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Capital formation with particular reference to venture capital

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Capital formation with particular reference to venture capital

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Content 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
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T h is thesis, w ritte n by
...........PETE_ZIDNAK...........
under the guidan ce o f h %. iS.... F a c u lty C o m m itte e,
and a p p ro ve d by a ll its m em bers, has been
presented to a n d accepted by the C o u n c il on
G raduate S tu d y and Research in p a rtia l f u lf il l
m ent o f the requirem ents f o r the degree o f
MASTER OP ARTS
Date.
Faculty Committee
.
- Gtwirman
To
My Wife
TABLE OP CONTENTS
CHAPTER PAGE
I. INTRODUCTION............................... 1
The problem............. 2
The purpose and scope of the thesis ..... I 4.
Sources of data................. £
Organization of the thesis................ 6
II. CAPITAL FORMATION ................... 11
Significance of capital formation . 12
What is capital formation? .......... l l } .
Capital formation and types of economic
systems . .............. ......... l6
Capital formation and savings .............. 19
Source of capital ......... 21
The necessity for capital formation ..... 2I 4.
Conclusion........... 26
III. VENTURE CAPITAL— THE LIFEBLOOD OF A DYNAMIC
ECONOMY ......... 2?
Nature of venture capital 28
Equity capital versus debt financing .... 29
Dearth of equity capital.................. 314-
Conclusion ................ ........ 39
IV. RETAINED EARNINGS AND DEPRECIATION ...... 1 { . 0
Retained earnings........................ I 4 . 0
V
CHAPTER PAGE
Depreciation ................ 10
Proposals for depreciation policy reform . . I j . 8
Conclusion ............ .......... 52
V. TAXATION IN GENERAL AND VENTURE CAPITAL .... 5 1 1 -
Conclusion ............... 6l
VI. CAPITAL GAINS TAXATION AND VENTURE CAPITAL . . 63
Past provisions regarding capital gains ... 6i j .
Present treatment of capital gains and
losses ............................... 6> I j _
Revenue from capital gains taxation ......... 6?
Effects of capital gains taxation on
venture capital ...... ............ • 67
Proposals for reform of the capital gains
tax structure ........ 73
Conclusion............................... 78
VII. SECTION 102 AND THE FORMATION OF EQUITY
CAPITAL................................... 79
The provisions of Section 102 ........ 79
Effects of Section 1 0 2 .................... 81
Proposals for the reform of Section 102 ... 83
Conclusion............... ................ 8l j .
VIII. DOUBLE TAXATION AND VENTURE CAPITAL
FORMATION.................................. 86
Nature of double taxation .......... 86
Vi
CHAPTER PAGE
Effects of double taxation . ............ 87
Proposals for reform............. . . . • 9^
Conclusion................................ 95
IX. THE CORPORATE INCOME TAX AND VENTURE CAPITAL . 97
The t t basisw for corporate taxes ....... 97
The provisions of the corporate income
tax law ........ ........ ..... 100
The receipts from corporate income taxes . . 101
The effects of corporate income taxes .... 103
Proposals for reform................. 106
Conclusion ......... 110
X. PERSONAL INCOME TAXATION AND VENTURE
CAPITAL FORMATION.......................... Ill
Provisions of present personal income tax . . 112
Effects of personal income taxation ..... 113
Reforms ............. 119
Conclusion ...... .... .... ... 12i{.
XI. OTHER FACTORS AFFECTING VENTURE CAPITAL .... 125
Fear and uncertainty........... 125
Lack of knowledge.......................... 132
Stockholder relations and managerial
policies......... 136
Conclusion................... 139
XII. INSTITUTIONAL FUNDS AND VENTURE CAPITAL .... lip.
vii
CHAPTER PAGE
Life insurance companies .......... l l j l j .
Investment trusts .............. 150
Conclusion • • . • ......... ............. 156
XIII. GOVERNMENT AND ITS INFLUENCE UPON EQUITY
CAPITAL FORMATION . . . ..................... 158
Governmental lending ............... 158
Governmental spending ....................... l6l
Government and business.................. 163
Conclusion................. ........... 166
XIV. SUMMARY AND CONCLUSIONS.......................... l6?
Summary of findings...................... 169
Recommendations .................. 175
Conclusion ............ ......... 178
BIBLIOGRAPHY......................................... 180
LIS 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, 1935-19...... 68
IV. Corporate Income Tax Liability and Dividend
Payments ....................... 102
V. Spending Units Owning Various Types of
Assets, Early 19^-9 ............. 115
VI. Federal Individual Income Tax Receipts .... 122
VII. Reasons For and Against Holding Various
Assets, Early 19^9 ............. 130
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, I9I 4 .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. It is
being burdened with onerous conditions. 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 modem industrial nations
have arisen . . .2
2 Xbid.. p. I j . * 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. A general background
of the trusts is presented. 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 .TSWTTpTVT
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
p
engage in productive enterprise.
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.,
19W, 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. Maybe
he could catch more fish if he worked faster. 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 bJ
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 (Cf. infra.
pp. 19 ff.). 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, 1 9 l | 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)
T " i
In billions of dollars and percentages for selected years
Gross
national
product
New
construction
Producers
durable
equipment
Change in
business
inventories
Total
domestic
investment
1929
1103.8 17.8 7.5$ #6.4 6.2$ #1.6
1.5$ #i5.8 15.2$
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 Adapted from Table 2, ’ ’ Gross National Product or Expenditure; 1929^46
National Income, supplement to Survey of Current Business (July, 194.7)» 19* and„
liable 2, "National Income and Product 1948 and 194$*” Survey of Current Business.
XXX, No. 2 (February, 1950) , ? 8. V ^ ; . ' . ' . " A • 7:'.77;:
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, 19W), 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.
l l j . 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
instability.The 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, op. cit.« p. 336.
16 Stahrl Edmunds, ’ ’Trends of Capital Formation,”
The Commercial and Financial Chronicle. CLXX, Humber l \ . o % 0
TOctober 27, 19WT, 17-
17 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.,
I9I 4 . 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. To do the job,
industry is necessary. 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 . 21
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
26
immediate source of investment funds. 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. The United
States has grown as industry has grown. 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 . 0 0 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 modem 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. Without it, our economic
system would become stagnant. 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,t t 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, I9I 4 - 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
19I 46
19147
; 19lf.8 I9I 49
(In billions of dollars) (Per cent of total)
EXTERNAL FINANCING
Loans...........
3.3
2.6 1,2 -1.8 10
9 1 4 -7
Bonds. . . . . . . 1.0
3.1
14.8 3.8
5
10 17 16
Stocks .........
1*3
1.3
1.2
1.3 7
1 4
5 5
5.6
6.9
7.2
3.3
22 23 26 28
INTERNAL OPERATIONS
Retained profits0.
