7 FT "Boston Attorney Lauds Mutual Funds Growth," The Commercial and Financial Chronicle. CLXX. Number 4860 (December 1. twjt;' 13".

l8 l|_

Bowen, Howard R., ’’The Personal Income Tax and the Economy,*1 The Annals of the American Academy of Political and Social Sciences, CCLXVI '{November, 1 ^ 9 > * 117-120. ‘ Brownlee, 0. H., ’’The C. E. D. on Federal Tax Reform,” The Journal of Political Economy, LVT, Number 2 (April, i9!iB)* 166 ff. Buehler, Alfred G., ’’The Taxation of Small Business,” American Economic Review, XXXVI, No. 2 (May, 1946), 25>0-

2WCarter, William D . , "Mutual Investment Funds," Harvard Business Review, XXVII, Number 6 (November, 19^9) > 715Chamberlain, John, "The Businessman in Fiction," Fortune (November, 194.8), 13I4. ff, Chilgren, Arthur D., "A Plea for Sensible Blue Sky Laws," The Commercial and Financial Chronicle. CLXX, Number I4.866 T^ecember 22, 19^9 ), 20 ff. Colm, Gerhard, "Conflicting Theories of Corporate Income Taxation," Law and Contemporary Problems, VII, No. 2 (I9ll.0), 281-290. Council of Economic Advisers, "The Annual Economic Review, ’’ U. S . News and World Report (January 13, 1950), 61j.-99 • "Depreciation— Replacement or Original Cost," The Conference Board Business Record. VI, No. 5 (May, 19!$)”," l91j-“2d0• Domar, Evsey D., "The Problem of Capital Accumulation," American Economic Review, XXXVIII, No. 5 (December, 19ll-8) , 777 i*f. Dulan, Harold A., "Common Stock Investment as an Inflation Hedge— 1939-19^-8," The Journal of Business. XXI, No. If (October, 19^8), 230 ff. Edmunds, Stahrl, "Trends of Capital Formation," The Commer­ cial and Financial Chronicle. CLXX, Number !j.B]p0 T6ctober 2f, 19*1-9)» 17 ff. Fackler, Clarence W., "A Four-Pronged Attack Upon Equity Capital Problem," The Commercial and Financial Chronicle. CLXX, Number ij.808 (December 29» 19*4-9)» 9

185 The First National Bank of Boston, New England Letter (August 31, 19^4-9)» 2* _______ , New England Letter (December 30, 19l}-9), 2* ______ New England Letter (March 31, 1950), 2. "For Easier Raising of Business Funds,11 U. S. News and World Report .(February 10, 1950), — i+9 * Froman, Lewis A., ftGan Individual Investment Be Stimulated," The Commercial and Financial Chronicle, CLXXI, Number P T O (January 57“l95o), 23 ff. "Government 'Take1 as 30$ Partner in Business," U, S. News and World Report (November 25, 19l|9)» 21-23* Graham, Benjamin, "Business and Government Must Compromise," The Commercial and Financial Chronicle. CLXX, Number p 5 2 (November 3, 19l|9)* 15 ff• Groves, Harold M., "Personal Versus Corporate Income Taxes," American Economic Review. XXXVI. No. 2 (May. 19U.6) . 2ip. ff. Hanes, John W., "A Businessman's Viewpoint on Tax Policy," The Annals of the American Academy of Political and Social Sciences. CCLXVI (November, 19I4. 9 ), 17^4- ff* / , "A Tax Policy for Enterprise," Fortune (June. 19ll-9),

U&~ff.

, "A Tax Policy for Enterprise," Tax Review, X, No. 5 TOr. 19149), 23-26. ---------Hoover, Herbert, "Taxes and Spending— Double Danger," Tax Review. X, No. 8 (August, 19I4. 9 )* 39-lp-* Hopkinson, Jr., Edward, "The Equity Capital Problem," The Commercial and Financial Chronicle. CLXX, Number 1|_B68 (December'~29 , l^I^TT’B'^Tf. Houston, G. Sidney, "Taxation and Corporate Enterprise," The Annals of the American Academy of Political and Social Sciences. CCLXVI (November, I9I49)» 93-99• "How Industry Is Meeting Capital Needs," The Conference Board Business Record. V, No. 7 (July, 1 9 p ) , 283~28lf.

