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A REFORMULATION OF TEE THEORETICAL BASES FOR A PERMANENT FEDERAL EXCESS PROFITS TAX A Dissertation Presented, to the Faculty of the Graduate School The University of Southern California In Partial Fulfillment of the Requirements for the Degree Doctor of Philosophy by Nelson H* C* Lo June 1950 UMI Number: DP23242 All rights reserved INFORMATION TO ALL USERS The quality of this reproduction is dependent upon the quality of the copy submitted. In the unlikely event that the author did not send a complete manuscript and there are missing pages, these will be noted. Also, if material had to be removed, a note will indicate the deletion. Dissertation Publishing UMI DP23242 Published by ProQuest LLC (2014). Copyright in the Dissertation held by the Author. Microform Edition © ProQuest LLC. All rights reserved. This work is protected against unauthorized copying under Title 17, United States Code ProQuest LLC. 789 East Eisenhower Parkway P.O. Box 1346 Ann Arbor, Ml 48106-1346 pk n > Be, T h is dissertation, w ritte n by .......... . JSelsoja.II.. ........ u n d e r the guidance o f Ais... F a c u lty C o m m itte e on Studies, and a p p ro ve d by a ll its m em bers, has been presented to and accepted by the C o u n c il on G ra du a te S tu d y and Research, in p a r tia l f u l fillm e n t o f requirem ents f o r the degree o f D O C T O R O F P H I L O S O P H Y D ean Committee on Studies Chairman CONTENTS CHAPTER PAGE I. INTRODUCTION................................. 1 II* A HISTORICAL RESUME OF FEDERAL EXCESS PROFITS TAXATION.................................... bl III. FISCAL PRINCIPLES OF EXCESS PROFITS TAXATION ... 90 IV. THE THEORY OF NORMAL PROFITS AND THE RESIDUAL CLAIMANT THEORY OF EXCESS PROFITS............190 V. RISK, EFFICIENCY, AND EXCESS PROFITS TAXATION. . . 275 VI. INVESTED CAPITAL, STATUTORY RATE OF NORMAL PROFITS, AND OTHER TECHNICAL CONSIDERATIONS. . . 316 VII. THE INCIDENCE AND EFFECTS OF A PERMANENT EXCESS PROFITS TAX. .................................^3** VIII. SUMMARY AND CONCLUSION....................... . 53^ BIBLIOGRAPHY........................................ 550 TABLE OF CONTENTS CHAPTER PAGE I. INTRODUCTION ............... . 1 Purposes of study. . . . • • ... . . . . . • 1 Objections to existing corporate income tax system .......... ......... 1 The double taxation of corporate dividends 1 Other theoretical and technical weaknesses *+ The excess profits tax .......... ..... 5 The superiority of the excess profits tax. 5 The lack of a systematic treatment of the theoretical bases for a permanent excess profits t a x .......................... 7 Purposes of study. ............. 11 Chapter organization .........•••• 12 A critical review of related studies ..... 15 M. H. Oopal*s The Theory of Excess Profits Taxation 15 / Introduction ...... 15 Theoretical basis for excess profits taxa tion • • • • • • • • • • • ......... 16 Scope of tax . . • • • . . • • ......... 17 Determination of the taxable excess. ... 18 Miscellaneous considerations . ........ 21 ii iii CHAPTER PAGE The effects of the tax........... . . ♦ . 21 A critical, comment .......... 21 Proposal by Carl Shoup and associates. . . . . 27 Introduction • • • • . • • • ........... 27 The concept of “excess” and its relation to “just price” . . . . . . . . . . . . . . . 28 Monopoly powers, monopoly profits, and excess profits taxation............... .. 28 Scope of business unit taxable......... . 29 Inclusion of capital entitled to only a fixed return ....................... 29 Length of accounting period........... 30 Determination of invested capital. • • • • • 30 Fair-return percentage ..................32 Tax rate 32 A critical comment •••••....•••• 32 William Edward Butt's | Permanent Excess Profit Tax. . . . . . . . . . . . . . . .......... 33 Introduction ............. 33 Explanations and measurement of excess profits. • • • • .......................3*f An ideal tax on excess profits...........36 The practical system.....................37 Conclusion........................... 38 A note on sources of data and references • • • • 39 iv CHAPTER PAGE II. A HISTORICAL RESUME OF FEDERAL EXCESS PROFITS TAXATION............... kl Excess profits tax, 1917-1921. • ....... Ml Immediate forerunner of the. excess profits tax. .............. Ml Munition manufacturer’s tax. .. ...... Ml Revenue Act of March, 1917......... M2 Historical preliminary •••.•••••• **2 Theory and. practice of tax . ..••••• MM War Revenue Act of October, 1917 ...... MS Historical preliminary •••••••••• M6 Principal features ........... **8 Revenue Act of 1918. 5M Historical preliminary.................. 5M Principal features •••...•••••. 56 The 1921 repeal of the excess profits tax. • 60 Excess profits tax, 19MO-19M5................ 63 Between two wars ................... 63 Tax recommendations of War Policies Commis sion ......... 63 Proposals of Nye Committee • . .......... 63 Legislative measures imposing profit limi tations. 6k Second Revenue Act of I9M0 ......... 65 V CHAPTER PAGE Principal features..................... 65 Estimated yield......... ................. 70 Excess profits tax amendments of 19*+1. . * . 71 Principal features ............ 71 Retroactive effect •••••••••••• 73 Revenue Act of 19^1. ............. 73 Historical preliminary . . ................ 73 Amendments enacted . . .. ... .. .. . 73 Revenue Act of 19^2. . .......... 7b Historical preliminary ......... 7b Amendments enacted . . . .........••••• 76 Revenue Act of 19**3............... 78 Historical preliminary . . .••••••• 78 Principal changes. . * •••••••••• 79 Tax Adjustment Act of 194? 80 Revenue Act of 19^5* . . . . .. .. ... . 8l Revenue aspect •••••••••••••... 85 Introduction ••••• 85 Period 1917-1921................... 85 Period 19^0-19^5 ............. . 87 III. FISCAL PRINCIPLES OF EXCESS PROFITS TAXATION . . 90 Introduction ••••••... .............. 90 Purposes and aims of business taxation • • • • 93 Revenue purpose. • • • • . • •..............91* vi CHAPTER PAGE Introduction......... 91 * Meaning of adequacy and. stability, . . • • 95 The cyclical budget theory . . • . . . . . 97 Concept of cyclical .budget and excess prof its taxation ......... 99 Qualification, ..........................101 Social control.purpose 102 The levy of excess profits tax: revenue or control? 105 Fiscal, and economic bases for business excess profits taxation ...... 110 Theoretical bases for business taxation, • • 111 Apathy among students of public finance. • 111 StudensldL's proposals, . • • • • • . . . . 112 State partnership theory; its proponents, 115 State partnership theory: its opponents . 121 State partnership theory: reconciliation, 122 Impersonal ability theory. ... ........ 129 Conclusion . 132 The corporate entity: legal concept or economic fact? ..................... 132 Introduction to the problem. ............ 132 The changing concept of corporate entity • 135 Significance of economic entity. • • . . • 138 vii CHAPTER PAGE Judicial recognition of economic entity . . l*+0 Recent developments in corporate concen tration......... l*fl Conclusion. ............. 1^3 Principles of choice and apportionment with special reference to business excess profits taxation............... ....................lMf Incentive and taxation...................... 1M+ The concept of taxable, surplus. ........... I*f 6 The Hobsonian concept .. .. ....... lh6 Vasiliuk criticism . ... ........ 1^-8 Other proponents of a tax on surplus. . . . 1**9 Excess profits tax sis the tax.on surplus. • 152 The relative aspect of impersonal ability to pay tax. 153 Unresolved state of problem . ............ 153 Enterprise entity and impersonal ability to pay....................... 155 Distinction between personal and impersonal ability to pay........... 157 Relative impersonal-abilities to pay trans lated into different degrees of tax"effect on investment incentive ........... 158 Conclusion. ..................... 167 viii CHAPTER PAGE Taxation and corporate savings ........ 168 Introduction .......... 168 Retention of earnings during prosperity: opponents. . . .............. ...... 170 Retention policy: defending arguments . . . 172 Retention policy: reconciliation........... 172 Effects of dissaving during contraction. . • 175 Conclusion . 180 The importance of incidence study......... • • 183 Summary of conclusions ..................... 188 IV. THE THEORY OF NORMAL PROFITS AND THE RESIDUAL CLAIMANT THEORY OF EXCESS PROFITS. . . . . . . . 190 A review of the historical development of the general theory of profits. ........... 191 The classicists......... . ............... 191 Smith, Say, Mill, and Marshall . • . . • • • 191 Other theorists. .......................... 193 Walker.................................... 193 Clark and Schumpeter 191 * - Conclusion........................... 199 The risk theory of profits..................... 200 Hawley’s risk theory ............ ...•• 200 Criticisms of Hawley’s theory. .•••••• 202 Criticism of risk and uncertainty theories of profits in general..................... 203 ix CHAPTER PAGE Concluding illustration................... 205 The theory of normal profits................... 208 Marshall1s. theoretical contribution . • • . . 208 Importance of time. 208 Nature of a functional approach to normal profits................................. 210 The normal, long period. ........... 215 Quasi-rents and the short run ....... 219 Criticism of Marshall1 s theory of normal profits ................... ........ 220 Inadequate consideration of institutional changes ................. ........ 220 Marshall^ organization as an element of normal profits. •••••••..•••. 222 Defects in Marshall. 1 s “tools” of analysis . 230 Validity of theory as affected by statis tical findings............... 235 The factor of organization Cor firm entre preneurship) . . . • . « • • • •........... 2*40 Organization and Studenskf1s theory .... 2b0 Recent developments in theory of entre preneurship 2U -1 Recognition of organization (or firm entre preneurship) as factor occupying position of residual claimant. • «•••••••• 2k6 X CHAPTER ‘ PAGE A restatement of the concept of normal profits for purposes of excess profits taxation . * • 250 General . . . . .................. 250 Constituent elements of income attributable to owner-capitalist function, • • • • , • 251 Conclusion. . . . ............... . . . . 257 The explanation of excess profits under the residual claimant theory of firm entre preneurship . . • . • . . . . . . • . . . . . 258 The residual, claimant theory of firm entre preneurship and excess profits and excess profits taxation....................... 258 Imperfect competition •»•••.••.••• 260 Deviation of actual market conditions from theoretical .assumption of competition . . 260 Explanations of the emergence of excess profits ............ ........... 263 Advertising, product differentiation, and the diversity of conditions surrounding each seller ................ 263 Restraint of trade. •••••••••••• 265 Underpayments of factors. .••••.••• 270 Windfalls and other lucky events. . ♦ . . . 272 Various advantages. • • • . • • • ......... 273 Conclusion............................... 273 xi CHAPTER PAGE V. RISK, EFFICIENCY, AND EXCESS PROFITS TAXATION . . 275 Risk and excess profits taxation ... . . . . 276 Refutation of alleged adverse effect of excess profits taxation on risk-taking. • • 276 Argument based upon discredited risk theory of profits. • 276 Neglect of loss offsets and negative corre lation between size and risk. •••••. 277 Beneficial effect of loss offsets on risk- taking.............................. . . . 27S General discussion. . . . . ••••.•••••• 278 Scientific treatment of the effect of loss offsets on risk-taking. •••....•• 281 Necessity for improving the system of loss offsets ................ 287 The effect of size on risk-taking 289 General discussion: Knight*s view. .... 289 Statistical findings by Crum. ••••••• 291 Statistical findings by Butters and Lintner 296 Significance of statistical findings to theory of excess profits taxation • • • • 298 Conclusion................... 299 Efficiency and excess profits taxation. .... 299 The theoretical aspects of efficiency .... 300 xii CHAPTER PAGE The relative or differential aspect of effi ciency and efficiency profits .•••••• 300 Efficiency profits, like differential rents, not a part of cost of production........... 303 The effect of taxing efficiency profits • • . 306 Relative efficiency of large, medium-sized, and small business: statistical findings . . • • 307 Introduction. • ...•••••••••••• 307 Temporary national Economic Committee Mono graph Ho. 13............. 307 Fetter's explanation................ 309 Findings by Blair . •••••••••..•• 311 Other findings. ......... 313 Conclusion. ...................••• 315 VI. IHVESTED CAPITAL, STATUTORY RATE OF NORMAL PROFITS, AND OTHER TECHNICAL CONSIDERATIONS. ....... 316 Invested capital and its valuation. • ...... 317 The invested capital approach . ............. 317 First-year invested capital. . . . 321 The nature of the valuation problem • • • • • 321 Cost versus value: protection of vested interests— the problem •••..•••.. 321 * - Arguments against recognition of current value 325 Xiii CHAPTER PAGE More mitigating, factors . • ......... . . • 329 Theoretical and practical defects of cur rent value theory 331 * Cost versus value: elimination of discrim ination 337 Conclusion. • • • • . . ............... 3*f0 Invested capital after first year of tax. . . 3*+0 Two more arguments in support of cost valua tion. ................................ 3^-1 The use of current value incompatible with the residual, claimant theory of excess profits............................ . 3**2 Actual experience with the invested capital method based on cost valuation. . .... 3**5 Conclusion. .•••• ........ ...... 3^7 Contents of invested capital. ................ 3^7 Borrowed capital. .................. 3*+8 Rentor's capital. . ...........••••• 3^9 Preferred stock......................... 351 Accumulated earnings, and.profits or surplus 352 Intangible assets ........ ........ 356 Inadmissible assets. 357 The determination, of the. statutory rate of normal profits. ................... 359 xiv CHAPTER PAGE Introduction 359 Factors affecting derivation of statutory rate .••••••••••••••.••• 361 Effect of unlimited liability..............36I Effect of size of enterprise..............3&*f Effect of loss offsets ..................365 Risk and. the. statutory rate. ....... 365 Miscellaneous technical, considerations .... 366 Depreciation....................... 367 Accounting for depreciation based.on cost. 367 The economist’s challenge. . . . . • • . • 368 The replacement cost concepts the theory. 370 The.replacement cost concepts its defects 37^ The replacement cost concepts a temporary “final verdict". . . . . . . . . . . . . 386 The replacement cost concept and excess profits taxation • • • • ................ 388 Conclusion...................... 392 Percentage and discovery depletion ..... 393 Introduction..................... 393 The inequities of percentage depletion • • 39^ Practical remedies ....................... Uoi Capital gains and. losses •••...••.• *+©3 The problem **03 XV CHAPTER PAGE Arguments for excess profits taxation of capital- gains • . • . . .................. ^03 Relief........................ ..........- . if05 Accounting period and income averaging. . . . *+07 Accounting period • • • . . . . . . . . • • k07 Income averaging and loss carry-over com pared ............... U-08 Loss carry-over ..•••••.••••••• *+09 Loss carry-overs and loss carry-backs compared. •••••••••••••••• *+09 Length of carry-over period ..••••«• *fll The concept of adjusted loss. • ••.••• *+12 Composition of loss subject to carry-over . *+1** Conclusion............................. .. *+17 Specific exemption...........................**18 Reasons for flat income exemption.. .... *tl8 Recommendations. ......... ^21 Rate; structure.......................... **22 Revenue and administration.-................. I *2l f Revenue pfospect....................... b2k Administration ..•••••••.•••• k-25 Suggestions for integration ••••••••• **27 Technical superiority of excess profits tax over existing corporate income tax. . . . ^27 xvi CHAPTER PAGE Relation to Sec, 102 surtax............... . *+29 Withholding and credit of tax.. • • . ; . . • *+30 Unincorporated businesses .......... . . . *+31 Some important technical problems not fully discussed • ••••••••••••..... *+31 Owner's salary allowances for unincorporated businesses. • *+31 Consolidated return ................... **31 Relief................................... *+32 VII. THE INCIDENCE AND EFFECT OF A PERMANENT EXCESS PROFITS TAX................................ *+3*+ Introduction. ...... .......... *+3*+ The traditional theory of incidence • ...... *+36 Seligman's theory of incidence of a general income tax. ...................... *+37 Theory of tax shifting. • ••...••••• *+37 Nonshiflability of a general, income tax . • * *+38 Seligman's theory supplemented; the marginal unit argument • • . . . • • • • • • • • • • *+39 The demand side approach to the theory of incidence . . . ...... ¥+0 Effect on demand ignored in. traditional theory......................... ¥+0 Antonio de Viti de Marco's theory ...... *+*+1 xvii CHAPTER PAGE Synthesis........... ^3 Seligman's incidence of a partial, income. . . ¥+** Conditions for. shifting . . ............... W Black’s qualification . . . . . • . . . . . ¥*5 Explanations of the nonshiftability of the federal corporation income tax. . . • . • U46 A dissenting note on the demand side approach to the theory of incidence. ...•••••• M+7 Effects of a general income tax on demand and prices • •.••••••••.... M*7 Possible effects of an excess profits tax on demand and prices. .......... **50 Balancing effect of government expenditure of tax proceeds k-52 Conclusion. *+53 The incidence of a permanent excess profits tax M-53 A. The incidence of a permanent excess profits tax under conditions of monopoly and monopo listic competition. ••••••••••••• Definition of terms .................... ^5^ The market period ............ k-56 The market period defined . . ... . . . • b$6 Incidence in accordance with deductive analysis......................... **58 xviii CHAPTER PAGE Possible deviations ................ ...• ^59 Comments on possible deviations ....... h62 Other factors hindering tax shifting. .... *+66 The importance of the long-period view of -incidence . . . . . . . . . . . . . . . . . k69 Conclusion....................... ^70 The short period. .........................^71 The short period defined. ............... **71 Deductive incidence..................... b72 Possible deviations •••...•••••.. *+73 Comments on possible deviations . . . . . • . **7^ Effect of tax on advertising expenditures . • b75 Comments. •••.•••... .......... . . ^7@ The long period . . . • • • .............. V 79 The long period defined •...••••••• V 79 Deductive incidence ...................... ^81 Possible deviations ^83 Tax shifting brought about by the differences between legal and. * ' owner‘s'* valuation of invested capital.................. ^83 Comments on tax shifting due to valuation differences ..................... ^87 Valuation differences due to improved profit prospect. *+87 xix CHAPTER PAGE Mitigating differences between economic theory and tax practice................. ^91 A situation which needs remedy* ...... Other issues. • • • • . ............... k-97 Tax shifting., in.. case of income irregularity *f97 Long-run incidence: conclusion ...••• **98 B. The incidence of a permanent excess profits tax under competitive conditions. ...... *+99 The long-run effect of a permanent excess prof its tax .................... 500 Allocation of investment. 500 The volume of investment. ........... 502 Supply side considered alone. . ...... 502 Demand side considered. ••••...•.• 50*+ Conclusion ........ 505 The effect of a permanent excess profits tax on the investment incentive . ........... 506 Small business. ••••.•••••••••• 507 The problem . . . . • • . .... . . • . • 507 General effect of taxes on the formation of new enterprise. •••••.••••••. 508 General effect of taxes on expansions. . • • 510 The effect of our proposed tax on the for mation and expansion of small, growing business 512 XX CHAPTER PAGE Large business ...................... Jib Possible effect of tax on managements decision to expand. .. .. ....... 511 * Statistical findings of Temporary National Economic Committee Monograph No. 12. . . 5l5 Effect of our. proposed tax on management * s investment decisions • •••••••.. 513 The adverse effect of a permanent excess profits tax. . . . . . • . . .... • • 521 Effect of tax on investment decisions by investor .......... 522 Conclusion . . ......... 526 Final conclusion........... 529 VIII. SUMMARY. AND CONCLUSION......................53^ Summary of theory. 53** Theoretical.bases of permanent excess profits taxation . ......... 53^ The residual .claimant theory of excess profits......... 531 * The theory of normal profits 536 Fiscal basis for business excess profits taxation ........... 537 Principles of tax distribution........ 537 Summary of salient features of proposed measure............. 539 xxi CHAPTER PAGE Scope of tax................................ 539 Invested capital-............................ 539 Valuation............ 539 Exclusion of borrowed capital. ............ 5^0 Inclusion of preferred stock without fixed rate of return . • .......... Inclusion of common stock and/or “owner * sn capital. ................. 5*+0 Inclusion of accumulated earnings and profits. •••••••••••....• 5*+l Intangibles,............. 5^1 Inadmissible assets. ••• ••• .. .. • 5^1 Statutory rates of exempt normal profits . • 5*+l Income determination ••...•.••••• 5^2 Elimination of percentage or discovery- value depletion. ....... ........ 5^2 Capital gains and losses .••••••.. 5^2 Loss carry-over............... 5^-2 Specific exemption ......... -5^3 Rate schedule................... 51 *1 * Some technical problems, yet to be dealt with Salary allowances of proprietors, partners, managers, and officers ....••••• 5^ xxii CHAPTER PAGE Consolidated returns . . . . . ......... . . $kk- Relief..............- . • ................. 5^5 Conclusion . . « • • • • ....................... 5^5 BIBLIOGRAPHY........................... 5^0 CHAPTER I INTRODUCTION I. PURPOSES OF STUDY OBJECTIONS TO EXISTING CORPORATE INCOME TAX SYSTEM The doable taxation of corporate dividends. The scheme of the current federal corporation income tax provides for a separate impost on the net income of any business enterprise operating in the corporate form of organization as a taxable entity,'*’ distinct in existence in the eyes of the law from its stockholders or "owners•" This principle of separate entity of corporate income taxation was expounded by the United States Supreme Court in one of its epoch-making decisions, Eisner v. ■ Macomber, 252 US 1 8 9, 3 AFTR 3021: ... We must treat the corporation as a sub stantial entity separate from the stockholder, not only because such is the practical fact but because it is only by recognizing such separate ness that any dividend— even one paid in money or property— can be regarded as income of the stock holder. Did we regard corporation and stockholders as altogether identical, there would be ho income except as the corporation acquired it. ... 1 As a rule, the corporate entity will be respected in federal income taxation. Disregard of the principle of separate entity generally occurs when a corporation organized to hold title to real estate but not to conduct any business activity becomes a mere "dummy," the separate entity of which is obviously unreal or a sham. (Favmer v. Commissioner. 150 F. [2d] 33^.) 1 2 It is logical to argue from this premise that if the corpora- tion and its stockholders are considered separate .taxable entities, the latter must be treated throughout the same scheme of income taxation as occupying the same "outsider1 * position with respect to the former as any contractual credi tor who possesses no equity status. Unfortunately, this is not the case. One of the most glaring theoretical inconsist encies of the federal corporation income tax is found in the statutory nondeductibility of corporate dividend payments for purposes of the computation of corporate net income subject to the tax. If interest expense is deductible and under the tax ing scheme the stockholder is generally regarded as an "out sider" as any creditor entitled to interest payments, dividends paid to the former, to be consistent, must also be deductible. The disallowance of these latter payments is theoretically indefensible. .Besides being inconsistent with the principle of separate taxable entity, it, in collaboration with the pro visions of the individual income tax, subjects the same cor- 2 porate income to the evils and inequities of double taxation. ^ Ironically, the United States has negotiated tax con ventions with various countries on both the American and European continents with the specific purpose of avoiding international double taxation, but one of the most flagrant forms of double taxation has been allowed to persist in her domestic economy for years and has successfully resisted all efforts at its eradication. The modern growth of giant corporations has further accentuated this inequitable and anomalous situation. Owing to the divorce of ownership and control, the numerous small stockholders are being relegated farther and farther into the unenvious position of the lowest class of corporate ‘ ’creditors** without any ves tige of their so-called “ownership** remaining. Under these circumstances they are not only theoretically but actually the “outsiders* 1 in every sense of the word. And under these cir cumstances to disallow to the corporation the deduction for dividend payments seems nothing short of unjust expropriation. The results of double income taxation of corporate divi dends are many and varied. One of them lies in the discrimina tion against equity financing. A practical effect of this discrimination is the promotion of credit financing. The fixed charge for interest on corporate earnings resulting from debt financing, however, has been viewed as a contributing factor of economic instability. From the point of view of public policy and sound business operation, equity financing is to be pre ferred over creditor capital. To the extent that it does not conform to this policy, the existing federal corporate income 3 The argument that double taxation of corporate income is effectively counterbalanced by the fact that the corporation income tax is shifted to the consumer in the form of higher prices of products is unconvincing in view of statistical findings to the contrary. (For source, see infra. Chapter VII, pp. Mfo-Mt-7. tax is deficient. The more technical relation between the double taxation of corporate dividends and the Section 102 surtax on corporations improperly accumulating surplus will not be examined in this introductory chapter. Suffice it to say that Section 102 of the Internal Revenue Code is another provision which, in its practical application, generally favors the large corporation and is extremely harsh on the small, close corporation. Other theoretical and technical weaknesses. The federal corporation income tax is also deficient in respect of its promiscuous taxation of all corporate income either without distinction between the portion of profits which is economi cally necessary to the maintenance of investment and produc tion and that which is not or without regard to the varying degrees of the ability of the taxable corporations to pay and bear the tax. The existing tax structure produces a tax effect that is exactly antithetical to what has come to be labelled as just and equitable distribution of the tax burden. The super normal and monopoly profits of the giant corporations are taxed at the same combined normal-tax and surtax rate of 38 per cent as the normal and necessary profits. Profits of small corpora tions falling within the income bracket between $2 5 ,0 0 0 and $50,000 are subject to a combined normal-tax and surtax rate of 53 per cent if their over-all profits do not exceed $50,000. The incentive of small corporations to seek profit 5 increment within the income bracket between $25>000 and $50,000 will therefore be diminished more (by some 15 per cent) by this differential taxation than that of large corporations to aug- i f ment their earnings at any point. The unequal taxation of small, close corporations and unincorporated business enter prises is another fruitful source of inequities, which the inept Section 102 surtax on surplus unnecessarily accumulated cannot be expected to deal with adequately. If distributive justice remains as it does, the criterion of the equitableness and the desirability of any tax measure, the federal corpora tion income tax is urgently due for an immediate overhaul. THE EXCESS PROFITS TAX The superiority of the excess profits tax. It is the opinion of this writer that in any future Congressional attempt at federal business tax reform the excess profits tax will command the closest attention of and deserve the most thorough study by the lawmakers who are entrusted with the task of reform. Following are some of the reasons for such an opinion. With respect to the taxation of corporate income, the excess profits tax exempts the normal profits necessary to the stimu lation of investment incentive. Theoretically, there should ^ The condition that total profits of the latter exceed $50,000 is implicitly assumed. be a consistent and commensurate relationship between dividend payments and exempt normal profits under normal competitive conditions. This exemption, it can be easily seen, satisfac torily resolves most of the problems connected with double taxation of corporate income. Besides, it also facilitates progressive taxation of the higher reaches of corporate profits without any unduly adverse effect on the all-important 5 investment incentive. The excess profits tax, as was in force during the last world war, bids fair to provide the final key to the problem of the taxation of corporate savings. Since the emergence of excess profits has no regard for the form of organization under which the business enterprise may be operated, the excess profits tax may yet be made a univer sal business tax, which, if properly designed, can eliminate most of the instances of unequal taxation of incorporated and unincorporated enterprises. Its permanent adoption, inciden tally, will recapture for the state some of the higher average profits existing in certain segments of the economy, which arise from the very monopolies and monopolistic practices the government, with legislative mandate, has been unable to extir pate for more than half a century. ^ We will show in a following chapter how the varying tax effects on the investment incentive may be translated into a conscious distribution of the tax burden according to the varying degrees of the ability of the taxable enterprises to pay tax. (See infra. Chapter III, pp. 158-167. ) The lack of a systematic treatment of the theoretical bases for & permanent excess profits tax. Despite this superi ority of the excess profits tax, there has never been any seri ous attempt, legislative or otherwise, to press for its adoption as a permanent part of the federal system of business 6 taxation. Its usefulness has been confined strictly to peri ods of sudden and unforeseen exigencies, such as in times of war. It is generally accepted that war excess profits were largely fortuitous and unearned in nature and their taxation was justified on the ground that enormous profits should not be allowed to inure to the benefit of a few individuals when the events that had brought about these profits demanded common sacrifice. But this writer contends that excess profits that emerge in many business undertakings in peacetime partake of the same elements of fortuity and unearned increment. What is, in view of the economic consequences, vastly more important than gains of an aleatory nature may be found in the excessive profits made by certain business and industrial enterprises, the operations of which are characterized by monopoly and 6 Representative Kitchin. Chairman of the Committee on Ways and Means, was attributed by Thomas S. Adams to have attempted to make the excess profits tax, as enacted by the Revenue Act of March, 1917> a permanent measure of the federal tax system. (Thomas S. Adams, “Should the Excess Profits Tax Be Repealed?*’ Quarterly; Journal of Economics. XXXV [May, 1921], 36^-365. ) 8 monopolistic practices, i f f l i y these monopoly profits should, in general, be taxed in the same manner as ordinary competitive business profits in a supposedly free enterprise system is hard to explain. If public utilities should be subject to profit-limiting regulation because of their tendency toward monopolization, there are really very few convincing arguments for not imposing similar regulation on industrial and business monopolies through differential taxation. In the pre-1929 era the requirements of industrial and economic expansion might have rendered it inadvisable to use excess profits taxation as a means to get at such monopoly profits. But we are now faced not with the expanding situations of the pre-depression days but with a relatively mature economy of the post-depression and the postwar era. Expansion and growth in a mature economy are apt to take the form of economic concentration and inte gration which are conducive to more and greater monopolies and more and greater monopoly profits. As concentration of 7 economic power grows in intensity, it becomes increasingly clear and indisputable that it is inequitable and economically disastrous to tax competitive normal profits at the same rate Q as monopoly profits, if the free enterprise system is to 7 See “The Giants,” Time. LIV, No. 10 (September, 19*+9) > 53* ® See supra, pp. *+-5* 9 survive. A tax scheme must be found which will tap monopoly profits at higher rates and yet spare competitive normal prof its by either taxing them at lower rates consistent with tax justice or exempting them. There may be as many such schemes as human ingenuity is capable of devising, but as matters stand now, a permanent excess profits tax, in the opinion of this writer, affords the best solution to the problem of taxa tion of monopoly profits. The proposal to employ the excess profits tax as a means to get at monopoly profits is not new. Haig suggested the excess profits tax as a means to recapture monopoly prof- 9 its in 1920. Shoup drew up a detailed scheme of such a tax on monopoly profits in 1937»1G Harriss had made suggestions along the same line."*"1 ' These authors, among others, proposed the excess profits tax as a means of tapping monopoly profits 9 ' Robert Murray Haig, ' ’The Taxation of Excess Profits in Great Britain,” American Economic Review. X, No. b, Supple ment (December, 1920), 17H~17i>. ^ Carl Shoup, et &1., Facing the Tax Problem (New York: The Twentieth Century Fund, 1937), 271-290. For a review of this work, see infra, pp. 27-32* Lowell Harriss, “Monopoly and the Excess Profits Tax,” TaxesT XVI, No. 12 (December, 1938), 717-720 and 7^1-7^. Harriss* approach to taxation of monopoly profits is similar to that of this writer, for he remarks that the difficulty of eliminating monopolies may be so great that “the anomalous policy of admitting their existence and sharing the fruits may offer an expedient course of action.” (Ibid.. p. 717*) 10 only, not as a punitive measure to eliminate monopolies or monopoly profits. But these proposals went unheard. There have been doubtless many reasons why the excess profits tax has been looked upon as being a punitive measure only, erratic and unorthodox. One of the reasons, this writer firmly believes, lies in the lack of a consistent theoretical basis or justification for the peacetime adoption of the tax. When the layman or the business man thinks of the excess prof its tax, its apparent moral and ethical implications immedi ately present themselves as being the normal considerations for resorting to it. Haig and Shoup1s approaches to excess profits taxation of monopoly profits stem unmistakably from the point of view of social control and/or the taxation of undesirable or unearned gains. This writer is of the opinion, however, that there must be something more to excess profits taxation than a pure ethical approach. The modern institu tional changes in the corporate world resulting in' the emer gence of the large corporation have brought about certain fun damental modifications of the traditional concept of profits. The fact that the institution of the large corporation tends to perpetuate monopoly or excess profits has been recognized as having rendered the Classical theory of profits inappli cable to the existing economic setup. A new theoretical approach to excess profits taxation must, therefore, be for mulated to explain the altered economic relationships under the new institutional setup. It is in such altered economic relationships that one may find a new theoretical basis for the imposition of a permanent peacetime excess profits tax. ' But until such a basis is formulated, the moral and ethical character of excess profits taxation will remain to color any objective approach to it. PURPOSES OF STUDY In view of the foregoing discussion, the purposes of the present study should be clear without much elaboration. Briefly and in outline, they are: 1. To propose a reformulation of the theoretical bases for permanent federal adoption of the excess profits tax as an exclusive tax on business enterprise in the light of the changed concept of profits. 2. To propose a new explanation of the concept of normal profits and of the emergence of excess profits within the confines of acceptable explanations of the phenomenon of profits, alternative to that of the Classical School, for pur poses of the reformulation as stated in 1 above. 3. To answer the fpllowing charges of alleged weak nesses of the excess profits tax, as advanced by its opponents a. Theoretically, the tax encourages wastes, discourages efficiency, penalizes risk, stifles busi ness growth, and discriminates against big business. 12 b. Administratively, the tax is impossible of successful administration on account of the “insurmount able1 1 difficulties in the segregation of normal from supernormal profits, in the determination of invested capital, and in the derivation of an equitable rate of exempt normal profits. II* CHAPTER ORGANIZATION A brief description of the subject matter treated in each of the seven remaining chapters of this work follows: Chapter II is devoted to a short historical resume of federal excess profits taxation during both world wars. The necessity for this resume is obvious, for the theoretical and technical discussion to follow has, as its background, most of the levying provisions of the repealed excess profits tax, as enacted by the Second Revenue Act of 19^0 and amended by almost every intervening revenue measure prior to its final repeal by the Revenue Act of 19^5• And the excess profits tax measure as enacted by the Second Revenue Act of 19**0 was closely patterned after the earlier levy during World War I. Further more, the outline of the permanent excess profits tax to be proposed hereinafter corresponds closely to that of the repealed measure. To avoid unnecessary repetition of legal provisions which must be familiar to most students of excess profits taxation, this resume is considered useful. 13 In Chapter III an attempt is made to reformulate the fiscal basis for a permanent federal excess profits tax* Included in the discussion are the fiscal objectives and aims of business taxation, the exposition of the state partnership and the impersonal ability theories as the theoretical bases for the imposition of a business profits tax, the principles of tax distribution with special reference to excess profits taxation, and the importance of the incidence and effect of a permanent excess profits tax. This writer attempts in Chapter IV to modify Marshall's concept of normal profits in the light of institutional changes in the modern world. In the process a new concept of firm entrepreneurship and a new factor of production, organi zation, are utilized to explain the proposed residual claimant theory of excess profits, the emergence of which Marshall's concept of normal profits does not contemplate. A refutation of the oft-repeated contention that an excess profits tax penalizes risk and efficiency is attempted in Chapter V. Both theoretical arguments and findings of statistical studies are introduced to drive home the point that the contention is but a general and vague one and the discriminative features of a well-designed permanent excess profits tax will enable the tax authorities to tap those por tions of profits to the earning of which risk and efficiency contribute very little and spare those earned as a result of Ik risk-taking and efficiency. The discussion of some of the most important technical problems involved in the actual designing of an excess profits tax measure forms the subject matter of Chapter VI. It includes the valuation of invested capital, the determination of the statutory rate of exempt normal profits, depreciation, percentage depletion, capital gains and losses, loss carry over, specific exemption, rate structure, revenue and adminis tration, and suggestions for integration with existing federal corporation income tax. To be an exclusive tax on business, the excess profits tax must possess such inherent qualities as to be able to resist the economic processes of tax shifting and Chapter VII endeavors to show that on the whole, the burden of a permanent excess profits, designed in accordance with the technical prin ciples as expounded in Chapter VI, is relatively nonshiftable and therefore rests with the taxable enterprise on which it is intended to rest. The last chapter summarizes the theoretical discussion made and conclusions reached thereinabove, gives an outline of a practical measure of a permanent excess profits tax as pro posed by us, and contains this writer's final thought conclud ing the study. 15 III. A CRITICAL REVIEW OF RELATED STUDIES Three of the more complete proposals of peacetime excess profits taxation will be extensively reviewed in the remainder of this chapter. M. H. GGPAL'S THE THEORY OF EXCESS PROFITS TAXATION12 Introduction. The most comprehensive and thorough treatment of excess profits taxation from the standpoint of the traditional theory of the tax and from that of practice is contained in Gopal*s book, the manuscript of much of which was completed in 19^1 > but which was not published until 19^7 because of the "exigencies of public service" required of the author during the last war. The book is divided into two parts. Part I deals with the historical background of the excess profits tax in various countries; the theoretical basis of the tax; a statistical account of profit trend as prevail ing in India, the United Kingdom, and the United States of America to prove that there exist profits above normal for the tax to get at over a period of time; the practical determination 12 M. H. Gopal, The Theory of Excess Profits Taxation CVanivilas Mohalla, Mysore, India: Bureau of Economic Research, 19^7)• This writer's attention was called to the appearance of this book in September, 19^8, but it was not Until a year later, after almost all the remaining portion of this work had been written, that he first had access to a copy ordered from India. Portions of this work have been rewritten to admit some of Gopal's arguments into the text. of the taxable excess; and the effects of the tax. Inasmuch as a theory of profits constitutes an indispensable point of departure for any tax on business profits, it is regretted that a chapter on the concept of profits was not included on account of publishing difficulties. Part II contains an exclu sive description of the Indian model of the excess profits tax, its history, structure, administration, and fiscal and economic consequences. It is Part I, especially the chapters dealing with the theoretical aspects of the tax, that we are primarily interested in. Theoretical basis for excess profits taxation. The basis of the excess profits tax, according to Gopal, is founded upon the principle of excessivity which is itself derived from an extension of Hobson’s analysis of income into ’ •costs” and ”surplus*” Thus, income may be split up into three distinct parts: costs, normal return, and excessive gains. Following the dictum of a German writer, Gopal*s justi fication for any tax based on such excessive gains is that it merely restores a part or the whole of a surplus to the society that is never actually the property of the owner, but that, being socially created, because it is not traceable to the efficiency of the gainer, is socially owned. From the very start the primary purpose of the excess profits tax is con sidered ethical, being an instrument of social control to rid 17 the society of the anti-social excessive profits above a norm that recognizes not only marginal returns, but elements of differential rents attributable to intramarginal factorial units as being the constituent elements of the ‘ 'normal 13 return.*1 Among the causative factors of excess profits are reckoned abnormal gains or windfalls, monopoly, and monopsony. The principle of progressive taxation is retained as applicable to excess profits taxation on grounds of adminis trative convenience and revenue productivity, not on the traditional basis of ability-to-pay. **If and so long as progressive rates can be applied and made a success adminis- 1*+ tratively, the excess profits tax should be progressive.** Gopal*s emphasis on the social standpoint in taxation led him to the belief that the excess profits tax has for one of its main objectives the diversion of investment, enterprise, and economic activity in general in directions more desirable to the community. In an economy of planned production and cen tralized control the destiny of the excess profits tax is thus clear. Scope of tax. By and large only excess profits airising 13 Ibid.. p. bb. Ibid., p. 57. 18 from business operations are taxed. “Profits are a special kind of income associated only with business and consequently 15 the tax can be levied on businesses only.** But farming, the professions, and the rentier class are exempt from the levy largely on grounds of administrative difficulties. Unincor porated business and co-operatives are brought within the scope of the tax. The factor of size is considered mainly from the size of net profits. Determination of the taxable excess. The exempt norm may be computed under two methods, according to Gopal, each with several minor variations and modifications to suit the circumstances. They are the income and the capital standards. To achieve the ethical purpose and the social objectives of the tax, the capital standard is preferable to any other. Normal profits are determined under three heads or in accord ance with three factors: the basic rate, the standard rate, and the effective rate. The basic rate is determined by the aid of the prevailing rate of interest and the average rate of industrial profits and is the irreducible minimum for any enterprise.^ The standard rate seems to be the basic rate 17 adjusted by considerations of the risk factor, social 15 Ibid.. p. 127. 16 Ibid.. p. 153. ^ Ibid., pp. 161-16**. 19 desirability in stimulating certain patterns of occupational 18 development, discrimination against foreign ownership and 1 9 control, ' and miscellaneous other grounds for discrimina- 20 tion. Thus tempered, the standard rate is said by Gopal to provide "for flexibility between types of business or 21 regions.*1 The effective rate, which is the rate applicable in practice, is the standard rate times efficiency,'which is 22 objectively expressed by the coefficient, 0/1, where 0 represents the gross money sale value of the main and sub sidiary products of the factory and I equals all the invest ment of business in the unit under consideration.2^ Thus determined, the effective rate is said by Gopal to provide "for entrepreneurial flexibility i.e., differences in the abilities of the different entrepreneurs and in the efficiency of the individual concerns, so characteristic of business and ok so important for progress.n* - 18 Ibid. 19 Ibid. 20 Ibid. 21 Ibid. 22 Ibid. 23 Ibid. 2)+ Ibid. pp. i6b~i65* p. 1 6 5. pp. 166-1 6 8. p. 1 5 3. (Italics in the original.) p. 173* p. 172. p. 153. (Italics in the original.) The next step is the determination of invested capital. The basis of the capital standard is the quantum of capital employed in the business on which the normal effective rate of profits is to apply. The problems connected with the determination are divided by Gopal into three categories: (1) the constituents of invested capital, (2) the initial valuation of capital investment, and (3) subsequent capital increases and decreases. The over-all approach to the con stitution of invested capital takes the liability side of the balance sheet as the proper point of reference. Borrowed capital is to be included in invested capital on the theoreti cal principle that “there is no ground whatever to discriminate between owner's funds and borrowed money." x Administratively, Gopal continues, "not only is it impossible to distinguish accurately between the owner's funds and loans but it is 26 unnecessary." As to valuation, the current appraisal method, the reproduction cost method, the last transfer method, the capital addition method, and the cost of investment method are considered, but Gopal does not seem to this writer as having made a choice among the aforementioned alternative bases of valuation. 25 Ibid.. p. 1?8. 2^ Loc. cit. 21 Miscellaneous considerations. Under the heading of “Taxable Profits'1 are examined the following technical prob lems, among others: annual versus average profits, provision for other taxes already paid, losses and set-offs, deprecia tion, depletion, and capital gains* The effects of the tax. As to the effects of the tax, the discussion is pursued under three heads: prices, produc tion, and planning. Normally the excess profits tax, without an exception, cannot be shifted through price increases pro vided the normal profits allowed are reasonably high. Experi ence with the tax in Great Britain, India, Canada, and the United States of America has, according to Gopal, verified its nonshiftability. Production will not be affected adversely by the tax, inasmuch as a less than 100 per cent tax will not impair efficiency, discourage risk and enterprise, and throw out of balance savings and investment* The discussion under the topic: the excess profits tax and planning, seems not to aim at a treatment of the effect of the tax, per se, but as an argument for the employment of the tax as an instrument to implement state planning. 4 critical comment. Gopal's treatment of the theory of excess profits taxation represents the most comprehensive and consistent treatment of the theory of the excess profits tax that this writer has come to know. Almost all articles in noted economic journals that touch upon the subject found their way into the text* As far as the contents go, the book conveys the impression, to this writer anyway, that virtually all known aspects of the theory of excess profits taxation have been examined and little, if any, remains to be investi gated. This is not to say, however, that Gopal has succeeded in resolving all the difficulties of the tax awaiting its designer and administrator. Theoretically speaking, Gopal has not succeeded in establishing a theoretical basis for a separate excess profits tax on business. Inasmuch as enterprises are owned and oper ated by individuals who may have other sources of ineome, the failure to establish a special ground for taxing the owned enterprises cannot insure the excessivity of the aggregate profits when the owners’ other income and losses are taken into account. Even from the standpoint of ethics, which Gopal stressed as being the foundation of excess profits taxation, there exists no reason to disregard the owners1 other profits and losses. He came near to establishing such a special and objective basis when he stated that excessiye gains, not traceable to the efficiency of the gainer, are socially owned. But since he ruled out the concept of benefit as a possible basis of the excess profits tax, his reasoning that excessive profits are owned by the society amounts to a dictum or asser tion which springs more from ethical than from theoretical 23 considerations. It is he himself who maintained that the principles of maximum social welfare, redistribution of wealth through taxation, and social control are rooted in ethical con siderations. His prepossession with ethical or subjective aspect of taxation must have prevented him from evolving an objective basis for business excess profits taxation. Thus, he glossed over one of Hicks1 objections to the tax that l , on grounds of equity, a progressive excess profits tax overlooks ability to pay [apparently of the owners of the enterprise].”^ One can see without much difficulty that the concept of benefit, if not rejected, provides the necessary justifica tion for the society or the state to demand a share of the excessive private gains and saves us from having to resort to ethics to justify social ownership of excess profits. Gopal*s rejection of the benefit principle is based on Seligman*s argu ments that (1) even if the benefit theory interprets correctly the relations of the individual to the government, the bene fits conferred by the government on individuals do not stand in any such relation to either property or to income and .(2) if the special benefit to the individual is separately calculable, the thing that we are dealing with is not a tax at all. Gopal*s final conclusion in this respect wavers between full acceptance 27 Ibid., pp. 55-57. 2b of the benefit theory and Seligman's rejection of it. He suggested that though there are elements of benefit in excess profits, he yet believed that benefit is not the basis of the excess profits tax. Seligman’s abandonment of the benefit concept, however, seems to involve a confusion of the theoretical basis for levying an excess profits tax with the principle of tax dis tribution. In our complicated modern society tax distribu tion certainly should not be based upon the benefit principle, even if that could be done. But the benefit concept, especi ally the state partnership variety of it, does form a theoreti cal basis for imposing a permanent business excess profits tax. It was Seligman who stated that the benefit theory interprets correctly the relations of the individual to the government. There is nothing in this statement to suggest that the same benefit theory also interprets correctly the relations as exist among individuals and enterprises. It is the fiscal or economic relations of the individuals and business enterprises to the government, as defined by the benefit theory, that form the rational basis for the latter to impose taxes on the former. But it is the economic relations among individuals and between and/or among such individuals and business enter prises, which relations the benefit theory does not define, that provide the secondary basis upon which the government apportions or distributes the tax burden among the various 25 taxpaying units* As soon as the basis for levying a tax is distinguished from the criteria of justice in tax distribu tion, even the ability-to-pay principle which Gopal ruled out as having no place in excess profits taxation should be allowed 28 to exercise its own right* Gopal’s neglect of extensive institutional changes in the corporate system of business conduct occasioned by the emergence of large corporations is understandable, for in the Orient, as a rule, such changes have not taken place. Still, the failure to establish firmly the separate entity of the enterprise, as distinct from its owners, led to an incomplete recognition of such entity as evidenced by the inclusion of borrowed capital for invested capital purposes. In principle, according to Gopal, there is no ground to discriminate between owner’s and creditor’s funds. In practice, however, if we compute the excess profits from the point of view of the owner, it is the actual profits that remain with him after all interest and expense deductions that are relevant to our compu tation. Since the contractual rates of interest are usually lower than the statutory rate for purposes of excess profits ^ According to Gopal, ’ ’ Ability ... is the test for an equitable distribution of the burden of taxation between individuals.» This test can easily be extended to tax-dis- tribution among business enterprises. (Ibid., pp. 61-62. Italics in the original.) 26 29 taxation, the amount of profits remaining with the owner on account of the inclusion of borrowed capital for invested capital purposes will be more than the exempt normal profits, or the statutory rate times the computed invested capital including equity capital only. If the actual rate of inter est is higher than the statutory rate, inclusion of borrowed capital will yield to the owner a less than normal return.^0 If the object of taxation is the separate enterprise entity, it is the profits that remain with the enterprise after the exempt normal profits that are relevant for excess profits tax purposes. Those profits can be obtained only by the allow ance as deductions of interest paid to the creditor and the exempt normal profits eventually to be, if not already, paid over to the owner. If interest is normalized, the actual profits remaining with the enterprise will either exceed or Ibid.. p. 157. For India, the average bank rate from 1918 to 1939 was never higher than 7 per cent and the same holds true in respect of interest rates on municipal loans. Interest rates on government loans were even lower. If we carry the theory of “norm1 * to its logical conclusion, we may have to use normal wages instead of actual wages, normal supply prices of materials consumed in produc tion rather than actual prices, and normal expenses instead of actual expenses, to arrive at the normal cost of produc tion. This procedure will be absurd. It is therefore equally illogical to insist that interest on borrowed capital must be normalized. In theory as well as in practice, there is no difference between wages, costs, expenses, and interest, all going to the outside factors of production, from the point of view of the owner (or enterprise). 27 fall short of the residual profits, properly computed, by the difference between the contractual interest payment and the statutory rate times borrowed capital included in invested capital. It is conceivable that in the absence of any properly designed system of loss carry-over or carry-back there might be a need for normalizing Interest* With such a system incorporated into the tax measure the need for the normalization of interest is largely eliminated. The only way out of the dilemma created by this “half-heartedM recog nition of the separate entity of the taxable enterprise lies in a reformulation of the concept of entrepreneurship to be based upon institutional grounds so as to permit the equating of excess profits with residual profits* We will attempt such a reformulation in a subsequent chapter. PROPOSAL BY CARL SHOUP AND ASSOCIATES Introduction. In Chapter 19 > headed “Taxation of Socially Undesirable Gains,’ ’ of the well-known work of research, •si Facing the Tax Problem. Carl Shoup, research director, and his associates (hereinafter referred to as Shoup) propose a permanent excess profits tax on all excessive profits. The tax is to be levied for purposes of social control. 31 Shoup, et £l., o£. cit., pp. 271-290 (and pp. 555 - 561). 28 Impersonality attributable to the unearned nature of excessive gains constitutes the one outstanding characteristic of the measure, The concept of 1 1 excess” and its relation to ' Must price.1 1 The concept of "excess,1 * according to Shoup, is extremely elusive and difficult to define both in theory and in practice. To some extent the emergence of excessive profits is said to be dependent upon the prices charged by the taxable concern for its products. Thus, the concept of "just price" is directly related to that of "excess." As a corollary, excess profits taxation is in some ways an alternative to price fixing. For example, if rate regulation of public utili ties fails to prevent excessive profits, an excess profits tax may be used to reduce them. Monopoly powers T monopoly profits. and excess profits taxation. Monopoly power refers to the ability to exercise sufficient control over supply to set higher prices and reap higher profits than are needed to induce production. A sub stitute term for "monopoly" is "imperfect competition." Monopoly powers, however, do not always result in apparent excess profits. Sometimes all that results is the prevention of heavy losses from competition. Sometimes the benefits accrue to the firm in the form of normal profits on excess capacity. Another possible variety is a higher average profit over the duration of the business cycle without an apparent excessive profit during any one period. The obvious existence of monopoly powers, therefore, may not inevitably mean that monopoly profits exist on a scale wide enough to make an attempt at excess profits taxation advisable. As a result, the monopoly aspects of excess profits will not be made the sole guide-post in the drafting and application of the excess profits tax law, though they will exercise great influence. Scope of business unit taxable. All income from capi tal provides the proper reference for the application of the tax. Separate business enterprises operated by the same individuals will be taxed separately and no combination is permitted by Shoup so as to allow the loss of one to offset the profits from the others. Nonbusiness assets, such as low-yielding securities purchased with surplus cash of the business, the personal funds of the enterpriser, or borrowed money, must be excluded from invested capital to prevent tax avoidance. The administrative difficulties in this respect are considerable, especially when the business is unincor porated. Inclusion of capital entitled to only a fixed return. If the proprietors are making excessive profits on their own capital contribution, considered separately, a merging of their proceeds with those of the creditors and preferred stockholders entitled to only a fixed return will, according to Shoup, reduce the average rate of profit subject to tax, thus defeating the purpose of levying an excess profits tax. But if the chief purpose of the tax is to obtain a portion of the monopoly profits for the government, the entire amount of invested capital, no matter who the contributors are, is the significant factor. This comes about through the recognition of the complete impersonality of the tax. However, the prin ciple of impersonality may be relaxed somewhat when inflation ary gains are the chief target of the levy and the case for the inclusion of only common stock is strengthened. Length of accounting period. The tax measure should provide for the offset of fluctuating income and losses of the taxable concern over the years. For this reason, among others, the net income figure obtained under the then current income tax law, Shoup continues, is unsuited for use in an excess profits tax.