7.7 11.1 } . 12.5 7.8 36 38
' k$ 33
Depreciation . . . i f . . 2
k*9 5.5
6.2 20 16 20 26
Other. ...... i f . . 8
6.9 2.5 -3.1
22
23 9 -13
16.7
23*2
20.5 10.9 78 77
72
Totals . • 22.3
30.1
27.7
1I 4.2 100 100 100" 100'
a Adapted from Table l6, , f Source 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: I 4 . 8 per cent in 19^-5 J 58 P©3? cent
in I9I 4 - 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. Such financing merely takes the
cream of the risks. 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 out1 1 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, 3BbT
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, I9I 4. 9T, 85•
10 Jobs and Taxes (New York: The New York Stock
Exchange, 19W), 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
’ ’ control1 1 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* l i | - «
15 Senate-House Economic Committee, Sehator Joseph C.
01 Mahoney (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 unprece-
dentedly large. The need for new production facilities
l8 S. L. Sholley, "Restore Equity Capital Flow by
Lowering Tax on DividendsI"The Commercial and Financial
Chronicle. CLXX, Number l j .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. They have not acquired
the necessary ownership interest. The test of whether people
will voluntarily place their money in the ownership position
is whether or not they do. The records in this connection
speak for themselves! 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
?1
these shares are offered in relation to earnings.
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:
25 For 1914-8, gross savings were estimated to be $2 i j .
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 I 4.868
(December 29, I9I 4 . 9), 6.
Billion
Government Securities $68
Savings Accounts.
Cheeking Accounts
Currency........
67
k3
22
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 IV
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 19I 4 . 6 through I9I 4 . 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$.h-
Such 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.
I j . S. L. Sholley, ’ ’ Restore Equity Capital Flow by
Lowering Tax on Dividends,” The Commercial and Financial
Chronicle. CLXX, Number I 4.866 (December 22, 19I 49), 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. Mew
firms play a very important role in our economy. They are a
leavening element of incalculable value. 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, 19I J . 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
I895-19I 4 . 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.
lj? [
T 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 retained-
earnings 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
11
competitive system— could never get started without it*
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. Depreciation is at best a
matter of rough estimate. 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: McGraw-
Hill 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 at 2 to 3 per cent. These rates
are based on a study of the estimated useful life of such
assets. Taxpayers are urged to use the rates set forth by
the Treasury Department. However, a Treasury regulation
(T.D. I 4 I 4 . 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
T ft
more and more of corporate profits and capital.
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
20
profits and undervalue assets. 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,1 1 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, 19I 4. 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
PP
standard of living.
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
p c ?
and ultimately the creation of more jobs.
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
2 i | - 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. 6l j - .
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.4-
Taxation 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. It should not penalize
risk taking. 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
11
ownership capital.
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)Vp. 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 , f newM 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,
Inc., 194. 0), p. 6.
llj. Harold G. Moulton, Capital Expansion. Employment,
and Economic Stability (Washington: The Brookings Institution.
I9W . p. 270:
5 9
i ^
impede or foster the investment process.
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 ... are, as you will note, Inter
meshed. 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
20
many business decisions.
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
P I
accounts of the American taxpayers. 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
oo
production.
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. Taxation can, in no way,
create this spirit. 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.
2 l | _ The Committee on Postwar Tax Policy, op. cit.,
p. 82. “
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•, I9I 46) * 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. A personal residence is con
sidered a capital asset. 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. Such gains are called long
term. 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. These
10 Jobs""and Taxes, p. l f . 0.
11 Groves, o£. cit.. p. 221.
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
1 9 * 4 * 4 - . 35*4-
19*4-5 721
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 con-
1 P
sequently, the economy as a whole will eventually suffer.
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. l j . 1 - l j . 2 .
l i t - 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, 19I 4 - 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.1 1 ^
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
. - i O .
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. I 4 . 3.
20 Emil Schram, "Present Tax Structure Throttles
Small Business!” The Commercial and Financial Chronicle.
CLXX, Number i| .86o ”(Decerab er 1, 1 9W ), 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
21
gains tax provisions designed to encourage risk taking.
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. I 4 . 0.
7 1 1 -
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
p"i
business could attract funds more easily. 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 —I f - l j . .
7 5
capital gains be taxed at a flat rate of 10 per cent.^ 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 indus-
trial 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
2 i j . The present rates on short-term gains (supra pp. 65-
66) 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. This
provision would involve no immediate loss in 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, I9I 4 - 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. On
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.
must be judged on their economic effects and needed adjust
ments must be made on that basis.
Conclusion. Ultimately, the capital gains tax should
be abolished. The tax under the capital gains provisions
is very complicated and inequitable. It discourages venture
investment in American industry. 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 Cf. HWhy Taxes Must Be Cut," U. S. Hews and World
Report (August 26. 19^9)* 3 3-3k, and "WhatTs 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
c f
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
Reasonabler t 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, 19if 8), 82f0.
f? Groves, o £. c i t . . pp. 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
11
tax if they are long-term gains. J
Furthermore, the tax should apply only to that part
lO^T^idney Houston, "Taxation and Corporate Enter
prise,” The Annals of the Amerlcan Academy of Political and
Social Sciences. CCLXV:TTNovember, 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. A measure
of double taxation was introduced. 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,
I9J 4 . 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, The
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.
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
6
is drastically reduced.
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 l j .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 L j . 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 tax-
exempt 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.
9 1 4 -
other 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 cost^ 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.
on
the Treasury is concerned. 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
21
corporate and individual taxes must necessarily come.
"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 IX
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
IT. 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. £
( 19I 1 . 0J, 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. They are merely associ
ations of individuals. 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..
I j . 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.
t t It 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. Tax burdens cannot be borne by
6
inanimate objects.
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
"notch1 1 rate provided the transition from the low
rates on small corporations to the generally
applicable higher rates.9
The receipts from corporate income taxes.Under
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 before
taxes
Corporate
tax liability
Corporate
income after
taxes
Corporate
dividend
payments
1942
121,098
111,665
#9,433 14,297
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 1 5
27,600 10,900 16,700 8,000
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 2I 4 . , 19!$), 21.
13 Loc. cit.
l l j . 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. l O i j . , 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
20
the same treatment as the wealthy investor.
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 risk-
taking 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. 2 i | 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}, 9< 3 £.'
108
practical and political conditions makes abolishment in
feasible. So, next to the need for abolishment, it is
extremely important that the undesirable features of the
tax be corrected or withdrawn.
The taxation of corporations doing business in various
states is a tangled web in no wise clarified by the federal
corporate income tax. Each state may enact its own tax
formula. Also, each state has the power to prescribe the
terms on which the corporations can do business within their
borders. Consequently, there can be and is a great deal of
overlapping and confusion between the states in taxing trans
actions which originate in one state and are completed in
another. This situation would be greatly improved if the
states would adopt a uniform, non-duplicating plan for the
taxation of corporations and of transactions that cross state
lines. Congress has the power to regulate commerce between
the states, §nd therefore, it would be entirely legitimate
for Congress to prescribe an over-all plan.^^
It is urged, therefore, that the Congress enact a
statute providing how interstate transactions, and cor
porations doing business in more than one state, shall
be taxed. A great amount of needless paperwork, con-
' * ’ ’ eliminated with
27 Hoswell Magill, MThe Tax Scramble,” Tax Review,
X, No. i j . (April, 191+.9), 21.