186 WIBA Repeals Grass Roots Education Program," The Commerc1al and Financial Chronicle, CLXX, Humber (November 24* W l 9 T 7 T o : ---- -------------

“Insurance: 2d Biggest Investor,” U. S. Hews and World Report (December l6 , 1949), 5>0-£>l. "Internal Revenue Collections," Treasury Bulletin (February, 1950), 44-47. "Investment Companies— A Neglected Source of Equity Capital?" The Conference Board Business Record. VI, Nos. 11-12 (November-Dec ember, 1949) * 458-462. "Jackpot?" Forbes. LXIV, No. 7 (October 1, 1949)» 18. Johnston, Paul A., "Public Not ’Sold1 On Stock Ownership," Barron* s National Business and Financial Weekly. XXIX, No. 49 (December 5» 1949)* 19-20. . "Super-Fund Suggested for Venture Capital," Barron*s National Business and Financial Weekly. XXIX, No. 4° (October 3, 1949)* 29-30. Jones, Homer, "Should Life Insurance Companies Invest in Equities," The Commercial and Financial Chronicle, CLXXI, Number 4°70 (January 5* 195>0), 18 ff. Keith, E. Gordon, "Tax Policy and Investment," The Annals of the American Academy of Political and Social Sciences, CCLXVI (November, 19497, 77-%. Kennedy, Joseph P., "No More Henry Fords," American Affairs. IX, No. 3 (July, 1947), 168 ff. Krauss, E. A., "How Federal Regulation Has Changed Structure of American Capitalism," The Magazine of Wall Street and Business Analyst. LXXXV, No. 7 (December 31, 1949), 1X5 ff. Landman, J. H., "Concepts of Section 102," Taxes— The Tax Magazine. XXVI, No. 1 (January, 1948), 19-29. "Life Company Holdings of Stocks Gain in 19li_8." The Exchange. X, No. 3 (March, 1949), 9. Likert, Rensis, "Public Attitudes Toward Owning Securities," The Commercial and Financial Chronicle. CLXX, Number Ij-ooa (December 29, 1949), 7 ff.

187 "Los Angeles Stock Exchange Celebrates 50th Anniversary,” The Commercial and Financial Chronicle, CLXX, Number 1^.8bl|. (December l3>7 19W )» 17 ff. Lutz, Harley L,, "The Budget and Private Enterprise,". The Annals of the American Academy of Political and Social Sciences, CCLXVI (November, 19i|-97, 1^1 ff. Macy, C. Ward, "Incidence or Effects of the Corporate Income Tax?" American Economic Review, XXXVI, No. 5 (December,

19^6 ), 903-906.

Magill, Roswell, "The Tax Scramble," Tax Review, X, No. Il (April, 19^9), 19-22. Mann, Everett J., "Tax Revision Can Increase Security Values." The Commercial and Financial Chronicle. CLXX. Number k86k T ^ c e S b e r ' l 5 ,;”‘l ^ W ) 7 B T f . ---------------

McGraw, Jr., James H., "Only A Prosperous America Can Be Free," Tax Outlook (May, 19J4.8 ), 3-5* Miller, Stanley L., "The Equity Capital Problem," Harvard Business Review. XXVI, Number 6 (November, 19^8 ), 671-679. Nadler, Marcus, "Equity Market Poses 1950*s Top Question," Finance, LVIII, No. 1 (January 15, 1950), 35 ff. Neill, Humphrey B., "What Path Ahead for Investment Trusts," Financial World. XCII. No. 7 (August 17, 19^9), 3 ff. Nelson, Godfrey N., "The Personal Income Tax and Business Enterprise," The Annals of the American Academy of Political and Social Sciences, CCLXVI (November. 19k9). 110-11 6 .

:

Newcomer, Mabel, "Taxation and the Consumer," The Annals of the American Academy of Political and Social Sciences, CCLXVI (November, 19i|9F, 5^-52. Noland, E. William, "Public Relations in Investment Banking," The Commercial and Financial Chronicle, CLXX, Number P 68 (December 29, 19^9 ), l6 ff. "No Sale? Employee Stockholder Plans," Forbes, LXIII, No. 6 (March 15, 19^9), 17. Noyes, C. Reinold, "The Prospects for Economic Growth," American Economic Review, XXXVII. No. 1 (March. 19k7). 15-53.