* This does not mean, however, the prolonga tion of the taxable period beyond the customary accounting year for taxation purposes. The government cannot postpone demand for payment until the concern’s production cycle or even its life ends. Determination of invested capital. To develop a con ception of excess that will prevent avoidance of the tax 31 through the writing-up of invested capital by way of capitali zation on the value of the monopoly privilege is one of the chief tasks of the proponents of excess profits taxation, Shoup maintains. Past records of the concern may be used to ascertain the cost of invested capital originally committed to business. Difficulties arise, however, on account of the length of time to be covered by the ascertaining process, the lack of records, capital contribution in kind, and the neces sity of ascertaining loss of capital through depreciation, obsolescence, et cetera. The fluctuating price level may cause the invested capital figure to vary from one concern to another depending on the time at which each happened to acquire its assets. The surest way to avoid including in the first valua tion something that should not be there, according to Shoup, is to make an inventory of all the assets of all the business firms as of the day when the tax is initiated. Cost of repro duction new, less depreciation and obsolescence, would presum ably be the basis of the valuation, with such provisions for eliminating the influence of changes in price levels as might be desired. The magnitude and difficulty of the task are admittedly great. The other way is for the authorities to wait for a number of years before the imposition of the tax so that in the meantime data may be gathered for the eventual introduction of the tax. In no case should adjustment be 32 allowed for any capital element that represented the monopoly privilege or any other profit source that it was intended to tax. Fair-return percentage. A strong case, argued Shoup, can be made for varying the capital return percentage from industry to industry according to risk involved and, indeed, from firm to firm within an industry. Tax rate. A 100 per cent rate is not recommended for the reason that there may be errors in administration or failure of the levying provisions to allow for unusual eases which may result in ruining the business enterprises affected. An undesirable effect on business initiative and other economic incentives may be engendered by a 100 per cent rate. A graduated rate scale may be justified because excess profits cannot be separated from fair profits with complete accuracy. Because of the chance of error, the rate that is levied close to the hazy dividing line might be made more moderate. 4 critical comment. Despite the attempt to play down the monopoly aspect of excess profits taxation, the proposed permanent excess profits tax is aimed at monopoly profits as its principal target. To make a permanent tax worth the difficulties of its administration, it must be directed at something which will assure greater stability of revenue over 33 the business cycle than windfall gains. The main concern of Shoup, et &!•, is unmistakably to prevent the designing of an excess profits tax measure which will allow monopoly profits to escape the tax. The criticisms with respect to Gopaks approval of the inclusion of borrowed capital in invested capital apply here also. Shoup’s distinction between monopoly and inflationary gains does not affect the validity of our criticisms. To allow the revaluation of business assets on basis of reproduction cost new less accrued depreciation for the first year of the tax under the existing rules of income taxation would result in taxing such capital appreciation (not including adjustments for the monopoly privilege) for that year either under the income tax or the new excess profits tax. The tax disadvantage for that year might be great. The appraisal might be expensive, unreliable, and time-consuming. WILLIAM ED WAHL BUTT’S A PERMANENT EXCESS PROFIT TAX32 Introduction. Buttes A Permanent Excess Profit Tax represents one of the first, if not the first, major attempts at analyzing the possibilities of a permanent exclusive tax 32 William Edward Butt, ”A Permanent Excess Profit Tax.” (an unpublished Ph. D. dissertation, Yale University, 1931). on windfall profits* His study does not encumber itself with an inquiry into the fiscal principles of imposing a business excess profits tax, the effect of institutional changes on the theory of business taxation, and the concept of normal profits, which is generally considered the point of departure for a study on excess profits taxation. Instead, he approaches his problem by going straight to the method of measuring excess 33 profits with a comparatively short discussion of the possible explanations of excess profits. We will review briefly in the following Butt's explanation of the causal factors of excess profits, their measurement, and both his ''ideal** and his practical system of a permanent excess profits tax. Our criticism will be blended with the review as we go along. Explanations and measurement of excess profits. Only three probable causes of excess profits are discussed, though the author takes cognizance of the fact that there are also other causal factors giving rise to excess profits. The three he discusses are uncertainty, managerial superiority, and strong bargaining position. But the windfall element of 33 As will be seen below, the method used is similar to the net worth method used by accountants as well as revenue agents nowadays when the condition of the records does not permit an accurate determination of net income by ordinary accounting and auditing procedures, except that current value, rather than the cost, of beginning and closing net worths is used. excess profits is attributable to the uncertainty factor only, for the gains of one party to the transaction arising from superior management and strong bargaining position are strictly in proportion to the losses of the other party to the same transaction. This line of reasoning is inconsistent with Butt’s principle of the taxable entity of the venture. If the venture is considered the unit of taxation, the compu tation of excess profits must be made with reference to that unit venture only without consideration of the profits or losses of other ventures. From the point of view of the society, no net excess profits may result from the superior management and strong bargaining position of a few ventures, but from the standpoint of the taxable entity of the individ ual venture, superiority of management and strong bargaining position do give rise to excess profits just as much as does uncertainty. The sudden shift from the point of view of the taxable venture to that of the society is hard to 'explain. Passing over this theoretical inconsistency, we find that even excluding from the category of excess profits gains arising from superior management and bargaining, windfall profits constitute only a portion of excess profits brought about by uncertainty. The percentage of windfall to excess profits varies with the nature of the uncertainty factor. But for the practical matter of measuring the taxable wind fall profits, the relation of windfall to excess profits is 36 assumed to be either directly proportional or mildly progres sive, that is, the larger the excess profits, the larger the aleatory portion in either fixed or varying proportions. The existence of excess profits is universal, accord ing to Butt. Since no definition of competition, within reason, eliminates uncertainty, excess profits and windfall emerge even under competitive conditions. Monopoly is not considered a cause of excess profits, however, inasmuch as the investor's prospects for acquiring excess profits by venturing in an established monopoly will be no greater than those from venturing in any competitive enterprise selected at random. An ideal tax on excess profits. The practical impossi bility of segregating portions of excess profits according to the various causal factors forced Butt to argue or reason that factors of superior management and bargaining rarely bring about anything more than a moderate figure for excess profits and therefore all excess profits may be considered, as a prac tical matter, to be derived from uncertainty. To overcome the problem of segregation, the logical procedure to get at the taxable windfall element of excess profits is to hit upon a scale of progressive percentage figures for paring off the windfall portion from the rest and to tax such portion at a 100 per cent rate or some other more moderate rates in accord ance with the urgency of revenue requirements. Rates must be 37 progressive, for the portion of windfall varies directly with the aggregate amount of excess profits caused by uncertainty. The ideal excess profits tax must be accompanied by a companion tax with reference to the status of the venture or the owner at a point time. In this respect, the excess profits tax is viewed as a tax on the process of ’ ’ move-up'1 or accretion from one point of time to another and the status tax aims at the taxation of the aggregate value of the property in posses sion of the venture or venturer at both points of time. Why the status tax is considered a part of an ideal excess profits tax system is difficult to see, despite the many explanations given by Butt, including that of the property tax and a com panion income tax. The taxation of property values without regard to income can hardly be viewed as being equitable. As will be seen below, in spite of Butt’s differentiation between excess profits and capital appreciation, his method of measur ing excess profits by comparing the current values of venture property at two points of time effectively includes in the taxable excess capital appreciation which is supposedly not excess profits. To tax such appreciation under the excess profits tax and to tax it again under the status tax can hardly be considered as Mideal.” The practical system. If available, stock market quota tions of the stock of a corporation should be used for purposes 38 of invested capital. Otherwise, current appraisal value should he used. The statutory percentage is made up of an allowance for the use of the venturer’s resources for the pertinent period, ordinarily known as interest, and an equi poise, being a quantity having to do with the presence of the factors of hazards, or conventionally known as the reward for risk-taking. Any divergence claimed must be reviewed and granted by a special board empowered to hear hardship pleas. Theoretically, there is no ground for exempting small ventures from the tax. But the fact that superior management and bar gaining, which are predominant in the operations of small business, do not generally result in windfall makes some exemp tion acceptable. Accordingly, the specific exemption is set at the relatively high figure of $100,000. The possibility of tax avoidance arising out of a high flat exemption does not seem to have been considered. The tax is assessed for a period of ten years with provisions for annual partial tax payments. The rate schedule is progressive according to the relation of the amount of excess profits to the amount of commitments and is to remain constant throughout the period. The proposed permanent excess profits tax is not a business tax, for non business ventures come under the levy. The status tax is absent in Butt’s practical tax proposal. CONCLUSION Gopal's principle of excessivity, Shoup‘s theory of 39 taxing socially undesirable gains, and Butt’s levy of a per manent tax on windfall profits have not, in the opinion of this writer, established a firm theoretical basis for impos ing a permanent excess profits tax on business profits. Modern institutional changes seem to have rendered the estab lishment of such a basis increasingly desirable. This writer, therefore, will attempt to build his proposed measure on such a sound basis in the following chapters. rv. A NOTE 01 SOURCES OF DATA AND REFERENCES Since the proposed reformulation of the theoretical bases for a permanent excess profits tax is predicated upon the occurrence of extensive institutional ehanges in the cor porate world of business in the United States of America, the sources of data and references are accordingly limited to those bearing upon these institutional shifts. Most of them were written by American authors and published in the States, as may be expected. No attempt has been made on that account, to examine economic and business literature published in other lands, with the exception of the British Isles and India. Most of the works and periodical articles on the sub ject of excess profits taxation have been consulted. Berle and Means1 The Modern Corporation and Private Property consti tutes the principal reference in the attempt to establish the altered economic relationships between the large corporation and its stockholders on account of the separation of ownership from control. The theses of Gordon's "Enterprise, Profits, and the Modern Corporation" and Stauss' "The Entrepreneur: the Firm" are followed closely in developing a functional approach to the theories of profits, excess or pure profits, and firm entrepreneurship. The theoretical bases for business profits taxation is based primarily on Studenski's "Toward a Theory of Business Taxation." Crum's Corporate Size and Earn ing Power. Domar and Musgrave's "Proportional Income Taxation and Risk-Taking," Monograph Nos. 12 and 13 of the Temporary National Economic Committee, and Gillim's The Incidence of Excess Profits Taxation are heavily drawn upon in writing the chapters on risk, efficiency, and excess profits taxation and on the incidence and effect of excess profits taxation. Shoup's three consecutive articles on the taxation of excess profits form the background material for the discussion on the techni cal aspects of excess profits taxation. Outside these and other works and articles of principal reference, publications of various learned societies and organizations, encyclopaedia articles, bound and loose-leaf tax services, publications of various governmental agencies, some pertinent court decisions, and other works of a related nature have been consulted. In acknowledging this writer's indebtedness for some borrowed ideas and passages, the original authors are referred to without the ordinary title prefixes of Prof., Dr., or Mr. No discourtesy is meant thereby, however. CHAPTER II A HISTORICAL RESUME OF FEDERAL EXCESS PROFITS TAXATION I. EXCESS PROFITS TAX, 1917-19211 IMMEDIATE FORERUNNER OF THE EXCESS PROFITS TAX Munition manufacturer's tax. The enactment of the first federal excess profits tax in March, 1917, was pre- 2 ceded however, by another strictly war tax measure, namely, the munition manufacturer's tax, a relatively unimportant part of the Revenue Act of 1916, passed in September, 1916.^ This was an excise tax, over and above the income tax, of twelve and one-half per cent upon the net profits of manufac turers of gunpowder, cartridges, projectiles, firearms and b motorboats, including submarines. Since it was an excise tax upon the privilege of doing business, the law permitted a credit of the tax against the capital stock tax, being also This historical account was compiled from mostly secondary sources, reference to which will be duly noted as the occasion arises. 2 F. W. Taussig, "The War Tax Act of 1917," Quarterly Journal of Economics. XXXII (November 1917), 3. 3 Kenneth J. Curran, Excess Profits Taxation (Washington, D. C.: American Council on Public Affairs, ^^B), p. 9. b Edwin R. A. Seligman, Essays in Taxation.-ninth edi tion (New York: The Macmillan Company, 1921), p. 682. hi k-2 5 an excise tax on the same privilege. Individuals, partner ships, corporations and associations manufacturing munitions or parts of munitions were subject to the tax. It applied to the year 1916 and was to continue until one year after the close of the war.^ REVENUE ACT OF MARCH, 1917 Historical preliminary. Within six months after the Revenue Act of 1916 was passed, the occasion for its amendment came when diplomatic relations with Germany were severed (on February 1, 1917)* It appeared then probable that war would follow, if no change were made by Germany in her submarine warfare. Military expenditures were on the increase and some IfOO million dollars would have to be added to the expected yield of the 1916 Act, if the national budget was to be kept 7 in balance. As the whole economy was affected by the inflated condition brought about by huge governmental expenditures, it had become abundantly clear that the so-called war profits were not limited to munitions manufacturers alone but were g seeping through the whole economy. A war tax measure, 5 Curran, op. cit., p. 11. 6 Ibid.r pp. 10-12. ^ Ibid., p. 13. ^ Loc. cit. considerably wider in scope and more productive of revenue than the 1916 munitions manufacturer’s tax, was therefore necessary. The upshot of these considerations was the passage of the Revenue Act of March, 1917> enacting into law the first excess profits tax in the history of the United States. With the exception of the few cases of corporations, the fiscal years of which ended in the spring and summer of 9 1 9 1 7» including those which liquidated their business in the 10 same period, the excess profits tax, levied under Title II of the March Aet and designed to yield 226 million dollars in revenue in the first year, 11 was never put into effect. It was outmoded almost as soon as it was approved on March 3, 12 1917- It deserves attention, however, not only because it was the first tax of its kind in the history of the United States"s federal finance, but also because its provisions reflect the plastic theories and views of the supporters and framers of the tax bill on the taxation of "excess profits," not just war profits. The following discussion of the main features of the bill attempts to unravel some of the 9 Joseph J. Klein, Federal Income Taxation (New York: J. Wiley and Sons, Inc., 1929), p. 6. Curran, op. cit., p. 23 (note 39). 11 Ibid.. p. I1 * - . 12 See the subsection immediately following. 1+If theoretical basis and principles, tempered by the necessary compromises with actual politics, of an excess profits tax in its pure form.^ Theory and practice of tax. In general, all businesses organized in the form of partnership or corporation were sub ject to the tax. Individual proprietorships, partnerships engaged in agriculture, and others were exempt. The tax was levied on net income (as computed for the income tax) over and l l j . above $5j000 plus 8 per cent on equity invested capital. The rate of the tax was a flat 8 per cent. Effective as of January 1, 1917, the tax was to continue indefinitely. The justification for the exemption of individual pro prietorships and the taxation of corporations and partnerships lay, according to the opinion of some legislators, in the attempt to equalize the tax burden on the different forms of business organization, that is, to reach the retained earnings of corporations that were not currently distributed as divi dends and were, therefore, not subject to the high surtax levied upon personal incomes. This line of reasoning falls to the ground if one recalls that under the revenue laws then in 13 J The following discussion is based primarily on Curran's work cited herein (pp. 15-23)* References to other sources will be duly footnoted. iL. In other words, excluding borrowed capital. 1*5 force partners, not the partnerships as business units, were taxed on their respective shares of the profits of the partner ships. The argument would stand if partnerships were exempt also, nevertheless, this mission of the excess profits tax to equalize the tax burden played an important role in shaping later excess profits taxes and was an obstacle to their final repeal. The real reasons for the exemption of individuals but not partnerships from the tax, however, were the fear of administrative difficulties in respect of individuals and that to tax the partnerships was to close an avenue of evasion for certain corporations that could reorganize as partnerships. Although the March tax employed the invested capital standard to measure normal profits, which indicates that the framers intended to devise a measure that could become a per- l1 ) manent part of the federal tax system, ' the tax was not presented to Congress as a permanent measure. Owing to the short time intervening between the date of the passage of the Act and the end of the 1916-191? fiscal year, the entire amount of revenue collected under its provisions by June 30, 1917 amounted to only $3 7, 0 0 0.^ ^ Thomas S. Adams, MShould the Excess Profits Tax Be Repealed?1 1 Quarterly Journal of Economics. XXXV (May, 1921), pp. 36* 4— 3 65, attributing to Representative Kitchin, Chairman of the Committee on Mays and Means, in particular, the attempt to make the tax a permanent measure of the federal tax system. ^ Commissioner of Internal Revenue, Annual Report. 1917, p. 39, (Curran, loc. cit.). k6 WAR REVENUE ACT OF OCTOBER, 1917 Historical preliminary. The March Act was soon super- 17 seded by the Revenue Act of October 1917* The pattern of events was clearly visible at the time. The country had been made prosperous by the war even before the declaration of war against Germany on April 6, 1917* Inflation threatened, profits were high, and military expenditures skyrocketed. Furthermore, revenues from liquor taxes were cut by the passage of the food administration act (August 10, 1917)> aiming alleg- 18 edly at food conservation and at the same time entirely pro- 19 hibiting during the war the use of grain for distillation. As a result, the War Revenue Act of October, 1917 was enacted after six months of legislative deliberations. The Act is said to have Hcreated a modern tax system,’ 1 placing its major 20 dependence for revenue on direct taxation. It was estimated to provide 3,*f00 million dollars in revenue, an increase of 2,500 million dollars over the yield of previous and the then 17 Klein, loc. cit. Not all of its provisions were repealed, however. We will presently turn to this. Randolph E. Paul, Taxation for Prosperity (Indianapolis and New York: The Bobbs-Merrill Company, 19^7), P« 25. Taussig, o£. cit.. p. 11. Curran, oja. cit., p. 2*+. h7 21 existing tax measures. The provisions for levying a general excess profits tax were expected to contribute a net addi tional revenue of one billion dollars or *K) per cent of the 22 total increase. The October Act, designed to secure this large amount of revenue, was based in some important respects on earlier 23 measures. The September 8, 1916 Act, as we have seen, pro vided for an initial levy at the rate of 12 1 /2 per cent on the entire net profits of munition manufacturers. The March 2lf Act levied a general excess profits tax. Some of the 21 Davis Rich Dewey, Financial History of the United States (Hew York: Longmans, Green and Company, 1936), p. 505» and Paul, loc. cit. 22 Curran, op. cit., p. 31. Cf. Dewey, loc. cit., setting estimated revenue to be collected under the excess profits tax provisions at $100,000,000. Curran’s estimate whs based on a table showing estimated revenue to be raised under H. R. *+280 (which was eventually enacted into law as the October Act). introduced by Representative- Kitchin on October 1, 1917 (Congressional Record, LV. 7586). Another estimate, made by the Hew York World (September 30, 1917) showing the total amount of revenue to be raised under the conference report on the new tax measure of the House and Senate conferees, which shortly thereafter passed both the House and the Senate, listed the estimated revenue contribu tion from the excess profits tax provisions at $1, 1 1 0, 0 0 0, 0 0 0. This estimate by the Hew York World was introduced by Repre sentative Smith of Michigan on October 1, 1917 (Congressional Record, LV, Appendix 619). From a purely war revenue point of view, $1, 0 0 0, 0 0 0 ,0 0 0 would be a more nearly accurate estimate than a figure 90 per cent smaller. 23 Supra. p. *fl. 2lf Supra, pp. b2-b6. kS provisions of both of these two acts were not repealed, the new Act merely taking the form of amendments or additional 25 provisions. Principal features. As one author puts it, the excess profits or war profits tax portion of the October Act was "by far the most important, the most significant and most hotly debated part of the measure.1 ' The main subjects of legis lative controversy concerned the standards to be used in deter mining excess profits or war profits, based upon either the invested capital or the profit level of the prewar years, the 27 latter idea being borrowed from England, and the applicable tax rates. The main features of the excess profits tax as contained in the final provisions of the Act, which Congress enacted into law under high pressure from both foreign and domestic sources, are summarized below. 1. Scope. Subject to the tax were corporations, ^ Taussig, op. cit.. p. 2. For instance, the 12 1/2 per cent tax on the net profits of manufacturers of munitions was retained for the single year 1 9 1 7* at the slightly reduced rate of 10 per cent. The invested capital method of determin ing standard profit remained the predominant part of the October Act, the war profits principle being merely a means of making minor adjustment in the determination of the standard (J. B. Hicks, U. K. Hicks, and L. Bostas, The Taxation of War Wealth [Oxfords The Clarendon Press, 19^-1j, pp. 120-121;. Taussig, op. cit., p. 27. Prentice-Hall, 19H-7 Federal Tax Service (New York: Prentice-Hall, Inc., 19^7), IV, 50,003. ^9 associations, partnerships and individuals engaged in business, professions, or occupations. All income, including salaries, derived from sources within the United States, unless specif ically exempted by some provisions of the Act, came within the ?8 purview of the tax. 2. Income determination. For the base-period years, corporate profits were to be determined under the corporation tax act of 1909 for 1911 and 1912 and under the income tax 29 act of 1913 for 1913* For the taxable year 1917 the deter mination was based upon the relevant provisions of the Revenue Act of 1916, as amended by the War Revenue Act of October 1917.^° This manner of determining income had the advantage of simplicity, as it required no recomputation of corporate net income for excess profits tax purposes. It should be noted, however, that the definitions of net income in these various laws, were not entirely comparable, the most important differ- 31 ences pertaining to the deductions for interest and depletion. In the case of partnerships and individuals, the Revenue Act of 1916, as amended by the War Revenue Act of October, 1917> 28 Curran, loc. cit. 29 Taussig, op. cit., p. 29* 3° Curran, op. cit.T p. 3 7. 31 Loc. cit. 50 32 was the basis for income determination. 3. Computation of the tax base. The tax was imposed on the amount of net income in excess of a specific exemption, being differentiated for the following three cases of tax- 33 payers: a. For a domestic resident taxpayer engaged in business during the entire prewar period: $3 ,0 0 0 in the case of a domestic corporation and $6 ,0 0 0 in the case of a domestic partnership or individual, plus the same per cent (between 7 and 9 per cent) of invested capital as was earned on the average in the base period 1911 through 1913. b. For one in business during a part only of the prewar period: The lump-sum (or specific) exemp tion remained the same but the invested capital per centage was fixed at a flat 8 per cent. c. A foreign or non-resident taxpayer: The exemption was the same as for the domestic corporation or individual but without the lump-sum (or specific) exemption. ^ Ibid., p. 38. 33 This classification is taken in condensed form from Ernest Ludlow Bogart, Mar Costs and Their Financing (New York: D. Appleton and Company, 1921), pp. 280-2 8 1. 3^ infra, pp. 53-5^ *f. Concept of excess profits. The House plan for the taxation of excess profits involved the computation of such excess at all profits over 8 per cent on capital. The Senate, however, proposed a plan based upon the British example by considering the average profits for the period, consisting of the taxable years 1911, 1 9 1 2, and 1913, as the basis of exemption and profits in excess of this base as taxable under 35 the war profits tax. The final version was a compromise; It adopted the average prewar profits during 1911, 1912, and 1913 as the basis for the computation of the exemption, but made a substantial concession to the excess profits principle by placing this exemption at not less than seven nor more than 9 per cent of the invested capital for the taxable y e a r . 8 ^ 5* Definition of invested capital. Invested capital was defined in terms substantially the same as those of the 37 March Act with certain limitations to preclude escape of 38 39 the tax by overcapitalization, to include: ^ Taussig, op. cit.. pp. 28-29. 8^ Paul, pp. cit., p. 26. ^ Taussig, pp. pit., p. 28. 8® Curran, pp. cit.. p. bO. 89 The following definition is based mainly on Curran, ibid., p. 3 2. 52 1. Cash paid in. 2. Paid-in surplus, earned surplus, and undivided profits used in the business. 3. Value of property, other than cash, as of the time paid in for stock or shares, except when paid in before January 1, 191^, in. which case the value as of this latter date would be used. if. The value of patents and copyrights paid in for stock or shares, no write-up in value being allowed. 5. Value of intangibles paid in for stock or shares before March 3> 1917* The inclusion of such intangibles as a group was limited to twenty per cent of the par value of the total stock out standing on that date. For individuals, patents, copyrights, and other intan gibles could be included only where specifically paid for in cash or tangible property and no write-up was allowed. Bor rowed money or property was excluded from the term r , invested capital." And so were stock, bonds and other obligations (other than obligations of the federal government), the inter est income from which was not subject to the income tax. M-0 6. Tax rate. The graduated rate scale is as follows: Percentage of Net Income Rate to Invested Capital % To 15 20 Excess over 15 but not over 20 25 h u 20 " " " 25 35 h n p5 " " " ^3 If5 H h 33 h « « 60 kO Taussig, op. cit., p. 33. 7» Relief provisions. Important exceptions to the regular method of assessment are listed below: a. In cases where the invested capital for the taxable year could not be determined, there was a specific exemption of $3 ,0 0 0 or $6, 0 0 0, plus the per cent of net income that the average exemption (exclu sive of specific exemption) of representative firms in a similar business bore to their average net income. b. Where the prewar income could not be deter mined, was zero, or was low when compared with that of representative firms in similar businesses, there was a specific exemption of $3 ,0 0 0 or $6, 0 0 0, plus the por tion of invested capital, which the average exemption of representative firms (exclusive of the specific exemption) bore to their average invested capital. c. In case the business was not in operation during the period 1911 through 1 9 1 3> there was a flat exemption, plus 8 per cent of invested capital. d. In case of nominal invested capital (as for salaried individuals), the tax was a flat 8 per cent of the net income over the specific exemption. It should be noted that the Act made no provisions for I |_1 Summarized from Curran, op. cit.. p. 33. 9* offsetting insufficiency in excess profits for one taxable 1x0 ' year against the excess profits for another taxable year. REVENUE ACT OF 1918 Historical preliminary. The war excess profits tax of October, 1917 bad hardly been placed upon the statute books than suggestions for its amendment were advanced from all quarters. This attitude was natural and inevitable, in view of the complexity and faulty draftsmanship of the law, so that the boldest administrative action was necessary for its proper functioning. It is understandable that the Treasury was reluctant to continue to collect the excess profits tax for another year without legislative sanction for some of the administrative rulings necessary to make the bungling law ) [ ) [ workable at all. Meanwhile, governmental expenditures had been mounting rapidly, estimated at twenty-four billion dollars Ixp This is the so-called "unused excess profits credit adjustment" under the provisions of the excess profits tax of 19I fO-191 +5. **3 Robert Murray Haig, "The Revenue Act of 1918,*' Political Science Quarterly. XXXIV, No. 3 (September 1919), 382. According to Curran (op. cit., pp. kk-‘ 4-5) , a special Excess Profits Tax Advisory Board was appointed by the Secre tary of the Treasury and Commissioner of Internal Revenue to interpret the tax legislation with the view to framing a set of workable interpretive regulations. Many of the regulations subsequently promulgated by the Treasury, however, were in later years admitted to be of doubtful legality. ^ Haig, op. cit.T p. 369. 55 for 1919 by Secretary MeAdoo in May, 1918, But Congres sional leaders, such as Kitchin, Simmons, Garner, Lodge, and k-6 Smoot all opposed a tax bill. President Wilson's sudden appearance before Congress on May 27, 1918, however, silenced all opposition and virtually assured the passage of a new h-7 revenue bill to meet the urgency of the situation. ' Hearings on the new bill was inaugurated on June 6, 1918.^ The first draft of the Revenue Act of 1918 was tardily introduced in the House on September 3> 1918, designed to raise eight billion dollars, one third of the estimated expenses of 1*9 the government for the coming year on a war basis. The war ended, however, a little more than three months before the end of congressional wrangling and the final approval of the Act on 50 February 2b, 1919* As a result, the original estimate of governmental expenditures was pared down to eighteen billion dollars and so was the estimate of the revenue to be raised Ibid.. p. 371. b6 Paul, loc. cit. ^ Haig, op. cit., p. 3&9* Loc. cit. lf9 Roy G. Blakey and Gladys C. Blakey, "The Revenue Act of 1918," American Economic Review. IX, No. 2 (June 1919), p. 213. Prentice-Hall, loc. cit. under the new measure, to six billion dollars, to which the excess profits tax was expected to contribute two and a half 52 billion dollars, about M-2 per cent of the total. Principal features. The 1918 tax measure placed an even greater emphasis on direct taxes on incomes, profits, and estates than the act of the preceding year. Direct taxes for 1919 were estimated to yield 82 per cent of the total revenue to be raised under the new measure, as compared with the actual receipts from the same taxes for 1 9 1 8, amounting to t j ' i 79 per cent of the total, under the old measure. The 1918 r t j . Act codified most of the internal revenue tax provisions. The language is clear and the technical work of drafting was well done. It was arranged under fourteen titles, Title III, "War Profits and Excess Profits Tax** being one of the two most elaborate and important sections.The main provisions of the Act regarding the excess profits tax are summarized 51 Blakeys, op. cit.. p. 21*f. Ibid.. p. 216. (Table I). 53 Haig, op. cit.. p. 373. 5^ Curran, op. cit., p. 6 3. The present Internal Revenue Code, however, did not come into existence until February 10, 1939, when it was approved as a re-enactment of the 1938 Act and other provisions of internal revenue law in force on January 2, 1939* (Prentice-Hall, op. cit.. 50,005.) 5? Haig, op. cit., pp. 373-37^. The other is Title II, "Income Tax.” 57 below. 1. Scope. The excess profits tax on partnerships and on individuals was discontinued. Only corporations, including foreign corporations deriving income from within the United States, but not corporations of the non-profit-seeking, per- 5 sonal service, and gold mining types, were subject to the tax. 2. Tax base. The tax is levied for 1918 upon the net income of a corporation in excess of the “excess-profits credit0 and/or the °war-profits credit.*1 The excess-profits credit consisted of a specific exemption of $3, 0 0 0, to which a foreign corporation was not entitled, plus 8 per centum of the invested capital. The war-profits credit consisted of the sum of $3 ,0 0 0 and an amount equal to the average net income of the corporation for the prewar period, plus or minus, as the case might be, 10 per centum of the difference between the average Invested capital for the prewar period and the average invested capital for the taxable year. The net income for the prewar period was determined for 1911 and 1912 upon the same basis as provided in the Act of August 1909 > and for 1913» upon the same basis as provided in the Act of October 3> 1913» and for the taxable year, upon the same basis as provided for income tax purposes in Title II of the Revenue Act of ^ Curran, loc. cit « 57 1918. 3- Invested capital. Invested capital is defined to include the followings 1. Actual cash bona fide paid in for stock or shares. 2. Actual cash value of tangible property, other than cash, bona fide paid in for stoek or shares, at the time of such payment, but not to exceed the par value of the original stock or shares. If shown to the satisfaction of the Commissioner, such excess, if any, might be treated as paid-in surplus. 3* Paid-in or earned surplus and undivided profits, not including profits earned during the current taxable year. b, Actual cash value of intangible property paid in for stock or shares, at the time paid in, but not to exceed the par value of such stock of shares, or in the aggregate 25 per centum of the total par value of capital stock outstanding on March 3, 1917, for intangibles paid in prior to such latter date or out standing at the beginning of the taxable year for intangibles paid in after such latter date (March 3, 19 1 7), whichever was the lower. Invested capital did not include borrowed capital and should be adjusted for inadmissibles. Invested capital should 58 also be averaged. 5^ Prentice-Hall, op. cit., 52,98*1—52,990. A minimum war-profits credit, however, was set at $3 ,0 0 0 plus 10 per centum of the invested capital of the taxable year (Curran, on. cit., p. 6b). 5^ Summarized from Prentiee-Hall, op. cit.. 52,990- 52,993* C£* Blakeys, pp. cit.. p. 228, giving 30 per cent as the over-all limitation for the inclusion of intangible values in the computation of invested capital. Curran (op. cit.. p. 6*f) and Seidman (J. S. Seidman, Seidman1s Legislative History of Excess Profits Tax Laws. 19*fr6-19*fr7 (Hew York? Prentice-Hall, Inc., 19^7),P* 332)agreed on 25 per cent. Apparently, the 30 per cent was the Senate amendment to House’s 20 per cent. The final compromise was 25 per cent. 59 b. Tax rate. The final excess profits tax liability of a corporation for 1918 is the result of applying to the balances of net income (computed as indicated below) the follow ing rates tax: First bracket: 30 per centum of the amount of the net income in excess of the excess-profits credit and not in excess of 20 per centum of the invested; Second bracket: 65 per centum of the amount of the net income in excess of 20 per centum of the invested capital; Third bracket: The sum, if any, by which 80 per centum of the amount of the net income in excess of the war-profits credit exceeds the amount of the tax computed under the first and second brackets. For 1919 and subsequent years the rate of levy under the first bracket was reduced to 20 per centum and that of the second to *+0 per centum, and the third was omitted. 7 A clause was inserted, however, to tax the net income of any corporation, deriving more than $1 0 ,0 0 0 from any government, contract, made between April 6, 1917 and November 11, 1918.^ 5. Relief provisions. The general relief section pro vided for the use by the Commissioner of the experience of representative corporations in similar businesses to deter mine the invested capital of the business under concern, in case of abnormalities. In case of a corporation with no 59 Up to this point this paragraph is based on Prentice- Hall, op. cit., 52,984—52,985* Balkeys, op. cit.. p. 227. prewar base-period experience, the war-profits credit was the sum of $3 , 0 0 0, plus an amount computed by using the same per centage of the invested capital of the taxable year as cor porations in the same general line of business earned, on the average, on their invested capitals in the prewar base period. (The tax was effective as of January 1, 1918 and no 62 date of expiration was set. The exemption of gold mining industry from the tax, in order to encourage the production of gold, was considered an unwise subsidy by some authors on the ground that reduced gold production would serve as a check on the excess of credit inflation and as a result, prices would fall.63) THE 1921 REPEAL OF THE EXCESS PROFITS TAX The outlook for continuing the excess profits tax after the dawn of peace was not good. Probably a majority of econ- 6*+ omists and practically all of the Treasury or administrative Curran, op. cit., p. 65. Loc. cit. 63 Blakeys, pp. cit.. p. 229. 6*+ Including Thomas S. Adams (pp. cit.) and Carl C. Plehn ("War Profits and Excess Profits Taxes," American Economic Review. X, No. 2 (June 1920), 283-298). 6l 6 5 authorities, most of whom were in the beginning predisposed 66 to favor the tax, had turned opponents of the tax measure. A practically unanimous sentiment for repeal was registered among business men. President Wilson seems to be the only politician of prominence, who, as late as May 20, 1919, recom mended in his message to Congress to make the excess profits tax (with a modified rate structure) “the basis of a permanent tax system which will reach undue profits without discouraging 67 the enterprise and activity of our business men.“ Many strong arguments were advanced by both sides. But it was the plea by Adams that the tax administrative machinery, with inade quate staff and constant turnover of experienced personnel, might collapse under the double burden of the income and excess 68 profits tax administration that prevailed over the arguments of Friday of Michigan and Haig of Columbia, based on tax jus tice, its effectiveness in eliminating monopoly profits, and its beneficial economic and industrial effects in 65 Secretaries of the Treasury, McAdoo (Annual Report, 1918. p. 52), Carter Glass (Annual Report, 1919, p. 23), and David F. Houston (Annual Report, 1920. pp. 29-3o)• 66 Adams, pp. cit.. p. 3 6 9. ^ Curran, pp. cit.. p. 8 8. Adams, op. cit.. pp. 370-371- 62 . 69 general* Republican Harding's election to the presidency of the United States in 1920 virtually spelled the doom of the excess profits tax* In addressing a joint meeting of both houses on April 12, 1921, he declared that the Republican party was 70 committed to the repeal of the excess profits tax. The road for the repeal was by now clear. The new revenue bill, repealing the excess profits tax, effective on January 1, 1922, 71 became law on November 23, 1921. As applied to the calendar year 1921, however, the war profits and excess profits tax, as amended by the Revenue Act of 1921, and patterned closely after its predecessor, the 72 1918 Act, underwent relatively few changes. Such few changes that were made related to the scope^ of the tax, dealing with foreign corporations and corporations conducting business within a United States possession, and in miscellaneous and administrative provisions, consisting of such things as the ^ Sidney Ratner, American Taxation— Its History as a Social Force in Democracy (New York: W. ¥. Norton & Company, Inc., 1942), pp. ^09-^10. The reference to Haig is connected with his "The Taxation of Excess Profits in Great Britain," Amftriflan Economic Review. X, No. M-, Supplement (December, 1920), pp. 17*+-175, and that to Friday, Profits. Wages, and Prices (New York: Hareourt, Brace and Company, 1921), pp. 176-206. Curran, op. cit., p. 8 9. ^ Prentice-Hall, pp. cit., 50,003. ^ Klein, pp. cit., p. 9. 63 retroactive legalization of consolidated returns for 1917 and the provision of an alternative method of taxing personal ser vice corporations, in the event that the courts should declare invalid the method employed since 1913, under -which the stock- 73 holders were taxed on their distributive shares, II' EXCESS PROFITS TAX. 1940-1945 BETWEEN TWO t&BS Tax recommendations of War Policies Commission. The strong agitation, led by the American Legion during the twen ties, to eliminate profits from future wars, finally crystal lized in the creation of the War Policies Commission by Congress in 1930. With the avowed purpose **to promote peace and to equalize the burdens and minimize the profits of war,1 1 the Commission began hearings in March, 1931* The final report of the Commission was submitted on March 5, 1932, with proposals to stabilize prices and tax at 95 per cent all income over and f , above the previous three-year average . . . M in times of war. Its tax proposals, however, were never enacted into law. Proposals of the Nye Committee. In April 1 9 3 "the Senate created the Nye Committee to continue the study of 73 Curran, jap. cit.. pp. 103-104. 6 1 4 - wartime economy. The final report of this Committee stated that it would be necessary to rely mainly upon taxation, rather than direct price control, to prevent excessive profits in war. The crusading liberal ideas of some of the members on the Committee can be seen in the proposals to tax personal incomes and corporate excess profits at rates graduated up to 99 per cent, this maximum rate to be reached at a taxable net income of $1 0 ,0 0 0 for individuals and at profits over 6 per cent of invested capital for corporations. It also proposed the nationalization of the munitions industry. This represented the culmination of the indignation developed in 7*4 - the twenties against the munition makers' large profits. 75 Legislative measures imposing profit limitations. Another offshoot of this situation was the passage of the 76 Vinson Act to limit profits on naval contracts and of the 7b The discussion in this and the preceding paragraphs were summarized from Curran's Excess Profits Taxation. 19*4-9- 1955j and Paul's Taxation for Prosperity, pp. 71-72. 75 1' The declared value excess-profits tax is not con sidered a true profit-limiting measure. (Temporary National Economic Committee, Monograph No. Taxation of Corporate Enterprise [Washington, D. C.: Government Printing Office, 19*+li, p. 87.) por a concise but complete account of the history of the Vinson Act, enacted as Section 3 of the Act of March 2 7, 193* 4 -, later amended, suspended, and revived by subsequent legislative acts, see Montgornery's Federal Taxes— Corporations and Partnerships. 19b6-lL9h7 (NewTork: The Ronald Press Company, 19*4-7), II, PP* 913-916. 65 Merchant Marine Act of 1936 to limit profits on all construc tion contracts for vessels completed under that Act.?? For constitutional reasons, the Vinson Act placed the excess profits tax on a voluntary basis. It was subsequently amended in 1939 and 19^0 to deal with situations arising from the unprecedented peacetime expansion of the Army and the Navy. Before the introduction of the Second Revenue Act of 19^, it was believed that the drastic restrictions placed upon profits by the Vinson Act were retarding plant expansion and production in the defense industries. With the passage of the 19*+0 Act, the earlier bill was suspended as expected, but provision was made for its restoration, when the general excess 78 profits tax should subsequently be repealed. SECOND REVENUE ACT OF 19^0 Principal features. As expected, the Second Revenue Act of 19^0, approved on October 8, 19*+0, suspended the profit- limitation provisions of the Vinson Act and the Merchant Marine 77 1 Even though the construction of merchant vessels under the Act cannot be directly linked to profiteering by the munitions industry, the limitations placed on profits made on such construction contracts were akin to those imposed by the excess profits tax. For this reason; the Merchant Marine Act of 1936, enacted on June 29, 1936, is considered an act pertinent to our discussion herein. For a concise history of the enactment, suspension, and restoration of the Act, see Montgomery^ Federal Taxes. II, pp. 925-926. see the next paragraph below. Act and in their stead, imposed an excess profits tax upon certain corporations for taxable years beginning after 79 December 31, 1939* stimulate the expansion of defense facilities a special provision was enacted to allow amortiza tion of such facilities over a period of five years or less 80 if the war ended sooner. The general scheme of the 1940 excess profits tax is outlined below. 1. Scope. Only certain corporations were subject to the levy with exemption from the tax granted to certain cor- 33. porate organizations. The tax did not affect individuals, proprietorships, and partnerships as did its counterpart of 82 World War I, the War Revenue Act of October, 1917. 2. Base of tax. The base of the excess profits tax or the adjusted excess profits net income was the corporate normal-tax net income, adjusted for various items as specified in Sec. 711(a)(1) or (2), I.R.C., and for abnormalities in income, minus a specific exemption of $5»000.00, the excess 83 profits credit, and unused excess profits credit. Whether 79 Secs. 401 and 402, Second Revenue Act of 1940; Sec. 201 of the same act amended the Internal Revenue Code by inserting a new subchapter, consisting of Code Secs. 710-752, which may be referred to or cited as the Excess Profits Tax Act of 1940. 80 Sec. 301, 1940 Act. 81 Sec. 727, I.R.C., for a list of exempt corporations. 82 Cf. sunra. p. 49. 53 Secs. 710(b) and 721, I.R.C. 67 adjustments under Sec. 711(a)(1) or (2) were to apply depended upon whether the excess profits credit was to be computed under the average earnings method or the invested capital method. Adjustments for abnormal income applied to both the taxable years and the base period years under Sec. 721, I.R.C. The Commissioner had authority under Sec. 722, I.R.C., to make such adjustments as may be necessary to eliminate abnormali ties affecting both income and capital. This represented a vast improvement over the excess profits tax of World War I, where income and capital abnormalities were not adjusted in 8*+ tax computation. 3. The excess profits credit or the statutory normal profit. The excess profits credit, or the statutory normal return on investment which was allowed to be free from the imposition of the tax, was to be computed under two methods: the average earnings method and the invested capital method. The taxpayer corporation had the right to elect the use of 85 either method which would result in the lesser tax. Under the average earnings method 95 per cent of the average base- period (the four years from 1936 to 1939, inclusive) net income of the taxpayer corporation was the starting point of Curran, op. cit., p. 177 and cf. supra, p. 51• 85 J Sec. 712, I.R.C. 68 its excess profits credit computation to be modified by vari- 86 ous adjustments on account of capital changes. Under the invested capital method the credit was 8 per cent of invested capital which included both equity invested capital and 87 borrowed invested capital. The concept of invested capital as defined in the 19^0 excess profits tax Act was fundamen tally the same as that of 1917 to 1 9 21, but there were some 88 essential differences. Besides equity invested capital con* tributed by the original stockholders, the borrowed capital, referred to in the preceding sentence, represented by the outstanding indebtedness of the taxpayer corporation which was evidenced by certain conventional instruments such as a bond, note, bill of exchange, mortgage, et cetera, was inelud- 89 ible at 50 per cent. 7 Furthermore, the law did not include 86 Sec. 713, I.R.C., and Reg. 109, Sec. 30.713-1 and -2. To be precise, the base period is defined in Sec. 713(b)(1)(A) as Hthe period commencing with the beginning of its first taxable year beginning after December 31, 1935* and ending with the close of its last taxable year beginnxng before January 1, 19*K). . . . 1 1 87 Secs. 711 * to 720, I.R.C. 88 Curran, op. cit.. p. 17 6. 89 Sec. 719(a) and (b), I.R.C. Since 50 per cent of borrowed capital was included in invested capital for purposes of excess profits credit computation, the interest deduction on account of such includible borrowed capital was reduced by 50 per cent. As may be noted, the 50 per cent reduction in interest was more than recompensed by the increase in the excess profits credit to the extent of 8 per cent on the 50 per cent of the includible borrowed capital, since in ordinary 69 the restrictions upon intangibles or the frequent limitations upon value at the par value of the stock issued in exchange for property, -which had been such prominent features from 1917 to 1921.90 *f. Hate schedule. The rates were graduated up to 50 per cent on various brackets of the adjusted excess profits 91 net income as indicated below: Adjusted Excess Profits Net Income $ 0 to $ 20,000 20.000 to 50,000 50.000 to 100,000 100.000 to 250,000 250.000 to 500,000 500.000 up Per cent 25 30 35 bo b 5 50 Total Excess Profits Tax $ 5,ooo Ilf,000 3 1 ,5 0 0 91,500 20^,000 5. Belief provision. Owing to the improved method of computing the tax base and invested capital provided by the 19*f0 excess profits tax, it was less of a necessity to make a general relief provision as it had been from 1917 to 9 (Continued) cases interest rates on corporate indebtedness were often much lower than 8 per cent. Why an excess profits tax purported to reach all excessive profits made out of the war emergency should have permitted a portion thereof to escape the impost by statutory assistance, this writer finds himself unable to explain. 90 _ x Curran, loc. cit. Cf. supra, p. 52. 91 Taken from Reg. 109, Sec, 30.710-2. 70 92 1921. The adjustments as to abnormalities affecting income and capital mentioned above were some of the relief provisions available to certain taxable corporations. Estimated yield. The estimated yield of the tax was placed at 300 million dollars from 19^0 corporate incomes and was surprisingly low in view of the record of 1917-1921. 93 According to Curran, this low yield may be attributed to the fact that the national economy began to feel the impact of defense efforts only in the last few months of 191 +0 and little price inflation occurred during that year. Furthermore, the rates were lower than in the past and the taxpayers were allowed many generous options. The corporate income tax was twice as high as during World War I and, in contrast to former practice, it was now deducted before computing the excess 9^ profits tax. This amounted to an increase in the exemption, 95 according to Curran: the 8 per cent exemption after the deduction of the income tax was roughly equivalent to 10 per cent before. 92 Curran, op. cit.. p. 177* 93 Ibid.. p. 179- 9l+ Sec. 711(a)(1)(A), I.R.C. 95 Curran, loc. cit. EXCESS PROFITS TAX AMENDMENTS OF 19*fl Principal features. Liberalizing amendments to the Excess Profits Tax Act of 19^0 were long anticipated before the final enactment of the Excess Profits Tax Amendments of 19^+1 on March 7, 19^1* The hasty provisions contained in the 19**0 Act to take care of unforeseeable circumstances by allow ing adjustments for abnormalities of both income and capital were now carefully studied and rewritten into law "to provide a set of flexible rules which would alleviate most of the 9 6 severe hardship cases which might arise.*1' As a result, the following avenues of relief were now available to the tax payers: 1. A "growth formula'1 contained in Sec. 713(f), I.R.C., was added to render the excess profits tax position of corpor ations which were undergoing substantial expansion during the base period, comparable to that of those which had already 97 attained a high and constant level of production. Since June 1, 19^0 was generally considered to mark the beginning of industrial expansion under the national defense program, any growth after May 31, 19^0 should not be taken into account in determining the average base period net income under this new ^ Paul, op. cit.. p. 75* 97 Sec. Mb), 19^1 Amendments. 72 98 growth method.' 2. The 19^1 Amendments rewrote Sec. 722, I.R.C., pro viding for the use of the so-called 1 1 constructive average base period net income*1 which was to substitute the actual average base period net income if the latter was not representative 99 of the normal earning power of the taxable corporation. This provision was one of the most complex and yet broad pas sages of the federal excess profits tax provisions. 3. Taxpayers were permitted for the first time to carry over for two years the unused portions of their excess profits credit, whether it was computed on the basis of 100 invested capital or of average earnings. This allowance was designed to relieve hardships caused by the irregularity or fluctuation of the incomes of many types of business cor porations and '*to benefit new corporations and old corpora tions undergoing a period of expansion. f,10’ L b• Provision for disallowance of abnormal deductions in base-period years was also made to give taxpayers a more 102 representative average base-period net income. Montgomery*s Federal Taxes. II, pp. 279-280. 99 Amended by See. 6, 19^1 Amendments. - * -00 Sec. 2(b), 19*+1 Amendments. 101 paux, oi3. cit*, P* 76. -^2 Sec, 3, 19^1 Amendments. 73 Retroactive effect. All of these amendments were made effective retroactively as of the date of the enactment of 103 the Excess Profits Tax Act of ISm). It was estimated that their effect would be to trim down the yield of the tax by 10*f some 100 million dollars. REVENUE ACT OF 19^1 105 Historical preliminary. Even after the enactment of the excess profits tax, the huge profits of many corporations growing out of the defense effort and government contracts were being lightly tapped or were not being tapped at all. As a result, the Treasury submitted to the House Ways and Means Committee a revised plan which broadened and strengthened the excess profits tax. This paved the way for the passage of the Revenue Act of 19l *-l> approved on September 20, 19^1. Amendments enacted. This Act was designed to raise an additional 3.? billion dollars and great reliance was placed upon the excess profits tax in securing the desired sum. The tax rate for each bracket of adjusted excess profits net Sec. 17» 19*+! Amendments. Curran, op. cit., p. 180. 105 ^ ^ 3 paragraph is summarized from Paul, op. cit., pp. 76-8 0, unless otherwise indicated. Curran, op. cit.. p. 181. 71 * 107 income was raised by 10 per cent. Income tax was no longer 1 O deducted before the excess profits tax was computed. Large t corporations were now being effectively taxed at higher and slightly progressive rates by the provision that the excess profits credit computed under the invested capital method be based upon 7 per cent on invested capital in excess of 109 #5,000,000. New capital was to be included in invested capital at 125 per cent of its amount.110 There was no change in the average-earnings credit, even though the Treasury requested that it be eliminated from the statute. REVENUE ACT OF 19*+2 Historical preliminary. . Pearl Harbor brought forth the same need for more revenue and more effective inflation con trol as World War I. Firmer than ever was the belief and con viction of the people that the incentives for greater produc tion should be balanced against the need for maintaining the sense of unity, which could come about only through common sacrifice. It was evident that as the need for more revenue 10? Sec. 201(a), 19^1 Act. 108 Sec. 202(a), 19^1 Act. 109 Sec. 201(b), 19bl Act. 110 Sec. 203, 19^1 Act. 75 grew, the excess profits tax, first revived by the Second Revenue Act of 19^0, would have to be further strengthened for another war emergency. The budget estimate for the year was #59»000,000,000. The recommendations of Secretary Morgenthau on a new tax program (submitted to Congress on March 2, 19^+2) proposed a $7,600,000,000 increase in tax revenue, which was later revised upward by some $1,100,000,000 on account of increase budget estimate (by some $1^,000,000,000) and a steadily rising cost of living. Bitter opposition to the Administration’s tax proposals developed and months of Congressional hearings and debate followed. But the war and the domestic economy moved faster than legislative delibera tions. The bill in its final form had already become com pletely inadequate before it was passed on October 21, V)h2.\ it had become apparent that $6 0, 0 0 0, 0 0 0 ,0 0 0 would have to be borrowed for the fiscal year 19^3* According to Treasury’s estimates, the new Act would add about $7,000,000,000 to government revenue. The new measure has been dubbed the “greatest tax bill in American history." In many respects it deserved the adjective ren- 111 dered in the superlative degree. According to one 111 Up to this-point, this subsection is based on Paul, op. cit., pp. 96-106. 