28 Loc. cit.
The so-called "notch rate" (p. 101, supra) of the
corporate income tax, providing for the,transition from the
low rates on small corporations to the generally applicable
higher rates, should be abolished. Such action has the
approval of the Secretary of the Treasury for he stated
that "the elimination of this high ,notch* rate would remove
an obstacle to the expansion of small business,
The corporate income tax rates should be lowered as
part of the tax revision objective. A reduction in the
rates would release more funds for capital formation. The
amount of the rate reduction should be determined by economic
opportunities. In view of the vast government expenditures,
it may be possible that a great reduction could not be made,
However, it is believed that a reduction at this time would
be much sounder than a rate increase. A rate increase could
very easily have adverse effects upon the attitude of the
business community. The present high rates are too great
a penalty upon efficient economic enterprises. An increase
in rates would be the entering wedge in a scheme to con
fiscate the rewards of economic achievement and to penalize
bigness per se. Such insidious policies should be vigorous
ly opposed by everyone interested in maintaining the free
enterprise system in this country.
110
Conclusion. Considerations set forth, in the preceding
pages indicate there is no rational basis for a corporate
income tax. However, abolishment of the tax would be
extremely difficult in view of the revenue requirements for
the vast governmental expenditures. Since complete
elimination of the tax is impossible at the present time,
the undesirable and restrictive features of the tax should
be corrected or withdrawn* A uniform taxing structure among
the several states would be preferable to the tangled web of
tax relations that now exists. A reduction in the corporate
income tax rates would constitute a very significant
revision, and its effects would redound to the benefit of
the entire economy.
30 See footnote 2, p. and pp. l6l-l63 for a more
detailed discussion of governmental spending.
CHAPTER X
PERSONAL INCOME TAXATION AND VENTURE CAPITAL FORMATION
Taxes are anathema to all mankind. Man, the tax
payer, regards himself as the traditional beast of
burden on which is levied all manner of financial
obligations.^
The present chapter is devoted to the personal
income tax. The provisions of the federal income tax
system are discussed. The effects of the highly pro
gressive personal Income tax on venture investment and
individual incentive are considered. In the last section
of the chapter, reforms are recommended so that the income
tax structure might be more equitable, and consequently,
cease being a deterrent to risk taking and initiative.
The character of the economic process has been
profoundly modified by many legislative changes and in
stitutional Innovations. Perhaps the most effective of
all these changes has been the personal income tax— a most
remarkable device by which it is possible to vary the dis
tribution of Individual income and the amount of govern
mental revenue merely by adjusting the schedule of rates
p
and exemptions and altering the definition of Income.
1 A. W. Zelomek, Here Comes Tomorrow (Chicago:
Ziff-Davis Publishing Company, 19i | i | . ), p. 5>1.
2 Howard R. Bowen, nThe Personal Income Tax and
the Economy,w The Annals of the American Academy of
Political and Soc i al 'S'cienc es, CCLXVI (November, 19lf.9), 117.
112
Provisions of present personal income tax* The
modern.federal personal income tax was adopted in 1913*
and since then, there have been numerous and drastic
changes in both the tax brackets and the tax rates. The
year 1932 marks the beginning of a period that has been
characterized by steeply progressive personal income tax
rates. The personal income tax rates had been raised
to unprecedented heights by 1935* when they absorbed over
50 per cent of the additions to personal income beginning
at the #80,000 level. The period during World War II
brought even greater increases. In 19Mj-» a 50 per cent
rate came into effect at the #16,000 income level, 75
per cent at the #50,000, and 91 per cent at the #200,000
level. Postwar reductions have provided some personal
income tax relief, but the rates are still very high.^
Today, the personal income tax ranges from the
effective rate of 17 per cent on income below #2,000 to
an effective rate of approximately 82 per cent of the
income over #200,000. In between the two extremes, the
personal tax begins to take over half of the additions to
individual incomes after about #22,000, and it takes over
three-quarters of the additions to income after about
#100, 000.
3 Jobs and Taxes (New York: The New York Stock
Exchange, 19^9V, p. 31.
Effects of personal income taxation. The incentives
that prompt people to undertake economic activity are
various and numerous. However, in a market economy, it
may be assumed that the acquisition of income is almost
invariably the prime incentive, regardless what personal
motive may also apply
It is not an invalid assumption that persons as a rule
are not inclined to assume increasing risks for a diminish
ing return. Prom this, it is reasonable to think that
personal income taxation with steeply progressive rates tends
to reduce the willingness of individuals to undertake
economic venture in the hope of large return.^ ? t It is too
well established to require argument that the ability to save
and invest, and also the willingness to do so, are directly
affected by the tax burden and the tax outlook.
Anyone contemplating making investments in new or
expanding enterprises is bound to weigh the risks
against the prospective returns, and he will invest
only if he considers the probable gain commensurate
with the risk involved. High personal income tax
rates shift the balance against risky investments by
drastically reducing the income an investor can
realize from a successful venture. • • • The larger
I 4 . b!.' W. Prentis, Jr., ”Taxation and Business Initiative,
The Annals of the American Academy of Political and Social
Sciences. CCLXVI (November, 19^9)> 71*
S > Loc. cit.
6 Harley L. Lutz, f , The Budget and Private Enter
prises,” The Annals of the American Academy of Political
and Social Sciences. GCLXVI (November^ 19^4-9)» \l•
111] .
the proportion of possible gain that will be absorbed
by taxes, the less attractive becomes any particular
venture and the less likely It is that people will
risk their funds in its promotion. When taxes take
as much as two-thirds or three-fourths of any income
that may be realized by the suppliers of equity
capital, few if any risky ventures will appear
attractive to them. Char present income tax structure
thus has the effect of making risky investment un
attractive compared with less risky ones and hampers
expansion of our industrial plant.?
The net result of the steeply progressive income
tax structure is to discourage people from making additional
effort and from taking additional risks. Individuals In
the upper levels whose incomes are most heavily taxed put a
large part of their savings into Government or tax-exempt
bonds and other debt securities. They seek to avoid risk,
and thus large amounts of funds that would be available for
Q
venture investment are channeled in other directions. In
this connection, see Table V on the following page.
The people who are able and willing to assume the
risks of enterprise are mainly In the middle and high
income groups. This very fact accounts for the restraint
that a highly progressive income tax structure puts on
economic progress. These steeply graduated taxes take a
terrific toll on the incomes of the very same groups from
which the funds for venture investment have been obtained.
To illustrate how the graduated taxes have taken
7 Jobs "and Taxes, p. 33*
8 Loc. cit.
115
TABLE Va
SPENDING UNITS OWNING VARIOUS TYPES OP ASSETS, EARLY 19^9
(As percentage of spending "units in specified income groups)
Corporate Life Liquid
stock insurance assets*3
Under $1,000 . . . .
* 3$ 5o$
Wo
#1 ,0 0 0 to #1 ,9 9 9 . . . 3
6I 4.
59
#2 ,0 0 0 to #2 ,9 9 9 • •
. 5
78 65
#3 ,0 0 0 to #3,999 • • • 6
85
78
#l|.,ooo to #1{.,999 . .