1 8 8

Pope, Allan M., "More Confidence in Business Weeded for More Equity Capital," The Commercial and Financial Chronicle, CLXX, Number if866~TDecember 22, 1949)* 13 ff. Phelps, Thomas W., "1929 Upside Down,” Fortune (November, 195-8), 95-96. Prentis, Jr*, H. W . , "Taxation and Business Initiative,” The Annals of the American Academy of Political and Social Sciences. CCLXVI (November, 1949), 70-76. "Private System of Capital Banks To Help Small Business Pro­ posed by 0 'Mahoney; U. S. Aid Excluded,” Wall Street Journal. Pacific Coast Edition, XLII, No. 2I4. (February 3» 1950), 2. "Proposes Plan to Finance Small Business,” The Commercial and Financial Chronicle. CLXX, Number Il86Il (December 15. 19^9). 22. "RFC: Haven For Businessmen in Need,” U. S. News and World Report (October 21, 1949), 22-23. “ ~ Ruml, Beardsley, "The Little Capitalists Get Together," Collier1s (January 21, 1950), 26 ff. , "Tax Policies for Prosperity," American Economic Review. XXXVI, No. 2 (May, I9J4.6), 265 ff. Saxon, 0. Glenn, "Mutual Funds and Their Investment Advan­ tages,” The Commercial and Financial Chronicle, CLXX, Number lj.852 (November 3, 1949)» 13. Schram, Emil, "Intent and Design of Stock Exchange Adver­ tising,” The Exchange. X, Number 2 (February, 195-9) * 9» . "Needed Measures for Tax Relief,” The Exchange. IX, No. 2 (February, 19^8), 1 ff. , "Present Tax Structure Throttles Small Business 1” Commercial and Financial Chronicle. CLXX, Number k&bO (December 1, 1949)/ 9 . "Stimulating Capital Markets,” The Commercial and financial Chronicle. CLXX, Number 4854 (November 10, 1949), 9 ff. _______ , "Taxation and Venture Capital,” The Annals of the American Academy of Political and Social Sciences. CCLXVI (November, 1949), 85-92/

189 . "Tax Proposals To Unlock Venture Capital," The Exchange. IX, Humber 12 (December, 19^8)» 3-J|"SEC Again Requests Supervision of Firms with Unlisted Stocks," Wall Street Journal. XLII, Ho. 6 (January 10, 1950), 8. "Secretary Sawyer Reports Taxation Discouraging Risk Capital," The Commercial and Financial Chronicle. CLXXI, Humber I4B 7O (January 5» 1950), 21. Shalett, Sidney, "Banking Saint or Bending Sinner?" Nation's Business. XXXVIII, Ho. 2 (February, 19^0), 29 ff*: “ Sholley, S. L., "Restore Equity Capital Flow by Lowering Tax on DividendsJ" The Commercial and Financial Chronicle. CLXX, Number i|.8EF"(December 22, 191*9), 11 ff. Smith, Dan Throop, "Effects of Taxation on Individual Invest­ ment and Corporate Financing," The Annals of the American Academy of Political and Social Sciences, CCLXVI {November, lW9>, 100 ff. Smith, Winthrop H., "How To Increase Equity Capital,” The Commercial and Financial Chronicle. CLXX. Number I l866 (December 22, I9I4.9 ), 13 ff. "State Taxes On Business.” The Conference Board Business Record. VI, No. 10 (October, 19i*9), 1^02-^03. "Stock Analysis," Forbes. LXIV, Ho. 1 (July 1, 19l*9), 13* "Stockholders on the Production Line," Forbes, LXIII, No. 10 (May 15, 19^9), 22. Stone, Goldie, "How the Capital Gains Tax Affects Buying and Selling Securities,” Taxes— The Tax Magazine. XXVI, Number 11 (November, I9I4.8 ), 1 ,0l*.l-1 ,0i*.8 . Studenski, Paul, "Toward a Theory of Business Taxation," Journal of Political Economy. XLVII. No. 9 (19it0). 621-6 ^ij.. Survey of Current Business. XXIX, No. 7 (July, 19^9)> 32 and S-li.0 pp. Survey of Current Business. XXX, No. 2 (February, 195>0), 32 and S-ij.0 pp.