76 112 author, the Revenue Act of 19^2, viewed from a practical standpoint, was a product of which both the Treasury and Congress could be proud. In the same breath, this author also states that it was "complex almost to a point of con fusion" and was "not a simple tongue, but a Tower of Babel," inasmuch as "never before had so many groups, so many diverse interests, been given their own kind of pan to fry in." The high rate (90 per cent) of the tax made complexity of the law a necessity. Amendments enacted. Some highlights of the amendments to the excess profits tax brought about by the Revenue Act of 19^2 are given below: 1. The rate was a flat 90 per cent on the adjusted excess profits net income with 80 per cent of the corporation surtax net income as the limit for all three of the corporation 113 taxes: normal tax, surtax, and excess profits tax. J 2. Against the excess profits tax there was allowed a postwar refund credit of 10 per cent in the form of bonds H l f not convertible into cash until after the war. 112 George T. Altman, "Corporate Highlights of the 19^2 Revenue Act," Taxes. XXI, No. 1 (January 19^3)> 113 Sec. 202, 19^2 Act. lllf Sec. 250, 19^2 Act. 77 3* Certain corporations engaged in the mining of cer- 115 tain strategic minerals were exempt from the tax. * 4 - . A two-year unused excess profits credit carry back was allowed in addition to the two-year carry-over pro vided in the 19*4-1 Act.116 5. Even though the excess profits tax rate was now a flat 90 per cent proportional rate, an effective graduation in rate structure was achieved by lowering the percentages on higher brackets of amounts of invested capital from one to three per cent in computing the excess profits credit on the 117 invested capital basis. 6. Falling within the relief provisions were: a. The net income of a base period year which was the lowest of all of the four base years was raised to 75 P©r eent of the average of the other i 1 O three years. b. The general relief provision, Sec. 722, is further liberalized, amendments being made retroactive to 19*4-0 and 19*4-1.119 115 Sec. 226, 19*4-2 Act. 116 Sec. 20*4-, 19*4-2 Act. 117 Sec. 217, 19*4-2 Act. 118 Sec. 215, 19*4-2 Act. 11^ sec. 222, 19*4-2 Act. 78 REVENUE ACT OP 19J +3 Historical preliminary- By the autumn of 19^3 the tide of war had already turned in favor of the United Nations. The production front in the United States was booming, but a phenomenal rise in the national debt, which on June 30, 19^3 stood at #136,700,000,000, had occurred. War expenditures for the fiscal year 19¥f were estimated at 100 billion dollars. Prices rose. Amidst inflation and increased expenditures, President Roosevelt requested of Congress (in January 19^3) a 16 billion dollars in new revenue. The Administration did not, however, produce sufficient evidence to show that the additional revenue, proposed by the President, was the result of careful estimate and the absolute minimum required. The Treasury’s subsequent reduced request of 10.5 billions helped to enhance Congressional suspicion that the revenue recommendations were indiscreetly devised. In fact, Congress was never convinced of the need. Besides, a rift between Congress and the Administration grew and became steadily worse. Treasury officials were in some instances excluded from Committee meetings on tax measures. For the first time in the United States revenue history Congress did not lean on Treasury recommendations in drafting a revenue bill. The initiative, so to speak, passed from the Administrative to the Legislative body, as it should be under the Constitution. The Revenue Act of 19^3» as was first passed by Congress, 79 had the distinction of being the first internal revenue bill to have received a presidential veto. But it was finally passed by Congress over the presidential veto on February 25, 19^• In its final form the bill provided for a net increase in revenue of only 1.19 billion dollars, a far cry from the Treasury’s 10.5 billion request. Corporation income and excess profits taxes were estimated to yield a net increase 120 of one-half billion dollars in revenue. Principal changes. The more prominent changes in the excess profits tax amendments as enacted by the Revenue Act of 19*+3 ares 1. The rate was increased to 95 per cent of the 121 adjusted excess profits net income. 2. The excess profits credit was effectively reduced on invested capital in certain brackets by a further reduc- 122 tion in the credit percentages allowed. 123 3. Exemption from the tax was further extended. 120 This paragraph is based ons Edward D. Allen, "Treasury Tax Policies in 19*+3,1 1 and Mabel Newcomer, "Con gressional Tax Policies in 19*+3 ,M American Economic Review. XXXIV, No. *+ (December 191 * 1*-), 707-733 and 73'+-7po, respec tively, and Paul, op. cit.T pp. 1^3-162. 121 Sec. 202, 19^3 Act. • * - 22 Sec. 205> 19*+3 Act. 123 Sec. 207, 19^3 Act. 80 b, The specific exemption was raised from $5»000 to 12b $ 10, 000. TAX ADJUSTMENT ACT OF In May of 19^5 the global war had narrowed down to a one-front action in defeating the Japanese. Cutbacks in war production were beginning. The big problem was how to mini mize their effect upon the economy and how to speed up recon version to meet the long pent-up consumer's demand. In so far as tax adjustments would help to ease the difficulties in the transition, a new bill was introduced to facilitate recon version by improving the cash position of business enterprises, by accelerating the refund procedure, with respect to both 126 carry-backs and the amortization recomputation adjustments, and by raising the specific excess profits tax exemption from $10,000 to $25j000 for years beginning after December 31, 19^5 > so that many small businesses would be relieved of the onerous tax burden. Congressional attempts to apply the increased exemption retroactively to 19^5 was unsuccessful. Because of the repeal of the excess-profits tax by the Revenue Act of 19^5? 12lf Sec. 20^, 19^3 Act. 125 fhis paragraph is based on Paul, op. cit., pp. 171- 181. Referring to both the net operating loss and the unused excess profits credit carry-backs. (Sec. *+, Tax Adjustment Act of 19*+5*) 81 however, the benefit which otherwise would have accrued to some 12,000 small corporations exclusively never materialized of its own accord. For 19^+ and later years, the postwar refund credit was made currently available and the maturity date of refund bonds issued for 19^2 and 19^3 were advanced to January 1, 19*+6. REVENUE ACT OF 19k5 The successful conclusion of the war with Japan in the fall of 19b-5 found the nation face to face with the tremendous task of immediate reconversion, as now the cushion to the impact of the transition on the economy of the one-front war, as originally contemplated in the framing of the act earlier in the year, had suddenly vanished. As can be expected, activity on the tax front was the first order of business for both the Administration and Congress. President Truman, in 127 his message of September 6, 19^5? called for the enactment, as soon as possible, of a transitional tax bill, consistent with the necessary expansion of the economy in peacetime. He was reconciled, however, to limited tax reduction and to the fact that “a total war effort cannot be liquidated overnight." Secretary Vinson’s tax recommendations, made to Congress less 127 Congressional Record. XCI, 838^-. 82 128 than four weeks later, were based on an estimated revenue drop of nearly $9,000,000,000 and on a total tax reduction not to exceed $5,000,000,000 for 19^-6• The primary aim of the bill, in the opinion of the Secretary, should be to remove serious impediments to a swift transition from a war economy to a prosperous peacetime era. He specifically recommended the repeal of the excess profits tax, effective January 1, 19^6, with the carry-back adjustments extended for one more year (or for 19^6). His grounds for repeal were that the tax had been intended primarily to be a measure to prevent war profiteering, rather than to provide revenue, and by the end of 19^5 such control measure could be dispensed with. He also considered the tax f , too erratic a tax engine to turn loose for even one full year of the postwar period.'* It needs no mentioning that the majority of Congress were extremely receptive to the Secretary's program of tax reduction. But it should be mentioned, however, that some members of Congress voiced excellent, though ineffectual arguments against the early repeal of the excess profits tax. One example is contained in Senator Fulbright's statement, l?8 Ibid., A*+126• (Statement by Secretary Vinson before the Ways and Means Committee of the House of Represen tatives on October 1, 19^5, included by Chairman Doughton in the extension of his remarks on the pending revenue bill on October 2, 19*+-5») 83 made before the Senate on October 26, 19i *5."^9 According to the Senator, the underlying factors making for high wartime taxes applied “with equal or even greater force during the critical period of reconversion,” for profits to be made in the next year (19^6) at least, would directly result from war expenditures, as they were after World War I, and there fore were ^ust as much war profits as if they were made when the war was on. Besides, the inflationary forces would be unleashed by the removal of wartime controls. As long as supply and demand were not in balance, taxation as an instru- 1^0 ment of control over inflation should remain. J Then with unusual foresight, he predicted that the effect of the repeal would be to invite the familiar wage-price upward spiral. He concluded his statement with the remark that the repeal of the excess profits tax would not only benefit the few and finan cially strongest corporations, but allow them refunds and other benefits at government's expense. His arguments fell on deaf ears. With less than two months of Congressional deliberations and debate, the Revenue 131 Act of 19^5 was approved on November 8, 19^5, granting tax 129 Ibid., 10093-1009^. Of. Hicks, et <il., op. cit., pp. 55-56, on excess profits tax and inflation. Prentice-Hall, pp. cit.. 50,008. 8 if reductions one-fifth larger than that which Secretary Vinson 132 requested. It was the first time since 1929 that a large- scale tax reduction bill was enacted by the federal govern- 133 ment. The provisions, repealing the excess profits tax 132* completely as of January 1, 19**6, would cost the govern- 135 ment about 2.6 billion dollars in revenue. The retention for one year beyond 19^5 of the unused excess profits credit 1 O A carry-back adjustment would entail additional revenue loss, the amount of which could not be forecast with any degree of 137 accuracy. 132 Carl S. Shoup, “The Revenue Act of 19^5,“ Political Science Quarterly. LX, Np. b (December 19^5)» M51. ' * ‘ 33 Doc. cit. 13lf Sec. 122(a), 19^5 Act. ^3^ Shoup, 0£. cit., pp. V87-**88. Of the total 12,555,000,000 reduction due to the repeal of the excess profits tax, $1,797»000,000 or 70 per cent, would go to some 900 corpora' tions, $6 2 8, 0 0 0, 0 0 0, or 25 per cent, to 6,000 corporations, and the balance of $1 3 0, 0 0 0, 0 0 0, or 5 per cent, to 12,200 corpora tions. Out of a total of 261,000 corporations to file income tax returns for 19*+6, 19,100 would also file the excess profits tax returns. (Congressional Record. XCI, 9610.) That the bene fit, accruing from the repeal of the tax, was concentrated on a few corporations, most likely the financially strongest ones, can be easily seen from this summary. 136 Sec. 122(c), 19*+5 Act. ^-37 u0 one could at the time of the passage of the Act forecast, with any pretension to accuracy, what business condi tions would be in 19*f6. Besides, the revenue loss might also result from net operating losses sustained in 19^8, the carry back of which to 19^6, disregarding fiscal year corporations, would conceivably increase the unused excess profits credit for the latter year, which, in turn, would affect the excess III. REVENUE ASPECT 85 INTRODUCTION That the excess profits tax proved to be a prodigious revenue producer during both world wars may be attested by tabulation of comparative revenue figures appearing on the following page. Period 1917-1921. For the fiscal years from 1918 through 1922, the excess profits tax furnished 28.18 per cent, more than one-fourth, of the ordinary total revenue receipts of the federal Treasury, being almost as much as the combined 138 personal and corporate income taxes in the same period. It is admitted that the excess profits tax had reduced the 139 return from income tax. According to Curran's estimate, the distribution of this reduction over the period was roughly as followss 1917— $100,000,000; 1918— $300,000,000; 1919— $ 1^0,000,000; 1920— $100,000,000; 1921— $35,000,000; and total ll+o — $675,000,000. But even if we subtract this $675,000,000 3-3? (Continued) profits tax liability for 19^ and 19^5. The involved nature of such carry-tack adjustments precluded any reliable forecast as to what the revenue losses, resulting from the extension of the carry-back of the unused excess profits credit would amount to eventually. •*•38 curran, op. cit.. p. 137* ■*"39 Both corporate and personal income taxes. Curran, loc. cit. 86 (1) Excess Profits Tax3 (2) Total Revenue Receipts*3 (l)/(2) Per cent 1917-1922: 1917 1918 1919 1920 1921 1922 $1,81+3,886° 2,505,566 1, 1 + 3 1 ,8 0 6 988,726 335,132 8. 1+66 «None^ 3,661+, 583 5,152,257 6 , 6 9 ? ,5 65 ? 62»f 933 if. 109,10*+ 19^1-19^7: 19^1 19^2 19ft 19^ 191+5 19^6 19^7 $7,113,582 $ l6l +,309 1, 6 1 8 ,1 8 9 5, 0 6 3, 861+ 9,3^5,198 11,003,520 7, 8 2 2, 1+88 3.566.178 $25.21+5.1+1+2 $ 7, 6 0 7 ,2 1 2 1 2,7 9 9 ,0 6 2 22,281,61+3 bb, li+8,927 i+6,i+56,555 °37,799 1+3,258,833 2 8 .1 8 #a8 . x 5$3.j¥> $219,590,031 17.57 a For 1917-1922, figures for excess profits tax liabil ity assessed were taken from Bureau of Internal Revenue, Statistics of Income, 1925, p. 23* Figures of receipts from the excess profits tax for 19^1 to 19^7, from Commissioner of Internal Revenue, Annual Report, 19^1-191 +7, inclusive. All figures are in thousand's oraoliars. ^ Total revenue receipts for all years were taken from Secretary of the Treasury, Annual Report. 19^8, pp. 1+00 and 1+02. 0 Including excess profits tax on individuals, ($101,250), partnerships ($103.,888), and corporations ($1, 6 3 8, 7^8), all figures being in thousands of dollars. j Since excess profits tax assessments in the Statistics of income were compiled from calendar year returns plus returns filed on fiscal years ended June 30 the following years, pay ments on the tax liability would flow into the Treasury in the years following the years of return. Thus, total receipts for fiscal year ended June 3 0, 1917 did not contain any payment on the tax and are therefore excluded. 8 ? from the $7,113,582,000 total excess profits tax for 1917- 1922, the ratio of this reduced total to total revenue receipts for the fiscal years 1918 to 1922 would be 25.50 per cent, still more than one-fourth of the total. The pro ductivity of the excess profits tax cannot thus be denied. Period 19I fO-191 +5. This spectacular productivity was not repeated percentage-wise however, for the period 19^1- 19^7* This result was not due to the decrease in the pro ductivity of the excess profits tax, but, rather, was brought about‘by the tremendous increases in other levies since World War I, especially the corporate and personal income taxes. While the excess profits levy netted revenue almost as much as the combined personal and corporate income taxes during the period of World War I, individual income tax collections alone exceeded the collections on excess profits tax during the period of World War II with the exception of 19^5. That , the combined corporate and personal income taxes outstripped the excess profits tax for the same period needs no comment. But what has been said in the foregoing should not be con strued as a detraction from the reputation of the excess profits tax as being a remarkable revenue producer. Collec tions on the tax during World War II amounted to 2^.71 per cent of the total tax on all income, 18.69 per cent on total internal revenue receipts, and 17*57 per cent on total revenue 1*+1 receipts. With the possible exception of individual income tax, the excess profits tax contributed more, both in amount and percentage-wise, to total revenue receipts than any other. 1^1 The percentages were obtained by dividing the following totals into the excess profits tax collections from 19^1 to 19^7 inclusive. Figures are in thousands of dollars. Total Tax on Total Internal Income Revenue Receipts 19**l $ 3,*+71,121* $ 7,370,108 19^2 8, 0 0 6,88** 1 3, 0^7 ,8 6 9 19*+3 1 6,298,888 2 2, 3 7 1,3 86 19M* 3 3, 0 2 7 ,8 0 2 k -0, 1 2 1 ,7 6 0 19*+5 3 5, 06 1,5 26 1* 3 , 8 0 0 ,3 8 8 19J+6 31,258,138 1*0,672,097 19^7 29.020.05** 3 9.108.386 Totals S156.W*.**16 $206.1*91.99** The figures were obtained from Commissioner of Internal Revenue, Annual Renort. 19*+1-19**7j inclusive. 31*? This conclusion was based upon an inspection of all the various revenue items appearing on Table 5 of the Annual Report, by Commissioner of Internal Revenue. It is to be noted, however, that the excess profits tax cut deeply into the receipts from corporate income tax. From 19*+2 to 191* 6, inclusive, the reduction in income tax on corporations on account of the excess profits tax is estimated by this writer to be in the neighborhood of $1 9, 0 0 0, 0 0 0, 0 0 0, more than 50 per cent of the aggregate collections on the tax for the same period of time. Since income subject to the excess profits tax was exempt from the corporate income tax (Sec. 26(e), I.R.C., since repealed), and the corporate income tax rate was 1*0 per cent for the same period, the reduction in corporate income tax may be obtained by multiplying !*0 per cent against the aggregate adjusted excess profits net income (or equivalent to income subject to the tax) for the same period, in the amount of $1*7,825,1*72,000. The net result is $19,130,188,800. The adjusted excess profits net income for the years involved were obtained from Statistics of Income. 191*6 T Preliminary Report, Part II, p. 19* 89 11+2 (Continued) 1942 $10,494,667,000 1943 14,552,878,000 1944 ' 12,935,510,000 1945 8,367,927,000 1946 1. 474. 490.000 1^ 8 ^ 4.72,000 No attempt has been made to ascertain or estimate the effect of the imposition of the excess profits tax on tax assessments attributable to the corporate income tax for 1940 and 1941. The rates were graduated for those two years and the method of computation was different, for instance, the final excess profits tax computed was allowable against net income for corporate income tax purposes. It is difficult, if not impossible, to estimate the reduction in corporate income tax assessments for those years. CHAPTER III FISCAL PRINCIPLES OF EXCESS PROFITS TAXATION I. INTRODUCTION The development of the principles of taxation is essen tial to any study of a new tax measure, A good tax system or a meritorious tax measure has been held to be that which fully accords with and promotes the public interest.1 The term, “public interest,'1 is an objective concept, which springs, however, from a multitude of conflicting private and subjective considerations. In a democracy where the con stitution gives the people the right to choose their own form of government and to air their private views on matters directly or indirectly concerning themselves through the legislative branch of that government, any piece of legisla tion that finally crystallizes into executive action neces sarily represents a political compromise of such divergent views of the public. In the process of political compromise, however, there is always room for "public interest," objec tively embodied in those enlightening views, and high ideals and principles on the subjeet, to be heard and given due weight in reaching the final settlement. How closely such 1 Carl Shoup, research director, et al., Facing the Tax Problem (New Yorks Twentieth Century Fund, 1937)? P« 392. 90 settlement conforms with the interest of the majority of the people is usually dependent on how fully these ideals and principles are heeded in effecting the final compromise. Cynical disregard of such views and ideals is comparatively rare under properly organized democratic political processes. Academic discussion of taxation principles, therefore, is not only not fruitless in a democratic state, hut also of positive educational value in producing an enlightened populace, who will be guided by such ideals and principles to influence, in turn, the legislative deliberations on measures, directly or indirectly affecting their private interests and finances. Furthermore, the principles and aims of taxation are the objective criteria by which a particular tax measure or tax system is judged as to whether it fully accords with and promotes the public interest. The choice of such principles and aims for use by the tax.student admittedly involves a certain amount of subjectiveness, for he who does the select ing has to weigh each factor according to his own opinion and views on the matter, however objectively derived. Neverthe less, they are the theoretical bases for the tax measure he proposes and with which only he is prepared to defend it against inevitable criticism coming from interests likely to be adversely affected by it. Judicious choice in this respect therefore, is apt to be crucial, for the proposed measure may stand or fall on account of it. 92 Before entering upon a discussion of such principles and aims of taxation, it is desirable, however, to set forth the fiscal objectives with which the aims of levying any pro posed tax measure should be consistent. This writer accepts as being the most important the two fiscal objectives set 2 forth by Groves: the maintenance of high national income 3 and reasonably full employment. The significance of these two objectives should be clear, to all and needs no further comment than the remark that they aim.primarily at bringing about and sustaining economic prosperity. In carrying out these objectives, the government is limited primarily to the maintenance of private enterprise, plus whatever positive intervention by it to bring about recovery from economic 2 Harold M. Groves, Financing Government (Revised edition; New York: Henry Holt and Company, 19*+6) , p. 6 0 7. 3 Groves used the term "adequate employment oppor tunity"* instead of "reasonably full employment," the latter term being supplied by this writer as being substantially the same in meaning as the former. It seems to this writer, however, that the maintenance of adequate employment oppor tunity represents an unnecessary retreat from the positive position of maintaining reasonably full employment. The latter conveys definitely more positive action on the part of the government than the former, which appears to limit its responsibility to only that of maintaining, employment oppor tunity, an essentially negative position. This negative position does not seem to be in harmony with more positive government action contemplated in the cyclical budget theory that Groves recommends (infra, p. 97). As it will be seen, the cyclical budget concept provides for intervention by the government to supply employment when none is available from private industry. 93 distress is deemed advisable. This is essentially Hansen’s “dual consumption economy,1 1 plus some, features of his “dual if production economy,*1 whenever necessary. At the risk of disputing with Terborgh over the maturity issue, these objec tives and the type of economy are accepted herewith as assump tions or working hypotheses, from which the discussion of principles proceeds. !£• PURPOSES AND AIMS OF BUSINESS TAXATION There are only two conceivable purposes for which any business taxes are levied, the revenue aim and the control aim. Fully aware of the fact that any tax levied for revenue purposes has such differential economic consequences that its net effect may be substantially that of a tax for control or regulatory purposes, this writer, nevertheless, recognizes this dichotomy both for purposes of the presentation of mate rial in this dissertation study and for the usual practice of L. Alvin H. Hansen. Fiscal Policy and Business Cycles (New York: W. W. Norton & Company, Inc., 19*+1) , PP* *+00-410. Hansen’s views on these two types of economy are easily dis cernible from the following quotation: “A dual consumption economy could, however, from the standpoint of full employ ment of resources, satisfactorily fulfill the requirements of a purely private economy in the production sphere. While the dual production economy offers certain advantages from the standpoint of stabilizing the income, the dual consump tion economy supplies the conditions requisite for the rela tively matured society.1 * (Ibid., p. *t-09*) 9>+ elassifying certain.taxes either as revenue or control meas ures, dependent upon the dominant legislative intent in their 5 enactment• REVENUE PURPOSE Introduction. Revenue raising by governments through tax levies to meet public expenditures dates back to ancient history when men had passed beyond the lowest stage of social development to find that some form of governmental organiza- 6 tion was essential for control functions. In modern times 7 and especially since the great depression in the thirties, there has been and there still is a constant need for sub stantial governmental revenue to meet the cost of such multi plying functions as may be required of the government in discharging its responsibilities toward the people as a whole. As the imposition of taxes entails complicated economic reper cussions on the economy as a whole, judicious choice of specific tax measures to produce the required revenue is therefore 5 Harvey W. Peck, "The Use of the Taxing Power for Non fiscal Purposes,'* Annals of the American Academy of Political and Social Science. CLXXXIIlTJanuary, 193&), C. F. Bastable, Public Finance (London: Macmillan and Co., Limited, 1917)? p» 1* 7 Not to mention the economic changes on account of the impact of the last war on the economy, which, however, are considered abnormal, unenduring, and transitory from a long- run point of view. 95 important. Meaning of adequacy and stability. Since a tax measure is to provide for the maintenance of some cost of government, it follows that the revenue to be raised under it should be adequate. It is obvious that adequacy is a relative concept. Adequacy of revenue is relative to the varying amounts of governmental budgetary expenditures. If the expenditures budgeted vary from year to year, as they are expected to do, the amount of revenue adequacy varies accordingly. Another concept closely related to adequacy is revenue stability, which has been made to refer to stable yields from year to 8 year, despite economic fluctuations. These concepts are chiefly and directly related to the annually balanced budget theory. A study of the respective merits of these two canons of taxation for revenue purposes can best be made in conjunc tion with other probably more important concepts of distribu tive tax Justice. In modern theory of government, adequacy from year to year under fluctuating economic conditions is rarely possible and stability from year to year not only would result in grave tax injustice, but is seldom necessary at all. Somehow, the two revenue concepts are intertwined. Under Committee on Postwar Tax Policy, A Tax Program for a Solvent America T first report (New York: Committee on Post war Tax Policy, 19^5)? passim, pp. 29-^0. modern theories of government finance, public budgetary expen ditures in periods of economic down-swing should mount, owing to the need for increased governmental activities in combatting depression, such as providing for relief, maintaining public works, and other stimulating devices. If revenue adequacy were the prime criterion in selecting tax measures to provide for the mounting budget during the downward spiral, a tax system must produce revenue in inverse proportion to the general diminution in national income. To resort to this measure is to commit both economic and political suicide. Overemphasis on the absolute stability of yield inevitably results in gross tax injustice. Yield stability in the sense adopted by the Committee on Postv/ar Tax Policy under the directorship of Q Harley L. Lutz, requires the development of a tax system which is resistant to depression and declining income in general. That is, the tax system must contain elements more or less insensitive to fluctuating economic circumstances of the taxpayers, whether they be business or individual. Such insensitive elements generally consist of poll taxes, sales tax on necessities, turn-over taxes, taxes based upon gross receipts, excise taxes, and property taxes. To increase these taxes (generally regarded as regressive) during Q Sunra. p. 95? footnote 8. 97 depression is to secure greater stability at the expense of tax justice.10 Ironically, such stability is wholly unneces sary. The more modern approach to stability under the dual consumption economy emphasizes stability over the business cycle, during which the budget is to be balanced. This is the cyclical budget theory. The cyclical budget theory. The general idea of this theory is that it is bad economics to balance the budget during depression when deficit spending and other stimulating measures are needed to bolster the sagging economy and, as a recovery stimulant, taxes should be held low and government expenditures should be increased. Deficits should be covered by borrowing, -which can be paid off during the succeeding recovery and prosperity when the general economic condition would permit raising the tax level above that of expenditures, thereby resulting in budgetary surplus. In other words, the budget is to be balanced during years of good employment only and a surplus is to be striven for during the best years, with which to repay the debt incurred during the poorest years.11 Temporary National Economic Committee, Taxation. Recovery, and Defense (Monograph No* 20. Washington: Govern ment Printing Office, 19^1), p. 28. Harold M. Groves, Postwar Taxation and Economic Progress (New York: McGraw-Hill Book Company, Inc., 19*+6), p. 357. 98 In conformity with this cyclical.budget concept, revenue sta bility is conceived of also as a cyclical concept. Cyclical balance, not annual balance, is the goal. The balancing of the budget over the complete business cycle has been accepted by a number of prominent economists versed in the science of _ _ , * . 1 2 public finance. The fundamental assumption of the cyclical budget is that the maintenance of high levels of national income and employment is more important than the mere balancing of bud get over the years without regard to its grave economic con- 13 sequences. Admittedly, a secular increase in public debt is a possible concomitant to government fiscal policy based upon a cyclical budget. But If one accepts the principle of government financial operations as instruments of economic and public policy, the concept of an annually balanced budget, however defined, can play no role In bhe determination of 1*+ that policy. For the public economy, furthermore, . . • expenditures ought to be weighed not in terms of the profit and loss of the state itself, but 12 For instance, William. J. Shultz, American.Public Finance (Third edition; New York: Prentice-Hall, Inc•, 191 +2), pp. ; Groves, Financing Government, p. 611; Shoup, et al.. oo. cit., p. 52; T. N. E. C., op. cit.. pp. 229-23**-; and Hansen, op. cit..j pp. 186-222. - * • 3 Groves, Postwar Taxation and Economic Progress. P. 358. ^ Hansen, ojd. cit., p. 188. 99 rather in terms of the effect of such expenditures on the full and efficient functioning of the economy as a whole. - * - ? Last, but not the least, the role of growing public debt should not be viewed from the standpoint of a private individ ual or institution. From the social point of view, the bene ficial economic effect of its growth has long since been recognized by many prominent economists. Concept of cyclical budget and excess profits taxation. The acceptance of the principles of the cyclical budget makes it desirable to incorporate into a tax system certain measures especially suited to the scheme of governmental fiscal policy over the cycle. Taxes more sensitive to the fluctuating market conditions, such as the income tax and the excess profits tax, are ideal instruments for the fulfillment of such governmental fiscal objectives. These taxes will supply the system with a factor of “built-in1 * flexibility, ■which relates it directly to the level of national income and the 17 volume of employment. In direct proportion to business ups Ibid.. p. 187. 16 Hansen ranks high among this group. For his views on this subject, see ibid.. pp. 135-185. Committee for Economic Development, Taxes and the Budget i A Program for Prosperity in a Free Economy (New York: Committee""for Economic Development, 19^7), pp. 20 , 22-29. The Committee for Economic Development terms the policy the stabilizing budget policy. The basic principle is to set tax and downs over the cycle, the excess profits tax will produce widely varying yields, which fact makes it unsuitable to a revenue system with the annually balanced budget as its objec tive. But under the cyclical budget and the concept of 1 1 built- in" flexibility, the tax is ideal, for it affects only the few fortunate ones during the full fury of the depression, thus lightening the general tax load at the appropriate time, encouraging economic recovery, and at least unlikely to accen tuate the downswing by curtailing, as heavy sales tax does, the effective demand, while during the ensuing prosperity it has the tendency to check possible inflation through business overoptimism and overexpansion. Furthermore, from the stand point of tax justice the excess profits tax with a moderately graduated rate structure is probably the most equitable of all 18 taxes. It is fully recognized, however, that any tax instru ment does not lend Itself readily to the operation of cyclical control as an emergency measure. "Control demands quick action, and tax bills do not go through Congress quickly and ^ (Continued) rates to balance the budget and provide a surplus at agreed high levels of employment and national income and thereafter to leave them alone unless there is some major change in national policy or condition of national,life. The principle is essentially the same to that of the cyclical budget policy. This point will be dealt with more fully in a following subsection. (Infra. pp. 1M+-168, passim.) 101 smoothly, as recent events demonstrate. Moreover the collec- 19 tions lag far behind the legislation.*1 It is, therefore, proposed that the excess profits tax be made a permanent part of the federal tax system, so that it does not have to go through Congress in order to be effective and collections do not have to lag even farther behind Congressional action. A permanent excess profits tax has the added advantage of removing an element of doubt and uncertainty, as well as an impediment, from the long-term expectations of the business- 20 men and will be taken into consideration in their planning for future business operations. Qualification. A word of caution should be introduced here. The acceptance of the concept of the cyclical budget does not mean that no elements^of revenue stability are required or contemplated in the cyclical budget. Indeed, a certain minimum amount of revenue stability is requisite for any concept of budget balance, whether it be annual or cycli cal. From the point of view of economic justice, the bene fits of government services cover and reach out to almost 19 From Mabel Newcomer, A Tax Policy for Postwar America (New York University on Postwar Reconstruction, New York, No. 10, 19*+3) , quoted by Groves, Financing Govern ment , p. 6 1 1. 20 Herbert Stein, ‘ 'Stability and Flexibility in Federal Tax Policy," Proceedings of the National Tax Associa tion, 19*+6 (Sacramento: National Tax Association, 19^6), p. 2ol u 102 every citizen in the land and he who is thus benefited should contribute toward defraying some of the cost of such services, A low basic normal tax on income and a nominal sales tax on non-essentials may be imposed to insure for the government some minimum of revenue receipts, independent of business 21 fluctuations in the economy. The imposition of a low tariff and some excise taxes at low rates may not be alto gether amiss in this connection. But to build up a tax system exclusively around these imposts, which are mostly regressive in character, purely on grounds of revenue adequacy and sta bility, is an entirely different thing. SOCIAL CONTROL PURPOSE It is generally recognized and conceded that the taxing power may often be used like the police power for the regula tion of industry in controlling production, distribution, or 22 consumption, and the promotion of general welfare, rather than in addition to the raising of public revenue. Under the socio-political theory of Wagner, taxation inherently becomes something more than a means of raising revenue and is con sidered a means of correcting that distribution of wealth ? 1 “Independent" is used in a relative sense. No abso lute Independence is possible. ^ Shoup, et al., op. cit., p. *+8. 103 which results from free economic competition.2* ^ The various canons of taxation, such as the ability to pay and tax exerap- 2b tions of small incomes, can be justified on this theory. It has been said that "the power to tax is the power to define 25 the character of our economic system." Thus, taxes do not cease to be regulative in their effect even when not con sciously intended to be regulative. Not only is every tax in its ultimate effect regulatory as to commodity competition, business competition, or distribution of national income, but . . • each and every variation of base or rate structure, introduced for revenue reasons or to further fiscal justice or to facilitate adminis tration, exercises more or less economic regula tory effect. Seligman had long ago disposed of the distinction between the taxing power of the government, or its power to raise revenue, and its police power, or its power to impose regulation, as ^ Adolph Wagner, "The Socio-Political Theory of Taxa tion," from Elmer D. Fagan and C. Ward Macy, Public Finance— Selected Readings (New York: Longmans, Green and Co. , ' 1936) ? p . 18 0. 2lf Ibid., pp. 180-181. 2^ Temporary National Economic Committee, Taxation of Corporate Enterprise. Monograph No. 9> p. xi. William J. Shultz, "Taxation as an Instrument of Regulation," Proceedings of the National Tax Association^ , 19*f0 (Columbia, S. C.: National Tax Association, 19^0), p. 128. The unsettled state of this issue is indicated by a lop-sided 25 to 1 vote, among the experts attending the meeting, as against regulatory taxes. lO^f being “to a great extent a fiction, referable to certain difficulties in American constitutional law and to a lack of economic analysis on the part of the judges."^7 This arbi trary differentiation between the police and taxing powers is, according to Seligman, wholly unnecessary from the economic 28 and fiscal standpoint. According to Commons, taxation is "the most pervasive and privileged exercise of the police power" and has also become "the most effective exercise" of 29 that power. It seems idle to deny to the government the privilege . . . to strive to attain [certain ends] by the stimulating or retarding force of the tax power without regard to whether this exercise of the tax power brings in pecuniary revenue or not.-*0 In fiscal practice, since the first general restrictive tariff act of 1789? declaring "the encouragement and protec tion of manufactures" as being one of the purposes of law co-ordinate with those of raising revenue,-^*1 ' the regulatory 27 Edwin R. A. Seligman, Essays in Taxation (Tenth edition revised. New York: The Macmillan Company, 1925)> p. *+02. Ibid., p. *+06. ^ John R. Commons, Institutional Economics. Its Place in Political Economy (New York: The Macmillan Company, 19349, p. 820. Peck, op. cit.. p. 57- •3 1 Leverett S. Lyon, et al., Government and Economic Life (Washington: The Brookings Institution, 19*+0), II, p. 53*+* tax power has been widely and liberally employed. Writing in 1936, Peck had occasion to observe that with the rise of monopoly and the growing differences in the degree of price flexibilities (or inflexibilities) of various commodities and services, the government had progressively entered the field 32 of industrial regulation* From this country*s experience with the depression and the war emergency, it can be definitely concluded that inasmuch as taxes cannot b© imposed without economic repercussions and taxes levied exclusively for regu latory purposes have consistently been employed throughout the history of the United States, the almost innate right of the government to use taxation as a deliberate means to achieve a given economic effect has become a fait accompli and its use should be restricted only to the extent that it be clearly in the public interest and be kept well within the limitations of the existing knowledge and ability to forecast 33 consequences. THE LEVY OF EXCESS PROFITS TAX: REVENUE OR CONTROL? The question naturally arises whether an excess profits "iO J Peck, loc* cit. 33 This qualification of the use of the taxing power as a regulatory instrument is taken from Robert M* Haig, “Final Report of the Committee of the National Tax Associa tion on Federal Taxation of Corporations,“ Proceedings of the National Tax Association. 1939 (Columbia, S* C.s National Tax Association, 19^0), p* 5ol. tax should he imposed for revenue or regulatory purposes. In the past war emergencies, this country had employed the tax 3 1+ for both revenue and regulatory purposes. The permanent excess profits tax, as proposed by this writer, is not to be levied for the regulation and control of monopolies, even though, as it will be made clear in a later chapter, the main burden of the tax will most likely fall on monopoly profits. In making this statement this writer is not unaware of the unfavorable differential economic effects of taxation on monopolistic industries. To restate his theme, the excess profits tax measure is proposed to recapture for the state some of the excessive gains*^ reaped by concerns possessing over other firms certain exceptional economic or political advantages, regardless of what these advantages may be or how they may have been obtained. No crusade against monopolies is intended. This country has been grappling with the monopoly problem for over half a century, apparently without much suc cess. The unexpectedly hasty repeal of the excess profits ok J See supra, Chapter II, passim. “Excessive*1 is used in the economic sense of the word. The distinction between “excessive1 1 and “excess” profits lies, according to Lutz (op. cit•, p. *f53)> in that the former term involves judgments, or opinions, or ethical connotations, while the latter purports to determine the profit that is in excess of some standard amount. This writer is of the opinion that “excess” may be used without practical distinction to connote both the economic excess over the theoretical normal profits and that portion of profits in excess of a legal normal. 107 tax after World War II seems to indicate a definite trend in the pendulum’s swinging to the right in favor of the corporate giants after over a decade of New Deal economics. The anti- monopoly movement seems to have passed its prime and is now exercising a considerably less influence upon American thought 36 than it did formerly. The agitation, led by the American Legion after World War I, against war profiteering^^ has yet found no counterpart during the first three years of this postwar era. Recently, the United States Supreme Court turned down the Justice Department Antitrust Division’s attempt to prevent the sale of Los Angeles & Consolidated Steel Corpora tion to Columbia Steel Company, a subsidiary of United States 38 Steel Corporation. Furthermore, it is still an unsettled ^ Harold M. Groves, Trouble Spots in Taxation (Princeton: Princeton University Press, 194-8), p. 3 6. 37 Supra. Chapter II, p. 6 3. 3® This summary is based upon a discussion covering the case by Time. LI, No. 25 (June 21, 19^8), 86. This Supreme Court decision may be balanced off against another of its recent decisions regarding the basing-point system of pricing adopted by the cement industry. The abolition of the basing- point system has already resulted in higher cement prices, due to higher freight charges (to the advantage of the cement makers). The economic effect has, however, gone beyond the cement industry directly affected by the decision. The steel industry, which also used the basing-point system of pricing, was ’ ’obliged” to comply with the principles of the court opinion, abandoning it in favor of the f.o.b. system of pric ing. The eventual rise in steel prices was expected to amount to 20 per cent. (Time. LII, No. 3 (July 19, 19^8), 8 7.) 108 issue whether extensive economic concentration and integration are not the natural consequences of modern technological pro gress and whether the breakup of the existing monopolies into small, duplicate, independent operating units is definitely •39 in the interest of the economy as a whole. Pending a final settlement in principle, the need for governmental revenue is constantly present. The excess profits tax, imposed upon business profits in excess of normal profits, should not be put into effect with a punitive intent, as it is not known to what extent the monopolies are guilty of being a contributing factor to economic maladies; and in the meantime, as will be argued in a following subsection, the tax can be made to con tribute toward the satisfaction of the need for revenue yet with the least restrictive effect on production. Besides, this writer agrees with Paul that the excess profits tax is probably too crude an instrument to ferret *f0 out and check or curb the undesirable monopolistic practices, 39 David Lynch, The Concentration of Economic Power (New York: Columbia University Press, 19^+£), pp* 3^-367, questioning the almost exclusive monopoly approach of The Temporary National Economic Committee. It, according to Lynch, assumed monopoly to be the basic cause of economic ills, but did not analyze what the basic forces, resulting in economic dislocation and maladjustment, actually were. ^ Randolph E. Paul, Taxation for Prosperity (Indianapolis: The Bobbs-Merrill Company, 19^7)j P* 385. 109 though he heartily disagrees with Buehler that because of the technical difficulties in the determination of what monopoly profit or income is, the excess profits tax is not warranted *fl as a revenue device. A tax should never be abandoned merely Alfred G. Buehler, "Should the Tax System Be Used to Check Monopoly?" in How Should Corporations Be Taxed? (New York: Tax Institute, Inc., 19*4-6), pp. 97-100. Buehler seems to be knowingly guilty of requiring of the excess pro fits tax a test of perfection which no tax in its actual performance is capable of surviving, while tolerating imper fections in other tax measures which happen to meet with his predilection. Would he say or argue that because of the difficulties of determining what true net income is, no income tax should be imposed? As is known to everyone, the theoretical net income is impossible of precise computation for short-run tax purposes. But Buehler did not disapprove of using the progressive personal income tax as a revenue device. (Ibid.. p. 100.) Groves also appears to maintain an inconsistent position regarding a peacetime excess profits tax. (Groves, Postwar Taxation and Economic Progress. pp. 76- 81.) He started out with "... the tax affords an opportun ity to recapture part of the excessive gains resulting from monopolistic business." (Ibid.. p. 7 6. Italics supplied.), but concluded with "as an antidote for monopoly, it would not be sufficiently discriminating to achieve its purpose, and it could do a lot of damage in the attempt. For the present, we are obliged to attack the monopoly problem with other weapons, however inadequate they may be." (Ibid.. p. 81.) In other words, his starting position on a peacetime excess profits tax was a tax for revenue purposes, as evidenced by "recapture part of the excessive gains," but his conclusion against the same excess profits tax was based upon the tax as an instrument of attack on the monopoly problem, which should have nothing to do with the problem of raising public revenue. In a paper, entitled "Equity and Expediency in Business Taxation," (published as Chapter III of How Shall Business Be Taxed? [New York: Tax Policy League, Inc., 193© J, pp. 39-l +l and *+3), Groves argued for the excess profits tax as a means to recapture monopoly gains, but not to prevent monopoly. The present change of position on this issue by this eminent author may perhaps be attributed to the influence of the general shift of public opinion since the 1930's. (Cf. Groves’s remark on monopoly, supra, p. 107» footnote 3 6.). 110 on the tenuous ground that it falls short of the theoretical perfection which some opponents of it maintain that it should attain. One author avers that "the absence of a dividing line between excess profits and non-excess profits" should never be allowed to be a deterrent to the levy of an excess profits k-2 tax. This is identically the same position this writer maintains. III. FISCAL AMD ECONOMIC BASES FOR BUSINESS EXCESS PROFITS TAXATION In recommending the incorporation of the excess profits tax as a permanent part of the federal tax system in the book, Facing the Tax Problem, the Committee on Taxation of the Twentieth Century Fund, Inc. fails to state the basic economic reasons or factors underlying an excess profits tax on busi ness and for that matter any form of business taxation. Itfhlle it does reason for an excess profits tax on business from the impersonality point of view and also from the "unearned ) ] ) [ income" point of view, it is silent on the basic economic ^ Shoup, et al., op. cit., pp. 277-278. ^ Ibid., p. 273* By impersonality is meant that the income in question should not be allowed to get into private hands, regardless of whose hands. ^ Loc« cit. "Unearned" or excessive profits can be taxed with little sacrifice. Ill justification of a tax on business, separate and distinct from its owner* The “impersonality” and the “unearned income” nature of the excess profits tax may justify a separate busi ness tax on grounds of expediency and social control, but they do not provide a basic economic rationale against taxing business profits to the owners. It is the purpose of this section to attempt the formulation of a theoretical basis of business taxation. THEORETICAL BASES FOR BUSINESS TAXATION Apathy among students of public finance. Opponents of business taxation have contended that taxes are imposed on business for no other reason than that of fiscal expediency. A business tax “is levied primarily as an expression of fiscal and social expediency. ... Business taxes assure governments larger and.more certain revenues and render tax collection more convenient.” Business taxation has, therefore, become an institution which is about as ancient and universal as b6 business itself. It is not denied that some elements of truth are contained in these statements. The theoretical LX " • Alfred G. Buehler, “The Taxation of Business Enter prise— Its Theory and Practice,” Annals of the American Academy of Political and Social Science. CLXXXIII (January, 1936), p. 9$7 U-6 Loc. cit. 112 approach to business taxes has generally been regarded as much "less important than an analysis of their incidence and ^7 effects." Studenski1s proposals. This negative state of mind toward a theory of business taxation has been brought about by the comparative neglect which the subject has suffered in the hands of the students of public finance. They "almost completely avoid inquiring into their [federal and state taxes on businessj economic and social justifications.1 1 To redress this undeserved neglect, Studenski proposes nine different bases toward a theoretical justification of business taxation. As regards these theoretical bases, this writer differs with Studenski on many points. To be specific, the eighth theory of social expediency does not, for obvious reasons, furnish any theoretical basis for the levy of business taxes and, therefore, should not be treated in conjunction with other principles which do. The same objection goes for the Groves, Postwar Taxation and Economic Progress, p. 20. 1+8 Paul Studenski, "Toward a Theory of Business Taxa tion," Journal of Political Economy. XLVIII. Ko. 5 (October, 19b0), 5221 ^ This deficiency is admitted by Studenski (ibid., p. 6*f0) • 113 50 social-control theory. Some combination of the fourth 51 principle of cost of general service rendered to business 52 and the fifth principle of state partnership might con ceivably be worked out to avoid duplication in certain respects and to present a separate, stronger, and more inte- 53 grated theory. The general welfare theory does not provide for a direct economic basis of business taxation and is more of a theory of apportionment than of a fundamental justifica- 5*f 55 tion of business taxation. The social-cost theories seem to have been advanced to justify punitive tax measures against business, akin directly in this respect to the social-control theory. It is extremely doubtful whether such damages as the blighting of formerly good residential districts, the over crowding of urban areas, industrial accidents, and technologi cal unemployment, among others, all being more or less the inevitable concomitants of modern technological progress, the 50 Studenski concedes that this theory involves dis tinctly separate issues (ibid., p. 625)• ^ Ibid.? P» 630. Infra, p. Il5j footnote 59* ^ This will be attempted below. 5k This is also partially admitted by Studenski (ibid.. p. 6 3 9.) 55 ibid., pp. 631-632. fundamental driving force of the Western materialistic civil! zation, should be attributed to business alone or at all. Science, urged on by the insatiable human wants, is really more responsible for such damages than anything else. In an era -when income taxes and other forms of direct taxation are increasingly depended upon for the provision of revenue needs of the government without, at the same time, sacrific ing the basic concepts of tax justice, especially those of ability to pay, the privilege and the cost of special service 57 theories diminish greatly in theoretical importance. When business is charged for special services rendered or for some special privileges, it is not taxed in the fullest sense of the word, but pays a fee for the service. Even though a fee is a manifestation of the taxing power, it is, nevertheless, assessed as a payment for a special privilege, since the basis of a fee is the special benefit accruing to the busi- 58 ness. Of course, the privilege and the cost of special service theories may be made the basis of a special business tax, for instance, a tax based upon business net income, the 56 . Only the Hindu yogis and spiritual devotees may have some legitimate claim against the Western technological progress. ■ ^ Ibid.« pp. 625-626. Seligman, op. cit., p. b07» 115 assessed amount of which may bear no commensurate relation to the particular benefits actually received. Even then, it is thought better, for the sake of sound theory, to formulate an entirely new principle, general in its application and having nothing to do with specialities, then to rely on a theory restricted in its scope of application. All this narrows the choice of principle down to the fifth theory of state partner- 59 t ship and the sixth theory of impersonal ability to pay tax. State partnership theory: its proponents. The basic idea of the state partnership theory of business taxation can be gleaned from Thomas S. Adams’s writing some thirty years 6 T ago. But it had not received serious attention until Colm made it one of his theoretical mainstays in the discussion of the concepts of relative tax justice in the gradual unfold- 62 ment of the capitalistic system. According to Colm, there are four different conceptual stages of capitalistic 59 One of the two variants of the general benefit theory (Studenski, op. cit.. pp. 626-6 3 1). 60 Ibid.. pp. 632-639. Thomas S. Adams, “Taxes Upon Income and Excess Prof its,“ American Economic Review. VIII, Ho. 1, Supplement (March, 1918), 21, to the effect that “moreover, the excess-profits tax may in the future serve appreciably to allay hostility to big business, by making the people a partner in the success of business enterprise.” (Italics supplied.) Z p Gerhard, “The Ideal Tax System,” Social Research. I, Ho. 3 (August, 193*+) j 32^-332. 116 development, i.e., the protective, the social, the state partnership, and the control stages. These stages overlap one smother in the process of gradual unfoldment and "in every capitalist epoch the actual state is a combination of these concepts [the four stages] although with a varying emphasis," J The criteria of tax justice in these four stages differ according to the differing functions the state 6*f performs. In the protective stage the benefit principle dominates. For the social stage the progressive income tax, based on the ability to pay, was most suitable to the prin ciple of redistribution of income. In the third stage the state appears as a partner in production side by side with capital and labor. The functions of the state in this stage include road building, industrial education, encouragement of technological research, economic and statistical reporting, and undertaking recovery programs during depression to reduce cyclical business risks. These functions enhance and assure returns from private production and establish the state as an agent of production to share indirectly in the product. The last conceivable stage is that in which the state not only . Italics supplied. ^ Which criterion or criteria of tax justice predomi nate presumably follows the predominant conceptual stage of some or all of the four stages combined in the actual state. participates in production, but actually dominates it to a greater or lesser extent. This is the control stage. This domination, which sometimes results in discriminatory inter vention of the state in the sphere of production, is governed by the concept of an ideal economic structure. Upon this concept, measures to equalize the standing of two different industries in the market through discriminatory taxation may be justified. According to Colm, the sudden shift of the economy of the United States from the protective to the part nership or even the control stage during the depression pre sents the most difficult tax problem of all. The reason is that the adjustments of the tax system to conform with the changing concepts of tax justice could not be made with suffi cient speed. As to specific tax measures which are deemed in conformance with the partnership theory of taxation, Colm suggests a general business tax, imposing an equal burden upon every branch of the industry. 65 Hunter's state partnership theory mainly revolves around the idea of "payment for benefit" in general. He criticizes Henry George1s single tax proposal on the ground that "society is pretty much of a partner in the creation of ^ Merlin H* Hunter, "Shall We Tax Corporations or Business?" American Economic Review. XXVI, No. 1 (March, 1936), 8^-89. 118 66 all values,” not just the economic rent of land. He, then, sets forth his theory of business taxation, which, as the following quotation reveals, is based entirely on the general benefit idea, which, in turn, gives rise to the state partner ship variant: Since, then, the cooperation of society is essen tial to the success of any and every business enter prise, whether it be a corporation, partnership or individual entrepreneur, it seems but the part of fairness that business should make some payment to society in return for the part it has played. Here is a logical basis for a tax upon business of what ever nature with no consideration of ability. It is a quid pro quo payment to society for benefits received. Any taxes upon persons, as such must be in addition to this. . . . It is of course impossible accurately to measure the contribution of society to the success of each business enterprise. A feeling is being expressed in many quarters, however, that society has received a share too small, or to put it the other way round that business has retained too large a share of the social income. • . .&7 It Is proper to Infer from the above quotation that both the concept of government as a beneficial factor of pri vate production and that of the state partnership theory are present in Hunter's theory of business taxation. In a more recent work he did not change his position regarding business taxation, as can be easily seen from: "this quid pro quo payment [for the contribution by society] is a logical basis ^ Ibid.. p. 86. (Italics supplied.) ^7 Ibid., pp. 86-8 7. 119 for a tax upon business of whatever nature without considera- / ; o tion of ability.1 1 Lindholm also thinks that Hunter1 s theory of business taxation is that of the state partnership. It is to be noted that Hunter did not propose any specific tax 70 measure based exclusively on his state partnership theory. Colm's idea of government as an agent of production was followed up by Studenski In 1939 in his article, entitled 71 “Government as a Producer.'1 An inkling of his theory may zo Merlin H. Hunter and Harry K. Allen, Principles of Public Finance (New York: Harper & Brothers Publishers, 19^-0), p. 3&+. . ^ Richard W. Lindholm, The Corporate Franchise as a Basis of Taxation (Austin: The University of Texas Press, 19 W , p. 113. 70 ' In his "Shall We Tax Corporations or Business?" this is made all the clearer by: "the suggestion to take a part of the socially created value in taxes not only can be defended as a base for taxation, but can be used to accomplish whatever 'redistribution1 of wealth may be deemed desirable. . . . So it may be a better policy to prevent the accumulation of large fortunes, granted that such accumulation Is undesir able, than to attempt to break them up once they have been accumulated. ..." Redistribution of wealth and the preven tion of undesirable accumulation are obviously the other cri teria to be considered in taxing business. ^ Paul Studenski, "Government as a Producer," Annals of the American Academy of Political and Social Science. CCVI (November, 1939), 23-"35 +. It should perhaps be mentioned here that Wasserman (Max J.