. 9 87 87
#5,ooo to #7,^ 9 9 . . . 15
92
9^
$7 ,5 0 0 and over. . . . 36 92
99
All cases . . 8
77 71
a Adapted from Table 1, ”19^9 Survey of Consumer
Finances, Part VI, Ownership of Automobiles, Stocks and
Bonds, and Other Nonliquid Assets,” reprinted from Federal
Reserve Bulletin (October, 19i|-9), 3.
b Includes bank deposits, savings and loan shares,
and U. S, Government securities; excludes currency,
NOTE: The figures show that as income rises, savings
increase. More significantly, the figures indicate that an
increasing percentage of savings takes the form of venture
investment as we move into the higher income groups.
ll6
their toll, the statistics for incomes over #25,000 will he
analyzed. The total pool of net incomes above the #25,000
level increased from #8,636 million in 1928 to an estimated
$9,1|.72 million in 19^8, or by 10 per cent.^ On the other
hand, between 1928 and 19^8, the federal income tax of this
group soared from $l,0l | . 5 million to #l4.,660 million, or by
more than four-fold. Consequently, the balance of net
income after taxes fell from #7,59° million to # i } . ,8l2 million
— a drop of 36 per cent.^
This decline in net income occurred despite the
increased number of persons in the group— 111,000 in 1928
to an estimated 171^,000 in 19^- 8--which means that a much
smaller pool of income had to support more people. The
average income of the over #25,000 dollar group was #68,000
in 1928. In 19^8, the apparent average was #28,000— but,
an adjustment for the purchasing power of the I9I 4 - 8 dollar
in comparison to the 1928 dollar left an average disposable
income of only #20,000. The average ’ ’ wealthy1 ’ taxpayer has
been, and is being, squeezed both by the rising living costs
1 n
and the increasing rates of taxation.
9 Really an amazingly small gain considering the great
expansion of the national income, influenced by war and in
flation, from $79 billion to $226 billion, or almost 200 per
cent.
10 ’ ’ Why the Dearth of Risk Capital?” Monthly Letter.
Rational City Bank (January, 1950), 5*
11 Loc. cit.
117
The economy is not only suffering from the lack of
fresh venture capital which is the lifeblood of business,
but also, the shrinkage in income after taxes of the
business leaders of the community is destroying the
incentives to assume the heavy responsibilities of
directing our economic activities. Because of high taxes,
it is becoming difficult to provide rewards which are ade
quate compensation to top executives for the worry, strain,
and energy expended in the arduous task of management.
Better products and better processes are usually
originated by individuals acting singly or in voluntary
associations. Technology cannot be advanced by corporations
as such. However, technology can be improved, and thus
progress insured, by the employees of enterprises. Conse
quently, the effect of taxation upon personal initiative
determines the rate at which the technology used in the
economy is improved. In America, technology and industrial
and commercial productivity have steadily increased. But,
it should not be assumed that these developments are only
natural and will always continue.^ A relatively small
group of business leaders, risk takers, innovators, and
scientists are largely responsible for the American system
12 The First National Bank of Boston, New England
Letter (August 31,. 1914-9), 3.
13 Prentis, Jr., oj>. cit.. p. 73.
118
which has lifted the living standards of the people to
an unparalleled level. Because of our unique system of
providing incentives and rewards, tremendous creative
energies of the people have been released."^ A tax
structure which penalizes the successful destroys the
initiative, responsibility, ambition, and productive
effort which made America great.
"Taxation that reduces a man's incentive to do his
best is actually a deterrent to those who have the greatest
ability to manage business operations.The extremely
high personal income tax rates now in effect are very
discouraging to business executives and enterprisers.
In a questionnaire conducted by Fortune magazine
among American business executives, 70 per cent
replied in the negative to the question, "If you could
double your income by working two or three hours a
day, would you do so?" And this response should cause
no surprise in view of the tax schedule. In the case,
for instance of a person whose salary is doubled from
$50,000 to $100,000 a year, he retains only $12,000
of the additional $50,000, while the Government takes
$38,000. It is obvious then that our tax policies not
only destroy "seed money” but also deprive the nation
of valuable talent that coulcl make a great contribution
to our material well-being.^
The present highly progressive personal income tax
system has affected investment in another and almost wholly
1 I 4 . The First National Bank of Boston, loc. clt.
15 Prentis, Jr., loc. cit.
16 The First National Bank of Boston, loc. cit.
119
unexpected way. The significance of this rather curious
result is to be found not in its effects upon the total
volume of investment funds, but in the way it influences
the direction which investment funds take. The extremely
high tax rate, together with the system of tax-free bonds,
work strongly against the sale of corporate equity
securities to those individuals whose incomes fall in the
higher brackets. This fact, taken in conjunction with
other taxation provisions, places almost insuperable
obstacles in the way of venture investments."^
. . . the effect of progressive personal income
taxes upon the incentive to own income-producing
property is aptly described in the words of the
investment counsel who said, HI cannot bring myself
to recommend to ray clients that they liquidate their
holdings of tax-exempt government obligations in
order to buy equities having much higher yields.”
It is a matter of simple arithmetic that a reason
ably well-to-do individual can obtain more income
from a tax-exempt state or municipal obligation
than from investment in an equity giving twice the
gross return.1°
Reforms. The individual income tax is our best
financial beast of burden. If business taxation is to
be lightened, some other element must play a more import
ant role in the tax and revenue structure. The personal
17 Harold G. Moulton, et al.. Capital Expansion.
Employment. and Economic Stability (Washington: The
Brookings Institution, 19I 4 .O), p. 30I 4, .
18 Prentis, Jr., op. cit.. p. 71•
120
income tax is favored as the major source of revenue.
The burden of the personal income tax can be determined
easily since there is very little shifting. The tax can
be readily adapted to meet the requirements of a dynamic
economy. Moreover, if the graduation of the rates is not
excessive and due allowance is made for investment losses,
the tax should prove compatible with adequate business
inc entives
However, °we must recognize that inordinately high
rates not only destroy incentive to invest in new enter-
prise, but discourage incentive to work.* The rates
for the progressive income tax now in effect are excessively
high, and as previously discussed, have detrimental effects
upon the economy.
To offset these deleterious effects, the present
structure of the progressive income tax should be changed
providing for a reduction of rates throughout all brackets,
especially the high group. While a reduction of taxes will
not of itself assure a conversion of savings in venture
capital, the tax reduction should help to reverse the
present undesirable trend. The reduction in individual
19 Harold M. Groves, Postwar Taxation and Economic
Progress (first edition: New 'York: McGraw-Hill Book Company.
TncTTISW, P. 165.
20 Godfrey N. Nelson, f , The Personal Income Tax and
Business Enterprise,H The Annals of the American Academy of
Political and Social Sciences. CCLXVI (November, 19^-9), ITS,
121
income tax rates, in conjunction with all the other
necessary tax^revisions and other desirable action, would
provide a tremendous stimulus toward achieving a healthy,
progressive economy.
The importance of the personal income tax in the
economy is two-fold. It is by far the largest single
21
source of* Federal revenue, and also, the personal income
tax affects every individual worker and indirectly every
business unit in the economy— truly a tremendous influence.
As previously stated, the most essential material
requirement for the maintenance of a strong, healthy, and
growing economy is a steady and ample flow of savings into
the creation of more and better capital. To enable adequate
capital facilities to be provided out of current income, and
to eneourage venture investment, the tax system should be
revised with respect to rates and the distribution of
burdens.^
As mentioned above, this revision should take the
form of lowered rates throughout all brackets;— with,
particular reference made to the higher income groups.
At the present time, any sizeable reduction in the
income levies is precluded by the tremendous revenue needs
21 See ‘ fable VI, page immediately following.
22 Industry Believes (New York: National Association
of Manufacturers, 19^4-9)» P• 15.