190 "The Trend to Trusts," Forbes, LXIII, No, 2 (June 1, 19*4-9) » 11

.

Truslow, Francis Adams, "Speculate or Stagnate!" Nation1s Business, XXXVII, No. 3 (March, 19*4-9), 29 ff. Turner,-Clarence L., "Unreasonable Accumulation of Surplus . . . Section 102," Taxes--The Tax Magazine, XXVI, No. 9 (September, 19*4*8 ), 839-8*4-6. "Wall Street Steps Out," Forbes. LXIII, No. 7 (April 1, 19*4-9), 1*4-. Waller, Herman S., and Sidney Waller, "Revenue Code's Section 102 Is Due for Tighter Enforcement." Finance, LVI, No. 2 (January 31, 19*4-9), 33-35. Warburton, Clark, "A Suggestion for Post-War Taxes,” American Economic Review. XXXVI, No. 5 (December, 19*4-6 ), 882 ff. Westfall, Othel D., "Integrating Federal Income Taxes on Corporations and Their Stockholders," Taxes— The Tax Magazine. XXVII, No. 3 (March, 19*4-9), 236-257. "What's Holding This Market Back?" Financial World, XCI, No. 13 (March 30, 19*4-9), 3 ff. "What's The Matter With The Market?" Financial World, XCI, No. 22 (June 1, 19*1-9), 3 ff. "What's Wrong With Prices of Stocks," U. S. News and World Report (May 13, 19*j_9), 26-29. "Who Gets RFC Loans and Why," U. S. News and World Report (December 2, I9I4.9 ), 1*4-16. "Why the Dearth of Risk Capital?" Monthly Letter. National City Bank (January, 1950), *4-7. "Why Taxes Must Be Cut," U. S. News and World Report (August 26, 19*4.9 ), 32-357 Wilson, Robert E., "How to Solve the Equity Capital Problem," The Commercial and Financial Chronicle. CLXX, Number *05*4- (November 10, 19*4.9 ), 6 ff.

191 "19*49 Survey of Consumer Finances, Part IV, Consumer Owner­ ship and Use of Liquid Assets," reprinted by the Board of Governors of the Federal Reserve System from the Federal Reserve Bulletin (August, I9I4.9 )* 16 PP* "19*49 Survey of Consumer Finances, Part VI, Ownership of Automobiles, Stocks and Bonds, and Other Nonliquid Assets," reprinted by The Board of Governors of the Federal Reserve System from the Federal Reserve Bulletin (October, 19*49)* 1& PP* "I9lj.9 Survey of Consumer Finances, Part VIII, Distribution of Consumer Savings in 19*48," reprinted by The Board of Governors of the Federal Reserve System from the Federal Reserve Bulletin (January, 1950), 21 pp. C . NEWSPAPERS

Los Angeles Times. December 5, 19*49* _______ , January 8, 1950. . February 2, 1950. _______ , February 26, 1950. D.

MISCELLANEOUS

"Adjusting to the Value of the Dollar." Policy Memorandum, Research Institute of America, October 20, 19*49* 19 PP* Dewar, Hal H., statement at 38th Annual Convention of the Investment Bankers Association of America, Hollywood, Florida, December 5, 19*49* McCabe, Thomas B., "The Equity Capital Situation." State­ ment submitted to the Subcommittee of the Committee on Banking and Currency of the United States Senate, August 5, 19*49* Schram, Emil, address before the General Management Con­ ference of the American Management Association, New York City, June 9, 19*49*

1 9 2

, speech at Washington University, St. Louis, Missouri, March 22, 19l|.8. Snyder, John W . , statement before the Committee on Ways and Means, House of Representatives, February 3» 19?°* Truslow, Francis Adams, "Capital, Jobs and Taxes.” Address before the Rotary Club of Atlanta, Georgia, April 25>,

i9te. , "Stock Market Speculation— How Does It Affect Venture Capital.” Address at Philadelphia, Pennsylvania, J anuary 2 9 , 19I4.8.

University of

Southern

California LlferSC#