-, "Taxes as a Share in Distribution," American Economic Review. XXVIII, No. 1 (March, 1938), 104-105) proposes the introduction into the distribution theory of gov ernment as a factor of production. That the suggestion was not well received may be seen in H. M. Somers, "Taxes as a Share in Distribution," American Economic Review. XXIX, No. 2 (June, 1939), 3^9. 120 be had In the statement that: “government is an agent of production, even though its services are furnished free at the time they are supplied. These services are valuable 72 economic goods. . . .“' In the following year he came 73 forth with an article on the theory of business taxation, in which he expands the theory of government as an agent of production into that of state partnership. According to him, the government, though actively participating in the work of every enterprise and having a claim on its profits, . . . is a peculiar partner: it is interested in the procurement of a share of profits of the busi ness, but only in an incidental way. The primary objective of its participation in the activities of business enterprises is to aid the producers engaged therein to earn their incomes and to pro duce the goods and services required by society. When business enterprises do not earn profits, government, as a partner, sustains losses in the sense that it does not receive any reimbursement for the outlays it has made, for the benefit of the enterprises.'4' In accordance with this theory, Studenski recommends taxing business enterprises on their net incomes at proportional rates. In 19*+*+ Lindholm also came forth as favoring the state partnership theory as a basis for levying business taxes, 72 Ibid., p. 29. ^ Supra, p. 112, footnote *f 8. ^ Ibid., p. 6 3 0. Cf. Edward D* Allen and 0. H. Brownlee, 121 though he was specifically concerned with corporate taxa- 75 tion. He agrees with Colm, Hunter, and Studenski as to the basic theory underlying business taxation, but disagrees with their specific tax suggestions, especially those regarding the taxing of all businesses at uniform or proportional rates. He is of the opinion that business enterprises should be taxed at varying rates. State partnership theory: its opponents. Most oppo nents of the state partnership theory maintain the generally negative position that any such theory, derived from the general benefit theory, does not indicate precisely how busi ness should be taxed or how much taxation business should 76 pay. Some, like Shultz, have even less respect for this theory. He writes in his widely used textbook on public finance: Unless some sort of single tax is proposed— a single business tax, or a single increment tax— the State-partnership doctrine provides no general standard of tax distribution. Moreover, the idea ? (Continued) Economics of Public Finance (New York: Prentiee-Hall, Inc., 19^+7)9 P* 311, “Yet government cannot share in the business losses of firms that never become profitable without increas ing the danger that this would adversely influence resource allocation.” ^ Lindholm, op. cit., pp. 112-115. ^ Alfred G. Buehler, ”Critique of Present Methods of Business Taxation in the United States,” in How Shall Business Be Taxed? (New York: Tax Policy League, Inc., 193oT, P* 5o* 122 of partnership between the government and individ uals is an analogy, an argumentative fiction, rather than a sound deductive premise. At most, the State-partnership doctrine can be but a supple mentary argument buttressing a tax which finds its major justification under some other doctrine. By itself, the theory would be tenuous support for the imposition of any particular tax.77 Groves also shows misgivings of the same nature about the theory when he writes: Will division among individuals be more equitable or otherwise more desirable if business taxes are levied? This is the important question, and, in searching for the answer, one gets little guidance from a consideration of benefits.7o State partnership theory: reconciliation. The field seems to be evenly divided between the pros and cons.'7 This writer thinks rather highly of the state partnership concept as a positive and substantial contribution toward the economic formulation of a theory of business taxation. It is, no doubt, an extension as well as a variant of the general bene fit theory, which Adams stated so well some thirty years 77 Shultz, o£. cit.. pp. 286-287* ^ Groves, op. cit., p. 2J +. 79 it should be noted that among the opposition group Buehler and Groves did not reject the state partnership theory outright as Shultz did. Buehler in his Public Finance, second edition (Hew York: McGraw-Hill Book Company, .Inc., 19^0) , pp. 613-61^, mentions the state as a "silent partner in business'* without rejecting it. 80 ago. Hobson apparently had the same idea in mind when he writes in his Taxation in the Hew State that the taxable sur plus ^expresses the aid rendered by the State, as the represen tative of Society, to the production of wealth . . . »ox Since the depression (and also the last war), those positive measures adopted by the government to maintain high employ ment and sustain business prosperity have caused such tremen dous increases in public expenditures that the older concept 82 of the non-productivity of governmental activities is no longer valid. It is inconceivable that none of those expendi tures are productive. If governmental activities are con sidered productive, as most of them undoubtedly are, the concept of the government as a factor of production and the state partnership theory immediately present themselves as Thomas S. Adams, "The Taxation of Business,n Pro ceedings of the National Tax Association, 1917 (Hew Haven, Conn.: National Tax Association, 1918), p. 1 8 7, '*. . . A large part of the cost of government is traceable to the necessity of maintaining a suitable business environment. . . . in the long run, the more business the greater will be certain fundamental costs of government. . . . Surveyed from one point of view, business ought to be taxed because it costs money to maintain a market and those costs should in some way be distributed over all the beneficiaries . . .1 1 The last quoted sentence presumably envisages the taxing of consumers, laborers, as well as business enterprises, since all are conceivably beneficiaries of government services. ^ J. A. Hobson, Taxation in the Hew State (London: Methuen & Co., Ltd., 1919)5 P* 78. Maintained by Adam Smith and Ricardo over a hundred years ago. the logical conclusion, Shultz's rejection of the state partnership theory was based upon two principal arguments: the idea of partnership is a fiction rather than a sound deductive premise and the theory fails to provide a general standard of tax distribu tion. This writer agrees with Shultz that the concept of partnership is, and necessarily so, a fiction, for the simple fact that private business is perennially reluctant to take in the government as a "superior" partner. But somehow, the direct benefits, resulting from productive governmental activi ties in the economic life of the nation, are quite substantial and the increasing business reliance on the government in par ticular, to prevent cyclical fluctuations and business reces sions and, in general, to maintain suitable business condi- o, tions ^ bears evidence to the fact that the role of government in the scheme of things as they stand today has undergone a fundamental change, from which there is no return. The pro ductive services rendered by the government are not free goods, but economic goods to be paid for out of public incomes, business or otherwise, which they help to produce. Government as a factor of production cannot now be ignored in any theory see Leverett S. Lyon, et al., Government and Economic Life, ' I and II (Washington: The Brookings Institution, 1939 and 19^0, respectively) for a comprehensive description of governmental functions relating to economic matters. 125 of business taxation as it could in the bygone days of 8b laissez faire. If the economic value of government ser vices to production is recognized, it affords a "sound deduc tive premise" on which to build a sound theory of business taxation* The other objection to the state partnership theory that it fails to provide a general standard of tax distribu tion, appears not to be well taken* All of the authors cited in this connection, with the exception of Buehler, Hunter, and Lindholm, seem to have confused the basic issue involved in the formulation of a theory of, business taxation* Briefly, this writer believes that in the building-up of a theory of business taxation the student of public finance endeavors only to discover an economic basis for levying business taxes. He is concerned not so much with the question as to how 8* + It is interesting to note in passing that J. H. Hicks has this to say on the economic activity of the state (op. cit., pp. 99-100): "Secondly, it [his system of the general equili brium of production] abstracts from the economic activity of the State; this is very important, but the State is a very incalculable economic unit, so that the extent to which its actions can be allowed for in economic theory is somewhat limited. (This is, of course, a deficiency of economic theory as such, and as a whole.)" (Italics supplied.) In other words, Hicks admits the abstraction of the economic activity of the state to be a deficiency of economic theory. The state part nership theory, which allows for the government factor of pro duction in economic theory, attempts to make up for just that deficiency. From the point of view of economic theory, there fore, the theory does afford a sound deductive premise for business taxation and is not merely an "argumentative fiction" as Shultz would have his reader believe. business enterprise should be taxed or how the tax burden is to be distributed, as with the economic basis for taxing business enterprise as a separate taxable unit. In the search for such a theory he is mainly interested in inquiring into the nature of business existence, as distinct from its owners, and its economic relations with the state. That the state partnership theory, as finally established, does afford a valid basis of business taxation from the point of view of economic theory, should not be taken to mean that it should also provide a standard of distributing the tax burden of the community as a whole. That theory establishes the proper economic relationships between the state and business enter prise, but it does not pretend to resolve the mutual relation ships among the various business units and between the various business units as a whole and the rest of the community. The resolution of these latter relationships pertains to the for mulation of principles or rules of tax apportionment. Thus, the state partnership theory, evolved out of the economic concept, as well as the fact, of the government as a beneficial factor of production, cannot be expected to serye, in its (proper) capacity of theory, as a standard of distribution with any degree of competence. But this should not condemn it, for even the theory of expediency does not provide for rules of apportionment. Shultz’s attack, there fore, misses the mark entirely. Buehler cannot be accused of 127 confusing the issue, since he just simply does not believe that a pure theory of business taxation, other than that of 85 fiscal and social expediency, exists. Groves makes the interesting statement: "it is not at all clear that we should distribute federal taxes according to benefits even if we 86 could. 1 1 The answer is clear: we should not. The general benefit theory furnishes only the basis for business taxation and, hence, does not lay down any empirical rules for distribu tion. Almost to an equal extent, the proponents of the state partnership theory, with the exception of Hunter and Lindholm as noted above, are also confused in this respect. After having stated the theory in admirably sound and convincing fashion, they went about designing specific tax measures, which, they thought, were in agreement with their theory. The measures admittedly do agree with their theory, but the great fault is that they do not agree with accepted and prevailing canons of tax justice. To be strictly formal and for argument's sake, a tax, based upon the principle of the state partnership theory, should be assessed at such a rate as the last unit of the government factor of production, ignoring its indivisi bility, contributes toward the total production of the Buehler, ojd. cit., p. 6l1 +. 86 Groves, ojd. cit.. p. 25. (Italics in the original.) 128 enterprise. But this is neither practicable nor necessary* It is not practicable, because the marginal productivity analysis is a conceptual process by which economists may theoretically resolve, to their own satisfaction, the value of total product into its component parts, but it has little known practical value, at least, in framing tax measures. Nor is it necessary, because in distributing tax burden framers of tax measures are usually guided by other principles more amenable to the accomplishment of tax justice in distri bution than the specific benefit or productivity approach. Thus, Colm's general business tax at uniform rate on the value added by manufacture should not be thought of as the only tax on business. As Lindholm argues, there is consider able room even under the state partnership principle for 8 7 special corporate taxation. Likewise, Studenski’s net income tax at proportional rates, though conforming to his state partnership theory in principle, may be replaced by a 88 business tax of many varying rates. This writer agrees with Lindholm*s conclusion that the uniform taxation of busi- 89 nesses of all types is not the sought-for panacea. ^ Lindholm, oj). cit., p. llU-. See infra, pp. -185-186, for another criticism of Studenski‘s measure. Lindholm, ojd. cit.. p. 116. 129 Impersonal ability theory. The other remaining of Studenski’s nine theories of business taxation emerges as the logical conclusion to his fundamental proposition that the distinction between business enterprise and its entrepreneur should be recognized and maintained, for business enterprise as a whole is a vast producing organization, having a person ality of its own. Thus, . . . modern business enterprise is, to a large extent, no longer the personal venture of the individual producer, inseparable from his person ality, but is a complex organization or group venture having an organic unity and collective personality of its own. . . . The product of modern economic activity is collective, rather than individual, in character. Each individual participating in, or employed by, the enterprise receives an income supposedly commensurate with his contribution to the common product. Modern business enterprise has produc tive capacity which is impersonal in character and must not be confused with the personal produc tive capacities of the individuals participating in its functioning. . . . It is the result of the effective combining of men, machines, and materials and the collaboration of government and society as a whole. . . . Taxes on business enterprise are levied very largely, as will be described below, on these collective and impersonal productive powers, • • • This distinction between the entirety of business organiza tion and the entrepreneur gives rise to its separate imper sonal ability to pay taxes. Studenski then went on to say ^ Studenski, op. cit.. pp. 623-62*+. 130 that . . . each enterprise has a peculiar ability to earn income and, in the light of its various requirements and obligations, to pay taxes there from, This ability, except in personally con ducted businesses. is distinct from the personal abilities-of the owners to pay taxes from their incomes.' Why should there be such a sudden shift from the standpoint of the entirety of productive capacity to that of individual enterprises, especially since such shift in position is not necessary to the validity of the theory, is incomprehensible to this writer. In theory, since from the society’s view point the entire productive machinery contributes to the total product just as labor and entrepreneur do, and inasmuch as the latter two income-earning factors of production are required to pay taxes, the organization factor, income-earning though impersonal and inanimate, should and could be successfully made to do the same for both social and economic reasons. Socially speaking, the income-earning capacity of the organi zational factor, ’ ’the result of the effective combining of men, machines, and materials and the collaboration of govern- 92 ment and society as a whole,” may be equitably apportioned among the various contributing factors, prior to legal 91 Ibid.T p. 6 3 3. (Italics supplied.) 92 Ibid.T p. 62^. 131 possession by its entrepreneur, without prejudice to his interest. Economically speaking, the above division before owner-possession has even stronger appeal. But the moment proprietorships, partnerships, and close and small corpora tions, presumably all personally managed by the owners them selves, are excepted from this rule, the usefulness of the impersonal ability theory as a universal basis of business taxation is diminished. To make it a theory of general appli cation, it seems that these personally conducted enterprises must be included among the impersonal totality of productive 93 capacity. As far as this writer is concerned, there appears to be no doubt that business enterprises have a separate, abso lute impersonal ability to pay taxes. The higher up the business size ladder the student of finance goes, the more real this impersonal ability becomes in fact. This brings him to the desirability of examining the theoretical sound ness of recognizing the corporate entity in the scheme of the ^ If the exception were based upon Studenski's mis givings about the practical difficulty of ascertaining the portion of the profits which is attributable to the personal effort of the owner, this writer would suggest that the mis givings be dispelled and a reasonable salary scale, as a r.emedy, be set up to be administered by the Treasury. If the exception were made to give a clear-cut tax advantage to small businesses, which could not be justified theoretically, it could not obtain the sanction of this writer. According to his opinion, the exception is justifiable on one count only, for which see infra, p. 1 5 7* 132 present federal income and the (repealed) excess profits taxa tion. Conclusion, Both the state partnership and the imper sonal ability theories provide a sound economic basis for levying business taxes. These theories do not, however, fur nish any standard for the distribution of the tax burden of the society as a whole. The quest for such a standard will be made in a later section of this chapter. THE CORPORATE ENTITY: LEGAL CONCEPT OR ECONOMIC FACT? Introduction to the problem. In the scheme of federal income taxation the individual proprietorship and the partner ship have not, with a few isolated exceptions during one time Qk or another, been made taxable as a business unit, separate and distinct from their owners. That is, the business income of either the proprietorship or the partnership is taxed under the personal income tax provisions to either the proprietor or ^ These exceptions refer to the excess profits tax ation of partnerships under the Act of March 1917 (supra. Chapter 31, p. W) and of individual proprietorships and partner ships .under the Act of October, 1917 (supra. Chapter H, p. **9) • Aside from these instances, this writer has not been aware of any federal income and profits tax provisions imposing a separate income and profits tax on these unincorporated busi nesses. 'Even under the current provisions permitting con solidated returns to be filed by a group of business organiza tions having the same economic controlling interest, proprietorships and partnerships, even though controlled by the same interest, do not come within the purview of those provisions. 133 the partners, without a special business income tax being imposed on the firm, as is the case with corporations. This double taxation of corporate income, which discriminates against the corporate form of doing business, has led to numerous proposals as to how to tax the corporate net income more equitably and in line with the taxing of unincorporated 95 businesses. One of the most-mentioned methods is the exten sion of the use of the partnership method in taxing corporate net income. Under this method each stockholder would be taxed on his proportionate share of the corporate net income, as earned, under the personal income tax provisions, without regard as to whether the earned income has been distributed as dividends or not, thus eliminating entirely the inter mediate corporate income tax. Opposition to the use of this method is primarily based upon the technical difficulties to be encountered^ in the case of corporations with a large" number of stockholders, numerous stock transfers, and complex capital structures. No theoretical objections have yet been raised, 95 ' . . Sample suggestions as to methods of 'reaching individ ual interests in corporate incomes Robert M. Haig, ’ ’ Federal Taxation of Corporations,” Proceedings of the National Tax Association. 1939. pp. 5^-561; RicharcT Goode, ’ *The Postwar Corporation Tax Structure,” pp. m- 6-58;, and, Howard R. Bowen, ’ ’Optional Partnership Treatment of Corporate Earnings,” pp. 61-71, respectively, or How Should Cornorations Be Taxed? (New York: Tax Institute, Inc., 19^7); and Paul, op. cit.. PP. 359-372. 13 l f as far as this writer is aware of. It should perhaps be mentioned here that the disregard by the courts of the legal corporate entity in corporate taxa tion is not new. In fact, the difficulties resulting from the recognition of the separate corporate entity have been quite numerous especially in connection with the income taxa tion of small and close corporations. Unusual and extraordi nary circumstances are ordinarily involved, however, if such judicial disregard is resorted to. These special occasions 96 relate, according to Ballantine, to corporate dividends 97 received by domestic corporations, consolidated returns in case of affiliated group of corporations, corporate reorgani- 98 99 zation, et cetera. 96 x Arthur A. Ballantine, “Corporate Personality in Income Taxation,1 1 Harvard Law Review. XXXIV, No. 6 (April, 1921), 575-576. 97 ' Sec. 26(b) of the current Internal Revenue Codes 85$ of the amount received by a corporation as dividends from a domestic corporation, but not in excess of 85^ of the adjusted net income, is allowed as a credit against its net income. 98 Referring to certain nontaxable corporate transfers, for instance, made under provisions of Sec. 112(g), I. R. C. 99 a great majority of these cases have reference to some "non-arm's length" deals‘between the controlling stock holder and the controlled corporation. (See Maurice Finkelstein, "The Corporate Entity and the Income Tax." Yale Law Journal. VIL (January, 1935), ¥+1.) There is, however, another instance where the disregard of corporate entity occurs, which Ballantine and Finkelstein did not mention directly, namely, in cases where the Commissioner is authorized by Sec. M-5, Internal Revenue Code, to "Distribute, apportion, 135 The changing concent of corporate entity. This ficti tious corporate entity was given to the corporation by an eminent jurist more than one hundred years ago.100 Since then, the concept of the corporation has undergone such a fundamental change in character that it is questionable whether a mere legal fiction suffices in describing the huge, compli cated modern corporations. In the fourth edition of his authoritative The Financial Policy of Corporations T Dewing defines the true conception of the corporation as an institu tion, not just a legal fiction any more, and likens it to the 101 human institution of marriage. Berle and Means envisage the corporate system as a whole to be an institution or social organization, having an actual, objective, and permanent ^ (Continued) or allocate gross income . . . between or among such organiza tions [owned or controlled directly or indirectly by the same interests] . . . if he determines that such distribution . . . is necessary in order to prevent evasion of taxes or clearly to reflect the income of any of such organizations. . . A case in point is Hugh Smith, Inc., 8 TC 660. 100 Chief Justice Marshall in Trustees of Dartmouth College v. Woodward. *+ Wheaton (D. S73 5lS (1H19TI “an artifi- cial being, invisible, intangible, and existing only in con templation of law" with personality entirely separate and distinct from its constituent parts, quoted by Henry E. Hoagland, -Corporation Finance, second edition (New York: McGraw-Hill Book Company, Inc., 193B), p. 10. 101 Arthur A. Dewing, The Financial Policy of Corpora tions . without footnotes (New York: The Ronald Press Company, 19*+1), pp. 9-11. existence. Their view seems to follow that of Walter Rathenau, which they quote in part: Wo one is a permanent owner. The composition of the thousandfold complex which functions as lord of the undertaking is in a state of flux. . . . This condition of things signifies that ownership has been depersonalized. . . • The depersonaliza tion of ownership simultaneously implies the objec tification of the thing owned. The claims to ownership are subdivided in such a fashion, and are so mobile, that the enterprise assumes an independ ent life, as if it belonged to no one; it takes an objective existence, such as in earlier days was embodied only in state and church, in a municipal corporation, in the life of a guild or a religious order. . . • The depersonalization of ownership, the objectification of enterprise, the detachment of property from the possessor, leads to a point where the enterprise becomes transformed into an 3. 0^ institution which resembles the state in character. Admittedly, both the Dewing and Berle and Means* concepts of the corporation represent a theoretical advance over the for mer theory of legal fiction. But there is this difference between the two new concepts. Dewing*s view abstracts the whole corporate system into the social institution which pro vides the enterprising people with an economic means for carrying on their collective enterprise. Berle and Means* conception, however, not only takes into consideration this 102 This new concept of the corporation is discussed by these authors (Adolf A. Beale, Jr., and Gardiner C. Means in their The Modern Corporation and Private Property [Hew York The Macmillan. Company, 19^0j , pp. 3 52-3!?7 • ) 103 Ibid.. p. 352 137 institutional aspect of the whole corporate system, but also defines the more subtle, but none the less radically real, shift in the economic relations between the corporation and the various interest groups, on the one hand, and among the various interest groups, on the other, the shift having been occasioned by the diversification, as a result of depersonali zation, of ownership and the consequent divorce of ownership from control. Dewing simply passes over without comment this more important and explosive issue of the modern corporate lO^fr system. Through the Berle and Means’ approach it is possible to differentiate both conceptually and practically between the giant public corporations, on the one hand, and the snail, close, and essentially personally conducted cor porations, on the other. Wow, it can be seen more clearly that not only there is the over-all institution of the cor porate system, but also there are the institutions of giant public corporations, each of which may be considered as a separate economic institution, around which a part of the economic life of the nation is built and upon which millions As a matter of fact, Dewing’s institutional approach to the concept of the corporation does not represent a real advance at all. Strictly speaking, the corporate institution has been coextensive with the establishment of the corporate mode of business conduct. The entity fiction has been a legal concept only and did not have the right to claim an economic existence until the advent of the modern huge public corporations. The existence of such right is essential to the progress of corporate theory. 138 of people depend for their livelihood. Significance of economic entity. The most important economic fact about these corporate giants is that because of the divorce of ownership from control through the diversifica tion of stockholdings, these corporations have no economic owners. Inasmuch as what the stockholder now possesses is '•passive property" in shares of stock or bonds, giving him an interest in an enterprise, but practically no control over it, and involving no direct ownership responsibility, and since the owner cannot dispose of the corporate property to satisfy his conventional property rights, the old type concept of private property, applicable where ownership and control merge 105 in the same owner-entrepreneur, clearly does not apply. He does not "own" the corporate property in the traditional sense of the word and what he does own is merely "a token representing a bundle of ill-protected rights and expecta- 106 tions." The tangible properties of the corporation are controlled by the controlling group, but have little value to him, for there is no ready market for them even if he could dispose of them at will. They are the active property, the value of which is "for the most part composed of the organized Berle and Means, og. cit.« pp. 3*+^—31* - / 7• 106 Ibid., p. 3^7. 139 relationship” of these tangibles, “the existence of a func tioning organization of workers and the existence of a func- 107 tioning body of consumers.” To push this line of reasoning to its logical conclu sion, the stockholder of the giant modern corporation, . . . becomes simply a supplier of capital on terms less definite than those customarily given or demanded by bondholders; and the thinking about his position must be qualified by the realization that he is, in a highly modified sense, not dis similar in kind from the bondholder or lender of money. This similarity is heightened as the typi cal bondholder comes to rely increasingly on the success of a going enterprise and less on items of its property (whether mortgaged to him or not) which may, and usually do, become almost valueless if the enterprise is discontinued. The law, of course, still recognizes the distinction between a bondholder as a lender of capital and the stockholder as a “quasi-partner” in the corporation, but economically the posi tions of the two have drawn together. They are all security holders, belonging to a hierarchy of individuals all of whom have supplied capital to the enterprise, and all of whom 109 expect a return from it. Since the stockholder economically is not a true partner in the corporation, as a partner is in the partnership, to tax to him the corporate profits according 107 Ibid.. p. 3*1-8. 108 Ibid.. p. 279. hoc. cit. I*t0 to the partnership method, which derives its logic from true economic ownership, cannot be defended on economic grounds. Judicial recognition of economic entity. Even in judi cial circles this new economic relationship between the stock holder and the corporation has long since received the recog nition of the United States Supreme Court. In Eisner v. Macomber. 2J?2 U. S. 189 (1920) , Justice Pitney, writing the majority opinion, had the following to say regarding corpora tions with large capital, carrying on a huge business involving the use of this capital, and having a great number of stock holders : But. looking through the form [the corporate entity!, we can not disregard the essential truth disclosed, ignore the substantial difference between corporation and stockholder, treat the entire organization as unreal, look upon stock holders as partners. when they are not such. treat them as having in eauitv a right to a parti tion of the corporate assets. when they have none. and indulge in the fiction that they have received and realized a share of the profits of the company which in truth they have neither received nor realized. 110 Eisner v. Macomber. 2?2 U.S. 189, 3AFTR3021 (1920). (Italics supplied.7 As a result of this decision, the Treasury Department was defeated in its attempt to tax stock dividends (or corporate profits before distributions as divi dends) to the stockholders.- Following the strict economic logic of the court, it would seem that such argument as Mwe must treat the corporation as a substantial entity separate from the stockholder, not only because such is the practical fact but because it is only by recognizing such separateness that any dividend— even one paid in money or property— can be 1^1 Recent developments in corporate coneentration* Since 1 9 2 0, economic concentration has increased beyond erstwhile expectations and has caused an investigation by the Temporary National Economic Committee in the late thirties. In this postwar era both concentration and stock dispersion have been accentuated by the developments during the war. It is a well- known fact that the awarding of war contracts, owing to the necessity for mass production of war goods, was conducted in a manner injurious to small business and accentuating the trend to industrial integration.'1 ' ' 1 " * ' After Pearl Harbor, despite the wartime boom, the number of firms which discon tinued operations was greater than that replaced by new 112 entries. From 19^ through 19*f6 more than 1,800 formerly independent firms in the manufacturing and the mining indus tries, alone, disappeared as a result of mergers and acquisi tions; and preliminary data indicate that the high level of , 113 merger activity continued into 19W» In a recent survey of 110 (Continued) regarded as income of the stockholder*' (ibid.. p. 581) should automatically give the corporation the right to deduct divi dends paid out in computing its income tax liability. That this has not been done has remained one of the more serious theoretical objections to the federal corporation income tax. Lynch, op. cit., p. 3. Ibid., p. J +. Harrison F. Houghton, "The Growth of Big Business," American Economic Review. XXXVIII, No. 2 (May, 19^8), 90. Ib2 the 120 largest United States manufacturing companies with total assets standing at $51,0*4-1, 0 0 0, 0 0 0, it was found that in only four of them does any individual own as much as 10 llh per cent of the voting stock. Control by the founding family was found in three manufacturing corporations not included in the survey, because of the inaccessibility of 11*5 certain vital information. y The 120 companies under survey 116 were owned by 6, 1 2 6 ,7 1 3 stockholders and of the sixty-two companies giving the proper breakdown, twenty-four reported that no individual held as much as 1 per cent of the stock. 117 Five out of every six holders owned 100 shares or less. About 9 per cent of the stockholders, accounting for *fl per cent of the shares, were institutions, which, in turn, repre- XX3 sented millions of other individuals. A specific example 119 is that of stock ownership in Montgomery Ward. No individ ual owns more than 1 per cent of the stock and no company or estate more than 2 per cent. Its 6 .6 million shares are “Who Owns *Big Business1?** Trusts and Estates. LXXXVII, No. 1 (July, 19H-8), 5. Loc. cit. 116 Loc. cit. . Ibid., p. 6. 118 Ibid., p. 7. 119 Time. LI, No. 26 (June 28, 19I *-8), 8U-. l*+3 scattered among 6 8 ,5 0 0 holders, the biggest of them being investment trusts. Conclusion. All these statistics indicate that the traditional concept of property rights and the object of ownership is no longer applicable to the economic relationship between the large corporation and its stockholder. He does 120 not economically “own1 1 it and nobody else does either. The significance of this economic fact is that the corporation, legally owned by owners who have no control over it and no tangible property rights to it and actually controlled by the controlling interest which does not legally as well as econom ically own it, acquires an objective existence, permanent and enduring, as long as its economic usefulness to the society continues. This economic entity of the large corporation must be recognized in any system of taxation involving its income .and that of its stockholder in the form of dividends. There fore, the partnership method of taxing corporate net income directly to the stockholders not only is economically faulty, 120 Berle and Means (op. cit.. pp. 355-356) have offered no solution to the ownership problem, but do propose the substitution of public policy, based upon the interest of the community, for the motive of private cupidity (this •has already diminished in importance as a guiding force, any way, because of the divorce of ownership frcm control) in assigning the profits of the corporation. 1M+ but cannot be applied without doing grave injustice to them,’ * -2' * ' let alone the technical difficulties, which were the only con- 122 cern of its proponents* IV. PRINCIPLES OF CHOICE AND APPORTIONMENT WITH SPECIAL REFERENCE TO BUSINESS EXCESS PROFITS TAXATION INCENTIVE AND TAXATION It is not possible to provide the desired range of governmental activities without revenues from business taxa- 123 tion* One of the cardinal principles of business taxation is that 1 1 it must not remove or impair any instrument of, or incentive to, essential or useful processes of production. But it goes without saying that any tax on business must remove or impair business incentive to some extent* The prob lem, then, reduces itself not to restraint from levying taxes which exert any such depressive effect whatsoever, but to the choosing of taxes which depress the business or investment 121 This refers to financial.inequity, since, some stock holders would have difficulty in finding the wherewithal to pay somebody else's tax. (See Paul, on. cit., p. 3 6 0.) 122 See Haig, op. cit.. p. 555* 123 Allen and Brownlee, op. cit., pp. 304- and 307- 309. 12lf This well-established criterion from Hobson* s Taratirm in the New State, p. 10, has been quoted frequently by authors on public finance. lk-5 incentive least. the appropriate, negative condition of this famous Hobsonian. principle• The investment incentive, how ever, is only one of the two factors pertinent to a basis of tax choice, the other and equally important factor being consumption. Thus, the other of the twin Hobsonian princi ples of taxation is that "it must not remove or impair any 125 essential or useful element of consumption." Inasmuch as consumption and investment income make up the entire national income, the level of which is an important determinant of an adequate volume of employment, the most fundamental of all guiding principles of apportionment and tax choice in business taxation is the effects of the tax, as compared with those of alternative measures, upon the functioning of the economic system as a whole, or more specifically, on investment, and con sumption, Business excess profits taxation, while it has no perceptible and direct effect on consumption,12^ has definitely 12^ Loc. cit. 12^ There are at least two assumptions underlying this rather bald statement: . the relative nonshiftability of the tax and the near-zero effect on personal income on account of the fact that the tax will be reflected largely in reduced corporate savings. (This latter assumption is taken from Richard A. Musgrave, "Should an Absolute Corporation Tax Be Retained?" Proceedings of the Rational Tax. Association. 19^7 (Sacramento, California: National Tax Association,_19^7)) p• ll1 *.)• Some might argue.that reduced corporate'savings.mean reduced dividend income to stockholders. The mitigating fac tors here are the low propensity to consume among the dividend- receiving higher income group and that the excess profits tax cuts into that portion of the corporate savings which under ordinary circumstances will not be distributed in the majority of cases. For the incidence of the tax, see Chapter VII on incidence• Ib6 less depressive effect on investment incentive than the ordi nary income taxation* This is so because the former reaches only the taxable surplus of business income, to the theory of which, this -writer now turns* * THE CONCEPT OF TAXABLE SURPLUS The Hobsonian concept. The theory of the excess prof- 127 its tax inheres in. Hobson's concept of the taxable surplus. ‘ This surplus, however, is not limited to business income alone, but ranges through all the factor incomes, wages, interest, rent, and profit. But the portion of profits repre senting the taxable surplus is this writer's only concern. Profit is defined by Hobson as "the remuneration of the business man. or entrepreneur for the work of organizing and conducting a business." Every intelligent and well- informed business man has a definite profit expectations in putting his brains, energy, and capital into a particular line of business. Any taxation which defeats those expecta tions would starve the trade of business ability and enter prise. Hobson also considers profits as the "residuary legatee" in the economic system, taking what remains of the product of industry, after the other factors have been paid 127 Hobson,.op. cit., pp. 19-25. 1 b7 X.23 their necessary hire. It should be noted, however, that his concept of profits also provides for an allowance for 129 business growth. But Hobson thinks that • . . there is good reason to believe that the proportion of the total wealth distributed as 1 profits * far exceeds the amount economically necessary to secure the application of the socially serviceable business ability.L130J For not only is much of this profit predatory or luck money, but the conditions of such effective competition as applies to ordinary workers in the trades or the professions often have no application in the higher business walks. Profits may, therefore, possess large portions of income which, if taxed, would not dry up and disturb industry. Besides, a tax on surplus is not shifted. Turning to the critics who maintain that there is no means of discovering exactly where costs end and surplus begins, and, therefore, the theory has no practical fiscal application, Hobson counters with the rejoinder that this Under this residual approach the composition of the taxable surplus may include not only that portion of profit which is not necessary to the calling forth of the requisite business ability, but also all other chance gains on account of the advantageous bargaining position of the owner-entrepreneur. Ibid.. pp. 7**-76. ■*•30 In the case of the giant public corporations this distribution of profits far exceeding the necessary amount is not likely to happen, for the Junior security holder is expected to look to market appreciation for the realization of his expectations in excess of current corporate distribu tions. l*+8 criticism applies to all distinctions whatsoever. Though this may call for the desirability of caution and for allow ing a considerable margin of error, it does not invalidate the distinction for practical purposes. Vasiliu's criticism. The theory of the taxable surplus 131 132 may easily be extended, as Hobson himself and Vasiliu J have done, to the domain of corporate enterprises, where the concentration of economic power by various legal and extra legal devices has brought about the conditions of monopoly, yielding a margin of surplus beyond costs, or monopoly prof its, to the monopolistic enterprises. Vftiile Vasiliu*s criti cism of Hobson's theory, on the ground that the distinction between costs and surplus is not quantitatively measurable, is irrelevant, since it does not attempt to refute Hobson*s own defense as set forth in the paragraph immediately pre ceding, his objection, based upon the difficulty to trace precisely where the incidence of a tax on surplus will rest, is valid. But again,.this objection should be made part of the major criticism of Hobson's attempt to design an entire tax system built around the taxable surplus or excess. It is obviously futile, in actual practice, to devise a tax system 131 Ibid., p. 29. 132 Vasiie G. Vasiliu, The Income Tax in Great Britain and Roumania (Bucuresti: Tip, I. C« Vacarescu, 1936), p. 229« Ib9 on surplus alone. Comparative ignorance or the lack of knowledge with respect to the incidence of the tax system as a whole makes it impossible to achieve workable-tax justice in devising the system. Besides, the emergence of the taxable surplus usually is sporadic, and is conditioned on general business prosperity, except in the case of monopoly profits, which may persist relatively independently of business ups and downs, and other chance gains, the appearance of which may average out on the whole to be quite regular over the years. To base sin entire tax system on such unpredictable 133 and irregular sources of revenue is recklessness supreme. Other proponents of & tax on surplus. In refuting the criticism of the wartime excess profits tsix that it discour aged enterprise, Friday states that this would be true if "profits and incomes at present were only sufficient to stimu late men to perform the various services which, they are 131+ rendering and to take the risks of industry." But, 133 But this is not to say that the taxable surplus may not be made the base of any particular business tax measure, like the excess profits tax, in. which case the fluctuating tax base is either anticipated or contemplated in accordance with predetermined tax policy, like the built-in flexibility con cept. It also should be mentioned that, under.modern theory of government intervention, economic fluctuations, while they may not be eliminated, may in the future be successfully con trolled. David Friday, Profits. Wages. and. Prices (New York: Harcourt, Brace and Company, 1921), p. lop. 150 according to him, the operations of the market at the time resulted in giving many people who furnish economic services . • . a share much larger than necessary to bring forth those services. There are ‘surpluses* which exceed the necessary amount which men demand by way of_,wages, salaries, interest, rents, and profit.” ? The significance of the distinction between “necessary** and •Unnecessary" incomes is that the "unnecessary" portion may be taken by the state without interfering in any wise with individ ual initiative and enterprise, A tax which falls upon all profits and incomes alike may discourage the man who receives only the ‘necessary* income before paying taxes; but a tax which falls only upon the windfalls, the fortuitous gains of industry, leaves.the orderly processes of business undisturbed, Friday admits, however, that income and excess profits tax, just as any other tax, may interfere with capital accumulation and may be undesirable for that reason, but that is a separate consideration* His final position is that , • • if we are seeking taxes which will leave the income of the masses undisturbed, and at the same time discourage industry and enterprise least, our present excess profits taxes are ^ Ibid,. p. 186, Ibid.j p. 188. This is, for all practical pur poses, a restatement of Hobson's theory of the taxable sur plus. Since windfalls or the fortuitous gains are generally not taken into account by businessmen in forming their profit expectations, a tax on.such.chance gains cannot affect the investment incentive. 151 137 founded upon the correct principle. A more recent proponent of a tax on economic surplus^^ 139 is Hunter. According to him, the concept of an economic surplus applies to that part of the receipts going to any factor of production which are not essential to retain or stimulate any desirable increase in its services. That means all factors of production may earn such surplus. But Hunter's main emphasis, however, is centered on the taxation of economic surpluses in rents and profits, even though he does consider the use of surplus as a general base for taxation. In his opinion a tax on surplus is not shifted, since it will have no effect on prices, for it does "not drive any. producer out of existence and will not change the supply of goods which will be offered for sale." It is true that the tax will lessen "the sum available for reinvestment, but this is true of any tax." The existing tax on business income, according to him, is not sufficient. Surplus of income above a definite return to investment and personal services is deemed Ibid.. p. 190. At one time prior to his book on wages and profits, Friday stated his views in favor of a tax system, based entirely on the taxable.surplus. (As partici pant in discussion on "The Excess Profits Tax," American Economic Review. X, No.- 1, Supplement [March, 1920J , 19-22.) ^-38 to ke confused with the psychic income type of economic surplus, or the consumer's surplus. ■*•39 Hunter and AllenT Principles of Public Finance t pp. ifrOB-^O. attributable to the direct and voluntary contribution of the society and is, therefore, able to bear heavy taxes. Also, the taxation of surplus may bring about business stability through “the maintenance of a balance between the amount of goods produced and the ability of consumers to take them from the market,'1 and will entail "the least possible burden. t r Excess profits tax as the tax on surplus. From the irrefutable position of the proponents of the principles of the taxation of economic surplus, the excess profits tax is obviously the best possible measure to get at the surplus profits, differential, windfall, speculative, monopolistic, or whatever they be, which are not necessary to retain exist ing business investment and to call forth any desirable increase in such investment. It is the tax that is least likely to impede enterprise and business activity. This is so because it leaves the normal profits intact, which, accord ing to Marshall, is the long-run supply price of "business li+l ability in command of capital," thus abstracting nothing from the remuneration of the owner-capitalist. By the same token, the tax is probably the most difficult of all taxes i L.n In this connection Hunter's earlier works on the taxation of surplus are not considered for obvious reasons. llf 1 Alfred Marshall, . Principles of Economics (Eighth edition. London: Macmillan and Co., Limited, 1920), p. 6l8. to shift, if it is shifted at all. Since only the normal profits enter into the ”true or long-period supply price” of l*f2 a commodity, the chances of shifting the tax by way of price increase in the long run.are decidedly slim. Hence, the tax is most likely to rest -where it is intended to rest. Generally speaking, the tax.does not ”penalize” risky busi nesses, for the concept of normal profits envisages an allow- li+3 ance for risk as an element of normal profits. In actual practice means may be found to relieve excessively risky businesses, especially the new and infant enterprises, of undue tax burden in the form of exemptions and loss offsets over a period of years of business operations. This sets aside, for the time being, one of the two theoretical argu- ments, advanced by Groves, against the continuation of the lh5 excess profits tax after the war. THE RELATIVE ASPECT OF IMPERSONAL ABILITY TO PAY TAX Unresolved state of problem. The principle of the separate ability of business enterprise to pay taxes is one of the still unresolved topics in taxation theory. Many 1 Ibid., p. 619. Ibid.. pp. 612-613. Groves, op. cit., p. 80. ^*5 For the other, see infra, pp. 166-167. 15b authors on public finance refuse to recognize any ability on the part of business enterprise to pay taxes. They argue that the ability to pay principle, first enunciated by Adam Smith a little less than two centuries ago, takes the subjective declining marginal utility theory of individual or personal income as its theoretical basis and is therefore a purely personal criterion of taxation. Since profits or net. income of a business belongs to the owners as a group, the taxation of this net income on the basis of a collective ability to pay taxes does not fully take into consideration the respec tive abilities of the individual owners under the subjective sacrifice theory of ability to pay. Representative of this l*+6 lb7 iJ +8 1 1 + . 9 position are Groves, Buehler, Hunter, and Shoup. On the other hand, an early proponent of a collective business ability to pay taxes is found in the person of Thomas S. Adams, who maintains that the ability principle is preserved intact in business taxation and they are not antag onistic to each other. They [business taxes] recognize, like the better ment tax. and. the inheritance tax, a species of Groves, 035. cit.. pp. Buehler, Public Finance. p. 6 1 3. Hunter, "Shall We Tax Corporations or Business?” p. 8 6. Carl Shoup, "Business Taxes," Encyclopaedia of the Social Sciences iNew York: The Macmillan Company, 1930), III, p. 123. 155 ability to pay created by the activities of the state or by a 'conjuncture * afforded by the com munity. . . . Moreover, business concerns do possess an organic unity; they are, -when compared with one another. less able or more able to pay; the ability standard does applv to them as cor porate or business entities.1-^ This was uttered in 1917*^^ Writing on ‘ ‘ Excess Profits Tax’ * in Encyclopaedia of the Social Sciences in 1931, Adams again reaffirmed his previous position that the principle of ability to pay is observed by levying an excess profits tax on busi ness, since it places heavier tax burden on those enterprises 15 with extraordinary successes and spares those less fortunate. Enterprise entity and impersonal ability to pay. The most insistent of the more recent proponents of a collective ability of business to pay taxes is Paul Studenski, whose relevant work in this respect this writer has already had 153 occasion to draw upon. Studenski proceeds from his proposi tion that a separate business entity, distinct from its owners, should be recognized, to the logical, conclusion that an imper sonal business, having a peculiar ability to earn income, 1^° Adams, o^. cit.. p. 192. (Italics, supplied.) Between 1917 and 1931, Adams had reiterated the same view many times. ■*•52 Thomas S. Adams, "Excess Profits Tax," Encyclopaedia of Social Sciences, 1931? V, p. 666. Supra. p. 112, footnote **8. 156 possesses, therefore, the ability to pay taxes therefrom The real and basic issue here seems to be that if the separate business entity is not recognized and any enterprise is regarded but as an association of individual o-wners for the convenience of business conduct, then, it has no independent existence and, therefore, no impersonal, tax-paying ability, 155 as observed by the opponents* But if the separate economic entity of business enterprise is recognized, the taxation of 156 it as an organic unity logically follows. It was argued above in connection with the establishing of an economic basis for business taxation, that business enterprises do possess an independent and impersonal existence as part of the totality of modern productive machinery, do receive remunerative income as any other factor of production does, and, therefore, do have the impersonal ability to pay taxes. Ibid.. p. 6 3 3. 155 One of whom is J. R. Hicks (with U. K. Hicks and L. Rostas, as co-authors. The Taxation of War Wealth (Oxford: The Clarendon Press. 19^1), p. ^2): . • all taxation is ultimately paid by individuals, not by corporate entities, which have a purely legal individuality. Taxing company prof its is a means of taxing shareholders. It is perfectly reasonable to discriminate between persons, taxing richer persons at a higher rate. . . . It is not reasonable to dis criminate between firms, without thinking what this implies among their shareholders.1 1 ^"56 Randolph Paul argues for a separate tax on cor porations, if they are economic entities, as is the case with most large corporations. (Op. cit., pp. 372-373.) A slight modification of this writer*s position in this con- 157 nection, maintained by him elsewhere, • should now be intro duced* If by small personally conducted businesses are meant those businesses or professions, the success of the operations • ' • 158 ~ of which depends mainly on the personal effort, ability, and acumen of their owners, their segregation from the totality of productive capacity for tax purposes is justifiable on many grounds, among which the following may be mentioned: (1) the theoretical correctness and advantage of taxing, under pro visions of the personal income tax, such business or profes sional income, largely derived from personal,energy and labor, just as any salaries, wages, and commissions; (2) the diffi culty of maintaining.the separate entity of the business, as distinct from its owner; and (3) technical difficulties in reaching such incomes under the more complex structure of special business profits taxes* Distinction between personal and impersonal ability to pay. Once taxation of business enterprise separate from its owners is admitted, the relative abilities of different busi nesses to pay taxes almost immediately present themselves. 157 See supra* p« 130. 158 Over 50 per cent of the. net income. This may be used as an administrative guide. It is foolhardy to insist that business firms have relative abilities to pay in the same sense that individuals have with reference to subjective sacrifice (which is objectively deter mined to be increasing as successive amounts of income are parted with) sustained by parting with income. In such a personal sense business firms certainly possess no ability to pay, but this is not to say that they do not have relative abilities to pay as separate entities or with reference to some other criterion or criteria, pertinent to the measure ment of the economic effect which business taxation may exert on the all-important investment incentive. Public finance students are apt, almost by their second nature, to associate the canon of ability to pay with the sacrifice or the declin ing marginal utility theory, the personal variety, and it is difficult for most of them to reason with the frame of refer ence shifted to some other criterion, impersonal in character but equally valid, in connection with business taxation. Relative impersonal abilities to pay translated into different degrees of tax effect on Investment incentive. It was stated above that business taxation should least impair the investment incentive. Since different types of invest ment incomes possess different degrees of sensitivity to taxation, by collecting a relatively larger share of the total business tax burden from the less sensitive types of investment incomes and a smaller share from the more sensitive 159 sources, the total tax pressure on the investment incentive 159 may be minimized. The difference in the degree of the tax sensitivity of various types of investment and profit incomes is due to the following economic and financial reasons. 1. The varying degrees of importance of alternative needs, which the profit income is expected or required to 160 satisfy. It is conceivable that the profit income of a business unit will be used to take care of more urgent needs first, before any portion of it will be used on other less pressing demands. Different economic circumstances, of course, determine which needs are more urgent than others. But, by and large, an increase in the profit income will enable the business unit to take care of its more urgent needs and, at the same time, satisfy a larger number of the other alterna tives in the order of their importance. If the profit income is reduced by taxation or other exigencies, less essential ^ This writer is heavily indebted to Richard A. Musgrave's paper, “Should an Absolute Corporation Tax Be Retained?” also cited supra, o. 1^5. footnote 126, for orientation and unavoidably will draw equally heavily on his pregnant ideas as well as his discussion thereof. It is realized that Musgrave dealt primarily with a special tax on corporate income and caution should, therefore, be exercised not to over-extend his “sensitivity” theory into other fields where it may not so readily apply. But it should also be pointed out and emphasized that the area where this theory and also that of the relative abilities of business to pay taxes are likely to be of the utmost practical significance encom passes the domain of large corporations. 3-6° Taken from Studenski, op. cit•, pp. 63^-635. 160 allocations of income will be foregone before the more essen tial ones in the reverse order of their importance. Consid ered from the business unit itself, apart from other enter prises, it would seem that the larger the income the greater the ability to pay taxes. 2. The differences in the economic characteristics l6l of business units, brought about by the following factors: a. Greater ability of the larger business units, especially the large corporations, to average out their taxable income over a period of years, i.e., to offset their losses in one year or from one venture against their profits in another year or from another venture. The imposition of a tax, and the allowance of loss carry-overs and carry-backs, while they will reduce the profit expectations of a venture, will reduce the loss prospects at an equal rate. The smaller the Taken from Musgrave, op. cit., pp. 114-117. 