122
TABLE VIa
FEDERAL INDIVIDUAL INCOME TAX RECEIPTS
(In thousands of dollars and percentages)
Total
internal revenue
collections^
Individual
income tax
Per cent
of total
19I 42 #13,029,915
# 3 ,262,800 2
191*
l j . 0,119,5 10 18,261,005
1914-6 ! { . 0,6 7 1 ,9 2 2 18,7014., 536 l j -6
19148 lp.,86i |.,536
20,997,781
50
19149 ^0,1 4 . 63,119
1 8,05 1,8 22
a Adapted from Table 1, "Internal Revenue Collections,"
Treasury Bulletin (February, 1950), Ml-*
b Includes employment taxes (old-age Insurance,
unemployment insurance, and railroad retirement) and mis
cellaneous internal revenue taxes (capital stock, estate and
gift, liquor, tobacco, stamp, manufacturers’ and retailers'
excises, and others).
123
of the Government. With the huge federal budget and. the
huge federal debt, there seems to be slim prospects for
ajny appropriate reduction.^ However, in order to forestall
any further drift toward economic nationalism and stag
nation, the individual income tax rate should range from a
low bracket rate of about 15 per cent to no more than 50
per cent in the top brackets. Rates over $0 per cent must
necessarily be considered as confiscatory.
. . . since there are wide variations in the
psychology and situation of individual income receivers,
no one can say at exactly what rate level income taxes
begin to discourage people unduly from putting forth
their best efforts and from taking risks with their
savings. There does, however, seem to be much merit
in the argument that 50 per cent represents a "psycho
logical breaking-point." After that point a person is
acutely conscious of the fact that the tax collector
takes a larger share of any additions to his income
than he retains for his own use.^q-
If the highest bracket rate of the individual income
tax was placed at 50 per cent, the individual income tax
liabilities for the calendar year 19^9 would be reduced by
only $ij;20 million. This comparatively small amount of
revenue derived from the highest brackets is being obtained
at a very high price in terms of the deterring effect on
23 To bring about a completely desirable revision
throughout the whole tax structure, a primary requisite
would be a change in national economic philosophy and policy
concerning vast governmental spending and deficit financ
ing— it would be necessary to live within our means1
Jobs and Taxes, p. 35*
12li_
risk taking.^
Actually, it is more than likely that any reduction
in taxes in the higher brackets would all go into increased
savings* Since a J?0 per cent limitation would leave half
the income derived as an inducement to risk taking, it
probably would lead to investment in new equity capital
p/1
issues.
Conclusion. The confiscatory rates now prevailing
in the personal income tax structure are in no wise com
patible with a highly dynamic economy. To avoid stagnation
and national ruin, a revision of the tax policy— lowered
tax rates throughout all brackets— Is necessary. Without
the revision, we will f , dry up the sources of capital, and
thus reduce our industry to impotence and our Nation to
poverty.”^7
25 Jobs~~and Taxes, loc. cit.
26 C. Reinold Noyes, ’ ’ The Prospects for Economic
Growth,” American Economic Review, XXXVII. No. 1 (March.
19V7), 33~
27 Willford I. King quoted in The First National
Bank of Boston, o£. cit.. p. 3*
CHAPTER X I
OTHER FACTORS AFFECTING VENTURE CAPITAL
Our tax system Is certainly a major obstacle to a
healthy equity market. However, taxes are not the only
barriers to the formation of risk capital. There are many
other obstructions.
In this chapter, some of the other hindrances to
venture investment are discussed. Fear and uncertainty
and their related states caused by false doctrines, mis
trust, suspicions, Inhibitions against risk taking, gloomy
recollections of the 1929 market crash, misconceived
attitudes toward business, and the inordinate desire for
security and stability are considered. The lack of know
ledge and apathy regarding venture investment are serious
impediments to sound equity financing. Proposals for the
removal of these deterrents are set forth. The last section
of the chapter is devoted to stockholder relations and
managerial policies and their effects upon venture invest
ment.
Fear and uncertainty. Fear and uncertainty as to
what may happen in the world— politically, socially, and
economically— make it very difficult to be confident about
the future. To have a flourishing capital market, the
126
confidence is necessary. Only time and good statesmanship
can remove this barrier. Despite the various temporary
set-backs, both seem to be working in that direction.^
There is also a huge brush pile of many false and
insidious doctrines which needs to be cleared away. The
years of teaching that our economy has become static and
stagnant and that growth is behind us must be overcome.
Leadership which has failed to encourage thrift and hard
work and self-reliance must be forgotten. Time and diligent
effort can clear up this rubbish.
There may still remain, to some extent, the obstacle
of mistrust of our financial men and machinery, although
great changes and time have already gone a long way toward
removing this once serious impediment. Wise leadership
in finance, earnest efforts to spread knowledge of what the
financial machinery is for and how it works, and a continued
demonstration of fair dealing are the best means for over
coming this obstacle.^
One of the most intangible and one of the most
difficult obstructions that has fallen across the way of
1 Francis Adams Truslow, f , Stock Market Speculation—
How Does It Affect Venture Capital,n address delivered at
Philadelphia, Pennsylvania, January 29, 19J 4 . 8.
2 Loc. cit. Cf. George W. Terborgh, The Bogey of
Economic Maturity (Chicago: Machinery and Allied Products
Institute, 1945).
3 Truslow, loc. cit.
127
venture capital is the inhibition which has been instilled
in people against taking a risk. The American economy is
based on individual risk. It relies on the willingness of
people to risk their capital. The whole system would
collapse if people ceased to take risks with their capital,
American society looks upon this absolutely needed and
legitimate speculation as a most harmful phenomenon, and
consequently has built a psychological barrier against the
risk taking which our economy requires,^*
Par too many people in this country have been led
to believe that successful people must be subject to
suspicion, that businessmen who operate enterprises,
especially the large ones, are enemies of some sort. There
has arisen a degree of class hatred never before known In
this country. Since such thoughts have become more and
more prevalent, there has been an unfair, unwarranted, and
undesirable feeling toward business, executives and business
in general.^ At the beginning of 19^9» only 8 per cent of
the American families owned stock in American industry. (See
Table V, p. Ilf?.) This may be the cumulative effect of the
attacks on businesses. We want adequate equity capital. We
will never get enough of it if businesses that use it and
i j . Truslow, loc. cit,
5 Cf. John Chamberlain, f , The Businessman in Fiction,w
Fortune (November, 19l|-8), 13^ ff.
128
f i
need It are improperly attacked, belittled, and berated.
Business has, reputation wise, fallen in estate.
This is also a consequence of the trend over the past
100 years toward urbanization and toward a laboristic
economy. Most people are employees. Values and pres
tige in the eyes of the community are shifting away
from business ideals. . . . It is natural in this
process that business enterprise should carry less
prestige and excite less aspiration. If most people
do not want to be businessmen as much as they used
to, they are less likely to strain themselves to
think about the problems of business venture— which
is required for equity investment.?
Too many people have been led to believe that
business people who undertake new enterprises or the
successful businessmen are some kind of enemies not to be
trusted. It is further believed that financing new under
takings is ”evil” speculation, and that those who speculate
have something wrong about them. Unfortunately, too many
American citizens have such ideas. But even more unfortu
nate is the fact that such ideas have led the people down
the path of personal security to the extent that any risk
now is frightening to them. Security and safety have be
come the watchwords. It appears as if the people even want
their future securely guaranteed by a benevolent government--
as a people, we have not yet seen the horrors that await
6 Allan M. Pope, ”More Confidence in Business Heeded
for More Equity Capital,” The Commercial and Financial
Chronicle. CLXX, Number Dee ember 227“l9l$y,' V T . ' " '
7 Stahrl Edmunds, ”Trends of Capital Formation,”
The Commercial and Financial Chronicle. CLXX. Number u.890
TOctober 27, 1959T,“20^
129
g
us when we overdo it.
The desire of individuals for security and safety
in investments has been revealed in the 19l|-9 Survey of
Consumer Finances. The survey suggests that an over-whelming
majority of the population as a whole save primarily for
security reasons, such as for a rainy day, old age,
emergencies, etc. In the survey conducted in the early
part of 19^9» 69 per cent of the individuals interviewed
were against holding common stock in business enterprises.
Twenty-eight per cent believed such securities were not
safe, while 3b per cent were not familiar with stocks as
investment opportunities.^
The emphasis of safety is further reflected in the
large volume of individual savings being held in the form
of Government bonds; of deposits, shares, and reserves in
such noncommercial bank and financial institutions as life
insurance companies, savings and loan associations, and
saving banks; as well as of reserves in private and Govern
ment pension and trust funds. A large proportion of
individual savings is channeled into these types of invest-
$ Pope,loc. cit.
9 ”19^4-9 Survey of Consumer Finances, Part VI,
Ownership of Automobiles, Stocks and Bonds, and Other
Nonliquid Assets,” reprinted from Federal Reserve
Bulletin (October, 19q-9)# 3>* For more detailed statistics,
see 'Sable VII, page immediately following.
130
TABLE VI I*
REASONS FOR AND AGAINST HOLDING VARIOUS ASSETS, EARLY 19^9
(Percentage of spending units with incomes of #3,000 and over)
Reason1*
Savings
account
Savings
bond
Common
stock
For holding. . . 92 8
Safe .... i j . 8 2
High rate of return. ... 6
3k 5
Liquid . . .
3
0
Familiar with. ...... (c) 1 0
Hedge against Inflation. . 0 0 (c)
Capital gain expected. . . 0 0 (c)
Against holding.
. 39
12
69
Not safe . .
. k
1 28
Low rate of return .... 6 1
Not liquid .
5
1
Not familiar with........ (c)
3k
Takes lots of money to buy o 0
3
Capital loss expected. • • 0 0 0
No reason given.
. 3k
2k 31
a Adapted from Table 3» '*1949 Survey of Consumer
Finances, Part VI, Ownership of Automobiles, Stocks and
Bonds, and Other Nonliquid Assets,” reprinted from the
Federal Reserve Bulletin (October, 19i|-9)* 5>*
b When respondent gave more than one reason, each
reason was tabulated. Totals will exceed 100 per cent.
c Less than one-half of 1 per cent.
131
merit.'*’ ® (See Table V, page 115.)
’ ’ The general public's desire for security seems
almost pathological— except when It comes to buying
lottery tickets or betting on the r a c e s . ’’The
venture is being taken out of American life and so we are
breeding a riskless people that demand security first and
the opportunity to work for it second.”^
The more such a feeling grows . . . the greater
the risk becomes that we will ruin ourselves by
becoming a non-venturesome nation. We will some day
wake up with a shock when we suddenly realize the
fact that there is no such thing as complete security
for anyone and never has been.^3
The dark, unpleasant memories of the tremendous
financial collapse and the ensuing severe depression of
the early thirties is another important reason which has
caused people to seek security in Investment as well as
in Government intervention to mitigate economic and social
disparities and Instability. llJ - "Deep s c ars” and ”burnt
" 10 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. 2,
11 Robert E. Wilson, ’ ’ How to Solve the Equity Capital
Problem,” The Commercial and Financial Chronicle. CB3DC,
Number k-Q5k- (November 10, 1914-97> 5V
12 Pope, loc. cit.
13 Loc. cit.
l l j . McCabe, loc. cit.
132
fingers” from the 1929-1932 stock market fiasco have
erected a tremendous psychological obstacle to common stock
investing. Furthermore, the influence of the collapse was
not felt solely by the immediate victims. Unfortunately,
by the oral and written word, the ghastly details of the
ruinous event have been spread over the entire face of the
earth— and a frightening mental barrier has been erected
against participation in stock market activities. Legis
lation and regulation put in after the crash will prevent
the re-occurrence of so devastating an incident. In the
meanwhile, time and education may eventually erase the
psychological apathy toward acquiring an ownership interest
in American industry.
Lack of knowledge. Despite the general and very
pronounced trend to safety, security, and stability, there
are many persons who are willing to take the risks and
invest their funds in the expectation of gain. Among these
are a new group of people with savlngs--the skilled laborers,
farmers, proprietors of small business, and professional
men. Unfortunately, many of these potential investors—
3 i f - per cent according to the recent Survey of Consumers
Finances^— lack knowledge about stock investment.^
l£ See Table VII, p. 130.
l6 McCabe, o£. cit.. p. 3*
133
Venture capital was, of course, much easier to raise
when it could be obtained from a comparatively small number
of people with comparatively large amounts of surplus
funds. However, such a condition no longer prevails. To
day, a great many more people have accumulated surplus
funds--but in much smaller average amounts— than was the
case in the past.^
Our present national savings are very large in the
aggregate, but they are not concentrated in the hands
of those who understand the rewards and risks in
supplying venture capital. Enlarged incomes are going
to farmers, highly skilled workers, small businessmen,
and individual merchants and manufacturers, who as a
rule have not learned the principle of investment.
Analysis of what is happening to their savings indi
cates an element of fear. They are maintaining large
bank deposits and keeping a substantial portion of
their funds in government bonds. Many of the younger
ones seem to have neither knowledge of, nor confidence
in, the private enterprise system. Perhaps they can
be educated as to the opportunity for profitable in
vestment in American industry.1®
The public which must be educated regarding owner
ship interest in American business is the broadest the
securities industry has ever had. As stated previously,
the potential investors are found in all walks of life.
Efforts can no longer be confined to bank presidents,
wealthy manufacturers, and their kind. Today, the farmers,
17 Francis Adams Truslow, "Speculate or Stagnate!"
nation's Business. XXXVII, No. 3 (March, 19^9), 69.
18 Emil Schram, "Taxation and Venture Capital," The
Annals of the American Academy of Political and Social
Sciences. CCLXVI (November, I9I J . 9T, 86.
1 3 1 } -
the skilled (and in many eases, the unskilled) workers,
the small manufacturers, and the storekeepers must be'
considered as possible investors."^
But these small customers are extremely important
to us [the securities people] for at least three
good reasons: (1) they will make money for us if we
design selling techniques that will minimize expenses;
(2) they will be among our most loyal customers and
boosters if we treat them right (this is the important
part of the public relations anglei); and (3) they will
be made stronger believers in the individual enterprise
system, less given to the debilitating "isms*1 that
threaten our American way of life.20
In many respects, the attitude of an individual who
holds surplus funds is an important factor in determining
whether the funds are going into the venture or debt market.