16 p x ^ This view is an abridged version of a similar one, reached, after a comprehensive study, by Musgrave and Evsey D. Domar in "Proportional Income Taxation and Risk-Taking, » * Quarterly Journal of Economics. LVIII (May, 1944) , 388-422. There, the statement is more precise and is made on the assump tion of an income tax levied at a proportional rate. The reduction in the loss prospects will, of course, not be at the same rate that the profit expectations are reduced, if the profit income falls under $50,000 (for corportions only) where the tax rates are progressive and in the case of pro prietorship and partnership incomes, which are taxable at progressive rates under the personal income tax provisions* Cf. Allen and Brownlee, pp. cit.. p. 310. Musgrave did not 161 business unit, the less the opportunity for it to offset its losses, on account of either insufficient profit income over a period of years or the lack of other sources of profit income. Under the existing federal income tax law, furthermore, the loss offset provisions do not pretend to give the small business units the sort 163 of advantage over the large units that they deserve. No interest is allowed on refunds resulting from net 162 (Continued) qualify his statement in this connection in the article cited, supra, p. 1^5, footnote 126. This is understandable, for he was mainly concerned with large corporationswhose incomes are likely to be over $5 0 ,0 0 0 and are, therefore, taxable at a flat 3 8 per cent rate under the then current federal corporation income tax. This point will be dealt with more fully in the chapter on risk (infraT Chapter V). . . £f. Shultz, joja. cit.y p. ^99) stating that a two- year prior loss carry-over tends to favor small rather than large corporations. In a sense, Shultz is right, for the carry- over provisions will be availed of more by the small business units than by the large units, to which current offsets are available. The advantage Shultz speaks about is apparent only. The law presumably attempts to remedy the hardships placed by the heavy income tax on small risky businesses by allowing loss offsets over the years, but this merely represents a legal attempt to equalize the tax positions of the small and large businesses. As an economic fact, not only are the small busi nesses not given a favor or advantage over the large ones, but they lose out on interest in so doing. (This is, however, not to deny that the small units are better off now with the right to offset than they were without it.) Musgrave was silent on this point. But he might have these very things in mind when he wrote: MThe extent to which loss offset is possible depends greatly upon the definition of taxable income, but such refine ments may again be applied more readily by the large corporation than by the small one.1 * (Op . cit.. p. 115*) 162 operating loss and/or the unused excess profits credit l6*f carry-backs, and interest is automatically lost in carrying forward a net operating loss (and/or the unused excess profits credit), owing to the allowance of this loss (adjusted accordingly) as a deduction against net income in the returns for the two succeed- 165 ing profit income years. The small business units and corporations, therefore, do not derive as much advantage as the large corporations to which current offsets and more future sources of income are avail- 166 able. With these economic advantages accruing to l6*t Sec. 3771(e), Internal Revenue Code. Interest does not begin to run until the filing of the refund claim and the net operating loss and/or the unused excess profits credit carry-backs are required by law (Sec. 122(b)(1), and the repeated Sec. 710(c)(3)(A), Internal Revenue Code, respec tively) to be offset against profit income (loosely speaking) of the two preceding years. l6 5 Sec. 122(b)(2), Internal Revenue Code. x Another similar instance presents itself in the matter of percentage depletion. In making the actual loss offsets over the years, the economic gain, occasioned by the excess of the allowance of a 27 1/2 per cent deduction for depletion over cost depletion, in the case of oil companies, (and also different percentage depletion allowances for some other mineral properties), is eliminated in both the year of loss and the year of offset, in arriving at the amount of the actual economic offset. (Sec. 122(c) and (d)(1), Internal Revenue Code). But no such eliminations or adjustments are necessary in the case of current offsets both in making the consolidated returns and in making the ordinary corporation or personal income tax returns (for percentage depletion is computed on a fixed statutory percentage on gross income from 163 the larger business units, it seems reasonable to maintain that they, with large incomes, have a greater ability to pay taxes than the smaller ones with small incomes• b. Greater ease with which the larger business corporations can obtain new capital from the invest- 167 ment markets. The larger the business units or corporations, the less dependent their growth is upon the plowing back of earnings than that of smaller and 168 less established firms. The tax incidence upon 166 (Continued) the property [Sec, ll*Kb)(3), Internal Revenue Code], ignoring the net income limitation, and according to Montgomery*s Federal Taxes - Corporations and Partnerships . 19^-6-^7, (Hew York: The Ronald Press, 19^7)V 1» pp, 830-032, oil wells belonging to different ventures are generally considered separate properties for purposes of computing percentage deple tion*) The economic advantage here is clearly available only to large oil and mineral corporations in most cases. This is also recognized, among others, by Berle and Means (op. cit., p. *+2), and J. K. Butters and J. V. Lintner (Effect of Federal Taxes on Growing Enterprises [Bostons Harvard University, 19^5], p. 3!)* 168 Berle and Means, loc. cit., to the effect that "here again the large corporation increases the wealth under its control by this means of expansion [the raising of new capital in the public markets] to a much greater extent than the smaller companies,** Berle and Means reckon that over 55 per cent of the growth of the large companies has been made possible by the public offering of additional securities. It would seem, then, that **5 per cent of the growth came from Internal financing. According to Albert R. Kock, The Financing of Large Corporations. 1920-1939 (New Yorks National Bureau of Economic Research, 194- 3), p. 102, the ratio of security sales to fixed capital expenditures for 1937 and 1938, is, 16b corporation savings which is found to be desirable from the consumption point of view will do less harm to investment in the case of the large than of the small firms• c. Owing to the divorce of ownership from con trol, investment by large corporations tends to be less sensitive to changes in the rate of return after tax, for investment decisions by the management are more likely to involve factors other than prospeets of earn- 169 ings from new ventures. It has been said, . • • the top executives of a large firm . . . are probably not as closely tied to the profits criterion of creativeness as are owner-managers• While they may lay pri mary emphasis on the yardstick of profits, they can follow their creative impulses in other directions, also, even if the result is not immediately realized larger profits for the firm.*'* 168 (Continued) respectively, *+3 per cent and 58 per cent. The ratio was con siderably higher for 1921 and 1929 (6l per cent and 72 per cent, respectively). The trend indicates that more internal financ ing was resorted to for expansion in the thirties than in the twenties and likely even more so in the future. This does not invalidate Musgrave*s theory, however, for it is the compara tively greater ease with which the large corporations may obtain their capital in the markets, if they so choose, than the small corporations that is his main concern. This is also recognized by Robert A. Gordon, among others, in his Business Leadership in the Large Corporation (Washington, D. C.s The Brookings Institution, 19^5). passim. pp» 305-316. 170 Ibid * T p. 308. 165 These other factors and directions may be the urge for power, the desire for prestige, the desire to serve 171 others, et cetera. ' This again sustains the conten tion that the large corporation has a higher capacity 172 to pay taxes than the small firm, 3. The existence of surplus profits. To serve as a 173 summary of the discussion in the subsection preceding, sur plus profits have a remarkable ability to bear taxes, because they represent superfluous profits over and above a minimum expected return sufficient to launch an undertaking or maintain it after it has been launched. For even though they are confiscated by the government no repressive effect upon business is exerted in the sense that business is not deprived of the capital necessary for its existence.1^ Even though this writer does not disagree with the author of this view from the theoretical point of view, he thinks that this is too extreme a position for a practical-minded student of public finance to take. The truth, it seems to him, usually lies midway between the two opposing sides • The other side In this 17 1 Ibid., p. 305. 1 7 2 This is true to the extent that there is a positive correlation between corporate size and the amount of income. ^73 Supra, pp. 1^6-153. Kenneth J. Curran. Excess Profits Taxation (Washington: American Council on Public Affairs, 19^3), p* *+• 166 case, comprises those economists who are prone to assume a positive correlation between the size of corporate organiza tion and its efficiency in production and, therefore, advise against taxing surplus for the simple reason that it may represent efficiency profits. Groves is among this group of 175 176 economists. This writer*s position is briefly this: the over-all effect on efficiency of a tax on surplus or monopoly profits must somehow be gauged before a definite . answer can be given to this question whether a tax on surplus profits will discourage to an unreasonable extent the quest for efficiency in the economy as a whole. Surplus profits are usually brought about by monopoly and monopolies of various types and are almost invariably exploited by the large cor- 177 porate-organized undertakings. Available information has proved to this writer’s satisfaction that beyond a relatively modest scale of output the economies or the efficiency of large scale production are in general quantitatively unimpor- 178 tant. It is reasonable to conclude from these facts that a ■*•75 Groves, op. cit., p. 80. ***76 This will be dealt with more fully, infra. Chapter V. ^*77 Lindholm, pp. cit., p. 109* •*■7® This view is maintained by George J. Stigler, "The Extent and Bases of Monopoly,t f American Economic Review, XXXII, No. 2, Supplement (June, 19H-2), 13. The sources of information referred to in this subsection will be dealt with more fully in 167 tax on surplus profits at moderate rates for the lower range and moderately progressive rates for the higher range of such profits will not only not discourage efficiency, hut also require monopoly profits to pay their greater share of the tax burden. This tax aim is capable of being carried out 179 through specific exemption and a progressive rate structure. Groves *s concern that efficiency profits may be deprived of their reward under the excess profits tax may, therefore, be 180 dispelled. Conclusion. The above arguments are intended to show that in general business units of varying earning powers possess varying abilities to pay taxes, as a result of the differences in financial and economic characteristics of their business organizations. An excess profits tax on sur plus or monopoly profits at moderately progressive rates will 178 (Continued) a subsequent chapter on risk and efficiency. Two of these are: Temporary National Economic Committee, Relative Efficiency of Large. Medium-Sized. and Small Business (Monograph No. 13; Washington: Government Printing Office, 19^1), especially pp. 12-l1 *, summarizing results of findings; and John M. Blair, “Does Large-Scale Enterprise Result in Lower Cost?" American Economic Review. XXXVIII, No. 2 (May, 1 9 W , 121-152. ^79 More about this point in Chapter V. 180 This completes a summary of this writer’s defense of the excess profits tax against Groves's two theoretical objections to the tax, namely, it penalizes risk (supra, p. 1 5 3) and discourages efficiency. For detailed discussion, see infra. Chapter V. 168 not discourage efficiency in production, 181 TAXATION AND CORPORATE SAVINGS Introduction, Opinion among students of business finance differs with regard to the economic significance of business and especially corporate savings of large corpora- 182 tions and their relations to cyclical fluctuations in the economy during the last depression and the subsequent 181 The term "corporate savings" used without any qualifying adjective is sometimes misleading and inadvisable. Corporate or business savings may refer to both gross busi ness savings and net business savings. Gross business savings consist of retained earnings plus allowances for depreciation and depletion, while net business savings are represented by retained earnings only (Temporary National Economic Committee, Savings. Investment. and National Income. Monograph No. 37, pp. 20-2 1) . In the field of taxation, the distinction between the two is significant, for the taxation of corporate savings (as attempted by the framers of the 1936 undistributed-profits tax to correct the allegedly economic ills resulting from unnecessary capital accumulations) would not affect the por tion of gross savings, represented by allowances for deprecia tion and depletion, if the constitutional principle not to tax business capital were to be maintained. In this dissertation study, unless specified otherwise, "savings" is used to desig nate gross savings. 18 2 q£ tiie gross savings averaging 1 3 .8 billion dollars per year from 1935 to 1 9 3 9, business enterprises accounted for 35 per cent. For 1937, gross savings of non- financial corporations alone accounted for $2, 8 3 7, 0 0 0, 0 0 0, which is about 59 per cent of all business gross savings. For the same year non-financial corporations with assets of more than $50,000,000 reported 39 per cent of these savings. But all corporations with assets of more than $5 0, 0 0 0 ,0 0 0 reported *f5 per cent of the gross savings by all corporations. (These figures were either taken or computed from data presented in Temporary National Economic Committee, .op. cit., pp. 15, 21, and 23.) The significance of corporate savings and especially those of the large corporations may be detected from these figures. 169 183 recovery* The postwar boom has somehow relegated the prob lem to the background, but it will have to be faced again, once the economy returns to a more or less even keel from its postwar fling of abnormal activity. Since taxation has a good deal to do with the retention of an “adequate” volume of cor porate savings, it is deemed necessary to devote some atten tion to this problem. Those writers who defend the policy of retention of earnings point to the popular American business practice of plowing back by growing enterprises portions of their earnings for purposes of expansion and also contend that large accumu lated surpluses during periods of expanding prosperity enable the provident corporations to withstand economic reverses during times of depression. It is this latter contention that an element of stability is introduced into the economic system by the retention of earnings during good years, which may be dissaved in bad times to maintain employment and dividend payments, that will be investigated below. 183 Besides approaching the problem of corporate savings from the relation to cyclical fluctuations, students of cor porate finance have also investigated that of the retention of earnings by the management to the separation of control from ownership. Since this aspect of the problem is in some respect tied to the former, no separate treatment is con sidered necessary. Retention of earnings during prosperity: opponents. Tugwell argues that the practice of the retention of corporate earnings has led to the misallocation of resources among indus tries through unwise investment and, consequently, to the over expansion of productive capacity in specific industries, thus contributing to wider fluctuations in the downswing of the l8*f cycle. Weidenhammer contends that, since retained earnings plowed back for reinvestment purposes do not go through the capital market where any offer of securities for sale is sub ject to the "scrutinizing analysis of the investment house and of the ultimate investor" and where through the equilibrating influence of the interest rate suppliers of loanable funds will find the most suitable outlets for the use of their spare capital, the faulty investment of such retained earn ings, especially monopoly profits, results. . The term "faulty investment" is used in the sense that such investment "yields in the long run less than the return offered in the capital 185 market on risk-free securities." Such "submarginal returns" investments will cause a more pronounced fluctuation of the 18** Rexford G. Tugwell, The Industrial Discipline and the Government Acts (New York: Columbia University Press, 19337, PP- 203-207- Robert Weidenhammer, "Causes and Repercussions of the Faulty Investment of Corporate Savings," American Economic Review. XXIII, No. 1 (March, 1933), 36. 171 186 rate of Interest in the capital market. The implications here are that over-expansion and faulty investment are attendant upon the separation of ownership from control, which tends to replace the profit motive as a guide in rein- 18? vestment of surplus earnings with other non-profit motives, Amos, in agreementswith other economists, reasons that cor porate reserves or savings, held in the form of domestic bonds and stocks, government bonds, and call money loans, swelled an already “redundant supply of funds in the market during the upswing of the cycle," and contributed greatly to 188 “the speculative orgy of the late nineteen-twenties." Besides, the purchase of these securities would usually be made in a dear market, furthering its dearness, and the sale of these securities in a cheap or “demoralized" one, deepen- 189 ing the downfall. From the point of view of the theory of savings and investment, it has been claimed that an accumula tion of corporate surpluses and reserves increases the 186 See the example given on pp. 36-37 of the article cited in Footnote 185 for explanation. Suora. pp. l6**-l 65• 188 J. Ellwood Amos, The Economics of Corporate Savings (Urbana: The University of Illinois Press, 1937)j PP» 78-79. 189 opinion was expressed by J. M. Clark in his Strategic Factors in Business Cycles. p. 20*+, cited by Amos, o p. cit., p. 8 0. 172 aggregate amount of saving in the community and, consequently, makes it more difficult to maintain the economy in equilibrium at a high-income level. Even if such retained earnings are reinvested promptly, the equilibrium is imperiled by virtue of the fact that insufficient investment outlets are left for 190 savings made by individuals. Retention policy: defending arguments. In addition to the "stability” argument, the main contention of the defenders of the retention policy is that with large surplus funds for reinvestment the corporate management need not look to a high capital market for financing important technical improvements and innovations and such freedom of investing funds, coupled with the absence of financing charges, tends to give the corporations with large surpluses superior plants 191 and high operating efficiency; Retention policy: reconciliation. The validity of all these contentions on both sides is hardly to be disputed. They are all true to a certain extent. Tugwell's argument of ^ These views of the opponents of the retention policy are mentioned by Sergei P. Dobrovolsky in his "Corporate Retained Earnings and Cyclical Fluctuations," American Economic Review. XXXV, No. % (September, 19*+5), 560. 191 Catherine G. Ruggles.,. "The Relation of Corporate Surpluses to Income and EmploymentAmerican Economic Review. XXIX, No. b (December, 1939), 727-729. 173 misallocation of resources, due to unwise investment, while 192 deductively true, is statistically difficult to verify. It, together with Weidenhammer’s faulty investment theory, is 193 qualified by the fact that if an additional investment succeeds in raising the return on the total invested capital from a lower per cent to a higher per cent, then the addi tional total profit justifies the investment, even if the return on the additional funds is lower than that obtainable in the market. Furthermore, the scrutinizing analysis of the Investment house and the probing by the ultimate investor are 19b by no means omniscient and faultless. The corporate manage ment, with the guidance of the ‘ ’ mixed1 1 profit motive, may be expected to invest available funds wisely at about 50 per cent of the time (for lack of proof either way). Amos’s argument that corporate savings swelled the glutted money market is subject to this criticism; as most dividends would have gone to the rich people, whose propensity to consume Is generally conceded to be low, the distribution of such corporate savings would have produced similar results, since such funds would have been presented in the glutted money market by these rich 192 Dobrovolsky, eg. cit.. p. 562. •*•93 Admitted by Weidenhammer, op. cit. t p. 35* and also statistically difficult to prove. Dobrovolsky, loc. cit. 171+ individual stockholders. The question of adequate investment outlets involves a broader issue than can be attributed directly to the sole responsibility of corporations. Besides, the ability to reinvest earnings without concern for the rate of return means that 1 1 some funds may be invested, which would not be put to use at all if an outlet for them had to be 195 found through the capital market,1 * The history of American business enterprise has wit nessed tremendous expansion through the continuous reinvest ment of earnings, or the f , New England method.M Hot only during a period of early development but also in the later stages of 196 maturity, corporations have pursued this policy. A great deal of specific information relating to the internal financ ing of individual corporations, including the United States Steel Corporation, the General Electric Company, the General Motors Corporation, and United Aircraft Corporation, was offered in evidence before the Temporary National Economic 197 Committee. Prom 1921 through 1937} 72 per cent of the expenditures by railroads for plant and equipment were 198 financed from internal sources. During the five years, ■*■95 Dobrovolsky, loc. cit. Dewing, oj). cit.. p. 600. 197 Temporary National Economic Committee, op. cit.« pp. 52-53- 198 Ibid.. p. 53- 175 1935-1939> 83 per cent of the average outlays for plant and 199 equipment ($5j 800, 000, 000) came from Internal sources. What proportions of these large amounts of Internal financing represent unsound and faulty investment is difficult for any one to even guess at. Effects of dissaving during contraction. It has been maintained by the proponents of the retention policy that the dissaving of corporate surpluses during business contraction enables the corporations to sustain, to a better extent, the volume of payments and, consequently, tends to mitigate the severity of unemployment and stabilize the payment of divi dends. To cite as evidence of this argument, it has been stated that in the six years following 1929 business paid out 3*f.5 billion dollars in excess of receipts, in the form of wages, taxes, dividends, and other obligations, which could not be met out of the low level of current gross income.2^0 But the opposing side points out that since over the six-year period the aggregate cash balance of all businesses changed from 7.3 to 6.7 billion dollars only, the vast amount of business dissaving cited above indicates not the excess of cash payments over cash receipts, but, to a large extent, the 199 Ibid., p. 56. 200 Dobrovolsky, op. cit.. 563* 176 failure to maintain assets (the reduction of inventories, 201 depreciation of fixed assets not made good, et cetera). Therefore, "negative business savings," though they need not reflect lower employment, "can never be regarded as increas- 202 ing employment." Despite contentions to the contrary that production may be maintained or even increased during depres- 203 sion by greater business negative savings, the chances are and past experience shows that such greater business disburse ments and, therefore, more employment, have not been of major 2Qlf importance. Buehler has given his sanction to the belief that the Don D. Humphrey, "The Relation of Surpluses to Income and Employment during Depression," American Economic Review. XXVIII, No. 2 (June, 1938), 22^-231. Dobrovolsky agrees with Humphrey on this point (loc. cit., Note 7). 202 Ibid.T p. 231. Ruggles, pp. cit., pp. 725-726. 2o*f Dobrovolsky, op. cit.. p. 569; two reasons are given: (1) owing to the principle of loss minimization, It is seldom feasible to continue operations resulting in the excess of variable costs over revenues; (2) inventories may be reduced to keep business in the market, rather than continuing produc tion. This is, in all likelihood, an understatement. 0. J. Curry says: "It is possible that a period of disinvest- ing, dishoarding, and real capital liquidation made possible In large part by surplus accumulation, may result in less employment of all factors of production during recession periods and hence the payment of less wages and dividends." (For source reference, see infra, p. 178, footnote 208.) 177 existence of corporate savings (or surplus) makes it possible 205 to maintain the regular payment of dividends. Of course, the existence of a surplus is required by the laws of certain states to legalize the declaration and payment of dividends. But the mere presence of a surplus balance on the financial statements does not insure the means with.which to pay them, for surplus is but an accounting terminology employed to desig nate “a part of the stock equity,1 * measuring **a cross section of all the assets of every kind.1 1 It is, therefore, not a cash fund and does not represent any specific assets. Surplus is a yardstick or gauge which shows the amount of dividends which may be declared without impinging upon capital, but Is not in itself a medium of disbursement. This means that surplus accumulation as a reservoir for dividends in lean years does not actually ensure the ability to main tain the stream of payments to stockholders.206 In fact, “dividends can seldom be long continued in the absence of current profits, no matter how much, surplus has been accumu- 207 lated in the past.1 * Curry has the following to say as to why surplus cannot be regarded as a satisfactory dividend reservoir: Alfred G. Buehler, The Undistributed Profits Tax (first edition; New York: McGraw-Hill Book Company, Inc., 1937)i p. 68. 20^ William A. Paton, Advanced Accounting (New York: The Macmillan Company, 19^15, p. 568. 207 Ibid*, P* 570. When the lean years come, sales volume drops off, profit margins disappear, collections slow down, and payables must be met. The retained earnings are invested primarily in inventories, receivables, and plant facilities— the fund or reserve to which we frequently refer. Receivables and inventories can be liquidated (probably at a loss), but the cash is not necessarily available for dividends. The business is geared to increased volume of produc tion and must operate at reasonable capacity to be profitable. Working capital may be excessive at the moment of depression, but corporate management must conserve the cash in order to start production at the first signs of possible profitable operations on an increased scale. To pay dividends from liqui dated inventories and receivables would be tanta mount to borrowing money to pay dividends in the face of declining production, falling prices, and a discouraging immediate future outlook. Plant facilities built up during periods of profitable operation (thereby representing a major part of the surplus) usually prove excessive during slack periods of unprofitable operation. It is entirely possible to liquidate the surplus thus invested in plant capacity, inventories, and receivables, and the funds may be used for cash dividends, but this process of drawing upon reserves is wholly dependent upon continued sales and. collections at prices below costs suid is exactly what managers and stockholders seek to avoid. This process of disinvesting throws labor out of employment, is devastating to the market value of the stockholder's investment, and- cannot be regarded as a satisfactory dividend reservoir.200 In agreement with Paton,^^ Curry concludes from an inductive study of corporate savings that depression dividends.were paid by corporations that continued to operate profitably; very moderate dividends were paid by corporations that reported 20^ 0. J. Curry, "Utilization of Corporate Profits in Prosperity and Depression." in Michigan Business Studies. IX No. 4- (Ann Arbor: University of Michigan, 194-1) » P* 20. (Italics in the original.) 2°9 See supra. p. 177* footnotes 206, 207* 179 losses, although there were exceptions, and a positive corre lation between earnings accumulated and reinvested during the twenties and dividends paid during the early thirties is 210 definitely lacking. Buchanan also stresses the fact that “the ability of a corporation to distribute cash to share holders in depression is in no way necessarily connected with 211 the size of its surplus.** The opponents of the retention policy further argue that since the accumulation of surplus during prosperity and the disinvestment to pay unearned dividends during depression would almost invariably involve the purchase of marketable securities at a rising market and the sale of such liquid instruments at a falling market, the retention policy would definitely contribute toward accentuating the fluctuations 212 of the business cycle, not to mention the unfavorable finan cial effect on stockholder's interests. Besides, it is not clear what tangible advantages there are to the stockholders ,213 by the maintenance of a regular and steady dividend rate. 210 curry, jop. .cit., p. 93* pi t Norman S. Buchanan, “Theory and Practice in Dividend Distribution,1 1 Quarterly Journal of Economics. LIII (November, 1938), p. 85’ . ~ — 212 James G. Smith, “Economic Significance of the Undis tributed Profits Tax," American Economic Review. XXVIII, No. 2 (June, 1938), 308. 213 Ibid.. p. 309. 180 The sale of corporate securities may be made easier by a steady dividend rate, but the ability to raise more capital from security sales is largely dependent on the prospective income of the corporation, A past dividend record does no more than 21h throw some light on the future earning power. Conclusion. As usual, the truth, it seems to this writer, lies somewhere in between the two extreme views, as surveyed above. Since surplus represents »*a part of the stock equity1 * and measures **a cross section of all the assets of every kind,** it is reasonable to assume that the larger the surplus, ceteris paribus and barring extraordinary circum stances, as in cases of insolvencies and bankruptcies, the more the likelihood that liquid.assets, such as cash and receivables, will be present in larger amounts. If this gener alization be assumed as valid, a large surplus does tend to strengthen the hand of the corporate management during depres sion in maintaining a somewhat higher cash disbursement and, consequently, a better record of employment and dividend pay ments than a small surplus. According to a survey made in 215 19*+3, the increasingly liquid position of most corporations Buchanan, op. cit., pp. 80-81. 215 _ I. K. Brandt, “Note on Corporate Expansion Since 19^+0,1 1 American Economic Review. XXXVI, No. 1 (March, 19*+6) , 141-1^3, summarizing the results of an investigation of the financial statements of 150 manufacturing corporations. 181 can become a very strong factor in mitigating the punishing effect of a possible postwar recession. As to the advantages of surplus accumulation, it may be mentioned that earnings retained may result in a relatively greater distribution of dividends to the stockholders during the profitable periods and, as a consequence, the market appreciation of their hold- ings may be very attractive. It should also be pointed out that the above arguments for and against the retention policy have reference to only the corporate savings of the corporate giants. No one would criticize a small corporation or business for following the time-honored and sensible policy of providence to retain and reinvest its earnings. In the process of so doing, the rela tively paltry sums involved would not affect the securities markets to any appreciable extent, although the combined effect of millions of small business units might be overwhelm ing. That, again, is to be expected in a free enterprise system of economy. By the same token, the large corporations should not be unduly blamed for retention of earnings and for its adverse effect in increasing the amplitude of business fluctua tions. One redeeming feature of this conservative policy lies A Curry, op. cit., p. 22* Market appreciation is looked upon as the stockholder’s only chance of realizing his expectations on his holdings. (Berle and. Means, op. cit.. p. 281.) 182 in the argument that ’ ’common stock financing and retention of earnings must be resorted to when times are prosperous if 217 the corporation is to have strength for depression periods*” Any attack in this connection should be aimed at a solution of the problems arising from the separation of ownership from control and the attendant lack of supervision over the action of the control in regard to reinvestment* Socialization of 218 retained earnings by taxation, as suggested by Weidenhammer, is not a fundamental solution inasmuch as the controlling management should be allowed some latitude in exercising its discretion over the predominantly internal business policy of retention and reinvestment without outside and governmental interference and earnings socialization still,would not solve the problems brought about by the separation of ownership from control, which issue this writer considers as fundamental* 216 (Continued) Prompted by Amos's conclusion that no theory of corporate savings has yet been formulated (op* cit*, p* 1 3 0), this writer, in answer to his second question, on a successful answer to which a theory of corporate savings depends (op. cit.* p. 126), suggests that the amount of corporate savings, to the extent that they do affect security values, should be maintained at such a level that the stockholder may look to the securities markets, in conjunction with income received through dividend distributions, for the realization of his expectations on his holdings• Harry G. Guthmann and Herbert E. Do.ugall, Corporate Financial Policy (second edition; New York: Prentice-Hall, Inc *, 19^-8 ) , p. ^90 • 218 Weidenhammer, pp. cit.. pp. 39-^0. In any event, this writer is against taxing corporate net savings for any purpose other than that of revenue. It is true that any tax levied on corporate net savings will retard capital accumulation to some extent, but this is true of any other tax. The retardation of capital accumulation in itself is not enough to condemn the excess profits tax with a moderately progressive rate structure and for that matter any other tax. In view of the more productive uses of the tax money by the government in sustaining business prosperity, it is not clear whether taxes which do retard savings are 219 "categorically inadvisable," since the benefits accruing to business enterprises may amount to much more than the low- yield investment securities, in which the savings may be invested, would bring. Moderation in taxing business net savings is, therefore, recommended. I* THE IMPORTANCE OF INCIDENCE STUDY A definite knowledge of the incidence of a specific tax measure is indispensable to the tax student in correctly pre dicting or gauging in advance its probable economic effects. The significance of tax incidence cannot be over-emphasized, for the entire discussion presented hereinabove, urging for a 219 Shultz, c>p. cit., pp. 271-272 I8*f separate permanent excess profits tax on business for revenue. purposes and lauding its merits in tax justice and economic advantages, has been predicated upon the most fundamental of all assumptions, that the excess profits tax will rest where it is intended to rest, that is, on business, or more specifically, on that portion of the net income of business which represents the taxable surplus (or residual profits) over and above the so-called normal profits. If the tax were largely shiftable, much of the argument would be deprived of its validity, strength, and economic logic. VThy bother about such economic concepts as the totality of productive machinery, the impersonality and separate existence of business enterprise, which economically justify business taxation, if the tax were 220 shifted? The shiftability of a business tax lends much The analysis of the possibilities of shifting a tax pertains more properly to a discussion of the principles of tax distribution, than to an examination of the economic basis of business taxation. This is properly so, because the economic effect of incidence is of primary importance in a consideration of tax justice. Its significance to the economic basis of business taxation is herein touched upon merely for purposes of completeness in presentation. As regards its ^relationship1 1 to the state partnership theory, this theory appears at the first blush to require that a tax on business be shifted on to the consumer, for it is based on the economic fact of the government as a factor of production and, as such, the cost of the government factor should enter into uhe equation of price determination. The mitigating factors here are; the state partnership theory, as argued above (supra, pp. 125-127), is not a theory of tax distribution and, therefore, should not be made a governing factor in the deliberation of tax justice; and the consumer-taxpayer can be taxed more equitably under 185 strength to Buehler’s cynical remark, that business taxes are levied for expediency and render tax collection more con- 221 venient. Even more important is the modification of tax justice through tax shifting. A business tax may be justified from many points of view, but if its incidence is unknown, it is impossible to measure, its economic effect and the dis tributive justice, on account of this inability on the part of the tax framers to foresee its effect, may be modified. Studenski’s proportional net income tax, supposedly based 222 upon his state partnership theory, suffers greatly in this respect, because of the hidden connections between his theory together with his proposed tax measure, and the incidence of the tax. His theory definitely calls for a separate tax on business enterprise as the totality of modern productive capacity and, yet, his proportional net income tax, proposed 220 (Continued) the income tax in accordance with ability to pay, than through price increases, the effect of which is equivalent to that of a special fee charged for government services rendered. In modern theories of taxation, the specific benefit does not possess sufficient merit to recommend itself as a principle of tax apportionment. ^2* * * Supra. pp. 110-112. It was admitted therein that there is some truth in Buehler’s statement, i.e., to the extent that the tax is shifted, Buehler’s argument is true, for it is unquestionably more expedient and convenient to collect the tax from the business and let it pass it on to the consumer through price increases, than to collect the tax direct from the consumer, if he is to be the final bearer of the tax burden. 222 Supra, pp. 119-120 186 as the measure in conformity with his tax theory, to the extent that it affects the marginal producer, is shifted forward to the consumer, so as to nullify, to the same extent, the 223 intended effect of the tax on business. Ironically, it may be pointed out in this connection that the excess profits tax, which is highly non-shiftable and, therefore, theoretically the best measure of all from the standpoint of his state partner- 22k- ship theory, was rejected by Studenski on the flimsy and untenable ground that high profitability may not indicate greater ability to pay as between enterprises operating under different conditions (with respect to risks and the facility of obtaining capital) and that such a tax may be difficult of 225 administration. This writerfs position in regard to the incidence of the excess profits tax may be summarized as follows. The excess profits tax, properly framed and admin- istered, has the greatest inherent resistance of all taxes to 22^ This point will be dealt with more fully in the chapter on incidence. (Infra, Chapter VII, passim.) studenski admits that himself (op. cit.. p. 635). 225 Ibid., pp. 635-6 3 6. The untenable ground refers to his fear that high profits may not be consistent with high ability to pay on account of different economic circumstances. It should be noted that his proportional income tax ignores the differential economic situations of different taxpayers entirely. Suffice it to say that these differences may be taken care of within the framework of the excess profits tax adequately through greater allowances for risk, loss offsets, and moderately progressive rates. The flimsy ground refers to administrative difficulties. 187 the ordinary processes of shifting through price increases. Normally, it is not shiftable at all and rests with business or surplus profits; under peculiar circumstances, it may be passed on, but never in the full amount of the tax. Because of its nonshiftability, the excess profits tax becomes a business tax, pure and simple.22^ Its nonshiftability also renders relevant and tenable such discussion and conclusions on the existence of relative abilities of business to pay taxes, on the minimization of the depressive effects of the excess profits tax (for that matter., any nonshiftable tax) on investment incentive, and on the retardation of capital accumu lation by taxation of corporate and business savings. It does A business tax may conceivably be shifted to the consumer, the wage-earner, or the owner. In ease of the large corporation the controlling interest may also be the final bearer of part of the tax burden. As control may usually be identified with the management which is, then, either the wage-earning or the salaried personnel of the corporation, the separate recognition given to control may be dispensed with in incidence study. As argued above (supra, pp. 132-lMf^ there is no economic owner, for the large, public corporations. But in the small business firm the owner does take possession of business net income after tax; therefore, such portion of the tax which is not shifted to either the consumer or the wage- earner is ordinarily considered as absorbed by him. Since any tax reduces the owner*s income to the same extent, there cannot be a genuine business tax to rest exclusively on business. It should be noted that this ordinary view of business from the proprietorship standpoint is contrary to the separate business entity theory discussed above. This entity point of view must be maintained throughout discussion in this dissertation study. According to this entity theory the owner’s proper legal claim to business income may be limited to that which is left after the tax, not the entire net income before tax. 188 not require any amount of economic reasoning to see that if the excess profits tax were shifted, the conclusions reached hereinabove would not be valid. Since the deductive analysis of tax incidence involves complicated economic theories and issues, a separate chapter will be devoted to its treatment. XI* SUMMARY OF CONCLUSIONS Taxation of business income and profits may be resorted to for purposes of public revenue and/or social control. A permanent excess profits tax is proposed as a means to raise such revenue without the intent of “penalizing1 1 the monopolies, but with due regard to and recognition of the differential effects of the tax on their earnings and their resultant market positions. A permanent excess profits tax dovetails beautifully into tax policies and measures which emphasize the concept of built-in flexibility and the theory of the cyclical budget. Inasmuch as the excess profits tax is intended as a tax on business, both the state partnership theory and the impersonal ability theory constitute the economic basis for such business taxation. In this respect, it is noted that on account of radical changes in the corporate structure, the status of the giant public corporations has rapidly attained that of a social and economic institution and their separate economic entities can no longer be ignored or adequately clothed in the concept of a legal fiction for taxation purposes. As a tax on business, 189 separate and distinct from its owners, the excess profits tax is just, for it takes away only the surplus portion of profits which is not necessary to maintain existing investment and stimulate increases in such investment, is equitable accord ing to the ability to pay theory, based upon the different degrees of sensitivity to taxation of different types of investment and profit incomes, and does not retard capital accumulation if it is levied at moderately progressive rates. The relatively nonshiftable nature of the tax makes it the tax which will rest where it is intended to rest, namely, on business enterprise having a conceptual and factual-existence, separate and distinct from its owners. This nonshiftability of the excess profits tax lends a certain degree of definitive ness and- finality to the conclusions about its theoretical merits, justice, and equitableness, which would not be possible, if the tax were shiftable* CHAPTER IV THE THEORY OF NORMAL PROFITS AND THE RESIDUAL CLAIMANT THEORY OF EXCESS PROFITS The soundness of the theoretical structure of the excess profits tax hinges upon the validity of the concept of normal profits. The theory of normal profits conceptually sets off that portion of business profits which represents the necessary cost of doing business, as against profits which are above normal and are, therefore, regarded as surplus and unnecessary for the maintenance of existing investment in the industry or the inducement of additional entries and capital. This concept is generally in accord with the now familiar Hobsonian concept of taxable surplus, which we discussed at some length in the preceding chapter. It is our purpose here, however, to subject the theory of normal profits to a thorough going qualitative analysis to prove and establish beyond doubt its economic and practical validity within its proper sphere of application and particularly in connection with excess profits taxation. Inasmuch as the theory of normal profits constitutes an integral part of the general theory of profits, it is deemed appropriate briefly to review the historical development of the latter as an introduction to an investiga tion of the former* 190 I. A REVIEW OF THE HISTORICAL DEVELOPMENT OF THE GENERAL THEORY OF PROFITS 191 THE CLASSICISTS Smith* Say* Mill, and Marshall* The evolution of the theory of profits has assumed two distinct aspects; (1) the segregation of the various elements composing business profits and the clarification of the conception of surplus or pure profit and (2) the explanation of the manner in which pure 1 profit is determined. It is fair to generalize that most prominent economists since Adam Smith*s days have recognized, though they may not have seriously attempted in some instances to differentiate in functional terms between the various profit components, that business profits, loosely speaking, represent the reward for not one but several elements of remuneration for the services of the owner-entrepreneur or owner-capitalist. Smith perceived of three elements of profits, namely, interest 2 on capital, wages of superintendence, and a payment for risk. Edmund Whittaker, 4 History of Economic Ideas (New York: Longmans, Green and Co., 19^3), P« 66EZ 2 Wealth of Nations* Bk. I* Chapters 9 and 10. These elements of profits are of unequal importance in Smith's con cept of profits. According to Whittaker (op. cit.* p. 610), Smith thought that profit was largely or entirely interest, together with a payment for the risk of capital. Knight is of the opinion that though reference was made to risk by Smith and his immediate followers, it was "in the sense of risk of loss of capital, which does not clearly distinguish 192 J. B. Say made the distinction between profits of industry and profits of capital. In the former he included wages of common labor and “the profits of the master-agent, or adven turer, in industry,** or the reward of the business organizer or the enterpriser, and in the latter he discerned interest i f . (not in their entirety), including an element of risk. Mill, treating formally of profits in his book on distribution, splits up business profits into their component elements, interest, payment for risk, and remuneration for the labor employed, though there is a substantial identification of profits with interest on capital in his explanation of the factors contributing to the fall of the rate of profits with p (Continued) profit from interest.*1 (Frank H. Knight, Risk, Uncertainty and Profit (Boston: Houghton Mifflin Company, 1921), p. 2*f.) As regards the element of wages, Smith considers the great apparent profit of the apothecaries as “frequently no more than the reasonable wages of labour.'* Obviously, risk, as a separate element of profits, does not play as important a part as the elements of interest and wages in Smith's theory of profits. 3 J. B. Say, A Treatise on Political Economy. Bk. 2, Chap. 7» According to Knight (op. cit., p. 25) , Say, in the *fth edition of his Treatise, included the reward for risk- taking in profit as accruing to the entrepreneur, not the capitalist, as contended in earlier editions. John S. Mill, Principles of Political Economy. Bk. 2, Chap. 15> Sect. iv. 193 the progress of society. In Marshall!s hands the classicists' profits not only were carefully segregated into the traditional wages of management, interest on capital, and a premium for risk, plus an additional reward for the organization, factor, which he introduced for the first time, but also were inte grated with his time study of economic behavior under his particular method of the partial equilibrium analysis. The term "normal profits" made its formal appearance. This we will study more closely in the section immediately following. OTHER THEORISTS Walker. It should be noted that the theory of profits as treated by the classicists is mainly concerned with the explanation of the necessary "minimum, profit" which enters into the cost of production or the natural price of a com- 7 modity. An entirely different approach to the. problem of profits had been developed in the meantime•by economists on the Continent and in. America. Walker was among the first economists who contended that profits emerge as does rent of exceptional business abilities. Since there are no profits 6 This view of Mill's interpretation of the relation ship between profits and interest is held by Whittaker (op. cit., p. 6l*f). ^ According to C. J. Foreman, "A Division among Theorists in Their Analysis of Profits," Quarterly Journal of Economics. XXXIV (November, 1919), 115-117. 19^ at the margin of production, as there is no rent, profits 8 do not enter into price. The central criticism of Walker’s theory lies in the fact that it explains only the differences 9 in profits but not their origin or causes. But Walker recog nized the functions of the entrepreneur, as separate and dis tinct from the capital furnishing function of the capitalist, though the two functions may be performed by the same person.10 This represents an advance from the older theories of profits, for separate recognition paved the way for theorizing about the emergence of pure profit without the possibility of con fusing it with interest on capital. Clark and Schumpeter. Clark and Schumpeter have attributed the occurrence of pure profit to economic dynamics. Being the first economist to propose the theory, Clark sets out in his Distribution of Wealth to define the role of the entrepreneur as that of co-ordination, the remuneration for 11 which he calls profits. Presumably, pure profit is an 8 Francis A. Walker, Political Economy (3rd rev. ed.; New York: Henry Holt and Company, l888), pp. 239-21 +0. 9 No thorough criticism of Walker’s theory is attempted here as this is familiar ground and the reader is referred to James P. Beddy’s Profits (Dublin: Hodges, Figgis & Co., 19^0), pp. ^or a summary of the opposing views. 10 Walker, op. cit., pp. 232-23^. 11 John B. Clark, Distribution of Wealth (New York: The Macmillan Company, 1899), p. 3» Clark’s conception of the entrepreneur is not sufficiently definite- to be above question. 195 additional reward to the entrepreneur over and above ordinary wages of superintendence, management, and direction of the 12 business. Under stationary conditions, pure profit does not arise and ’ ’ normal prices are no-profit prices.”1^ Dynamic changes, however, alter static values and prices. An inven tion, making it possible to produce something more cheaply than formerly, yields a profit to the entrepreneur (and also Ik occasions an increase in wages and interest). But because of active competition, he cannot hold on. to his gains for long and, as the movement and reallocation of capital, brought about by competition, proceed, each bit of his gains dwindles to nothing. The movement will stop when the no-profit state 15 is again attained. The transition from one no-profit state to another would not have been accompanied by the temporary economic phenomenon of pure profit, had there been no friction in the actual world to the tendency of competition to (Continued) According to Beddy (op. cit.. p. 78), his entrepreneur ”is so shadowy a being that it is difficult to believe that he is the explanation of profits.” - 1 * 2 Clark, op. cit.. p. 111$ and George J. Stigler, Production and Distribution Theories (New Yorks The Macmillan Company, 19*4-1), p* 319* * * • 3 Clarkv. loc. cit. ____ llf Ibid., p. *+05. 15 Ibid.. p. 290. 196 annihilate it. This is the gist of Clark*s dynamic-friction theory of pure profit. Apparently, the emergency of pure profit is made contingent upon the presence of both economic dynamics and friction. Proceeding from the static state, dynamics alone would not produce pure profit if there were no friction in the economic system, for, then, "if competition worked without let or hindrance, pure business profit would be annihilated as fast as it could be created— entrepreneurs. as 17 such, could never get and keep any income," The Schumpeterian concept of pure profit is that of the entrepreneurial profit which represents a surplus over costs, the latter including "all the disbursements which the entrepreneur must make directly or indirectly in production," plus an appropriate wage for labor performed by him, an appro priate rent for any land which may chance to belong to him, l8 a premium for risk, and interest on capital. This surplus 16 Ibid.. p. 111. ^ Ibid.. p. ^10. (Italics in the original.) See Knight, o£. cit.. p. 3*+, note M-, for criticism of this cited statement. The last part of the quotation, however, seems to contradict Stigler and this writer’s understanding of the minimum remuneration of the entrepreneur under the static condition, (Supra, p. 195, footnote 12.) ■j D Joseph A. Schumpeter, The Theory of Economic Develop ment . translated from the German by Redvers Opie (Cambridge: Harvard University Press, 193^), P» 128. The last-named cost, interest on capital, may be left out of account at the option of the reader. This comes as a result of Schumpeter's peculiar theory of interest on productive capital,, for which see pp. 1 5 5 -2 1 1 of the same book by the same author. 197 arises from the development by the entrepreneur of new, profitable, and successful combinations of the services of labor and land that will enable the production of a greater physical product at lower cost than the older method. But “the alluring profit” soon attracts new businesses and compe tition will bring about a new equilibrium position, "in which, with new data, the law of cost again rules,” so that product prices are again equal to its eost.^ The disappearance of this surplus occurs "as a rule only after a longer or shorter period of progressive diminution." It constitutes a definite amount of net returns even though, only temporary. This profit falls to those individuals who have carried out new combina- 20 tions, namely, the entrepreneurs. The entrepreneur is never the risk bearer, even though he "finances himself out of former profits" or contributes his own means of production "belonging to his ‘static* business, for then, the risk falls on him as 21 capitalist or as possessor of goods, not as entrepreneur." 19 Ibid., p. 131. Schumpeter regards capital goods as merely the embodiment of the wages and rents of the services of labor and land that have gone into their production. So, the cost here includes not only those of the services of labor and land now employed in direct production of the product, but also those embodied in the capital goods. (Loc. cit.5 20 Ibid., p. 132. 21 Ibid., p. 137. 198 Pure profit is, therefore, not the reward for risk-taking.22 Both the Clarkian and the Schumpeterian theories of pure profit contemplate it as being the residual element in the distribution of income. As such, it does not enter into 27 the cost of production and therefore, the price of the product. As to the social-implications of the occurrence of pure profit as the result of friction or imperfect or monopolistic competi tion, Clark keeps a discreet silence and does not go further in his Distribution of Wealth than to remark that dynamic theory should endeavor to explain “the principles which govern p i t . trusts, labor unions and other consolidations.“ Schumpeter is more outspoken in this respect. According to him, the size of profit cannot be considered in the sense that "it just suffices to call forth precisely the 'quantity of entrepreneu- 25 rial services required.*" The mere prospects of dispropor tionate individual success— pp In the opinion of this writer, the risk premium, mentioned above (supra, p. 196), presumably is intended as an insurance against the loss of any land owned by the entrepreneur as a capitalist. This Is implied in.Clark*s discussion of pure profit and explicitly stated by Schumpeter (op. cit.. p. 153)s “One might say of the latter [profit], but with more right, what the classical economists asserted of rent of land, namely that it does not enter into the price of the products.** 2lf Clark, pp. cit., p. ¥fl. 25 Schumpeter, op. cit., p. 15^- 199 • • • belong, as it were, to the ‘remuneration* of those entrepreneurs for whom they are not realized* Nevertheless it is quite clear that in very many cases smaller amounts [of profit] and especially smaller total amounts [of profit] would have the same result, as it is also clear-that the connec tion between quality of service and private success is here much weaker than,for example in the market for professional l a b o r . 2o This explains why the “salaried" entrepreneur can generally be adequately remunerated with much less than the full amount of the profit. For, The more life becomes rationalized, levelled, democratised, and the more transient become the relations of the individual to concrete people (especially in the family circle) and to concrete things (to a concrete factory or to an ancestral home), the more many of the motives enumerated in the second chapter lose their importance and the more, the entrepreneur’s grip on profit loses its power. To this process the progressive ‘auto mat isat ion’ of development runs parallel, and it also tends to weaken the significance of the entre preneurial function.2? We will return to this conclusion of Schumpeter’s theory in a later section of this chapterj in the opinion of this writer this theory is of paramount importance to the theory of excess profits. Conclusion. It is strikingly noticeable that the aforementioned theories of profits, especially those of the 26 Ibid.. p. 155. Loc. cit. The motives referred to are the dream and the will to found a private kingdom, the will to conquer, the joy of creating, et cetera. (Ibid.. pp. 93-91 *-.) 200 English economists, have not adequately taken into considera tion the effect of institutional changes brought about by the 28 evolution of the large corporations. Considering the immense strategic importance of the large corporations in the national economy and therefore, in the field of excess profits 29 taxation, this deficiency of these traditional theories of profits, which was pointed out by Gordon over a decade ago,^ must somehow be made up before an adequate theory of profits suitable to the theory of excess profits taxation is possible. This will be attempted in a later section. II. RISK THEORY OF PROFITS Hawlev1s risk theory. The different economists noted in the foregoing have taken cognizance of risk as being a com ponent of the profits of the business man. But theirs do not represent the risk theory of profits. This latter theory envisages profits remaining after interest on capital, which pQ Schumpeter may be excepted. “Because of this more extensive investment in the larger corporations, it is quite proper that the study of corporation finance be directed primarily to this group.“ (William H. Husband and James C. Dockeray, Modern Corpora- ~ tion Finance (Chicago: Richard D. Irwin, Inc., 19^) , pp. 602- 6 0 3.) If this is true of corporation finance, by the same token it is so with any study of business profits. 30 For source, see infra, p. 221, footnote 68. 201 from the point of view of the enterprise itself is all borrowed, and wages for workers, as being the remuneration of those who 31 undertook business risks. Hawley was among the foremost exponents of the risk theory of profits and wrotes This theory asserts that the profit of an undertaking, or the residue of the product after the claims of land, capital, and labour (fur nished by others or by the undertaker himself) are satisfied, is not the reward of management or co-ordination, but of the risks and responsibili ties that the undertaker . . . subject himself to. * And as no one, as a matter of business, subjects himself to risk for what he believes the actuarial value of the risk amounts to— in the calculation of which he is on the average correct— a net income accrues to Enterprise, as a whole, equal to the difference between the gains derived from under takings, and the actual losses incurred in them. This net income, being manifestly an unpredeter mined residue, must be a profit, and as there cannot be two unpredetermined residues in the same undertaking, profit is identified with the reward for the assumption of responsibility, especially, though not exclusively, that involved in owner ship.32 In short, profit is simply the price paid by society for the assumption of business risks. There are two types or risks: insured and the uninsured risks. . It is in connection with the latter that profits arise and, until the uncertainty ends with the sale of the entrepreneurs products, the amount of the reward cannot be determined. Profit is, therefore, a Whittaker, ojd. clt.. p. 62^. Frederick B. Hawley, Enterprise and the Productive Process (New York: G. P. Putnam's Sons, 1907)> pp7 106-107• 33 residue. 