Lack of knowledge and apathy, regardless of what it is
caused by, are two of the biggest obstacles to adequate
venture financing. These two must be removed.
Fortunately, people of the securities industry, as
well as others interested in the problem, are becoming
more aware of their great responsibility in this connection.
Vast programs are being undertaken to educate the public in
common stock ownership.
Various agencies--such as, the stock exchange,
brokerage houses, investment companies, etc.--are conducting
IQ E. William Noland, ’ ’ Public Relations In Investment
Banking," The Commercial and Financial Chronicle. CLXX,
Number q.868 {December 29, 1949)» 1&.
20 Loc. cit.
135
intensive and extensive projects designed to set forth
before the public all the necessary information concerning
stock investment. Lectures are being presented which cover
the theoretical and .practical aspects of investment.
Exhibits and booths are maintained at fairs, conventions,
and trade shows. Educational films regarding investment
and the financial mechanism are being shown throughout
the nation to schools and organizations. Along with the
distribution of much educational literature, the newspapers
of the country have been enlisted to reduce financial
illiteracy. Radio and television advertising has been
used in connection with joint and individual firm advertis
ing campaigns. Furthermore, speakers bureaus have been
organized, and speakers are made available to any group.
All along the line, moribund merchandising methods
are being dusted off and revivified. With many stocks
begging for buyers, security merchandisers are pepping
up sales presentations, jettisoning ”wait for the
customer” attitudes and hawking their wares like any
small-town merchant.21
The extensive promotional efforts are necessary in
order to educate the whole new generation which has grown
up with but little or imperfect knowledge of the financial
markets and institutions and with only a vague idea regard
ing the role of equity capital in the economy.
21 1 1 Wall Street Steps Out,” Forbes. LXIII, No. 7
(April 1, 19l|-9)» 3 l } - *
136
Stockholder relations and managerial -policies.
Many companies realize that the existing body of stock
holders constitute their best prospects for new equity
capital. As a result, they are doing everything possible
to win the confidence and raise the interest of this group.
Stockholder relations, one-time corporate step-child,
is now being trotted out of industry’s back room and ushered
into a front-row seat in many public relations programs. In
stead of merely mailing shareholders a copy of the annual
report and their dividend check (If any), wide-awake firms
are now going out of their way to curry favor with those who
put up the money to spin industry’s wheels.
Simplified year-end statements,^ annual meetings in
easily accessible places^— with soft drinks and sandwiches
22 The SEC analyzed stockholders’ communications from
159 unlisted corporations (l9lf-9) and found that there was a
"general failure” to disclose important non-financial infor
mation, and there was also ”little discussion of pending
developments.” Twelve per cent of the corporations failed
to publish one or more of the three basic statements— the
balance sheet, the profit and loss statement, and the state
ment of surplus. Balance sheets of 89 of the 159 companies
were described as ”patently efficient” as judged by SEC
standards. Thirty-two had obvious ''deficiencies” in report
ing on fixed assets, inventories, reserves, and capital
stock. Eleven corporations did not furnish any Income state
ments, and 83 put out statements which the SEC regarded as
deficient. ”SEG Again Requests Supervision of Firms With
Unlisted Stocks.” Wall Street Journal. XLII. Ho. 6 (Januarv
10, 1950), 8.
23 As was reported In Forbes. July 1, 19^4-9» page l l | . ;
"Like the North Pole, annual stockholder meetings are known
about by everyone but seldom visited.”
137
thrown in— coast-to-coast showings of movies depicting
company operations, even televised annual reports (Union
Oil Company of California)— these and other techniques are
being dusted off and polished up by today’s stockholder-
conscious corporations.^-
The small percentage of earnings which have been
paid out in dividends by many concerns in recent years
has also caused many stockholders to voice objections.
In many instances, these criticisms are justified. In
fact, as previously shown, low dividends have been a
factor in the reluctance toward equity investment. There
is a very close inter-relation between the various
aspects of the low dividend problem and its effects upon
the economy. To adequately solve the problem, the various
reforms suggested in this paper should be carried out.
However, it must be pointed out that the corporations
themselves are attempting to mitigate the results by being
as liberal In their dividend policy as circumstances permit.
Although there has been some concentration by
management to further their relations with existing stock
holders, business enterprisers have not neglected their
employees in attempting to promote better relations and to
stimulate ownership interest. Stock acquisition plans
2 k - ^Stockholders on the Production Line.1 * Forbes,
LXIII, Ho. 10 (May l£, 19^9), 22.
138
which are open to all employees have been put into
operation. Although, new capital is obtained, the
primary purpose of stock acquisition plans have been
to stimulate ownership interest on the part of the em
ployees* Westinghouse Electric Corporation set aside
900,000 shares for employee acquisition, and announced,
"We have adopted the plan because we believe it is to
everybody's interest— yours, management's and stockholders'
— that you and your fellow employees have an ownership in
the company."^
As more workers become part owners of these enter
prises, it will be demonstrated onee again just how
illusory are any attempts to draw a hard and fast
line between labor and capital. More often than not,
any one individual finds himself daily in both roles
— as a worker and as an acquirer of capital.
However, at the present time, it appears that the
line between capital and labor is clear eut. Union labor
recently has had a tremendous rise in political influence.
In fact, it has risen to the point where unions seek to
dictate legislation and influence elections, to the detri
ment of business, and with total disregard for the interests
of the shareholder-owners of business.^ And, it might be
25>Thomas Baimer, "Broader Interest in Employe Stock
Purchase Plans," The Exchange, IX, Number 10 (October,
I9I 4. 8), I * . .
26 Loc. cit.
27 "What's the Matter With the Market." Financial
World. XOI, No. 22 (June 1, 19^9), 23.
139
added, with total disregard for even their own long run
Interests!
If we are to preserve the American system, the
importance of influencing the workingman toward an owner
ship Interest in industry becomes apparent.
Short of education there is no stronger tool of
democracy in an industrial society than the ownership
of wealth in the form of securities. The mechanism
for encouraging and transferring savings into pro
ductive enterprise and the keeping alive of a liquid
and competitive market is essential in preserving and
strengthening our democratic institutions.28
Conclusion. The obstructions to greater partici
pation in equity financing caused by fear and uncertainty,
lack of knowledge, attitudes based on false notions, apathy,
etc., must be removed.
For the good of the individual citizens of America,
of industry, and of the country as a whole, more of the
surplus funds of the American people should go into venture
investment. The individuals need a regular stake in the free
enterprise system. The existence of many more small stock
holders would greatly improve the climate for business enter
prise. Industry needs the capital, but it needs even more
the better understanding and the greater community of
28 Hal H. Dewar, 19^9 President of the Investment
Bankers Association of America, statement at the 38th
Annual IBA Convention, held at Hollywood, Florida, December
5, 19^9.
Interest which should result from stock o w n e r s h i p . The
common stock investor is the very foundation of our free
society and of our free economy.
CHAPTER X I I
INSTITUTIONAL FUNDS AND VENTURE CAPITAL
The funds of financial institutions— such as savings
banks, life insurance companies, trust companies, credit
unions, savings and loan associations, aid miscellaneous
institutions can be used to a larger extent for equity
financing in the future.