202 Criticisms of Hawley*s theory. The criticisms that have been directed at the risk theory of profits are too numerous to be discussed in full. We will note only several more important ones in the following. 1. The risk theory of profits which is based upon the assertion that no one assumes risks unless he is paid to do so is not in accord with racecourse speculation which is under taken in spite of the knowledge that on the average a loss results.^ 2. If profits are associated exclusively with the assumption of risk, profits should then be proportionate to 35 the risk assumed on the average. The more risky the enter prise or industry, the higher should be its average rate of profits to attract timid funds. Profit statistics for a variety of industries, however, do not reveal such a positive correlation.3^ 3* Risk does not offer a full explanation of all the gains arising from business activities, monopolistic or 33 Beddy, op. cit., p. 85. Whittaker, loc. cit. Robert B. Pettengill, Price Economics (New York: The Ronald Press Company, 19^8), p. ^72. 36 Loc. cit. 203 37 semi-monopolistic. if. Risks arise also in connection with the use of factors of production other than capital.^ Though he recog nized that workers were also risk-bearers, Hawley attached 39 very little importance to this fact. But this vitiates his theory that risk is the sole cause of profits which belong solely to the enterpriser. 5* In Hawley’s exposition a confusion exists between risk and uncertainty, the former being a known factor or quan tity, insurable, and "remunerated by a sum just sufficient to cover the actual loss involved and that no possible profit existed or was concealed in this remuneration" 5 the latter, a result of imperfections in human knowledge causing errors in Judgment, unmeasurable, uninsurable, and for which profit is ifO the proper remuneration. Criticism of risk and uncertainty theories of profits in general. This represents the gist of Knight's uncertainty theory of profit, pure and in excess of normal profits. We do not deny that uncertainty, subjective in nature, must be 37 Beddy, pp. cit. T pp. 85-36, stating that Hawley was conscious of this fact himself. 33 see infra, p. 20b. 39 Beddy, op* cit., p. 90. ^ Knight, op. cit.. pp. 197-232. 201+ rewarded in order that it will not exercise an unfavorable influence on the supply of the functionary (or functionaries bl as argued below) which it conditions. Uncertainty-bearing is, like pain and abstinence, one of the resistances on which costs of production rest, and is not a productive act but a circumstance attendant upon production. There can be no doubt about its entering into costs of production. . . . But the important point is that uncertainty attaches to the utilization of all factors of production and the uncertain ties borne by the workers and the owners of capital equal and in some instances exceed those borne by the enterprisers 1+ 2 in degree and intensity. Yet wages are paid not solely for the passive role of the worker as an uncertainty bearer, but also for the positive productive function he performs. The same may be said of the interest paid to the owner of capital. Of course, the wage and interest rates are adjusted for this The discussion to follow is based upon Beddy, op. cit.. pp. 117-11+6. 1+0 In the passages quoted in the preceding note, Beddy furnishes an excellent description and explanation of the universal occurrence of risk and uncertainty in the business world. Uncertainty is simply one of a number of resistances upon which costs of production rest, and is, therefore, rewarded in the same way as other costs of production* This is in direct contrast to Knight’s assertion that pure profit, being the remuneration for uncertainty-bearing, does not enter into cost of production. Beddy concludes his objection to a theory of profits based upon uncertainty by saying that ”it conveys an exaggerated impression of the importance of uncer tainty and offers a vague, unreal and altogether too unscien tific and elusive an explanation of profit.” 205 factor of uncertainty, but this is not what we are concerned with. What we would like to know is why the entrepreneur, bearing as much risk and uncertainty as the worker and the capitalist, should, according to the risk theorists, be entitled to a remuneration based entirely upon uncertainty. But if he is a person performing the work of co-ordinating the work of labor and capital and possessing no capital of his own, he is then simply a worker of a high grade and his risk and uncertainty will be similar to those of other workers, i.e., possible loss of income and of future employment. Uncertainty, therefore, is no more the cause of profits than the cause of wages and interest. Concluding illustration. The validity of this princi ple may be demonstrated by the case of the giant corporation. In the modern large corporation the stockholder, as we have *+3 argued elsewhere, occupies the same “outsider" position as the contractual creditor. Management and ownership functions are distinctly separate and generally are performed by differ ent persons. The return to the stockholder in this case will be no different from that of the contractual creditor. Accord ing to the traditional theory of profits, the former will be paid dividends for the use of his capital, equivalent to ordi nary contractual interest plus an additional amount commensurate **3 Supra. Chapter III, pp. 132-lMf with the greater degree of risk incurred by him than that by the creditor. The managing officers from the corporate presi dent down will be remunerated with salaries and wages. They incur risks too, as we contended above, and those risks, not excepting the stockholder's, are rewarded by way of additions to salaries and wages (and interest, as noted above). What about the remainder of corporate profits not thus allocated and distributed? It can hardly be regarded as a reward for uncertainty-bearing. For if it were, by whom? The point of our contention is that we do not deny the existence of uncer tainty or that it must be remunerated in the long run, but merely maintain that because of its presence in the supply of all agents of production, to attribute surplus profits to uncertainty-bearing, as if it were a separate function exist ing independently of any supply functionary, does not conform to the set of factual data as presented immediately above. This is true also in connection with small business. If we can conceptually segregate the capital supply function from the legal ownership with the right of appropriation, in case the owner is also the capitalist, the process of imputation will attribute to the supply of capital the equivalent of ordinary interest plus a risk premium, just as in the case of the large corporation. Ignoring the effect of unlimited liability in the case of unincorporated business for the time being, it is admitted that as a rule, the degree of risk 207 incurred by small business is_ higher than that by large busi- Mf ness corporations and therefore the risk premium should be set at such an amount that it will reflect the higher degree of risk involved. But this is a far cry from the risk theory of profits which attempts to supply risk as being solely responsible for and as the only explanation of the emergence of surplus profits* The effect on risk-taking or uncertainty-bearing of the institutional factor of unlimited liability in the case of unincorporated business is admittedly great, but even here the risk theory is untenable, even though it is more relevant. It is relevant because the greater risk and uncertainty involved may conceivably require a long-run return that may, in particular instances, equal the entire amount of surplus profits. It is untenable because the fact that the long-run return for risk-taking and uncertainty-bearing may claim the entire surplus profits does not necessarily mean that uncer- . L j - J ? tainty-bearing is the general explanation, of surplus profits. For explanation, see infra. Chap, V, pp. 275-299* 1+5 Marshall's view on risk as an element of profits and cost is in harmony with ours as presented in the text, "In trades that handle costly materials, success depends very much upon good fortune and ability in buying and selling; and the order of mind required for interpreting rightly and reducing to their proper proportions the causes that are likely to affect price is rare, and can command high earnings. The allowance to be made for this is so important in certain trades as to have induced some American writers to regard profits as remuneration of risk simply; and as consisting of what remains 208 III. THE THEORY OF NORMAL PROFITS MARSHALL*S THEORETICAL CONTRIBUTION Importance of time. In the explanation of value Marshall's economics has effected a synthesis of the utility ^ (Continued) after deducting interest and earnings of management from gross profits. . . . It is of course true that as a rule a person will not enter on a risky business, unless, other things being equal, he expects to gain from it more than he would in other trades open to him, after his probable losses had been deducted from his probable gains on a fair actuarial estimate. . . . And where the risks are not insured for, they must be compen sated in the long run on a scale about as high as if the practical difficulties of insurance against business risks could be overcome. ..." (Alfred Marshall, Principles of Economics (Eighth edition; London: Macmillan and Co., Limited, 1920), pp. 612-613. Pigou also writes, "The payment for uncer tainty-bearing, therefore, consists, not in the whole of the excess above normal profits earned by these successful under takers, but only in that (generally small) part of this excess which is not cancelled out by the corresponding losses of other undertakers who have fallen out of the race." (A. C. Pigou, The Economics of Welfare (Fourth edition; London: Macmillan and Co., Limited, 1932), P* 776 (italics supplied by us), cited by Carl Shoup, "The Taxation of Excess Profits I," Political Science Quarterly. LV, No. (December, 19l HD), 5*+7* According to Marshall's reasoning, additional allowance may be computed on an actuarial basis to compensate for risk-bearing greater than the risk premium contained in the interest element of normal profits can provide for. Pigou*s view supplies further seconding of our position that in individual cases the payment for uncertainty-bearing does not consist in the whole of the excess above normal profits earned. Even in the economy as a whole, pure profit, or the excess of aggregate profits over aggregate losses, is not wholly attributable to risk- or uncertainty-bearing. Only a very small part of this excess constitutes the payment for uncertainty. This is exactly what we have been arguing for in the text. Dr. Pettengill advanced the following argument against the risk theory of profits: "In the first place, risk begins the moment one takes the equity position. Risk does not remain absent until after a certain opportunity-cost level of profits has been reached." (Pettengill, op. cit.. p. **71; italics supplied.) 209 theory of the Austrians and the cost theory of his English predecessors. The element of time, which has found use fully divided into some five periods of varying duration, each being carefully defined in relation to the degree of the fixity of supply and to other factors like the changes in the basic economic data, is of crucial importance in the deter mination of value in his method of the partial equilibrium ka analysis. While maintaining that value is governed by both utility (demand) and cost of production (supply), just as it is the upper and the under blades, together, of a pair of * + • 9 scissors that cut a piece of paper, he, nevertheless, places different emphasis on the influence each force exerts on value in relation to the different and relevant time periods under consideration. Thus he writes: . . . as a general rule, the shorter the period which we are considering, the greater must be the l±A Lewis H. Haney, History of Economic Thought (Third edition; New York: The Macmillan Company, 1936), p. 637* For a detail discussion of these time periods, see Robert B. Pettengill1s A Summary of Alfred Marshall * s Theories of Value and Distribution (Los Angeles: Graduate Seminar in Economics, The University of Southern California, 1939), pp. 3 8. '•For the nature of the equilibrium itself, and that of the causes by which it is determined, depend on the length of the period over which the market is taken to extend." (Alfred Marshall, Principles of Economics (Eighth edition; London: Macmillan and Co., Limited), p . 330). 1+9 Ibid.. p. 3^8. 210 share of our attention which is given to the influ ence of demand on value; and the longer the period, the more important will be the influence of cost of production on value. For the influence of changes in cost of production takes as a rule a longer time to work itself out than does the influence of changes in demand.2° The “longer time" Marshall has in mind apparently refers to his normal long period which is defined as being the time period during which "Supply means what can be produced by plant, which itself can be remuneratively produced and applied 51 within the given time, , . It is only with reference to this normal long period that the concept of normal profits has any significance in Marshall's theory of distribution. Nature of ^ functional approach to normal profits. From the side of distribution the total value product or the cost of production in the normal long period resolves itself 53 into normal wages, normal interest, normal profits, and rent. Normal profits represent in the long run the total remuneration Ibid.. p. 3^9* (Italics in the original.) Ibid., p. 379* The differentiation between his normal short and long periods is discussed in Principles. Bk. V, Chap. V, Sec. to 8, pp. 369-3 8 0. Unless otherwise stated, the discussion contained in this subsection is entirely based upon Marshall, op. cit., Bk. vi, Chap. vii and viii, pp. 596-628. We are here traveling through familiar ground and detailed references are considered unnecessary. ^ Since land is not reproducible, the normal concept does not apply to its remuneration, rent. 211 of a capitalist-employer who "is a man of normal ability (normal that is for that class of work), and is on the margin 6b of doubt whether to make the venture or not. . . ." To Marshall the capitalist-employer is a prototype of the tradi tional business enterpriser who contributes both his own 66 capital and his own labor. What are the functions that a capitalist-employer performs to entitle him to the remunera tion of normal profits in the long run? His functions are three in number: the supply of the capital needed, the ability and energy required for business management, and that organization by which the appropriate business ability and the requisite capital are brought together. Normal profits may be defined, therefore, as the sum of the normal supply price of the capital, normal supply J The word I ’ normal," as used by Marshall in the quoted passage, appears to mean ' ’ representative*' and therefore, does not seem to refer to any particular time period. This inter pretation is based upon the continuation of the passage quoted in the text, ’ * . . . they may be taken as true representatives of the (marginal) normal expenses of production of the services in question. Thus the whole of the normal profits enter into true or long-period supply price." (Ibid.T p. 619.) Again, in analyzing the normal cost of producing a commodity, Marshall advises us to select that of a representative producer as our point of reference. A representative firm is described to be "one which has had a fairly long life, and fair success, which is managed with normal ability ..." (Ibid.. p. 317; italics supplied.) The above passages are quoted to clarify the meaning of "normal" ability at the suggestion of Dr. Pettengill. ^ To be sure, Marshall had occasion to discuss the~ work of management in joint-stock companies. (Ibid., pp. 6o4~ 605.) 212 price of business ability, and the normal supply price of organi zat ion. These three elements of the supply of business power in command of capital should now be examined. 1. The normal supply price of the capital needed is obviously the normal interest on the capital. Interest, as 56 Marshall understands it, may be either net or gross. Net interest simply consists of the earnings of capital, or the reward of waiting. But what commonly is understood by the name of interest includes other elements and may be called gross Interest. The other elements of gross interest besides 57 the reward of waiting are some insurance against risk and earnings of management of a troublesome lending business. Gross interest may properly be regarded as profits of the 58 money lender. Since the degree and contingency of risk and the arduousness of the task of management vary with different industries, the tendency of competition will not reduce gross interest among different industries to equality. But net 59 interest does tend to equality. Ibid., pp. 588 ff. ^ Marshall analyzes risk into that of insecurity (ibid.. p. 588) and those of trade and personal in character (ibid.. p. 590), being extra to those applicable to business, much of the capital of which has been borrowed. This will again be dealt with in the following paragraphs. 58 Ibid., p. 590. 59 Ibid.. pp. 590-591. 213 Incidentally, Marshall’s risk concept is mainly that of loss of capital* He emphasizes the additional risk incurred by the owner-capitalist as compared with the credi tors of business. This represents an institutional approach to the owner’s risk. 2. The normal supply of managing ability and energy is clearly wages for management, superintendence, and direc tion of business. Marshall’s analysis of the management func tion of the employer is not very satisfactory. In addition to mere routine labor, it is possible to discern those entre preneurial functions of a higher order. Thus, organizing ability, superintendence, and other duties demanding certain ’ ’ natural qualities” or the faculties of judgment, promptness, resource, carefulness, and steadfastness of purpose, are found in his discussion. The remuneration for these qualities of business ability is termed ”net earnings of management.” Individuals with exceptional natural abilities, however, do receive additional rewards, surplus incomes which partake of the nature of rents. Marshall admits that it is difficult to ascertain exactly what is the price that is being paid for business ability in any trade, for the simple fact that no one can foretell with any degree of accuracy what the gross earnings of management of business are. According to Marshall, such gross earnings may be arrived at by deducting interest on business capital._from true business profits. If true business 21k- profits are composed of wages, interest, and earnings of organization, to deduct interest from profits will not yield the wages figure, but the remainder is itself composed of wages and earnings of organization. Unless organization and management are synonymous or two aspects of the same factor, 60 labor, the formula above will not enable us to find the gross earnings of management. Difficult though it is to foretell accurately what these earnings are, nevertheless, . . . there is a general agreement among business men that the average rate of profits in a trade cannot rise or fall much without general attention being attracted to the change before long. This possibility of change of trade by business men constantly in pursuit of greater opportunities does affect the supply of natural abilities and their supply price, in much the same manner as the supply of skilled labor and its supply price are affected by its mobility. In analyzing the causes that govern profits Marshall takes institutional factors into consideration, as is indi cated by his discussion of the difficulty of ascertaining profits of small businesses, which is largely absent in the case of large corporations, since the earnings of the labor We will see that this is what some economists con sider to be the key to the solution of the problem. Infra, p. 225, footnote 75» 215 of the head of a small business are reckoned among his prof its, This fact accounts for the wide divergences in the rate of profits between small and large businesses and also affords the explanation of why "the rate of profits is low in nearly all those trades which require very little ability of the highest order," He concludes that even when correction as to the labor portion of profits has been made, "the rate of profit reckoned in the ordinary way declines generally as the size of the business increases," 3, Marshall*s concern about institutional factors and their influence on profits is again indicated by his recogni tion of a new agent of production, organization. The normal supply price of organization would seem a distinct and unique type of income accruing to the factor of organization, but somehow it inures to the benefit of the capitalist-employer and is, therefore, considered the third element of profits. This appears to this writer to be a most vulnerable part of Marshall system of profits and the discussion of it and its vulnerability is postponed to a later section dealing with £l certain criticisms of his theory. The normal long period. It has been pointed out in the foregoing that normal profits in Marshall*s theory are 61 Infra, pp. 220-230 216 realized only in the normal long period in which cost of pro duction governs value. On account of the constant action of the principle of substitution, the profits share of the normal cost of production cannot for long diverge from the sum of the normal supply prices of the capital, business ability, and organization. Mhat are the characteristics of this normal long period? The normal long period has been defined to be that period in which . . . all investments of capital and effort in providing the material plant and the organization of a business, and in acquiring trade knowledge and specialized ability, have time to be adjusted to the incomes which are expected to be earned by them: and the estimates of those incomes therefore directly govern supply, and are the true long-period normal supply price of the commodities produced.®2 In other words, it is the period of time in which equilibrium of the industry in Marshall’s -partial equilibrium analysis is attained. Normal profits, as exist in this period, may be taken to represent the theoretical net earnings that must obtain in every industry and be obtained by the representative firm in every industry in equilibrium through the forces of substitution and competition. There is no occasion for pure profits to arise under these conditions. Let us look beyond ^2 Marshall, op. cit., p. 377. The discussion following is based primarily on ibid., Bk. V, Chap. v, pp. 363-38O. 217 the garb of defining language to see what economic attributes are characteristic of this normal long period. In his method of partial equilibrium analysis, Marshall reduces some central point to a stationary state and the forces that affect the things by which that point is sur rounded and any tendency of these forces toward equilibrium are then studied in relation to it. Since forces that bring about normal profits in the end take time to work themselves out, the state of rest is prolonged for the same length of time. The logical conclusion from this is that there is no difference between the stationary state and the normal long 63 period. This Marshall implicitly admits. In emphasizing the distinction between average price and normal price, he maintains that "In a stationary state alone • . . the term normal always means the same thing: there, but only there, ’average price’ and 'normal price' are convertible terms.” In other words, only in the state of equilibrium is average price the same as normal price. A little description of the stationary state will shed some light on what normal long period is like. In the stationary state the general conditions of pro duction and consumption and of distribution and exchange remain motionless, but yet it is full of movement; for it is ^ Same conclusion by Stigler, op. cit., p. 3^+8. 218 a mode of life. The average age of the population remains unchanged. The same amount of things per head of the popula tion will have been produced in the same ways by the same classes of people for many generations together. The charac ter of man himself is a constant quantity. The size of the “representative firm1 * remains always of the same size. Exter nal and internal economies resulting from subsidiary indus tries in the neighborhood also remain constant. Under these circumstances equilibrium will reign and the plain rule is that cost of production governs value and no pure profit can arise. It goes without saying that these conceptual features of a stationary state do not fit the description of the aetual world. The closest practical model or counterpart of the con ceptual stationary state would be the picture of a matured economy wherein the frontiers of exploitation have been reached, the rate of population growth.and the death rate of- its population about balance each other out, the rate of new invention is either zero or somewhere near that low point (in other words, there is no change in the state of the arts or technology), human taste and desire remain constant and pre dictable, and so on. Growth of itself does not invalidate the concept of the stationary state, if all factors grow in proportion or “at about the same rate.1 1 For it is always conceptually possible to project the stationary state through time and even though there is growth and activity, yet all concerned are growing at the same rate so that they remain in equilibrium with respect to one another throughout the process of proportionate change* For purposes of excess profits taxation it does not matter much whether it is possible to define the normal long period in terms of some specified length of time or with pre cision. What is important in this respect lies in the recog nition of the fact that since the tax is imposed on profits in excess of normal profits and since the latter are the resultant of forces tending toward equilibrium which require a relatively long period for them to work themselves out, the excess profits must be computed with respect to the same long 6b period. Quasi-rents and the short run. We will not allow our selves to tarry long on these topics. Briefly, Marshall’s short run profits are explained by his concept of the quasi rent. This concept is an extension of the land rent theory to the return from all capital investments whose supply in the short run is considered unvarying or fixed. In other words, the return is price-determined rather than price- determining. Marshall refuses to recognize the existence of ^ See infra. Chap. VI, pp. ^07-^17, how loss carry overs serve as the link between the excess profit tax levied as an annual affair and the so-called ’ ’long-run excess profits. 220 permanent pure profits, for he maintains that in the long run quasi-rents will tend toward the normal factor prices, suffi cient to call forth the necessary supplies of the agents of production concerned, plus any rents resulting from permanent 65 monopolistic situations. CRITICISM OF MARSHALL*S THEORY OF NORMAL PROFITS Many criticisms have been hurled at Marshall's theory of profits, but this writer considers the following to be among the most important ones, a discussion of -which is most relevant to our present investigation. Inadequate consideration of institutional changes. Marshall's theory of profits fails to take sufficient account of the drastic change in the institutional setup of the economy. We levelled this charge at nearly all theories of profits dis- 66 cussed above, but we have not had the occasion to explain this charge until now. The drift of the practical effect of this institutional change was discussed in the preceding 67 chapter. In summary, it concerns the divorce of ownership ^ This discussion is based upon Marshall's Principles. Bk. V, Chap. ix, pp. I fl3-i *-2L f - . The last statement of this paragraph is abstracted from Whittaker, op. cit.. p. 623. ^ Supra. p. 200. ^ Supra. pp. 132-lMf and 168-180. from control and management in the large corporations, which results: in the owning group*s not receiving profits tradi tionally regarded as belonging to it by virtue of its property rights, in the substitution of non-profit motives on the part of the controlling group for the profit-maximizing motive in the conduct of business to the detriment of the owning group, and in the excessive accumulation and reinvestment of profits, to which none, neither the legal owners nor the legal control, have any economic claim, though legally and in name only the former are still regarded as possessing the power of appro priation and disposition. The occurrence of these changes in and shifts of ownership rights covers such an important area of the economy that they may not now be ignored even in theory. A theory of profits like Marshall's which is based upon the identification of entrepreneur with owner breaks down on three counts. To begin with, it fails in its attempt . to explain ownership income in functional terms , < as the return 68 for entrepreneurial activity. This it fails to do in so far as there is any income in excess of interest and a risk premium This is certainly true if enterprise be regarded as anything more than merely passive risk-bearing. Next, in tacitly 68 Robert A. Gordon, ' ‘ Enterprise, Profits, and the Modern Corporation,'1 reprinted from Explorations in Economics *n Readings in the Theory of Income Pistribution. Selected by a Committee of the American Economics Association (Philadelphia The Blakiston Company, 19^-6), p. 566. identifying owner with entrepreneur, it leaves out of the pic ture the active and dynamic entrepreneurial function involved in business leadership and fails to explain the income going 69 to those who exercise this leadership. Lastly, it does not explain the emergence of pure profits and surpluses, which under the institutional setup of the large corporations clearly do not accrue to any apparent functionary. It is not to deny that Marshall did furnish some answers to some similar problems that he foresaw. All we are saying is that the answers are inadequate. His statement that in the long run quasi-rents tend to the level of normal profits does not allay the fear that such may not be the case in the actual business world. His recognition of monopoly and monopoly revenue serves only as a partial and very inadequate answer to this question of pure profits. A more ingenious solution is provided by his separate consideration of the income accruing to the factor of production, organization. We will now turn to a discussion of it. Marshall1s organization as an element of normal profits. In the opinion of this writer Marshall's fourth factor of pro duction, organization, is but another veiled attempt to explain the existence of profits in excess of normal without having to 223 cast overboard his system of profit analysis. He writes, The earnings of a successful business, looked at from the point of view of the business man himself, are the aggregate of the earnings, firstly, of his own ability, secondly, of his plant and other mate rial capital, and thirdly, of his good-will, or business organization and connection.'/0 Immediately business organization is linked with good-will 71 and/or business connection. According to this definition of normal business profits, the normal interest on capital, the normal earnings of management, and the. normal supply price of organization would seem to be the only constituents of normal profits or earnings of a successful business man. This inter pretation is consistent with the foregoing discussion of the 72 elements of normal profits. Somehow, this is now not true. Paradoxically, on account of goodwill, business connection, and/or business organization, normal profits of a business amount to more than the sum of the aforementioned three profit elements, the normal supply prices of capital, ability, and organization. This comes about, For his efficiency depends partly on his being in that particular business; and if he were to sell it at a fair price, and then engage himself in Marshall, op. cit.. p. 62!?. (Italics supplied.) We will by-pass the question whether the discussion of goodwill is compatible with Marshall's economics based principally upon free competition. 72 Infra, pp. 210-215. 22k another business, his income would probably be much diminished* The whole value of his business connec tion to him when working it is a notable instance of Conjuncture or Opportunity value. It is mainly a product of ability and labour, though good fortune may have contributed to it* That part which is transferable, and may be bought by a private individ ual, or by a large amalgamation of firms, must be entered among their costs; and is in a sense a Conjuncture or Opportunity cost.73 But this reasoning is clearly inconsistent with his theory of normal profits which encompasses the normal supply price of organization as being a constituent part of normal profits. 7I4. Since, by deduction, the employer attachment to business,' giving rise to this opportunity value, must be considered as a normal long-run factor of production, as long as the busi ness is not sold, a long-run value must be attributed to this “factor*1 employer attachment. In other words, employer attach ment must possess a long-run existence and therefore a long- run supply price. It is not identical with the factor organi zation inasmuch as it is the explanation of the extra value, the opportunity value. How this reasoning can be reconciled with his system of normal profits, analysis which recognizes only three elements of normal- profits, namely, capital, ability, and organization, is more than this writer can imagine. As can 73 Marshall, op. cit.. p. 6 2 5. (Italics in the original.) 7^ This writer considers it as legitimate to ignore in the discussion hereinafter another, manifestation of organiza tion or opportunity value, the employee attachment to business. 225 be seen from the above quotation, Marshall attributed this opportunity value to ability and labor and possibly good for tune, The contradiction there is plain* Ability and labor of the employer may not be transferable on the sale of busi ness, but the good fortune of the business may follow the sale of it to the purchaser. If the ability and labor of the employer accounts for this extra value, there is no reason why this value may not be combined with that of his other ser vices so as to assign a normal supply price to his ability and services, including all of his personal, services. If that is done, there will be no occasion for this extra opportunity value to appear. In fact, that is what some, economists have 75 attempted to attribute to Marshall's organization factor. But this is obviously not what Marshall had in mind, when he wrote the afore-quoted passage and cannot be reconciled with the appearance of the extra value. The cause of good fortune is unfortunately, incompatible with his. assumption of free ^ Whittaker (op. cit.. p. 620) maintains that the factor of organization is resolvable into the other three factors, land, labor, and capital. “A specialized class of laborers, often able, active, and willing to take great risks, but sometimes unscrupulous and risking only the funds of others, is what many economists identify with the •organization* or •enter prise* which makes up Marshall's fourth factor of production.*' Even if this interpretation be accepted, the earnings of organization would then go to this class of laborers, risking only the funds of others. But the earnings of Marshall's organization are supposed to go to the owner of funds himself. The conflict is glaring. 226 competition. From good fortune to monopoly, monopolistic, or excess profits is a very short step. It would be catas trophic for Marshall to acknowledge the existence of the elements of monopoly and monopolistic competition in his analysis of normal profits under conditions of competition. As far as this writer can see, the dilemma.is insoluble upon Marshall's narrow definition of organization. If the employer attachment is made a fourth factor of production, that may explain the extra value, but would ruin his analysis of normal profits, which recognizes only three elements of normal prof its. To attribute the opportunity value to good fortune may also explain the existence of the extra value, but that would vitiate his assumption of free competition. The only solution, in the opinion of this writer, lies in viewing organization in an entirely new perspective as we will do in a subsection below. Even grant, for the sake of argument, that employer attachment may pertain to organization as a factor and that the normal supply price of organization includes both the extra value attributed to employer attachment and the normal supply price of organization without the inclusion of employer 76 attachment. Even under this broad, and perhaps unwarranted, ^ In this way we would be assuming away the existence of an extra opportunity value, so as to make Marshall's analysis of normal profits conform to the expectations of the business man himself. assumption, the statement that normal profits attributed to organization pertain to the owner-capitalist is rooted in tenuous ground. The mere notion of organization serves to associate it with more than one person. Combination and co-ordination are two functions which are not necessarily exclusively performed by the owner. Especially in the case of large corporations, the owner may be excluded altogether from performing these functions. These functions represent only services of a higher order, nevertheless to be remuner ated as part of the wages of management, inasmuch- as partici pants in these same functions other than the owners obtain their remuneration in the form of wages. There are no con vincing functional reasons why a protion of the normal profits should be set aside permanently as accruing exclusively to the owner, for some services which he never performs in the case of large corporations. Furthermore, unless mere attachment to the business can be construed as the performance of an extra function, the employer attachment cannot functionally entitle him to an additional compensation in the form of a portion of normal profits. Marshall’s argument that he may earn less in another business does not prove that the differ ential is due to business connection or attachment. In equilib rium factors of production have already achieved their maximum earning positions so that it will not pay them to move out of their current positions, except into those with higher rewards. 228 Marshall's own concept of organization reveals his concern about the growing importance of organization, both public and private: Capital consists in a great part of knowledge and organization: and of this some part is private property and other part is not. Knowledge is our most powerful engine of production; it enables us to subdue Nature and force her to satisfy our wants. Organization aids knowledge; it has many forms, e.g., that of a single business, that of various businesses in the same trade, that of various trades relatively to one another, and that of the State pro viding security for all and help for many. The dis tinction between public and private property in knowledge and organization is of great and growing importance: in some respects of more importance than that between public and private property in material things; and partly for that reason it seems best sometimes to reckon Organization apart as a distinct agent of production. • . .77 But to attribute the earnings of this distinct agent of pro duction, organization, to the owner is inconsistent with the altered relationships between the financial institutions of the large corporations and their nominal owners. It also deliberately minimizes the role of the State in the economy, the services performed by which have since the thirties out- 78 grown their erstwhile label of "unproductive.1 1 Furthermore, if the going-concern value of a business is, accordingly to Marshall, greater than its cost, or the aggregate cost of the transferable part, owing to the existence ^ Marshall, on. cit., pp. 138-139 ^ Sunra. Chapter III, pp. 12l +-126 229 of goodwill, then to consider the excess as being attributable to goodwill logically follows. But the existence of goodwill is inseparable from the emergence of excess profits. Commons recognizes three main classes of goodwill: commercial good will, favorable attitudes of customers; industrial goodwill, willingness of employees to work for a particular employer; financial goodwill, favorable attitudes of credit institutions 79 and investors.' To these may be added general reputation or 80 public goodwill. These various classes of goodwill cer tainly cannot be brought into existence through the effort of the owner alone. Moreover, advertising may be considered one of the causes of goodwill. Now, other things being equal, the tipping of the demand curve facing the enterprise due to consumer preference so as to enable it to maximize profits at a point where price is much higher than either its marginal 81 cost or its average cost certainly may not be functionally attributed to any exclusive services performed by the owner and the resulting excess profits, which generally give rise to the existence of goodwill, certainly need not be the exclusive 79 j# r . Commons, Legal Foundations of Capitalism (New York: The Macmillan Company, 192*+), pp. 199-200 and 267-272. Rn f W. A. Paton, editor, Accountants1 Handbook (Third edition; New York: The Ronald Press Company, 19*+3)» P» Qb6, 0*1 See infra, p. 265. 230 reward of the owner. To ascribe this excess in profits to the owner by reason of owner attachment or connection is an illegitimate means of by-passing the functional approach to a theory of profits. Our criticism notwithstanding, Marshall’s concept of organization serves as a useful tool in economic analysis which we will utilize to our advantage in developing a theory of excess profits for excess profits tax purposes. The use fulness lies in the fact that organization forms the background underlying the fundamental economic relationships existing among the various economic groups, including the producer, the wage-earner, the capitalist, and the consumer, on the one hand, and between these economic groups and their government, on the other. We will return to this discussion in a later section of this chapter. Defects in Marshall * s ’ ’ tools” of analysis. Marshall’s industry concept and his partial equilibrium methodology are presumably inapplicable in an actual world of imperfect compe tition, The industry concept and the partial equilibrium analysis are acceptable tools of theoretical exploration only under conditions of perfect competition. In other words, Marshall’s theory of normal profits, purported to describe the profit phenomenon in the business world, is valid only when the conditions in that world.approximate these assumptions relating to perfect competition under which his theory is valid. 231 But in a world of imperfect competition, as a result of almost universal product differentiation, which is, in turn, due partly to certain characteristics of the product itself and 82 partly to the conditions surrounding its sale, the industry concept loses much of its former clear-cut lines of demarca tion* Gn account of product differentiation, there exist now very few identical products, the producers of which may be grouped under the same industries. There are only substitutes of various degrees of interchangeability* Chamberlin is among the first economists who have reorientated the traditional value theory under assumptions of perfect competition to his theory of monopolistic competition under universal product differentiation. He did not, however, abandon altogether the concept of industry or “group** in his treatment of price theory. His tangeney solution to the problem of group equilib rium under monopolistic competition still accepts as theoreti cally possible the earning of normal profits by all firms in the group if entry is free.^ But realizing that the group concept under the new set of assumptions of imperfect Op For a full description or discussion of product differentiation and its effect on value determination, see Edward Chamberlin*s The Theory of Monopolistic Competition (Cambridge: Harvard University Press, 1939)j third edition, Chap. IV, pp. 56-70. ^ Ibid., pp. 81-9*+• 232 competition is open to serious question, Chamberlin has him self proposed a reinterpretation of the connection between entry and the group concept* We cannot speak of freedom of entry into an industry, even in the limited sense here defined, unless profits for all producers in the industry are reduced to the minimum included in the cost curve, through demand curves being everywhere tangent to cost curves. Even supposing that this were true, there would remain the bothersome fact that some of the profit elimination is achieved, not by substitutes composing the ‘industry, 1 but by substitutes outside of it; in other words, the results in terms of which .freedom' of entry for an industry are defined, actually involve a degree of freedom to produce substitutes over a much wider range than the ‘industry* as defined. The upshot of the matter seems to be that the concept is not very useful and may even be misleading in connection with monopolistic competition. It is, in reality, a concept usually related to a market for a definite commodity, and.the fundamental diffi culty is that there is no such commodity under monopolistic competition beyond that produced by an individual firm. In the matter of entry, all that we need to say is that wherever there are profit possibilities they will be exploited so far as possible. The enjoyment of large profits by any particular firm is evidently an indication ,that.others, by prpducing close substitutes, may be able to compete some of them away. The results may be very simply described without any concept of freedom or restriction of entry— without even the concept of an ‘industry's some firms in the economic system earn no profits in excess of the minimum counted as a cost, others earn more than this, and in various degrees.04- This change of view, however, has damaging consequences 8^ “Monopolistic or Imperfect Competition?" Journal of Economics. LI (August, 1937)> 567-568. (Italics in the original.) 233 to the no-profit solution usually associated with the industry concept and freedom of entry. ' Under competition between 86 firms producing close substitutes, the profits of existing firms are only a very distant and uncertain indication of the profit prospects open to new entrants. The fact that the existing firm is at the no-profit point will no longer pre vent the entry of new competitors; the position of the former may deteriorate even further and additional entries may go on, 87 irrespective of the losses made by it. ' Vlhen the no-profit point or the level of normal profits of an industry does not serve as an equilibrium lever to regu late entry and exit, Marshall's theory of normal profits which does not explain surpluses or excess profits breaks down. One solution to this difficulty has been pointed out by 88 Chamberlin. But that is almost equivalent to the abandon ment of the industry concept and partial equilibrium metho dology, under which the exposition of the theory of monopolistic 85 J Robert Triffin, Monopolistic Competition and General Equilibrium Theory (Cambridge: Harvard University Press, 1940), p. 163. 86 Triffin calls it "heterogeneous competition," the term "heterogeneous" being used to denote a certain degree of influence of price cutting by one firm upon the volume of sales by another, which maintains its price unchanged. (Ibid.. pp. 103-10&) 87 Ibid.. p. 163. 8^ Supra. p. 232, in the quoted matter. 23^- competition was first carried out, in favor of the more cum bersome and unwieldy general equilibrium analysis, Triffin is apparently in favor of the general equilibrium approach to 89 an explanation of profits. Regardless of how more inclusive the general equilibrium analysis is than the partial equilib rium analysis, this writer is not much impressed with the practical usefulness of the former. Perhaps, a quotation from a work by George J. Stigler will serve as a good indica tion of this writer*s predilection toward the latter for pur poses of excess profits taxation. From the viewpoint of formal analysis the wide scope and small content of the general equilibrium studies offer no objections. But in a specific problem, such as the explanation of the price of milk in one city, the complexity of the problem requires that the investigator's limited powers of analysis be concentrated on only the most relevant data. It is not useful, even though it.is correct, to say that the price of milk in one city depends upon, among other things, all the other prices in America.90 This writer is also of the opinion that even though the indus try concept is not definite and concrete enough for theoreti cal purposes under assumptions of monopolistic competition, it, nevertheless, fulfills the need of any practical statisti cal study of business profits in general. Although the 89 Triffin, op. cit•, Chap. V, pp. 1 $ > 8-1 8 7. 90 George J. Stigler, The Theory of Price (New York: The Macmillan Company, 19*+ 6), p. 2 8. 235 boundary lines between various manufacturing trades are often times difficult to draw, yet for statistical studies of profit trends, earning power, and others, the grouping of these trades under various broad industry divisions has frequently been resorted to and has been found both practicable and use ful. In conclusion, it is not Marshall*s industry concept and partial equilibrium, analysis that should be discarded, but it is his theory of normal profits that needs to be modi fied or extended to cover the economic phenomenon of pure or excess profits. Validity of theory as affected by statistical findings. The theory of a tendency of profits toward a normal level or toward zero pure profit level has been called into question by the findings of a number of extensive statistical studies, including those of Jozsef. Kbrosy, Ewald Moll, Friday, Foster 91 and Catchings, Secrist, Sloan, Epstein, and Crum. These findings have shown that there are a wide scatter and erratic variations in profits and no tendency of profits gravitating toward the normal level is discernible* 92 We are not interested in how these various investigators compiled their 91 Frank H. Knight, “Profit," Encyclopaedia of the Social Sciences, XII (193*+)» **-85. 92 Loc. cit. 236 statistics and computed the relevant figures upon which they based their conclusions, but we are definitely interested in what they had to say in regard to the explanation of the * differences existing between theoretical principles and statistical results. We will concern ourselves with some of the explanations proposed by two of these investigators, Epstein and Crum. As to the finding, revealed by his study, that competi tive influences do not serve to bring about profit equality in different industries over a ten-year period, Epstein empha sizes the institutional factors that tend to modify the forces 93 of competition working toward such an equality. These ares 1. The highly specialized character of much fixed capital in modern industry makes it difficult, if not impossi ble, to withdraw all of the capital of an enterprise over a ten-year period; insufficient profits or actual losses are preferred to complete loss of business .capital by withdrawal. 2. Under the corporate form of enterprise reorganiza tion is far more frequent than liquidation. Corporate policies may be drastically altered, methods changed, and executive per sonnel replaced, but the old framework of the enterprise con tinues. 93 Ralph C. Epstein, Industrial Profits in the United States (New York; National Bureau, of Economic Research, 193*0 » pp. 107-113. 237 At all events, it is often a long time before an unsuccessful corporation gives up the struggle entirely. Even then, the enterprise frequently disappears in name only; if the establishment is of any size, it may be absorbed by, or merged with, some other concern. 3* When reorganizations do take place, capital values are written down on the books of the unsuccessful corporation and the same earnings on smaller capital values will naturally give a higher "new" rate of return. The imperfect character of competition: the prevalence of trade-marks, special designs of products, patents, quasi-monopoly advantages of all sorts, serves to explain why the tendency towards equality is not realized. V Epstein's own conclusion to the above is: The character of modern manufacturing and mer chandising, therefore, furnishes some explanation of the lack of uniformity in the average profit rates of large corporations, when classed by indus tries, for two important conditions essential to perfect competition— a quick mobility of capital and a homogeneity of competing products— are absent in a large proportion of industries. To be sure, a substantial mobility of capital exists over a period of time. But on the side of withdrawal, this mobility exists in the possibility of not creating new plant and organizations of particular types rather than in withdrawing from service those that at any given time are under way. We do not thus undertake to say that the classical doctrine of equality of profit rates is invalid as a 'tendency': but we do say that under modern conditions, as they existed in 1919-28, the evidence seems clear that the tendency was scarcely effective over this ten- year period. 9*+ ^ Ibid.. p. 112 (Italics in the original.) . A later study by Crum of corporate earning power, relating that earning power to the size of corporations, reveals that in each of the six years, 1931-36, inclusive, the average rate of return on equity, with negligible irregu larities, varies directly and progressively with the scale of 95 size. Here, the variations in rates of return are directly correlated with the varying sizes of the enterprises, an apparent institutional cause. This raises the ominous ques tion whether monopoly plays any significant part in bringing 96 about this result. But Crum, like Epstein, played down the 95 William L. Crum, Corporate Size and Earning Power (Cambridge: Harvard University Press, 1939), p. 17. This is at variance with conclusions reached by Epstein (035. cit., p. k-5) that “The larger manufacturing enterprises, in the main, do not earn profits at higher rates than the smaller ones.” This difference is only apparent and is due to the fact that in calculating the average rates of return for the various sizes of corporations, Crum includes in the computations all the corporations, whether they had net income or hot (ibid., p. 31)> while Epstein takes in first, only those smaller or non-identical corporations with net incomes and, second, in making comparisons between large and small corporations, the data for the large corporations are recast to exclude corpora tions with deficits, so as to make the figures comparable (op. cit.. p. 350). For corporations with net incomes only, the conclusions of the two authors are identical in that the small corporations made better showing than the large ones, but Crum*s findings yield another profit behavior which demon strates that in the case of deficit corporations, the large corporations lost, on the whole, much less than the small corporations, so much so that when the income and deficit corporations are averaged together, the large corporations, on the average, earned more than the small ones for the six years under review. (0^. cit.. pp. 27-3 2.) ^ Ibid.. pp. 6-7. 239 issue by plausibly dissociating size from monopoly.-7 But the findings of the aforementioned statistical studies have by no means proved that the theory of normal profits is invalid. On the contrary, profit discrepancies over a period of time are what they should be when actual conditions diverge from the economist’s assumptions. Knight has the following to say with respect to the discrepancy of theoretical conclusions about profits and statistical results compiled by inductive studies: The reasoning to any negation of price theory (by the erratic variation of profits) is not easy to grasp, since general theory creates no presump tion for any particular form of distribution of behavior. It is true that if conditions remained unchanged and transfer of investment were free, competitive theory would call for an approximation of extreme rates of return toward a norm with the passing of time. . . . Theory does not call, how ever, for any particular rate of return on invest ment; even if investment were known, conditions do not remainQconstant and transfer of investment is not free.vo Epstein made similar observations above, as may be noted. After extensive review and criticism of Epstein’s statistical and sampling methods, Tucker also agreed that the continued differences in profits among industries, even allowing for differences in the degree of risk, may be attributable to the slow process of withdrawal from, unprofitable enterprises in 97 Ibid., p. 7* 9® Knight, loc. cit. 2bO years of apparent prosperity, like 1925-29, of artificially low interest rates, like 1927, and of abnormal speculative activity, 192h-1929«^ After this discussion of what the above economists have had to say with regard to profit differences among indus tries, it is almost superfluous for this writer to add that even though statistical findings have not elicited factual evidence to prove the tendency of actual profits toward a normal, the latter is by no means invalidated thereby. IV. THE FACTOR OF ORGANIZATION (OR FIRM ENTREPRENEURSHIP) Organization and Studenski1s theory. Our foregoing criticism of Marshall*s treatment of his fourth factor of production, organization, should not be mistaken as an out right denial of the existence or the usefulness of organiza tion either in a system of technical production or in a system of economic analysis. Functionally, organization may explain firm profits over and above normal profits to the owner, though its existence does not furnish the basis for an extra compensation to him, as Marshall, would have us believe. If Marshall's theory of distribution is that of marginal ^ Rufus S. Tucker, “Is There a Tendency for Profits to Equalize?" American Economic Review. XXVII, No. 3 (September, 1937), 52*f. 2bl productivity as Stigler maintains that it is,100 the share of profits attributable to organization cannot in any way conceiv able to this writer be made part of the normal profits which may be functionally attributed to the owner.101 The factor of organization, however, is a useful concept which, the reader may recall, bears close similarity to Studenskifs theory of the totality of productive machinery of the society as a whole, distinct and separate from the personal productive capacities of the individuals participating in the functioning 102 of modern business enterprise. . This usefulness is especi ally manifest in an economic treatment of the modern giant corporation, to serve as a theoretical link between normal profits in theory and the pattern of profits in the actual world. But we have to digress from our chief concern for a brief moment to consider, first, recent theories and discus sion dealing with the possibility of assigning to the firm the role of entrepreneurship. Recent developments in theory of entrepreneurship. Knight is among the first economists who have attributed pure or excess profits to the entrepreneur as remuneration for his 3*00 Stigler, Production and Distribution Theories. ; v p. 356. 101 Supra, pp. 222-230. 102 Supra. Chap. Ill, pp. 129-132. functions of risk and uncertainty-bearing. Schumpeter regards pure profit as the reward to the entrepreneur who undertakes functions of new combination of factors of produc tion or innovation so as to bring about such pure profit, which, however, tends to disappear on account of eompeti- 10*+ tion. Marshall, it appears to this writer, attempts in his Principles to explain pure profit through the existence of organization.10- * In this respect Knight and Schumpeter may be distinguished from Marshall in that while the former propose only short-run explanations of pure profit, maintain- ing that in the long run it will tend to disappear, Marshall sort of "perpetuates1 1 pure profit by ascribing it to organization, which thus acquires a definite normal supply price in the normal long run. Marshall vitiates his own theory by considering the normal supply price of organization to be part of the owner’s normal profitsj as extensively dis cussed above. But are the short-run explanations of pure profit valid? We have already criticized the risk or uncertainty 10^ Knight, Risk. Uncertainty and Profit, pp. 26* 4— 3 1 2. 10lf Sunra. pp. 196-197. 10^ Supra, p. 222. 10^ Since risk and uncertainty tend to naught in the stationary state, synonymous with the normal long run (supra, p. 217), Knight's theory is essentially a short-run explana tion of pure profit. 