This chapter deals with institutional financing in
relation to the venture investment problem. The first
part of the chapter deals with institutions in general and
their present and possible relation to equity capital.
The second part of the chapter is devoted to a detailed
analysis regarding the present and potential role of the
insurance companies as a source of venture capital. In the
last section of the chapter, investment trusts are discussed.
A descriptive and historical background of the investment
trusts is presented, and their importance to and influence
upon equity investment are set forth.
At the present time, institutional investment is much
more rigid than personal investment.1 The individual is
free to take his own risks as his judgment indicates. On
the other hand, in their Investment activities, the
1 Laws of most states prohibit or severely restrict-
equity holdings by Institutions.
1 k2
2
institutions are governed by investment laws.
i n ' 2 in California, Section 2261 of the Civil Code, as
amended in 19^- 3* provides that:
nIn investing, reinvesting, purchasing, acquiring, ex
changing, selling, and managing property for the benefit of
another, a trustee shall exercise the judgement and care,
under the circumstances then prevailing, which men of
prudence, discretion and intelligence exercise in the
management of their own affairs, not in regard to spec
ulation, but in regard to the permanent disposition of their
funds, considering the probable income, as well as the prob
able safety of their capital.”
Moreover, ”a trustee is authorized to acquire every
kind of property . . . and every kind of investment,
specifically including, but not by way of limitation,
corporate obligations of every kind, and stock, preferred
or common, which men of prudence, discretion and intelli
gence acquire for their own account.”
In Mew York, amendments were recently passed— to be
effective July 1, 19 3>0— 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.
I 4 . 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 uriwhole-
6
some for a private enterprise economy. 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 Bonds* 5
Government
securities Otherd
1903
# 2.2
* *16 7.3$ * $ #
i
...... i
1910 3.8
.13 3.3
1921
7.9
.06
.9 1.9
23.6
1.5 19.1
1 4 *1 4 5 6 4
1930 18.8 • I 4 .6 2 4
t.9 25.9 1 4
7.8 12.0 63.9
19140 30.8
.55
1.8 8.6 28.0 84 27.1
13.2 I 43.I
1 9 1 4 .6 I 48.I 1.2 2.6 11.8 2I 4.6
23.5
148.8 11.6 2I 4.0
19V7 51.7
l 4
2.7 4.7 28.5
22.0
M.5
13.6 26.3
19148 55.6
1 4
2.6 18.9
3*4.0 19.1
3I 4 4 16.2 29.O
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.
l l j . 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 I 4 . 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.
l f y - 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,
l l j . Sherwin C. Badger, "Equity Investment and Life
Insurance," The Commercial and Financial Chronicle. CLXX,
Humber l j -852 {November 3, 19 W)* 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.
i5o
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, , f More 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. 965-
972.
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 mutual funds will be
the main topic of discussion 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. The investment company is a
sort of co-operative. 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; ( I j . ) 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 193W 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. l j . 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 f l j l j . 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.^
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., I9I 4 . 9),
pp. 11-12.
By and large, new business is not the business of
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
pfi
through their large holdings of voting stock. The first
two objections are closely inter-related. 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. I 4 . 9 (November l i j . , 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. Government and business relations are
examined. 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
ToStobeF 27; i9W , “ --------------------
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.®
I j . The RFC has made an astounding infiltration into
American business life. The Agency's business loans out
standing amount to f > ! | . l 6 million. More than £,14 . 0 0 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 t j-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 + . 8 5 1 + .
(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, New England
Letter (August 31 > 19^9)» 3*
10 f , Why the Dearth of Risk 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
1 P
liberty is to prevail. ^
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?) > 2J 4. .
1 I 4 . Benjamin Graham, ’ ’ Business and Government Must
Compromise,1 1 The Commercial and Financial Chronicle. CLXX,
Number ij.852 . (November 3, 19 V?) , 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. Profits are
not socially harmful. 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 I 4.866 (December 22, I9I 4. 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, I9I 4 . 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--
p
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.
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. Low and
inflexible rates of depreciation are in effect. 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. It creates
serious injustices among taxpayers. 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. This double taxation is
discriminatory and unfair. 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. The incentive to work and to
invest are suppressed. 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
"mobilization1 1 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. Present
conditions make this action somewhat infeasible. However,
a revision is deemed necessary. 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. We are now
spending and taxing too much. 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 enter-
O
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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The Commercial and Financial Chronicle. CLXX, Number I 4.866
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(October, 19^8), 230 ff.
Edmunds, Stahrl, "Trends of Capital Formation," The Commer
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Fackler, Clarence W., "A Four-Pronged Attack Upon Equity
Capital Problem," The Commercial and Financial Chronicle.
CLXX, Number i j .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,1 1 U. S. News and World
Report . (February 10, 1950), — i+9 *
Froman, Lewis A., f t Gan Individual Investment Be Stimulated,"
The Commercial and Financial Chronicle, CLXXI, Number
PTO (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 p52
(November 3, 19l|9)* 15 ff•
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U&~ff.
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Hoover, Herbert, "Taxes and Spending— Double Danger," Tax
Review. X, No. 8 (August, 19I 4 . 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.
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The Annals of the American Academy of Political and
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"How Industry Is Meeting Capital Needs," The Conference
Board Business Record. V, No. 7 (July, 19p), 283~28lf.
186
WIBA Repeals Grass Roots Education Program," The Commerc1al
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W l 9T 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.
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National Business and Financial Weekly. XXIX, No. 4°
(October 3, 1949)* 29-30.
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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,
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Kennedy, Joseph P., "No More Henry Fords," American Affairs.
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of American Capitalism," The Magazine of Wall Street
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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 ^ . 8 b l | . (December l3>7 19 W )» 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.
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The Commercial and Financial Chronicle. CLXX. Number k86k
T^ceSber' l5 , ;”‘ l ^ W )7 B Tf.---------------
McGraw, Jr., James H., "Only A Prosperous America Can Be
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Finance, LVIII, No. 1 (January 15, 1950), 35 ff.
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Financial World. XCII. No. 7 (August 17, 19^9), 3 ff.
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k&bO (December 1, 1949)/ 9
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Studenski, Paul, "Toward a Theory of Business Taxation,"
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621-6 ^ i j . .
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.
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... Section 102," Taxes--The Tax Magazine, XXVI,
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19*4-9), 1 * 4 - .
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Warburton, Clark, "A Suggestion for Post-War Taxes,”
American Economic Review. XXXVI, No. 5 (December, 19* 4 - 6),
882 ff.
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Corporations and Their Stockholders," Taxes— The Tax
Magazine. XXVII, No. 3 (March, 19*4-9), 236-257.
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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, I9I 4 . 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, I9I 4 . 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 29, 19I4.8.
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Creator Zidnak, Pete (author)

Core Title Capital formation with particular reference to venture capital

Degree Master of Arts

Degree Program Economics

Publisher University of Southern California (original), University of Southern California. Libraries (digital)

Tag Economics, Finance,OAI-PMH Harvest

Language English

Contributor Digitized by ProQuest (provenance)

Advisor Phelps, Clyde William (committee chair), Anderson, William H. (committee member), Garis, Roy L. (committee member)

Permanent Link (DOI) https://doi.org/10.25549/usctheses-c20-438207

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