2*+3 107 theory of pure profit. At the risk of repetition, this writer wishes again to pursue the point a little further. If pure or excess profits are remuneration for entrepreneurial risk or uncertainty bearing and for managerial functions of such higher order as that of supervision, co-ordination, and decision-making in view of uncertainty, commonly regarded as entrepreneurial, then no standard or typical class of individ uals may be singled out as the entrepreneur entitling to pure 108 profit. This statement is true if it is remembered that there are other functional groups which bear risks as much as, though possibly less directly than, the owner and which too share in decision-making involving uncertainty within their 109 own spheres of action. ' In other words, “risk-bearing is a substantial element of the role of the supply functionary, whether laborer, owner or capital resources, or possessor of an equity share.” It goes without saying that supply func tionaries other than equity owners are also engaged in making crucial decision, by which plans are devised and administered, new combinations are introduced, much liability to error is 107 Sunra. pp. 200-203. Unless otherwise noted, the discussion to follow on this point is based upon James H. Stauss, "The Entrepreneur: The Firm," Journal of Political Economy. LII, No. 2 (June, 19 W , 112-127. Cf* supra, pp. 200-203. 2M+ incurred, and thus risks are directly and significantly condi tioned* This is true in respect of the small business enter prise as well as the giant corporation* With respect to the latter the merit of the argument is even more easily under standable and outstanding, inasmuch as the separation of ownership from control has practically divorced the legal owners from active participation in corporate management and the traditional concept of the owner-entrepreneur as the risk or uncertainty bearer is no longer applicable or acceptable to the fact-minded economists of today. Under these circumstances it is futile to attempt to isolate the functions of risk or uncertainty-bearing and decision-making and. to attribute them to one single “standard type1 1 of functionary, i.e., the owner- entrepreneur. To this argument' (in connection with the large corpora tion) Knight countered with a “lasU-ditch“ defensive suggestion that the stockholders, who have the right to select responsible directors to manage the corporation and look after their inter est, are still the entrepreneurs entitled to pure profit. In this respect Knight defines the entrepreneurial function of ultimate control or ultimate management as that of selecting 1: men to make the decisions required in the conduct of the firm. To narrow the risk or uncertainty function to that of selecting Knight, op. cit., pp. 291-302. 2k5 responsible corporate directors is not justifiable, however. In addition to the fact, as pointed out in the foregoing, that risk or uncertainty is common to all supply function aries, the small or ‘ ’ minority*1 stockholders in large corpora tions seldom have the chance to elect directors of their own 111 choosing. A negative voice in the election of corporate directors can by no means be regarded as an essential func tion entitling the stockholder to the full amount of excess profits. Schumpeter’s solution to the problem is immediately more promising. He considers the corporate managers as entre preneurs entitled to pure profits, but because of their loose grip on profits and other reasons, they allow themselves to be underpaid, that is, paid less than their full share of 112 pure profits. But he does not explain to whom the excess or pure profits not paid over to the managers belong. It cannot go to the owner-capitalist of a giant corporation, since pure profit is defined as profit accruing to the_entre- preneur and there certainly is no need, in such a case, to distribute it to the owner-capitalist to retain his investment The word “minority” should, be read with caution, for large corporations are frequently controlled by some minority interest, on account of diffusion of stock ownership. “Minor ity” here means those legal owners whose voice is not dominant in the management of corporate affairs. See also Chapter III, supra. pp. 132-lMf. *^2 Supra, pp. 196-197• 2k6 in the business. Stauss, in this writer’s opinion, has offered the best possible solution; to veer away from the traditional concept limiting entrepreneurship to a class of functionary and in its 113 stead substitute the firm. It logically follows that any pure profit remaining after deducting expenses of operations must go to the firm as the residual claimant. Recognition of organization (or firm entrepreneurship) as factor occupying position of residual claimant. The impor tance of organization to any system of production cannot be overemphasized. Without proper organization it would not have been possible for the modern large corporation to emerge. Even * in a small business, organization is indispensable to profit able operations. Division of labor, as expounded by Adam Smith in his Wealth of Nations. is predicated upon the existence of organization which threads through the various phases of pro duction so that workers may perform their tasks separately and yet in harmony with one another. The intangible existence of organization is vicarious and is derived from the smooth running and co-ordination of all phases of business operations and from the team-work and co-operation of all productive func tionaries including the government. In private property it is 113 Stauss, oj>. cit.. p. 127* 2k-7 vicariously represented by the firm, its tangible assets and personnel. In public finance productive services are per formed by the government in behalf of private business. The aggregate of all firms constitutes the same productive totality Studenski envisages in his article, the main issues of which we l L. discussed rather thoroughly in the preceding chapter. Broadly defined, this productive totality may conceivably embrace governmental machinery and activity, as Marshall did. It is the contention of this writer that this intangi ble factor of organization possesses an income of its own, though residual in the process of computation, commensurable with its functional contribution toward the total product. Though organization is inanimate and impersonal, the share of the total product attributable to it cannot be economically 'and functionally assigned or imputed to any other agent of production, not excluding the legal owner. He alone cannot run the whole machinery of production even in a small manufac turing plant and must therefore hire engineers, plant superin tendents, and other skilled and unskilled workers to assist him in keeping the factory organization going. Again, he is seldom solely responsible for the good will the firm possesses. Invariably, good will may be traced to numerous causal factors, productive efficiency, good salesmanship, good public relations, lllf Supra. Chap. Ill, pp. 129-130. advertising, and so forth* We have already thoroughly dis cussed the presence of the risk element in the supply func tions of all factors to make it impossible and illogical to isolate a class of individuals as entrepreneurs and to hold them solely accountable for risk-bearing by awarding them the entire amount of profits. Combination and co-ordination, involving decision-making, are required of any corporate offi cers and employees who need not be stockholders concurrently. All of these facts are not only indisputably and literally true in respect of large corporations, but also theoretically and economically valid with respect to small business concerns, though there the demarcation lines are sometimes less clear and the logic is therefore less apparent. The inevitable result of this contention is that the share of the total product, functionally attributable to the firm organization as a whole but not to its parts, must belong to the firm through the taxa tion of which the share going to the government for its func tional contribution will be determined. The legal or economic owner of the firm, if any, can no longer lay any functional or economic claim to that share going to the firm, although he may have the legal right to appropriate it. Institutional reasons prevent him from exercising his theoretical right to all corporate profits in the case of large corporations, in which the profits attributable to organization must 2b9 It follows that the position of the factor organization or firm entrepreneurship, as Stauss would wish to name it, must be that of the residual claimant. Since its existence is a sort of superimposition upon the firm assets and firm personnel working in unison, it can share in the total product only after land, labor, and capital have been satisfied. The residual character of its remuneration disposes of the possibility of ever assigning or imputing a normal supply price to the organi zation or firm entrepreneurship factor. This is practically defensible, for the factor organization, inanimate and indes tructible, devoid of subjective will and volition and devoid of the so-called mental “felicific calculus“ of a natural per son, need not be imputed a positive remuneration as to impart to it a positive normal supply price in the long run. As long as the other supply functionai-ies, from the concatenation of which it derives its superimposed and intangible existence, 115 . . . “If the entrepreneur be defined as the profit receiver, it would seem to follow that, under modern condi tions (barring the small store and small factory that have survived in the hands of individuals or partnerships) the corporation is the entrepreneur.** (Arthur H. Cole, “Entre preneurship as an Area of Research," Journal of Economic History. Supplement [December, 19^2},1227) As discussed above, the exception of small.concerns may be attributed to considerations of practical expediency rather than theoreti cal inapplicability. _ 250 earn their normal returns, there will be organization11* * and hence, production will not be curtailed* V. 4 RESTATEMENT OF THE CONCEPT OF NORMAL PROFITS FOR PURPOSES OF EXCESS PROFITS TAXATION General. After our inquiry into the nature of firm entrepreneurship and firm organization in the preceding sec tion and as a result of our theoretical deductions in the light of modern institutional developments in the business world, we have attributed to firm organization the residual claimant position in the sharing of firm product, it should have become clear by now that the concept of normal profits represents essentially a theoretical basis for imputing to the owner his share of the total product. His share varies according to ■fefoether he furnishes both capital and his per sonal services or only capital. The remuneration for his supply of capital and business ability and management must be based upon their respective functional contribution to the production of the total product. Though the owner’s services are generally considered non-contractual in nature, Since the productive function of the government is normally maintained not with a view to a positive return, our assumption of possible negative long-run return is not invali dated with respect to the broad definition of organization, which includes the government. In practice, government ser vices usually go to all business enterprises, irrespective of their ultimate profit or loss. 251 a functional approach to the determination of his remuneration must needs involve the consideration of the same set of factors as that in determining the return to resources supplied under 117 some form of contractual guarantee. The problem is essen tially this: what are the economic functions that the owner- manager-capitalist performs which must be remunerated so that in the long run under conditions of competition such functions will continue to be supplied and production will not be cur tailed? In this connection it is optional whether or not we retain Marshall's industry concept and his partial equilibrium analysis. But it is imperative that we take sufficiently into account the institutional factors which have inestimably influ enced the supply of these ownership functions. Constituent elements of income attributable to owner- capitalist function. We will discuss the various elements first and then proceed on to institutional effect on the con tents of those elements. 1. The supply of capital. The function of capital contribution is associated with ownership in almost all con ceivable cases. In fact, capital provides the only legal basis of property right to the assets of a business enter prise, which is ownership. The reward for the supply of 117 Gordon, .op. cit•, p. 568. capital is ordinarily interest plus a premium for risk* It is abundantly clear that in this respect ownership or equity capital performs the same function in the enterprise as creditor or borrowed capital with two important differences, however; first, the latter's return is contractually deter mined in practice, while that of the former is not; and secondly, the former is in a less preferred position than the latter, in so far as the degree of risk-bearing is concerned, or the risk of loss of capital is greater with equity capital than with borrowed capital* That this higher degree of loss in respect of ownership capital is entirely due to institu tional reasons is hardly to be questioned* Economically, from the standpoint of the firm as the residual claimant, both are considered outsiders and both provide it with the same productive function, the furnishing of funds for busi ness operations* It is business convention and legal require ment to make the owner's position subordinate to that of the creditor in the distribution of business assets in satisfac tion of various claims that cause the difference in the degree of risk incurred. Aside from this difference of risk, there is no essential economic difference. This is one of the reasons for considering borrowed capital to be equivalent to equity capital in excess profits taxation during both world wars. Because of this difference, however, the level of normal interest return to equity capital, other things being 253 equal, will have to be higher than that of normal interest return to borrowed capital in order to maintain equity invest ment without causing it to shift into the contractual position. (This is again required by the legal provision that a business must have some capital of its own.) The level of business risk differs from industry to industry and that of a particular industry represents a result ant of numerous factors having to do with the operations of business enterprise therein. Our discussion here is carried on an entirely qualitative basis and we are not concerned with the determination of specific rates of return for the indus tries. But we will submit the following as indicating a method of approach to such a determining process. The basic rate of return to equity capital should be equal to the sum of several returns: first, that paid on or applicable to very safe long term loans, competitively contracted, the risk element of which approaches a minimum practically possible. To this should then be added a rate differential, representing the difference in yield between this very safe loan and the type ordinarily contracted by business enterprises in the industry, plus an adequate premium rewarding the investor for his shouldering the higher risk attributable to the Junior status of his William E. Butt,"A Permanent Excess Profit Tax," (an unpublished Doctor's dissertation, Yale University, 1931), p. 23^, adopting the same concept. 25*f investment in the business enterprise. In theory, this rate corresponds to the Mill-Marshall-Hobson criterion of necessary costs, sufficient to permit returns on capital that, having regard to what investors think are the risks involved, will call forth the necessary supply of that capital. It may be seen that the difference between the ulti mate rate and that on a very safe loan is composed of two 119 elements, both of which pertain to risk. One of them has reference to the degree of risk the creditor investor incurs in respect of contractual loans. This the equity investor also incurs upon his investment, except that he bears an addi tional risk because of his inferior position, an institutional cause of risk. It is here that our normal concept in connec tion with interest differs from Marshall’s, which takes into account only the economic interest necessary to a continuing supply of capital without regard to institutional factors. The probable reason for his disregard of the necessity of providing for institutional risks is that Marshall dealt with a hypothetical stationary state where all capitals were rewarded with normal interest and, therefore, there was no institutional necessity to treat any capital as being the inferior equity factor. Since we are not dealing with that Ignoring the cost of management. 255 theoretical state of affairs, we feel justified to modify on Marshall's concept. (The reason for treating interest and risk premium together, instead of separately, is that the reward for risk is usually included in interest which is generally considered .120 as the price paid for the use of capital with risk. ) 2. Wages of management. The function of management performed by the capitalist-enterpriser, must be remunerated at a competitive rate not lower than he could obtain by taking the contractual position of a wage-earner in the best alterna tive occupation requiring similar ability in management, if he is to be kept from shifting into this latter status. These two elements of ‘ ’ normal profits” or income to the owner-manager must now be studied in connection with the institutional setup of the business world. We are particularly interested in the differences in the application of our prin ciples to the large corporation and the small enterprise. The problem of earnings of management does not apply to the large corporation. Even in the small enterprise, encompassing 120 pure rate of interest is the price paid for the use of capital with no premium for risk. In practice, the rate of interest quoted on a given loan is generally made up of pure interest and an additional amount, which, supposedly, measures the risk involved in that transaction. . . (Ralph Eastman Badger and Harry G. Guthmann, Investment Principles and Practices [Third edition; New York: Prentice- Hall, Inc., 19^1 J > P* !?*+•) (Italics supplied.) the individual proprietorship, partnership, and the close corporation, the problem is that of determining the reason ableness of the owner-manager*s compensation. But the problem of normal interest occasions more difficulties in this respect. The differences of risk among business enterprises are the results of some underlying causes, among which are the degree of freedom of entry, or the degree of monopoly or monopolistic competition, the size of the establishments, and the legal provisions of limited and unlimited liability, relative per manence of business existence, et cetera. Some of these causes of risk differences will be elaborated on in a later chapter. Their significance in formulating the concept of normal profits for excess profits tax purposes should be apparent. Generally speaking, the risk premium that a con cept of normal profits should consider varies inversely with the difficulties of entry, the size of the establishment, and the relative permanence of probable business existence. In other words, the risk premium, generally, should be higher for proprietorships, partnerships, and small close corpora tions, whose existence is relatively impermanent and whose owners, excluding corporate stockholders, incur unlimited liability. It is lower for large corporations, which have relatively permanent existence and whose owners have only limited liability. However, only premium for “normal risk" will be included in our normal interest rate, which does not 257 purport to cover those risks to which investments in exces- 121 sively risky or new businesses are exposed. Conclusion. With organization recognized and accepted as another factor of production to take the residual claimant position in profit sharing, it is only logical to conclude that the traditional f , normal profits’ * is but another term for the portion of total product attributable to the ownership function, the determination of which involves the considera tion of the same set of forces as that determining the remuner ation of other factors of production. Owing to institutional reasons, the ownership function usually consists of the supply of capital and/or the supply, of business ability in management. The normal return to capital is only normal interest of sort, which, because of the inferior status of equity capital, is ordinarily greater than that paid on borrowed capital, by virtue of greater institutional risk, in order to prevent the equity owner from shifting into the more preferred contrac tual creditor’s position. The normal return to business ability is normal wage for management, now that the contro versial issue of entrepreneurship is eliminated by our attribut ing it to the firm organization. The normal interest and normal 121 This point will be dealt with more fully in a later chapter. (Infra. Chap. VI, pp. 359-366.) 258 wage for the owner are determined in accordance with the principles of opportunity cost at a rate equal to those for comparable wage-earners and/or the creditor-capitalist. There is only one exception to this statement, however. The reduc tion of risk as a result of combination and other institutional factors must be considered, in addition to ordinary economic forces, in the determination and comparison of the normal interest returns to the equity owners of both the large and small enterprises. VI. THE EXPLANATION OF EXCESS PROFITS UNDER TEE RESIDUAL CLAIMANT THEORY OF FIRM ENTREPRENEURSHIP The residual claimant theory of firm entrepreneurship and excess profits and excess profits taxation. The profits of the firm that remain after the imputed share of the total product representing the normal return to the equity owner has been abstracted, are, by definition, profits for purposes of excess profits taxation under our theory of the residual firm entrepreneurship. These residual or excess profits pertain to the firm organization as the residual claimant, on which the burden of the tax is to fall. Since the validity of the normal return to the equity owner can be upheld only with reference to the normal long-run period, the imposition of a tax on excess profits must also be associated with the same normal long period. It is admitted that excess profits emerge without regard to time periods and without regard to 259 122 whether normal profits have been earned or not. However, abnormal profits may be made one year and subnormal profits or losses in another and still the long-run average may approximate the norm. If a tax on profits in excess of normal is imposed in a hypothetical case, characterized by such income irregularity, the concept of excess must of necessity be related to the long-run normal period during which normal profits are to be earned. Furthermore, the practical impossi bility of isolating the elements of excess profits from those of normal profits has rendered it necessary for an excess profits tax measure to regard all profits as being "normal profits" first before any portion thereof is later determined as being excess profits. A strict compliance with our residual claimant theory of excess profits, which equates excess profits with residual profits, requires establishment of a normal long period rate in order to estimate the taxable excess profits in the short run. We will see in a subsequent chapter how 123 the system of loss carry-over, properly designed and admin istered, can achieve the theoretical requirement of relating 122 For instance, windfall gains during periods of sub normal operating profits or operating losses. 123 loss here refers to both net loss and insuffi ciency in normal profits. In tax law they are referred to as net operating loss and unused excess profits credit, respec tively. 260 excess profits to the normal long period, even though the levy of the excess profits tax is an annual or short-run affair. Our attention is now directed toward an explanation of the emergence of the excess profits over and above the normal returns to all factors of production, excluding organi zation, of course, to serve as a partial answer to certain criticisms of and objections to an excess profits tax on busi ness income. IMPERFECT COMPETITION Deviation of actual market conditions from theoretical assumption of competition. In the last analysis any actual profits in excess of the theoretical normal profits are attributable to the actual deviations of market and produc tion conditions from the theoretical assumptions of free competition. A theory of profit is inherently a theory of aberrations of actual economic conditions from the theoretical consequences or tendencies of the more general price forces which tend to eliminate them, a theory of the imperfections of competition, sup plementary to the theory of perfect competition, defined in a sense which excludes profit.-1 *^ The reason why perfect or even free competition does not prevail in the business world may be detected from below. 12^ Knight, "Profit,** p. *+83. "Profit** here means just the excess over normal profits, for even under perfect competition normal profits exist. 261 There are at least five requirements for perfect competition to obtain in the actual market, namely:12- * 1* The commodity dealt in must be supplied in quan tity and each unit must be so like every other unit that buyers can shift quickly from one seller to another in order to obtain the advantage of a lower price; 2. The market in which the commodity is bought and sold must be well organized, trading must be continuous, and traders must be so well informed that every unit sold at the same time will sell at the same price; 3# Sellers must be numerous, each seller must be small, and the quantity supplied by any one of them must be so insignificant a part of the total supply that no increase or decrease in his output can appreciably affect the market price, and likewise for the buyers; There must be no restraint upon the independence of any seller or buyer, either by custom, contract, collusion, the fear of reprisals by competitors, or the imposition of public control; and 5. The market price, uniform at any instant of time, must be flexible over a period of time, constantly rising and falling in response to the changing conditions of supply and ■*■^5 Adapted from Temporary national Economic Committee, Competition and Monopoly in American Industry (Monograph No. 21. Washington: U. S. Government Printing Office, 19H-0), p. 2. 262 demand; there must be no friction to impede the movement of capital from industry to industry, from product to product, or from firm to firm; investment must be speedily withdrawn from unsuccessful undertakings and transferred to those that promise a profit; there must be no barrier to entrance into the market; access must be granted to all sellers and all buyers at home and abroad; there must be no obstacle to elimination from the market; and bankruptcy must be permitted to destroy those who lack the strength to survive. It would be too optimistic for anyone to expect that the actual market conforms to these requirements in order that it may be said to operate in perfect competition. Since it is not possible for the actual market to achieve its theoretical perfection, actual profits always deviate from the theoretical normal profits and excess profits may result at one time or another, Friday writes: , These statistics [computed profit ratios] leave little doubt that the range of fluctuation in the ratio, of income to capital is greater than most of us had expected. . . . In an Industrial system like ours there are, at all times, excess profits, for tuitous in nature. If some portion of these be taken, we leave profits nearer that normal which is assumed to result from the workings of the competi tive market. T oA David Friday, “The Excess Profits Tax— Discussion,” American Economic Review. X, Wo. 1, Supplement (March, 1920) , 21. 263 That there are excess profits arising from imperfections of competition seems to have been established beyond question. Their taxation was also approved by Friday in the quoted pas sage. But before we examine the tax aspect of excess profits more fully, it is deemed necessary to explain the causes of market deviation from the workings of perfect competition, giving rise to excess profits. EXPLANATIONS OF THE EMERGENCE OF EXCESS PROFITS Advertising, product differentiation, and the diversity of conditions surrounding each seller. Fundamentally, the emergence of excess profits is due to the ability of business concerns to produce more and sell more of their products at prices higher than their average costs of production. Under monopoly or monopolistic competition, the slanting, due to advertising, product differentiation, and other causes, of the demand curves confronting the individual sellers makes it difficult to eliminate excess profits by the ordinary processes of pure competition. “Where such differentiation exists, even though it be slight, buyers will be paired with sellers, not by chance and at random (as under pure competition), but accord- 127 ing to their preferences." The existence of consumers1 preferences will, in all probability, render the sellers' Chamberlin, op. cit.. p. 56. 26b monopoly profits either difficult to compete away or beyond * | aQ the reach of competition. This is so because there are numerous factors involved which make consumers* preferences unevenly spaced over the field of sellers. Chamberlin’s tangency solution to the group equilibrium problem, whereby competition among close substitutes drives every seller of the group to the point of operations where average cost equals average revenue, is possible only by ignoring the variations 129 in the conditions confronting each seller. If these varia tions are taken into consideration, the no-profit solution will not be possible even in the long run. The most important diversity, in the opinion of this writer, lies in the varia tions, among sellers, in the position of their demand and cost 130 curves relative to each other. Many factors contribute to the prolonged existence of this diversity and therefore of the excess profits attributable thereto. Chamberlin mentions, among others, patents, copyrights, trade-marks, peculiarities of individual sellers (personality, for instance), reputation, 131 skill, and special ability in the professions. All of 128 Ibid., p. 82. 129 Ibid.. pp. 82-83. 130 Ibid., pp. 110-111. 131 Ibid., pp. 111-112. 265 these factors both on the demand and on the supply side com bine to restrict entry into certain portions of the field in such a manner that competition, in so far as it enters the field at all, pushes the demand curves to the left, and the demand and supply curves toward or apart from each other, in uneven degree, leaving monopoly profits scattered throughout the field. These profits will persist even in the long run. Restraint of trade. In the actual.market, in addition to such natural factors making for imperfect competition as advertising, product differentiation, patents, trade-marks, personal qualities of the seller, cost of transportation, relatively large amount of starting capital, and the immobile nature of capital installations, monopolistic conditions and advantages may be brought about to benefit an exclusive group of business firms by restraints on trade by contract, agree ment, and/or collusion, and other monopolistic practices. Competition is usually thwarted by tacit understanding or actual collusive contracts or agreements between or among business concerns to control their entire supply or “enough of the supply of a broadly defined commodity to enable them to augment their profit by limiting output and raising 132 price.1 ' The most important fact about this ability on Temporary National Economic Committee, Monograph 21, p. 10. 266 the part of conniving concerns to control supply is that their profits are apt to be consistently above normal or above those 133 of competitive firms in the long run, as long as the agree ments to restrain trade are observed by the contracting parties and go unchallenged or unsuccessfully challenged by the proper government agencies in charge of enforcing anti- monopoly laws. These profits constitute the most fertile field for taxation purposes, inasmuch as they are persisting and in excess of the amount of profits necessary to the main tenance of investment, and their existence gives the firms that receive them an advantage over those competitive concerns that do not. It is now time for us to turn to the tax aspect of excess profits arising from monopolistic competition. Under the current federal corporation income tax profits arising out of monopoly and/or monopolistic practices and advantages are taxed at the same rate and in the same 13b manner as normal profits. The former constitute surplus, supernormal, unnecessary, and excess profits, while the latter -*-33 Under our theory of the firm being the residual claimant, we are barred from such incongruous notions as the capitalization of monopoly profits so that profits in the future will be brought down to the level of normal profits on cost of reproduction. 3-3** Generally speaking, this is true for all corporate profits in excess of $5 0, 0 0 0, since they are taxed at a flat 38 per cent. As if there were not enough injustices, a por tion of the profits below $50 ,00 0 is actually taxed at a rate of 53 per cent. (Supra. Chap. I, p. **.) 267 are normal and necessary. The best device to reach the hereto fore inadequately tapped monopoly profits, so that the ordi nary normal profits will not be concurrently penalized, is the excess profits tax. And yet many tax authorities, includ ing Groves, Buehler, and Lutz, fully aware of the fact that the enforcement of anti-trust laws in this country has proved to be singularly unsuccessful, have advanced arguments against a permanent excess profits tax as a revenue device because 135 there are other ways of dealing with the problem of monopoly. This writer does not dispute, for the sake of argument, the statement that to restore competition (presumably by vigorous 3.36 enforcement of anti-trust laws) or to regulate prices are the better and more direct ways to check monopoly. But he is of the opinion that pending the final success of such law enforcement and economic measures, these excessive monopoly profits should be brought under special taxation such that elementary tax justice may be preserved. It has been esti mated that the group of business activity, including manufac turing, mining, finance, transportation, and public utilities, in which the typical enterprise is large, the degree of 13$ Sunra. Chap. Ill, pp. 108-109. 136 devices were proposed by Harold M. Groves, Postwar Taxation and Economic Progress (New Yorks McGraw-Hill Book Company, Inc., 19^-6), p. So. concentration is high, prices are rigid, and monopoly is as usual as competition, produces more than k-5 per cent of the national income and accounts for more than half of the income 137 produced by private enterprise. Even among those indus tries which do not fall in this group, numerous illegal 138 restraints of trade have been found to exist. These facts show that monopoly is now far too common to justify its treatment as an occasional exception to the general rule of 139 competition. If we should allow profits arising from monopoly and monopolistic practices to be taxed in the same manner and at the same proportional rates as ordinary and normal profits obtaining in competitive fields, we would be acting against our best traditions of free enterprise. Since the tax benefit and advantage enjoyed by the monopolistic industries discriminate against the free enterprisers, the government might be viewed as abetting the law breakers financially while paying only lip service to the cause of capitalism. In recommending for a permanent excess profits tax our appeal is to economic justice in tax distribution, as Temporary National Economic Committee, Monograph No. 21, pp. 307-308. 138 Ibid., p. 308. ■ 3 -39 Loc. cit. Also C. Lowell Harriss, “Monopoly and the Excess Profits Tax,“ Tax Magazine. XVI, No. 12 (December, 1938), 7^. 269 viewed from the standpoint of our traditional free enterprise, and not to unreasoned hysteria about or crusade against monopoly. It is admitted that once the excess profits tax is imposed, its main burden will fall, as can be easily seen, on those concerns whose excess profits persist over a long period of years or whose profits remain consistently at a higher level than those of their neighboring concerns. Under conditions of competition, any excess profits will not long persist. But when monopoly endures usually on account of l*fO artificial devices and factors, such excess profits, generally speaking, will also endure, other things being equal, and the tax will, therefore, largely and co-extensively affect them. But this effect of the tax is only coincidental to our main purpose in imposing the tax, namely, the upholding of the principle of justice in tax distribution. Just like the progressive taxation of higher personal income, excess profits taxation will in one of our days be regarded not so much as a penalty on higher business profits, but as an equitable means of distributing the tax burden among the various units of taxpaying business enterprise in accordance with the best traditions of our concept of free enterprise. Temporary National Economic Committee, Monograph No. 21, p. 315. 2 70 Underpayments of factors. Prom the residual claimant point of view, if the firm can hire factors of production for less than what they contribute to its total value product, excess profits result. The explanation of this phenomenon in respect of labor is simple. The pay of labor is usually determined by bargaining between the firm and organized labor. In the process of such bargaining the relative strength of the bargaining position of each group determines the wage rates finally settled upon as in favor of or against either the firm or organized labor. Since the New Deal, however, the importance of the underpayment of organized labor as a source of excess profits has declined. In fact, the opposite situa tion may sometimes be true. . . . the monopoly profits of a highly centralized and wealthy industry might be extracted by power ful, well-organized labor unions, so that the monopoly advantage flows to favored, labor groups rather than to the investor group. In modern times the underpayment of factors as a source of excess profits chiefly arises in connection with the pay of unorganized clerical labor, in general, and that of the management, in particular. The exploitation of unorganized white collar workers needs no special comment. But the under payment of the managers as a source of excess profits should llfl Harry G. Guthraann and Herbert E. Dougall, Corporate Financial Policy (Second edition; New Yorks Prentice-Hall, Inc., 19W ; p. 6^7. 271 require some attention. We have already mentioned Schumpeter’s concept of the role of the salaried managers of the modern corporations. Though we do not agree with him in regard to his concept of the entrepreneur and entrepreneurship, we do agree with him concerning his conclusion about the underpayment of the l i * . managers of the large corporations. According to Schumpeter, the substitution of the non-profit motives for that of profit maximizing is largely responsible for it. Gordon also stresses the non-profit motives as being an important factor in deter mining the compensation of managers. Says he, Power, prestige, desire for security, an urge for creative work, and group loyalty are all motives. A large company can offer in the power and prestige that go with a position of authority a very important substitute for a high salary. If a man has been long associated with a particular firm, loyalty and a feeling of security may hold him in one company even if a higher income is available elsewhere.1^3 This tendency is further accentuated by policies of internal iMf promotion from within the ranks. All these factors add up to the fact that executive ability operates in an imperfect market in which personal and non-economie considerations play 1 J+p ££•- supra« p. 199? for quoted matter and footnote 27. llf3 Robert A. Gordon, Business Leadership in the Large Corporation (Washington, D. C.s The Brookings Institution, 19^5),' P.^78. Loc. cit., footnote 17. 272 an important role in determining what an executive earns It needs no more elaboration on this point than the remark that the interposition of non-profit motives among the forces determining executive compensation frequently results in the underpayment of corporate managers, resulting in excess prof its to the residual claimant, the firm. Windfalls and other luckv events. That lucky events may lead to excess profits, which are not foreseen and are not in any degree due to efforts made, intelligence exercised, 1^-6 risks borne, or capital invested, is a fact hardly open to dispute. The taxation of such excess profits at relatively high rates will not in any way curtail production and invest ment, for they are not prospective gains entering into the necessary normal profits which draw business enterprisers into the trade. Windfall profits, in other words, do not iktf Ibid.T p. 279* A vivid example of such non-profit motives replacing the profit motive is contained in the follow ing account appearing in "American Production," Life. XXV, No. 1*+ (October 19^8), 77• One production man of a large company was asked why he seldom took time off and the reply was: "'Well,' he said, 'It's like this. First you're tooling for your new models and you work night and day for weeks with out sleep, hardly. You just get your new line working and a bug develops, and you can't rest until it's ironed out. Then, when it's finally going, you don't like to take a day off because it's such a pleasure just to stand there watching and listening to the damned thing hum."' . A. G. Pigou, A Study in Public Finance (London: The Macmillan and Co., Limited, 1928), p. 177- 273 constitute a reward for any productive function, or any busi ness expectations* Their special taxation has found many prominent supporters* Various advantages* Beddy in his book on profits endorses the theory that profits arise as a result of acquired advantages of various kinds. They consist of legal and politi cal advantages, secrecy, mobility, the possession of capital, location, size, separate markets, monopoly, market control, 1^7 advertising, various predatory methods, and even luck* This endorsement of advantage as an explanation of profits ll+8 necessitates a non-functional theory of distribution. We will not discuss this new approach to a theory of profits in this work* Passing mention of it is, however, considered necessary, for whatever we have left out of our treatment of excess profits will find in this advantage theory of profits its probable explanation. Conclusion* A permanent excess profits tax imposed on all excess profits without regard to their causes obviates the necessity of segregation, the difficulties of which con stitute one of the principal arguments against the tax. A Beddy, ojd. cit.. pp. 266-326. lhQ Ibid.. pp. 361-370. common characteristic of all excess profits, monopoly, monopo listic, windfalls, or those arising from factorial underpay ments and acquired advantages, is that they do not represent a necessary reward for a certain productive function, the supply of which may not be forthcoming in the long run if it is deprived of its normal remuneration, A heavier tax on this unnecessary excess over the necessary normal return without discrimination against a portion of such excess as being attributable to restraints of trade cannot be considered as a penalty on monopoly. Rather, it is one of the tools available to the framers of tax measures to give the principle of justice in tax distribution its practical application. CHAPTER V RISK, EFFICIENCY, AND EXCESS PROFITS TAXATION It must now be clear that the excess profits tax we propose is imposed on the firm as a separate entity and on its residual profits after deduction for all expenses and cost, including the share of the total product imputed to the owner, traditionally known as “normal profits*** Our con tention is that the tax will not engender an adverse or restrictive effect on production on the whole since all factors engaged in the productive process are permitted to earn their long-run supplyprices before the tax is allowed to affect the residual income of the firm.. Question has been posed, however, by many students, or shall we say opponents, of the excess profits tax to impugn the validity of our con clusion presented in our inquiry in .the preceding chapter. This chapter is devoted to answering two of these questions relating to the effect of the tax on risk and efficiency. ” * * 1 One of the most important effects of the tax relates to its influence on price or the price level in general. This aspect of excess profits taxation will be explored in Chapter VII. 275 I* RISK AND EXCESS PROFITS TAXATION 276 REFUTATION OF ALLEGED ADVERSE EFFECT OF EXCESS PROFITS TAXA TION ON RISK-TAKING Argument based upon discredited risk theory of profits. One of Groves' principal arguments against the excess profits tax is directed at its adverse effect on risk-taking. Since an excess profits tax applies to the marginal segments of income, or those above the allowable credits, it discourages 2 the incentives for risk-taking and expansion. Behind this assertion lurks unmistakably the risk theory of profits, which, as we have seen, has been generally discredited. Groves' con tention would be much stronger, were risk.the sole cause or explanation-of all -profits ♦ Since it is not the sole explana- 3 tion of profits, and the tax we propose is levied at rates far short of confiscation, and does not discriminate against risk-taking, what was profitable and, therefore, worth-while taking in the absence of the tax will remain to be profitable and worth trying even though...part of the probable gains will 2 Harold M. Groves. Postwar Taxation and Economic Progress (New Yorks McGraw-Hill-Book Company, Inc.. 19i *6), PP* 77-78* The credits mentioned apparently refer to the statutory offsets allowed in the computation of the excess profits subject to the tax, for which see infra, pp. 278-279; and Chap* VI, footnote 216, p. *f09. ^ Suora. Chap. IV, pp. 200-208. be turned.over to the government in the form of taxes,1 * ’ In view of this, our. position is that a moderately progressive excess profits tax will not deter risky investment or risk- taking on the whole. In this connection further comment by Groves to the effect that "No techniques in exeess-profits taxation have been devised to allow for differences in the 5 risk factor. » • ." should be qualified by the fact that the excess profits tax law, enacted by Great Britain during World War I, contained provisions permitting trades operating under conditionsof unusual waste, risk, or deferred returns, to appeal to the Board of Referees for increases in the statu tory percentage in the computation of their excess profits 6 subject to the tax. The work of the Board received high 7 praise from allquarters,' Neglect of loss offsets and negative correlation between size and risk. Aside from the foregoing replies, Groves* con tention of penalization of risk-taking by the excess profits L , A similar argument for a high-rate income tax was advanced by Abba P. Lerner in his The_ Economies of Control (Hew York: The Macmillan Company, 19^), P« 239• ^ Groves, oja. cit. T p. 78, ^ Robert M. Haig, "The Taxation of Excess Profits in Great Britain," American Economic Review. Supplement, X, No, *+ (December , 1920), 125-12$, and 1^-1. 7 Ibid.. p. 136. tax is subject to yet two more serious objections. Firstly, he neglected the beneficial.effect on.risk-taking of the possi bility of loss offsets and secondly, the negative correlation between size of the business unit and risk. Above all, we should not focus our attention on the adverse effect on risk in some particular instances. In the administration, of a tax it is virtually_.irapossible to administer it with justice pre vailing in all quarters. Isolated instances of injustice should not be allowed to color our general view in regard to any tax measure. If the. over-all situation presents a reason able picture of fairness and vindicates that risk is not unduly penalized, the tax should not be condemned, just because it falls short of the expectations of some of its obstinate opponents in isolated cases. It is our intention in this section to establish beyond doubt that when the possibility of loss offsets and the inverse relation between business size and risk are taken into consideration, the imposition of an excess profits tax does not unduly, at least not more and probably much less than the current income .tax, discourage risk-taking on the whole. As a result, the general statement that risk-taking is penalized by the tax lacks much, of the scientific precision and factual support requisite to make It worthy of serious consideration. BENEFICIAL EFFECT OF LOSS OFFSETS ON RISK-TAKING General discussion. In practice, the loss offsets 279 should be segregated into two categories: first, offset of losses resulting from one source against profits from others for the same time period or over different time periods and second, offset of insufficiency in normal profits for one period against supernormal, profits for another period or periods. In principle, these two categories of loss offsets, tend to produce the same beneficial.effect on risk-taking for all.business enterprises which are capable of availing themselves of such offsets, as we shall see. Groves suggestively writes: It is worth noting that if a business now launches an^advertising campaign, 80 per cent of the cost of such an outlay may beftfinanced in effect by the federal government.® But he inexplicably failed to notice that this same principle of implicit financing of business expenditures by the govern ment applies with equal validity to the incurrence of business losses. By virtue of Sec. 122 and the repealed Sec. 710(c), Internal Revenue Code, the federal government may be said to have undertaken the responsibility of sharing in the function of business risk-taking by permitting, for purposes of excess profits tax computation, the deduction for net operating losses and the adjustment for unused excess profits credits over an effective period of five years. Through these o Groves, jop. cit. T p. 78* 280 provisions not only is the alleged adverse effect of the tax on risk-taking positively reduced, but sometimes an opposite and saintory stimulation in. J;he taking of greater risk is created, by the contemporaneous offsets of losses from one source against profits from other sources and/or by the off sets of losses incurred in one period against profits earned 9 in.other periods* The principle of this aspect of the effect on risk-taking of a tax on business profits was first advanced, as far as this writer is aware of, by Sir Josiah C. Stamp in 1928. He then wrote, In the first it should be noted that wherever losses of capital, proceeding by the usual way of accumulating annual trading losses, are incurred by a large concern with numerous other activities, they are a set-off against .profits before taxation* The return to the investor is reduced by taxation to a much less extent than if there were two busi nesses run by separate companies, and he had a dividend from a profitable business and ’nil* from 9 This writer has had some acquaintance with the opera tion of these carry-over and carry-back provisions of the Internal Revenue Code* A most ingratiating experience came in 19^7 when he was asked to prepare for a client an applica tion for tentative adjustment for losses suffered in 19w* The client had been making money all along except for 19*+6* The net operating loss carry-back and the adjustment for unused excess profits credit for 19^-6 wiped out the entire excess profits tax paid for 191 * 1* - * Because of the net operat ing loss, the deficiency in other related taxes, as a result of the carry-back of the unused excess profits credit, amounted to very little* The net result was that the refund for 19M+ equalled .the losses .sustained in 19^6* The client , was a small, close corporation* The question may be posed: Did the excess profits tax. penalize risk in this particular instance? Apparently, not. 281 the unprofitable. This risk is thus borne partly out of high taxation, analogous to the expenses which were so lightly undertaken when the excess profits duty bore 80 per cent of them.2- 0 This statement by Stamp, not only, states the correct principle of loss offsets, but also confirms our criticism of Groves for his neglect of the salutory effect on risk-taking of the possibility of loss offsets. It should be noted, however, that, while stating the correct principle, in terms of contem poraneous offsets, Stamp did not mention any such offsets over time. The recognition by modern taxing authorities of the economic necessity of allowing.loss offsets over the various 11 taxable periods has further reinforced our position. Scientific.treat ment of the effect of loss offsets on risk-taking. It is not until Domar and Musgrave undertook in 19Mf to investigate this subject more thoroughly than anyone else ever had done before that we, aware of the evident detracting effect on risk of a tax on business income, have come into possession of some definite conception of the less evident but equally important fact that the same tax, in the “Taxation, Risk-taking and the Price L e v e l Economic Journal. XXXVIII, Wo. 150 (June, 1928), 209. (Italics in the original.) In Footnote 1 on the same,page of the same article, Stamp makes the impression-that a similar principle was advanced by him. in his British Incomes.and . Property. Chap. VI. ^ The necessity has arisen from.the hardships experi enced by business on.account of the increasingly higher tax rates• 282 computation of which loss offsets are allowed, may also reduce 12 the degree of business risk-taking* Their deductive analy sis involves the use of probability distribution and indiffer- 13 ence curve approach in the study of investment behavior, and the application of the principles thus obtained in the comparative analysis of the effects of a proportional income lb tax on investment without loss offset, with full loss off- 15> 16 set, and with variable loss offsets* According to the authors, the imposition of an income tax makes the Treasury a partner with the investor, in whose gains it will always share, but in whose losses it will share in direct proportion to his ability to avail of himself of the benefits of loss offsets, as provided in the taxing statutes* Three possible^ cases as noted above, are distinguished: 1* The investor bears the entire burden of the loss 12 Evsey Domar and Richard A. Musgrave, "Proportional Income Taxation and Risk-taking," Quarterly Journal of Economics. LVIII (May, 1944), 308-422* The co-authors acknowledged their debt to Abba P. Lerner for his suggestions in this respect in his "Functional Finance and the Federal Debt," Social Research (February, 1943)* Lerner reiterated this point in his Economics of Control.. supra. pp. 238-240* There have been, according to the authors, other books and articles (for example, Stamp r op* cit., supra) belaboring this same point* 13 Ibid** pp. 393-403. llf Ibid*, pp. 403-409. 1? Ibid., pp. 409-415. ^ Ibid., pp. 415-421. 283 if loss offsets are not available or are not provided in the statutes* This is obvious since the tax reduces the yield 17 (by an even higher percentage than the tax rate), but leaves the degree of risk unchanged, so that the compensation per unit of risk-taking is reduced. A shift towards less risk will likely result* A relatively low tax imposed under depressed economic conditions, when, expectations are bad, may have more harmful effects on investments than a much higher tax imposed under more favorable conditions. 2. The Treasury shares part of the investor’s 18 losses, if a complete offset of losses is possible. The following example is given by the authors to illustrate the point: Suppose the investor receives an income of $1,000, which is independent of,the investment in question, so that after a 25 per cent tax he retains $750. If he now makes an investment and suffers a loss of $200, this loss can be fully deducted from his. other income, so that only $800 remains subject to tax. Accord ingly, the tax is reduced to $200 and his total income remaining after the loss, net of the tax, is now $6 0 0, as compared with $750 before the investment was made and the loss suffered. The net loss is thus only $150, the remaining $50, or 25 per. cent, having been absorbed by the Treasury in the form of a reduced tax bill on the investor's other income. ^ Mathematical proof is given (ibid.. p. . This should be obvious, since all gains are reduced by the rate of the tax, while all losses are left unchanged. 18 Equal.to the applicable tax rates times the losses. 28*f In this instance both the yield and the risk of the invest ment will have been, reduced by the rate of the tax, so that the return per unit of risk-taking remains unchanged# The investor’s reaction to this situation can be studied in terms of the income and substitution effect. The tax produces no initial substitution effect, because the reward for risk- taking has not been changed, the yield and the degree of risk being reduced in the same proportion. The income effect, produced by the reduction in his total income due to the losses, will make him shift to an asset combination with higher risk, in order that he may~ regain his starting income 19 position. The combined result of the. two effects is that 19 A geometric demonstration of this conclusion is given on pp. ^11-^13, including Footnote 9, p. *+12. Stamp also mentioned the possibility of a decision to shift by the old four-percenters, free from risk, after the imposition of the tax which reduced their net return to below b per cent, to a more risky investment, thus generating the effect of raising the gilt-edge rate, reducing the risk addition (to the interest rate), and closing up the spread between the two. ©p. cit., p. 206.) A similar possibility was.elicited by Stamp from one of the witnesses questioned during the Colwyn Committee hearing, the relevant passages of the testimony being quoted by Stamp in.his article herein cited (ibid.« pp. 207-208). In other words, sometimes a high rate of taxa tion enables the more risky businesses to be financed, for the business man with additional, capital to invest, fully aware that high taxation is going to cut down his profits to the unremunerative level, decides against further investment, but a man who has not got much money and likes to save quickly will take a risk and invest in somebody else's risky business. 285 private risk.(borne by the investor alone) taken after adjust ment (on account of the loss) to the tax exceeds that taken 20 prior to this adjustment and total risk, (borne jointly by the investor and the Treasury) taken after the tax will also exceed that taken before the tax. From the point of view of the economy, whetherthe pre-tax level of private risk is recovered or not is relatively unimportant. What matters is the degree of total risk taken jointly by the investor and the government, which will always be greater after the tax 21 than before it • This, admonished the authors, should not be construed to be an argument for a tax rate approaching 100 per cent. In general, a. comparatively favorable market and lower tax rate will be conducive to a higher level of private risk. 3. When loss offsets are not complete, the effect on total risk varies with the degree of the completeness of the offset and the tax. rate. Since now the yield is reduced by a greater percentage than the degree of risk, the results we expect fall between those of cases (1) and (2) and are therefore, uncertain. But there is little doubt that the 20 Although it does not necessarily exceed private risk taken prior to the imposition of the tax. This is true, for all taxes tend to reduce the reward for risk-taking to some extent. A proof of this conclusion is presented in Domar and Musgrave, op. cit., p. *+l5« 286 higher, the rate of loss offsets is, the higher willbe the degree of risk taken after the tax. As regards total risk, with a given tax rate, total,risk will,_with minor exceptions, be the greater, the higher the rate of loss offsets and with a given rate of loss offsets, there will be an optimum tax rate at which total risk will be at its maximum. It follows that the optimum tax rate will be the higher, the higher is the rate of offset. In other words, the more complete the loss offsets are the higher the tax rate may go without exer- 22 cising an unduly damaging effect on risk-taking. The above analysis was carried out on the basis of a proportional, income tax. Given a progressive rate schedule, tax savings due to loss offsets are likely to be made at different rates than those which would have been imposed on 23 the gains. This, would modify some of the conclusions ?2 The possibility of only partial loss offsets raises two more considerations: (1) since the immediate offset may not be possible, loss of interest may result (see supra, Chap. Ill, pp. 160-163) and (2) the uncertain extent of the offsets, in turn, raises probability problems. (Ibid., p. k-15,) ^ This writer is inclined to disagree with Domar and Musgrave in the remark that the tax.savings due to loss off sets are likely to be made at rates mostly lower, but possibly higher than those which would have been imposed on the gains. (Ibid.T p. **22.) In the case of a progressive rate schedule, the tax savings, in practice, on account of losses are always considered from the top rate down. For instance, given an income of $1,000, $500 of which is taxed at 10 per cent, $300 at 20 per cent, and $200 at 50 per cent, an offset of $200 less against this original $1,000 would, always result.in a tax sav ing of $100 ($200 at 50 per cent) and an offset of $600 loss would result in a tax saving of $170 ($200 at 50 per cent, $300 at 20 per cent, and $100 at 10 per cent). 287 reached above, but the case for loss deduction would become even stronger, In this connection the authors also raise pointedly the related problem of discrimination against fluc tuating incomes when rates are progressive and its possible 2b elimination through income averaging. Necessity for Improving the system of loss offsets. Leaving the analytical and theoretical aspects of loss offsets aside, the authors observe that, since increased risk-taking is highly desirable, a high degree of loss deduction is of vital importance* In order for a business to enjoy the bene fits arising from loss offsets, there are two prerequisites; the availability of sufficient income from other sources than that of the loss and the offset provisions enacted in the statutes. On both counts the large corporations enjoy advan tages over the small enterprises. As regards the availability of other income, a large corporation.or a large-scale finan cial investor may undertake a risky investment as. a side line and know that possible losses are covered by other income which is reasonably certain to be derived from the main line pL, This furnishes an adequate answer to Groves' remark that the excess profits tax penalizes a concern whose income "alternates between a 16 per cent return and. no income." (Op. cit.. p. 78.) An excess profits tax with a moderately progressive rate schedule and with provisions for loss offsets over time plus interest would have approximately, the. same tax effect as income averaging. 288 of* business or investment. The relative certainty of loss offsets in the case of large corporations, other things being equal, places them at a competitive advantage over the small concerns which might consider the same risky venture, since the latter are likely to be less diversified and are thus more apt to suffer a net loss in any one year, thus being deprived of sufficient income against which losses from new ventures may be offset. The new small business is in even worse shape. They are not able to offset their losses against past income simply because they were established only recently so that available past income is either insufficient or none. There is, of course, always the prospect of offsetting such losses against future income under the loss carry-over pro visions of the statutes. But the period of two years, as contained in the current income tax and the repealed excess profits tax provisions, may not be sufficient for the new con- v * cern to get established, let alone the earning of sufficient income to recoup past losses. Thus, under the present law the Treasury often shares in the losses of large and estab lished businesses but singularly fails to do so for the small, new, and yet needy ones.2^ ^ Alvin H. Hansen, "Stability and Expansion" in Financing American Prosperity, edited by Paul T. Homan and Fritz Machlup (New Yorks The Twentieth Century Fund, 19^5)> p. 2*+2. 289 The statutory provisions and the various technique of loss offsets also work to the advantage of the large corpora tion, In Chapter III we mentioned the advantages enjoyed only by large business in respect of interest and percentage depletion. The two-year loss carry-over is definitely inade quate for small, new enterprises, as referred to above. The two-year loss carry-back not only causes administrative prob lems, but favors only the established, businesses. These and other related problems in connection with insufficient as well as irregular incomewill be discussed more fully in the next chapter. It is not unfair, however, to conclude that existing tax statutes favor unnecessarily the large corporations and 26 discriminate against the small, new, and needy enterprises. THE EFFECT OF SIZE ON RISK-TAKING General discussion; Knight1s view. The argument that the excess profits tax penalizes risk-taking is subject to yet another qualification that in practice combination, merger, 26 We.mentioned above (sunra. p. 279) that in principle net loss offsets and the allowance of offsets of insufficiency in normal profits against supernormal profits produce the same beneficial effect on risk-taking. The discussion here applies directly to income tax offsets, but may be considered applicable to an excess profits tax in a rather indirect manner. Since deficiency in profits must be made up before excess profits appear, the allowance of such deficiency bears,.therefore, indirectly on any carry-back or carry-over of deficiency in normal profits. This is illustrated, in. the example given in sunra, p. 28 0, footnote 9« 290 or consolidation has been resorted to extensively to reduce risk-taking. The risk differential between large and small business must be taken into consideration before the argument may be regarded as valid. The operation of the principle of reducing uncertainty to measurable risk through grouping constitutes a strong incentive to extend the scale of opera tions of a business establishment. This fact must account partly for the extraordinary increase in the average size of industrial establishments, a familiar..characteristic of our modern economy. Knight’s view on this point, is summarized 27 here. The individual proprietor can extend the scope of his exercise of judgment over a greater number of decisions by borrowing capital or otherwise, so that there is a greater probability that bad guesses will be offset by good ones and that a degree of constancy and dependability in the total results will be achieved. The reduction of risk to borrowed capital is probably, however, the principal desideratum lead ing to the displacement of individual enterprise by the partnership and the same fact with reference to both owned and borrowed capital.explains the substitution of corporate organization for the partnership (and the.individual pro prietorship) • The superiority of the higher over the lower Frank -H. Knight, Risk. Uncertainty and Profit (Bostons Houghton Mifflin Company, 1921) , pp. 2pl-25I +7 291 form of organization from this point of view consists both in the extension of the scope of operations to include a larger number of individual decisions and ventures, too broad in scope to be managed by the individual proprietor or the partners, and in the more effective unification of interest which reduces the moral hazard connected with the assumption by one person of the consequences of another person’s decisions. This, view of Knight is hardly open to dispute. The large size of a corporation and the great variety of its activities and operations permit it to average out the risks incurred by off setting the gains from correct judgments against losses from ill-considered decisions. In a sense this aspect of the insur ance principle of risk reduction through offsets serves as the theoretical basis for loss offsets discussed in the preceding section of this chapter. Statistical findings bv Crum. This theory of risk reduction through combination has been substantiated by the findings, of a recent statistical investigation conducted by pg Crum, The main object of the project was to discover the relationship between corporate size and earning power. Three different approaches to a solution of the problem were William L. Crum, Corporate Size and Earning Power (Cambridge: Harvard University Press, 1939)9 Chap. II. 292 individually developed for the statistical material for each of the six years from 1931-36. The findings and conclusions are summarized as follows. 1. Rate of return compared with size, for all income and deficit corporations. For the six-year period, the six curves show, without exception, the progression of earning power with size and run nearly parallel throughout most of their course, strongly implying that the progressive rela tionship is not peculiar to any one year or the stage of the business cycle, as the six-year period includes years of sub stantial business recovery as well as deep depression. As a class, the smallest size corporations (with assets of less than $50,000) are notable for their systematic record of losses, with no annual net profit on equity in the aggregate, and the next three size corporations (with assets respectively of from $50,000 to $100,000, of from $100,000 to $250,000, and of from$250,000 to $500,000) show a slightly less system atic adverse record. The very slow advance in rate for 1936 29 above the $250,000 class, with an actual decline in the top class (with assets of over $5 0, 0 0 0, 000), should also be noted. The differences in the level of the six curves, together with their approximate parallelism, indicate that cyclical changes This writer notes that for all. years, the turning point in the rate of advance in rate of return seems to be located somewhere between $250,000 and $500,000 classes. 293 in business affect corporations of various sizes equally. The close approach to parallelism further implies that these changes were approximately uniform in amount for most classes: a given cyclical change in business contributed an approxi mately uniform percentage of their total equity to the earn ings rates of the various size classes. 2. Time comparisons between the rates of return for the $5 0 ,0 0 0 class, the $10,000,000 class, and all nine (ten in 1936) classes combined. The purpose of the selection is to yield a contrast between very large and very small corpora tions, while avoiding the lowest and highest classes. The curve for the large size class is in all years above the general curve for all classes combined, and the curve for the small size class is much lower. The $10,000,000 class curve is, in -1931=33» below the zero line and the $5 0 ,0 0 0 class curve is, except in 1936, below the zero line. The giant corporations as a group— the top class, for which no curve is drawn— had no net loss, even in the worst year of the depres sion; and the_smallest corporations as a group (under the $50,000 class) had no net profit, even in the best year of the six. The approximate parallelism between the curves again suggests that cyclical change and fluctuations have about equal impact upon corporations of all sizes except the smallest. 3. Rate of return compared with size, for income cor porations alone and for income and deficit corporations 29b combined* Mhen the rates of return on equity for income corporations only are compared, the systematic upward course of the curves, as revealed in (1), is replaced by a much less regular downward tendency. In other words, for the income corporations only, the rate of return tends to decrease as size increases. For all years the maximum, rate of return for income corporations only appears in the smallest size class; and for all years, except 1931, the, minimum rate appears for the largest size class. Crum was thereupon forced to the con clusion that the systematic upward course of the curves, as charted in (1), is due entirely to the experience of the deficit corporations. A simple comparison, based upon a six- year average of the six annual rates of return of the deficit, corporations (only) of various corresponding sizes, indicates that the upward course of the combined curve for all income and deficit corporations, as distinguished from the irregu larly downward curve for Income corporations (only), is fully accounted for, and more, by the striking and persistent advance in the rate of return or, what, is equivalent, reduction in negative rate of return for the defieit corporations up the scale of size. The rate advance for the deficit corporations ranges from below negative 39 per cent for the smallest size class to about negative 1.5 per cent for the largest; whereas the corresponding decline, for the Income corporations, from nearly 11.per cent to nearly 6 per cent, respectively. 295 Another pertinent observation in this respect relates to the wide spread between the income and deficit curves for the lowest size class (for 1 9 3 6, negative 33*78 per cent to positive 1 2 .9 0 per cent), reflecting a much greater disper sion in earning power among the corporations falling within that class, and the relatively narrow gap for the larger size classes (for the same year, negative 1.3*+ per cent to positive 5 .9 6 per cent) . 30 The conclusion to be drawn from the findings of Crum*s work points to a negative correlation between size and the probability of business losses. The smallest size corpora tions are noted for their systematic record of losses with no net profit even in the best of the six years under review. This result confirms our earlier argument against the risk theory of profits as stated elsewhere, that profits are not 31 positively correlated to the degree of risk assumed. But since the maximum rate of return for income corporations appears in the smallest size class, that fact substantiates the theory that in games of chance the possibility of large 32 winnings must be present. The fact that the giant corporations 30 Ibid.. p. 31, Table II. 31 - Suora. Chap. IV, p. 202. 3^ Robert B. Pettengill, Price Economics (New York: The Ronald Press Companyj 19^8), p. ^73* 296 as a group had no net loss even in the worst year of the depression and the fact that the large corporations as a group had progressively better earnings record in relation to size indicate that greater stability, less insecurity, and hence, smaller probability of loss characterize their opera tions. The greater stability of the large corporations as well as greater probability of loss of the small corporations may also be indicated by the narrow spread of earnings for 1936 among the former (from negative 1.31 * per cent to posi tive 5*96 per cent) and the wide spread among the latter (from negative 33*78 per cent to positive 12*90 per cent). The smaller losses sustained by the deficit large corporations, as compared with the larger losses of the deficit small cor porations , also point to the same conclusion. Statistical findings by Butters and Lintner. As if the foregoing evidence indicating the wide differential exist ing between the degree of risk incurred by the small enter prises and that by the large corporations had not been enough, a case study of five corporations, conducted in 19*+5 with special reference to the effect of federal taxes on growing enterprises, comes to virtually the same conclusion that the same high federal taxes are more repressive on small growing firms than on large, established, corporations. One of the reasons accounting for this, conclusion is the high risk differential against the equity owners of the former in favor 297 33 of those of the latter. The,injustices of the present federal income tax on corporations are altogether clear, inasmuch as it taxes the small corporations in the same manner and at the same and sometimes higher rates than the 3^ large corporations. Since the continued formation and growth of small and independent enterprises have been widely regarded to be crucial to the maintenance of a tolerably healthy industrial competitive structure, in view of the domination of a large segment of the economy by the very large corporations highly susceptible of monopolistic ten dencies and practices, **. . . every reasonable step [should] be taken to remove unnecessary impediments to.the growth of 35 new enterprises in the postwar economy,** among which differential taxation of the large and, small businesses is 36 one of such steps. A reasonable and scientific means of 33 j. Keith Butters and John Lintner. Effect of Federal Taxes on Growing Enterprises (Boston: Harvard University, 19W, p. H-7*The five corporations, Clarkson Manufacturing Company,-Continental Machines, Inc., Lithomat Corporation, Lockheed Aircraft Corporation, and Polaroid Corporation, all had outstanding records of development stemming from the early thirties. Their growth is characteristic, according to this writer, of the development of many new enterprises which spring from the imagination.of their founders and are the media through which the dreams of inventors are realized. 31 * " See supra. Chap. IV, p. 266, footnote 13*K 35 Butters and Lintner. op. cit.. pp. 1-2. 36 Ibid.. pp. 133-13 achieving this end is the excess profits tax. 298 Significance of statistical findings to theory of excess profits taxation. Needless to say that these findings tally remarkably well with what Knight has postulated in theory. Even though they were based exclusively upon corpor ate data, they and the conclusions drawn from them are undoubtedly applicable to the risk situation among unincor- 37 porated businesses. Their significance in excess profits taxation is apparent. Since the burden of an excess profits tax on the whole falls upon large successful corporations with monopolistic tendencies and the small businesses are ordinarily exempt from the tax, with the probable exception of the unusually successful ones, the knowledge that both in theory and in practice the operations of large business are not characterized by exceptionally high degree of risk necessarily deprives the risk penalization argument of most of its theoreti cal and practical validity. We are then left with the excep tion of the unusually successful smalL. enterprises. If they remain successful for a long period of years, a moderate por tion of their profits being taken away by the government in the form of taxes will not deter new entry or restrict 37 some of the five corporations surveyed by Butters and Lintner Cop. cit., Chaps. X-XIV) were unincorporated enterprises prior to the imposition of the excess profits tax of World War II, 299 production. The risk-penalization theory, thereby, falls to the ground. CONCLUSION In view of the arguments presented above with respect to the advantages enjoyed by the large corporations over the small business in matters of loss offsets and of the rela tively low degree of risk characterizing the operations of the former as compared with the latter, a properly constructed excess profits tax, sufficiently discriminating to spare the small, new, risky enterprises, while stringent enough to relieve the large, less risky corporations of part of their surplus profits, cannot be said to have the effect of penaliz ing risk-taking. II* e f f i c i e n c y a n d e x c e s s p r o f i t s t a x a t i o n Another alleged adverse effect of an excess profits tax on business income has to do with productive efficiency. It has been maintained by Hicks, that the excess profits tax is “particularly likely to damage efficiency just because it falls with its main force upon extra profits," which profits “the business man thinks twice, whether it is worth while 38 making the effort** necessary to earn them. The adverse 38 J. R. Hicks, U. K. Hicks, and L. Rostas, The Taxa tion of War Wealth (Oxford: The Clarendon Press, 19*+1), p. *+3* 300 effect may be twofold: a possible diminution of the incentive to take on any particular piece of business and to make any particular effort in the search for economy. It should be pointed out at the outset that Hicks' remark was directed solely at the 100 per cent excess profits tax as levied in Great Britain during the last war and the propriety of its application in the case of a permanent peacetime excess profits tax with a mildly graduated rate schedule, therefore, may well be questioned. Our attention is, however, strictly centered on the effect on efficiency of an excess profits tax levied at considerably less than the confiscatory 100 per cent rate. THE THEORETICAL ASPECTS OP EFFICIENCY The relative or differential aspect of efficiency and efficiency profits. Efficiency in production is essentially a relative term and its relevancy is, therefore, stressed only when producing firms differ in respect of their relative pro ductive skills and. technique. Thus, under conditions of com petitive equilibrium efficiency would lose much of its significance in relativity, since all producing firms, regard less of size and other relevant factors, would be operating at the same minimum points of their respective long-run 39 average cost curves. The requisite conditions for such a These minimum points may be varyingly distant from the ordinate, but are equidistant from the abscissa. 301 perfect equilibrium are that marginal revenue of each firm is equal to its marginal cost and its average revenue is also equal to its average cost. Profits will, therefore, be bo normal when these conditions are fulfilled. Under this state of full equilibrium the efficiency of each firm at the U-l margin of production is the same, each earns the same amount of normal profits, factors are paid their remunera tion equivalent to their marginal productivity, and nothing the firm may do can change its lot for better or for worse, for each has reached its optimum productive and economic position, A less drastic but more realistic condition of competi tive equilibrium pictures a series of producing firms, each operating at slightly more than its optimum size and each having its marginal revenue equal to its marginal cost, with the sole exception of the marginal firm whose average revenue will also be equal to its average cost, in addition to the b2 equality of marginal revenue and marginal cost. Under this k-3 condition of competitive equilibrium rent appears for all Lq Joan Robinson, The Economics of Imperfect Competi tion (London: Macmillan and Co., Limited, 19^2) , p. ^ The intensive and the extensive margins, are one at this point, ^ Robinson, op. cit.. p, 121 * - . And also, the size of the marginal firm is optimum. *+3 Or shall we say "unstable equilibrium*" Robinson 302 intra-marginal firms, representing the difference between marginal and average cost to these firms, multiplied by out- put. This appearance of rent, measuring “the difference between the transfer earnings of intra-marginal efficiency units of the factors and the earnings of units which are on the margin of transference,” is attributed to the use of a factor or factors, the supply of which is scarce. The theory is that as successive units of the variable factors are combined with those of the scarce factors, cost will rise, r inasmuch as the proportional increase in the variable factors alone cannot cause the same relative increase in output which would result from a proportional increase in both the variable k6 and the scarce factors. But as output of the industry expands in response to increases in demand, marginal cost of the intra-marginal firm increases as its output swells, enabling more of the less efficient firms which were ^ (Continued) may argue (loc, exit.) that from the standpoint of industry rent is cost, but the fact that it is noi cost to the individ ual enterprisers of the intra-marginal variety, but pure profits over and above their normal profits, will encourage new entry, which will, in turn, upset the unstable equilib rium, This will go on until .perfect equilibrium is reached as set forth above, kk Robinson, loc, cit. Ibid. t p. 121. ^ Paul H. Douglas, The Theory of Wages (New York: The Macmillan Company, 1931 *-), p. 25. This represents also an adaptation of the familiar Ricardian theory of differential rent. 303 heretofore submarginal to enter the industry. Since the reward to all units of the same factor must be equal to that obtained by the marginal units (for the same industry), rent, excess profits, or the so-called efficiency profits, will arise from the intensive exploitation, of the units of the scarce factor or factors by the intra-marginal firms. But at the margin the efficiency of all firms, whether they be mar ginal or intra-marginal, is equal. Efficiency profits, like differential rentsT not a part of cost of production. From the point of view of the firm, the residual claimant, the difference between what it pays the various factors (their transfer earnings at the margin) and its total receipts, price (marginal cost at the proper volume of output) multiplied by output, represents excess profits, "since they do not arise from the productivity of the marginal units of the factors of production," In other words, efficiency profits inure non-functionally to the benefit of the firm, the residual claimant. From the point of view of the firm, the proper viewpoint for excess profits taxation, they are pure profits or excess profits, do l. « 7 See infra, p, 30*f, footnote 51? ^or source, ^ James P, Beddy, Profits (Dublin: Hodges, Figgis & Co., 19>+0), p. 229, 30** not constitute remuneration for any particular productive functionary, and, therefore, do not enter into the long-run M-9 cost of production. These excess or efficiency profits are similar, in origin, to the so-called differential rent. As the margin of production extends when demand increases, the successive increases in these profits, supposedly due to the relative efficiency of the intra-marginal firms as com pared with the increasingly less efficient firms which are now called into production, bear the same characteristics of successive rent increases as more of less fertile land is put under cultivation in response to rising demand. It is diffi cult to distinguish between scarcity and efficiency rents, since "In a sense all rents are scarcity rents, and all rents 50 are differential rents.1 * Scarcity rents are not price- determining, yet Foreman contends that such efficiency profits, arising from new inventions, patents, trade secrets, and others, 51 are price-determining. His observation, with respect to trade secrets is contradictory to this positions Consequently, whenever the entrepreneur’s trade secret becomes by fair means the property of the ^ This is an adaptation of the familiar Ricardian theory that rent does not enter into cost of production. Alfred Marshall,, Principles of Economics (Eighth edition; London: Macmillan and Co., Limited, 1938), p. k22. Clarence J. Foreman, Efficiency, and Scarcity Prof its (Chicago: The University of Chicago Press, 1930), p. M-2. 305 public, he loses a differential advantage in pro duction, and his efficiency profits tend to dis appear. • • .52 This trade secret giving its possessor a differential advan tage over his competitors produces only a differential profit or rent which does not acquire a cost status in the long-run normal, as being a sort of functional remuneration for its possessor. Since price is determined at the margin where there is no rent or profit arising from the advantage of possession of such secret, the amount of that profit or rent is not a governing cause of price, but is itself governed by the price of the product. Despite Foreman's attempt to 9+ distinguish, between scarcity and efficiency profits, this writer is of the opinion that in formal analysis, for reasons presented hereinabove, efficiency profits do not enter into 55 cost of production. This conclusion may be extended to temporary profits arising from other differential advantages in production, 52 ibid.T p. 29* (Italics supplied.) 53 MarshallT op. cit. T p. *+27. Foreman, ojg. cit., pp. h-3-71* 55 Joseph A. Schumpeter T in his The .Theory of Economic Development. translated from the German by Redvers Gpie (Cambridge: Harvard University Press, 193*+), advanced a similar approach to profits emerging from new invention, com bination, et cetera. Despite the similarity. Schumpeter maintained that such.profits do not enter into cost of pro duction. (Ibid.. p. 153•) 306 which some firms luckily possess and some do not* These prof its will disappear as knowledge and technological know-how are diffused throughout the industry. This is true under competitive as well as monopolistic condition, except that under the latter collusive agreements may render the ultimate diffusion of productive technique a more remote possibility. The effect of taxing efficiency profits. It follows from the above discussion that moderate taxation of such efficiency profits or excess profits should occasion little restrictive effect on the supply of any particular factor or factors of production. Production, therefore, will not be curtailed greatly. A tax imposed on such profits at a con siderably less than 100 per cent rate should, not diminish very much the incentive to take on any particular piece of business or to seek for further economy. The reasons are twofold: (1) since the rate is less than confiscatory, most of what appears economical and. profitable before the tax will 56 remain economical and worth taking, after the tax and (2) under ordinary circumstances where demand warrants, the firm will always expand output to the point of equality between marginal revenue and marginal cost, for that point always marks the most profitable volume of output. Since the tax does not ^ Supra. p. 276, also footnote *f, p. 277* 307 affect the marginal unit of output, being the unit devoid of any efficiency profits, it cannot prevent the firm from 57 achieving that volume of production. RELATIVE EFFICIENCY OF LARGE, MEDIUM-SIZED, AND SMALL BUSINESSs STATISTICAL FINDINGS Introduction. We have mentioned elsewhere the proba bility that the burden of a permanent excess profits tax will fall on monopoly and monopolistic profits, which are, generally speaking, netted by large business. It is pertinent for us to devote some space to the possibility of damaging efficiency, popularly associated with mass or large-scale production, of which only large business is ordinarily capable, again bearing in mind that it is the total picture that is important, not segments of that picture* Temporary National Economic Committee Monograph No. 1^. In 19*+0 the Temporary National Economic Committee made an 57 ' It has been suggested to this writer that in the actual world few firms would achieve the optimum volume of output where marginal revenue and marginal cost are equated. There are several answers. First, we are now dealing specif ically with the theoretical aspects of the efficiency argument. Secondly, the imposition of an excess profits tax may actually spur the affected firms toward further increase in their pro duction in order to achieve greater efficiency and hence, greater net profits after tax. (David Friday, Profits. Wages. and Prices (New Yorks Harcourt, Brace and Company, 1920), p. 20*+, advancing a similar argument.) For other reasons, see infra. Chap. VII, pp. 503-50*+. 308 extensive investigation into the relative efficiency of large, medium-sized, and small business and published its findings in one of its monographs, serial number 13, entitled Relative Efficiency of Large. Medium-sized and Small Business. The results and conclusions of the findings, as summarized on pages 12-20, combine to refute, in convincing fashion, the popular notion that efficiency is the concomitant and out- 59 standing virtue of large business,According to the findings, . 60 in the 128 combined tests employing cost figures, large size, whether represented by a corporation, a plant, a group of corporations, or a group of plants, showed the lowest cost in only eight tests, less than 6 per cent of the total number of tests. The medium-sized business had the best showing in fifty-seven tests, roughly per cent, and the small business 58 ' Temporary National Economic Committee, Relative Efficiency of LargeT Medium-sizedT and. Small. Business (Mono- graph No, 13* Washington, D, C,: U. S, Government Printing Office, 19^1), pp. 12-20. 59 Groves maintains.(on. cit., p. 80) that efficiency may be adversely affected by an excess profits tax on monopoly profits. He did not explicitly say that efficiency is neces sarily associated with, large business. But the fact that monopoly is almost invariably practised by large business would seem, in absence of express language, to link Groves with those who entertain this point of view. £0 Altogether 233 tests were made under six basic test groups employing different standards to measure efficiency. Two of the six (consisting of 105 tests) used figures of return and investment, which are less pertinent for our pur poses and are, therefore, not considered herein. 309 Z • » in sixty-three tests, approximately *+9 per cent of the tests. When comparison is made upon the basis of the total tests of 2 3 3, as was done in the monograph, the percentages of large, medium-sized, and small business are, respectively, 1 1, 5 5, and 31 * - * These findings strongly suggest that the small and medium-sized business is much more efficient than large busi ness in the sense that low cost signifies efficiency. In spite of his unrelenting criticism of this particular mono graph, especially with reference to methods, scope, and con tents, Stigler, nevertheless, came to effectively the same conclusion that “beyond a relatively modest.scale of output the economies of large scale production are in general quan- titatively unimportant.” Fetter^ explanation. An able explanation of the fallacy in associating efficiency exclusively with large business is contained in a testimony which appears in Temporary national Economic Committee Monograph Ho. 13 as Appendix D— The Funda mental Principle of Efficiency in Mass Production by 6l These figures and percentages are computed by this writer from pertinent data appearing in the monograph cited in supra. p. 3 0 8, footnote 5°. George J. Stigler, “The Extent and Bases of Monopoly,” American Economic Review. Supplement, XXXII, No. 2, Part 2 (June, 19^2), 13. 310 6"^ ££• Frank Fetter. According to Fetter, the economy of mass or large-scale production springs primarily from a relatively large degree of specialization in a single plant which turns out a large number of a particular kind of product. Fetter reviews five categories of technical advantages of large- scale production, but states that Obviously, the economy of mass production in its proper sense does not even imply the necessity of very large size in a single unit factory. It is more a matter of the degree of specialization attainable within a single factory than a matter of the size of the plant as a whole. Thus, a plural-unit business may not be as efficient as, or more efficient than, a single-unit plant. Integration or horizontal combination which involves only the mere common ownership of two or more duplicate plants without such tech nical improvements as to facilitate relatively large degree of specialization within.the plants, cannot be expected to result in the economy of mass production, or the more effi cient operation of the plants. Vertical combination may result in an increase of the efficiency of plants only when such integration is related to the elimination of technical waste In production. Besides, there'is always an optimum volume in mass production beyond which the advantages of mass 6*f production turns into disadvantages. To be sure, there are ^3 Temporary National. Economic Committee, op. cit.. p p * 3 9 S - lK L 5 » ^ This technical or technological, limitation on the 311 pecuniary economies resulting from integration, such as the low cost of purchases of services and factors because of the stronger bargaining power of the larger firm, but they are not technological economies, ordinarily associated with 65 efficiency* As an offset against such pecuniary economies, integration often takes the form of unfair competition in that it permits large business with adequate resources to integrate to practise price discrimination and to undersell small business not financially able to do so* Fetter's final opinion is that his analysis would not lead him "to expect that big-business combinations would prove in practice to be more truly efficient in the welfare sense than business of moderate size*** Findings by Blair* In May, 19^8, John M* Blair of the Federal Trade Commission presented a paper before the sixtieth annual, meeting of the American Economic Association, entitled 66 "Does Large-Scale Enterprise Result in Lower Costs?" in 6h (Continued) optimum size of the producing plant , requires no elaboration, . for it Is general knowledge that the long-run average cost curve of a firm will eventually rise* These pecuniary economies do not represent effi ciency in the true welfare sense of the term* Stigler con siders them merely as transfers and not to constitute net social gains* (Op . cit*, p. 11.) ^ John M. Blair, "Does Large-Scale Enterprise Result in Lower Costs?" American Economic Review* XXXVIII, No. 2 (May, 19^8), 121-152. which he proved convincingly that for important segments of industry size and efficiency are not positively related* Blair found evidence for the belief that the trend toward large size, "apart from whatever long-range effects World War II may have had on plant size, came to an end during or shortly after World War I." Between 191^ and 1937 the aver age size of plants, contrary to ordinary belief, was actually decreasing in a significant number, of industries, on account of new technological developments, which tend to promote smaller rather than a large scale of operations and thus, toward decentralization* Many of such decentralizing tech niques were reviewed, including _thedevelopment of light metals and plastic. Blair queried, "If these techniques do lead to a significant decentralization of the productive units of industry, why should not ownership and control also be decentralized?" The traditional rationalization of large size is that technology requires a large scale of operations and efficient operations are possible under common ownership and control rather than under individual ownership. Now that technological developments are towards decentralization, large-scale economy can be based only on alleged efficiency arising from common ownership and control. Fetter has already disposed of this argument, as we have seen. Blair also cited Arthur S. Dewing's statistical study of the earnings capacity 313 67 or combinations taking place before 1903* The findings and conclusions of Dewing are well-known. The earnings of the separate plants before consolidation were greater than the earnings of the same plants after consolidation. Other findings. More recent studies by the Federal 68 Trade Commission and the Office of Temporary Controls have revealed the same tendencies for smaller and medium plants to have lower cost of production. The result of another survey by the Department of Commerce in 19M-569 is indicative of, even though it does not prove, the fact that small firms are at least as efficient as, if not more so than, large firms. In almost all branches of industry, according to the survey, earning power of small firms relative to medium and large firms is markedly improved when the economy moves toward higher operating rates. The exceptions are concentrated in the extractive industries, mining and. quarrying,.petroleum ^ Arthur S. Dewing, “A Statistical Test of the Success of Consolidations,*' Quarterly Journal of Economics. 1922, cited by Blair. 68 Federal Trade Commission.. Wholesale Baking Industry. 19^6, and Office of Temporary Controls, Office of Price Admin istration, Economic Data Analysis Branch, Survey of Rubber Tire and Tube Manufacturers. No. 10, OPA Economic Data Series, 19^7> both cited by Blair. 69 Joseph L. McConnell, “Corporate Earnings by.Size of Firm,'1 Survey of Current Business. published by the Department of Commerce, Bureau of Foreign and Domestic Commerce (May, 19^5) , 6-12. 31*+ refinery, stone, clay, and glass manufacturing, and the manu facture of foods and tobacco products. The only field wherein small firms are not comparable to large and medium firms is retail trade, the cause being relatively easy entry and hence greater competition. (The relative importance in the economy of those industries mentioned above where the small firms are not superior is indicated in the schedule appended herewith 70* as a footnote. ) The conclusion reached by the survey is 70 The position of those manufacturing industries in which small business does not experience a marked improvement in their earnings position as the level of production is raised, may be indicated by comparing the number of establish ments xn those industries with that, in the entire field of manufacturing and by comparing the value of products turned out by these same industries to that by the entire field of manufacturing establishments. The figures used in the follow ing comparison were taken from the 1939 Census of Manufactures. Vol. I, Table 5, PP* 22-23. (Dollar figures in $000,000.) Number of Value of Establishments Products All industries Food and kindred products Mining and quarrying Tobacco manufactures Petroleum and coal products Stone, clay, and glass products Total 18^.230 51, ^ 8 10,618 765 1 ,3 2 2 989 2,95^ . . . „ . . Z* P2 h 1.M+0 6 0 .2 2 6 3 2.69$ I6,3.3it It is apparent that in 1939 those industries in which small business did not enjoy a marked improvement in their earnings position, accounted for considerably.less than one-third of the total value of products manufactured and provided for less than one-third of the total number of establishments in the field of manufacturing. 315 that as long as a high level of production is maintained, small firms are able to hold their own as against the large and medium firms, except in retail trade. It is not illogi cal for this writer to draw a corollary that as long as there is sufficient demand, to assure a high level of produc tion, small firms are more efficient than large firms in most fields of industrial and commercial.activities, except retail ing. Conclusion. We have presented, in brief, some recent studies on the subject of efficiency, as related to size of firm, with the intention to prove that efficiency and size are not positively correlated in important segments of the business world. Excess profits in the case of large business, it would seem, arise more likely from price discrimination, restraint of trade, and other monopoly and monopolistic prac tices than from outstanding efficiency, frequently attributed to large size. It is within the ranks of medium-sized and small business that profits from efficiency are likely to be of vital importance in nurturing productive incentive. A permanent excess profits tax with its burden falling mainly upon the relatively less efficient large enterprises, should not, therefore, damage productive efficiency to any unbear able extent as to be detrimental.to the welfare of the nation. CHAPTER VI INVESTED CAPITAL, STATUTORY RATE OF NORMAL PROFITS, AND OTHER TECHNICAL CONSIDERATIONS The technical aspects of excess profits taxation with its attendant knotty problems and the principles involved in their solution constitute the main topics of this chapter. Space does not permit am examination of all of the technical problems involved in-designing the tax. A few of them which this writer considers as transcendently important will be discussed. A word must be said at the outset about the scope of a permanent peacetime excess profits tax, as it will be seen that such an introduction will facilitate the technical dis cussion to follow. The term "invested capital" should immedi ately suggest that our tax is restricted to excess profits attributable to capital used in the course of business. No satisfactory practical test has yet been devised to measure the excessiveness of income other thanfrom capital, chiefly wages, salaries, some part of broker's and agent's fees, 1 professional fees, and farming income. All business profits in the earning of which capital plays a predominant and 1 Carl Shoup, "The Taxation of Excess Profits I," Political Science Quarterly. LV. No. b (December, 19^0), 536-537. 316 31? measurable role, regardless of the form or organization under which business is conducted, are brought within the scope of 2 the tax. As the discussion to follow is primarily academic, a more precise definition of the scope is not considered neces- 3 sary. Admittedly, many controversies will arise in connection with the taxability of firms the character of whose profits borders upon but is not quite that of capital earnings. The allowance of a relatively high specific exemption, say around #5 0 ,0 0 0 as we will recommend in a later subsection, will, however, do away with many, if not all, difficult problems relating to the scope of the tax* !• INVESTED CAPITAL,AND ITS VALUATION THE INVESTED CAPITAL APPROACH The importance of the valuation problem lies in the simple fact that a correct valuation of invested capital is indispensable to a correct measurement of normal profits and coextensively to that of excess profits. As the tax is pro posed as a permanent part of the federal business tax system, the invested capital method of arriving at statutory normal Fifty per cent of the earnings attributable to capital may be viewed as the demarcation line, as suggested in Chap. Ill, supra. p. 1 5 7, footnote 1 5 8. ^ For exempt corporations under the repealed excess profits tax of World War II, see Sec. 727, Internal Revenue Code. profits under the repealed excess profits tax provisions of the Second Revenue Act of 19M-0, is the proper approach, and the alternative method of the computation of normal profits by appeal ing to base-period profits experience, or the average earnings 5 method, is no longer available. There are several theoretical and practical reasons for discarding the latter method. In theory, appeal to base-period profit experience in computing exempt normal profits necessarily regards all base-period pro- 6 fits as normal, even though such profits were excessive and con- 7 tained monopoly and monopolistic gains. The fundamental ** See sunra. Chap, II, pp. 66-6 9, Loc* cit. 6 0 It should be pointed out that under the provisions of the repealed excess profits tax of World War II only 95 per cent of the average base-period earnings was considered as normal, (Sec. 713va)(1)(A).) This is equivalent to reckon ing as taxable excess profits J > per cent of the average based period earnings of all firms subject to the tax, irrespective of the possibility that the 5 per cent might have been part of normal profits properly defined. This arbitrary element in the law was tolerable because the tax was of the war profits variety and therefore temporary and besides, the option to use either the average earnings method or the invested capital method whichever would result in lesser tax lessened consider ably the arbitrariness of the former method. But in a per manent excess profits tax the average earnings method has no place, (T. S* Adams, “Federal Taxes upon Income and Excess Profits. 1 1 American Economic Review. VIII. No. 1, Sunolement [March,’ 1 9 1 8J, 1 9 . ) -------- ' If the base period chosen for the purpose at hand pertains to the normal upswing of the industry, sudh a stand ard of normal profits may defeat the aim of any excess profits tax. 319 theoretical limitation of the income method is, however, the inequity of applying a static standard based upon the experi ence of a firm in a past period of time to dynamic conditions of investment of which the past experience may not be repre- 8 sentative. The static standard will-become more illogical and incompatible with the general economic conditions in the 9 taxable year as time wears on. In practice, the income method can be applied only to those concerns which existed in the pre-tax period the experience of which is adopted as the standard and which have not undergone fundamental changes 10 sinee that time. Also, the difficulty of selecting a true 11 base period is bound to be great. Following the American precedent, we approach the problem of valuation of invested 12 capital from the liability side of the balance sheet. The asset side approach of the British excess profits tax, while 13 eminently superior in certain respects, is, in the opinion o M. H. Gopal, The Theory of Excess Profits Taxation (Van!vilas Mohalla, Mysore: Bureau of Economic Research, 19^7), p. 1^+6. There are remedies, to be sure, but the theoretical objections still remain. 9 Adams, loc. cit. Gopal, op. cit., p. lU-1. 11 hoc, cit. 12 There is an exception to this supposedly exclusive liability side approach. See infra, fp. 3^7^*358. For instance, the asset side approach .makes it possible to reckon “capital employed" from the date or dates 320 of this writer, especially deficient in being fundamentally inconsistent with the residual claimant theory of excess profits, as explained in Chapter IV, supra. An invested capital approach, based on the British method, will permit some excess profits arising from the underpayment of contrac tual factors to escape the tax. To allow a part of the resid ual profits to go untaxed cannot be reconciled with our theory that the firm is the residual claimant, entitled to all resid- ual profits, on which the burden of the tax is to fall. Throughout the following discussion the realities of tax practice and tax administration will constitute the primary considerations in deciding upon the adoption of certain tech nical measures in preference to others. While the resolution of some problems will inevitably require us to repair to the theoretical point of view, theoretical perfection will not be allowed to prevent the imposition of a workable permanent excess profits tax. ^ (Continued) of acquisition rather than the date or dates of original investment, thus in some cases shortening the relevant time for changes in the ownership of shares to have taken place. (J. R. Hicks, U. K. Hicks. and L. Rost as. The Taxation of War Wealth (Oxfords The Clarendon Press, 19^-1), p. M-2.)A related advantage lies in the possibility to take the more recent cost of capital equipment into account in computing invested capital. To the economists delight, recent cost is thought to be more indicative of the current value of business capital than original.cost of investment. Supra. Chap. IV, pp. 2^6-250, especially. 321 FIBST-YEAR INVESTED CAPITAL The nature of the valuation problem. The most baffling nature of the problem of valuation of the first-year invested capital springs from the economic principle that the value of capital is but the capitalization of expected future earnings. “The famous economic process of imputation applies without exception and levels out, under static assumptions, any 'surplus* no matter whether the entrepreneur be a monopolist 15 or not." By this process of imputation and capitalization the producer, whether he operates under conditions of monopoly or competition, makes no excess profits except windfalls* A strict application of this principle to excess profits taxa tion means that the legal provision levying the excess prof its tax would have to exempt even the highest return that was anticipated if it is not to restrict investment in the business in question.1^ The nature of the problem and the significance of the capitalization principle can best be brought out by using an example similar to that which was 17 employed by Adams some thirty years ago. Two firms, Robert Triffin. Monopolistic Competition and General Equilibrium Theory (Cambridge: Harvard University Press, 19^0), p* 1 6 3* Note the use of "entrepreneur" in this sense is incon sistent with our theory of firm entrepreneurship* (Supra, pp* 2^0 ff.) ^ Shoup, oj>. cit., p. Adams, loc. cit. 322 employing the same amount of capital, say $1,000,000, came into existence at about the same time many years prior to the imposition of the excess profits tax. Both have been profit able to the same extent and out of profits have retained sur plus earnings in the amount of $2,000,000. With the same prospect of success in the future both are worth $5,000,000. It so happens that one of the firms sold its business at this value sometime prior to the introduction but not in anticipa tion of the excess profits tax.. If it is cost that should go into the value of invested capital for excess profits tax purposes, the new acquiring firm will have as its invested capital $5,000,000 as against the $3,000,000 original invest ment and accumulated earnings and profits of the old firm. At an 8 per cent statutory rate of normal profits the new firm can make $160,000 more in profits than the old firm without having to pay any excess profits tax on the excess, as long as they both make more than their respective normal profits. This fact has led many theorists to the belief that unless the concept of invested capital takes cognizance of the current appraisal value of the original investment. of the old firm, the vested property rights of the stockholders, especially the rights of those who have bought their way into the ownership of the firm, after its earnings capacity has been established, will be violated and the stockholders 323 18 themselves will, hence, suffer capital losses. These same theorists, do not contend, however, that the opposite require ment, to value invested capital at current market if that is smaller than original cost, should also be recognized to pro- 19 tect the government from revenue losses. It is not difficult to see that to allow the capitali zation of monopoly profits is to reduce our proposed permanent excess profits tax to a tax on windfall profits only, which is 20 what Butt advocated some twenty, years ago. The impractica bility of an exclusive tax on windfalls from the point of view of both revenue and administration has been commented upon elsewhere and need not be commented upon here. Anyway, the current appraisal value of business investment has had no place in the levying provisions of the American excess profits tax during both world wars and for that matter in any federal tax system. (We wish we could dispose of this issue simply by appealing to its past nonrecognition.) In the hypothetical situation depicted above in regard to the invested capital 18 Shoup, c> b. cit., p. 550. ^ Sec. 718(a), defining equity invested capital, does not require that invested capital be scaled down by accumu lated deficit in the surplus account. This is, of course, proper and logical when the cost of original investment con stitutes the sole basis for the computation of invested capital. See supra« Chap. I, pp. 33-38, for a review of William Edward Butt*s "A Permanent Excess Profit Tax,” (an unpublished Doctor*s dissertation, Yale University, 1931)* 32** difference of the two firms, the problem may be examined in its two distinct aspects: Would vested property rights be protected by valuing invested capital at cost? and, Would the requirement that invested capital be valued at cost dis criminate against one firm, as compared with the other, both being similarly situated in every respect except that some fortuitous event, such as a sale of the business or a taxable reorganization, puts one of them in a more advantageous tax position? Adherents to the imputation theory would undoubt edly answer “no1 4 to the first question and "yes4 4 to the second. We will probe into both of these issues in detail to determine whether the imputation and capitalization-theory, valid though it may be in theory or a, priori reasoning, is not infallible and irrefutable in practice. Cost versus value: protection of vested interests. The problem of the protection of property interest generally will not arise in a case where a taxable transfer of the entire 21 business property was completed not long before the imposi- 22 tion of the tax. It does arise, however, when the tax is imposed long after the original-investment or the last taxable transfer subsequent thereto was made. It is in these latter Plus intangibles, such as good will. ^ But not as a resuit of the prospective imposition of the tax. See infra, Chap. VII, p. footnote 126 for explanation. 325 situations^ that the proponents of current value argue that the original cost of firm investment does not represent the current value of the business and to base invested capital on such cost, therefore, will injure vested property interests by taxing a portion of normal profits or profits anticipated at the time of investment as excess profits. Arguments against recognition of current value. Never theless, it remains true, in the absence of taxable transfers of business property or interest subsequent to original investment, that the original investors are entitled to share in the profits of an enterprise only on the basis of the original money cost of their investment, not a higher or lower current value. If it is remembered that our residual claimant theory of excess profits calls for a recognition of the separ ate entity of the firm as distinct from its owners, the original stockholders, just as the contractual bondholders, cannot expect the firm to guarantee them a .stable return in real terms if the appreciation in asset values is due pri- 23 marily to monetary depreciation. By the same token, the ^ There is nb reason why the stockholders alone should be favored with a recognition of the appreciation in their stockholdings, since from the point of view of the firm there is economically no distinction between equity and borrowed capital. For a full discussion on this point, see Eliot Jones and Truman C. Bigham, Principles of Public Utilities (New York: The Macmillan. Company, 1937), pp. 222-223* 326 government cannot afford to discriminate among various groups of taxpayers toy allowing one group to earn a stable return in 2*f real terms while not doing likewise to others* If the interval between original investment and the imposition of the tax is not too far apart and the higher price level repre sents only a temporary shift in business conditions, cost is probably a better guide as the going-coneern value of busi- 2 5 ness than any current appraisal* The real problem arises when a young and efficient enterprise has attained maturity with an improved profit prospect during the interval between original investment and the imposition of the tax and has built up such a substantial intangible value in respect of good will and/or monopoly advantages that its current value is grossly out of proportion to the original cost of invest ment of its owners* In the absence of such substantial intan gible values, the allowance of accumulated earnings and prof- 26 its in the computation of invested capital will mitigate against, though it does not eliminatethe effect of failing to recognize current appraisal value* After all, retained earnings constitute the major sources of funds for the 2lf See infra, p* 390. ^ George 0. May* Financial Accounting (Hew York: The Maemillan Company, 19*+35 , p* 67* See infra, pp* 352-356* 327 27 expansion of young and growing enterprises and their inclu sion in invested capital makes up for a large part of the 28 probable difference between original cost and current value. But when the growing business has become so successful that its net worth is no longer indicative of its current value, based upon the capitalization of its prospective earnings, even the inclusion of accumulated earnings and profits for invested capital purposes will not be sufficient to allow an invested capital on which..a.fair rate of normal return may be expected. One reply is that the future profits, as indi cated to be in prospect by the existence of intangible values, are exactly the excess profits to be taxed and therefore should not be allowed to escape the tax by being capitalized into a higher current value for invested capital purposes. 29 Again, even in this case nonrecognition of current value, paradoxical though it may seem, works to the advantage of the taxpayer in terms of actual tax savings under most ordinary circumstances. Granting that an appraisal of the current worth ^ J. Keith Butters and John Lintner, Effect of Federal Taxes on Growing Enterprises (Boston: Harvard University Press, 19^5’ ), p. 6l. ?8 Bear in. mind that portions of these retained earn ings represent realized excess profits attributable to the intangible elements of a successful business. ^ The argument following applies to other situations, too, all depending upon the amount of trading profits. 328 of a business is practical, inexpensive, and, above all, 30 reliable, recognition of such current value for invested capital purposes will require the inclusion of the differ ence between original cost and current, value due to improved earnings prospect, in gross income subject to the excess profits tax by virtue of a long-standing tax practice and rule that Mno amount arising within the business can be allowed a tax-free fair return until it has itself passed 31 through the taxing machine**1 The * ' bunching” of this value increment with the regular trading income for the first year of the excess profits tax would almost certainly swell the tax liability to an unnecessarily. high. figure* What would be even more unbearable for the business is that it would then be required to pay a tax, most likely out of current trading profits or borrowed funds if profits were not enough for the purpose, on an uncertain increment in property value without In all probability it will be impractical, expensive, and unreliable. ^ Carl Shoup, ”The Taxation of Excess Profits Ily" Political Science Quarterly. LVI, Ho. 1 (March, 191 *-!), 8o. Shoup applies this rule to the valuation of invested capital only for years after the first year of the tax. This writer is of the opinion that it applies to all years including the first. The higher current .value of. invested capital.for the first year generally represents the excess profits to be prospectively earned in subsequent years. An excess profits tax on firm residual profits would not be worth its name if in practice such excess profits were statutorily allowed to escape the impost. first realizing on such increment* This also runs counter to the accounting principle that appreciation must first be *52 realized before it may be recognized in the accounts. Furthermore the argument does not stop here. Assuming a minimum excess profits tax of 50 per cent, such recognized increment as well as the amount includible in invested capi tal would be reduced by 50 per cent through a similar reduc tion in accumulated earnings and profits. Since we will propose a graduated rate structure, the reduction will be even greater, accentuating the tax disadvantage of a firm having irregular profits. ’ Miat the theorist considers to be the proper and fair thing to do for the taxpayer will turn out to be not only of dubious advantage to him but actually harmful. More mitigating factors. But this is not to deny that there exist few remedies for those owners who have bought their way into the enterprises affected at prices closely commensurate with their current values. To some extent they 33 will incur capital losses. However, for the real investor, 32 W. A. Paton and A. C. Littleton. An Introduction to Cor-porate Accounting Standards (Chicago: American Accounting Association, 19*+o), pp. 48-49. ^ See infra. Chap. VII, pp. *+9**—*+97, for more mitigating factors. 330 as distinguished from the speculator, such losses will be implicit only, since he is more likely to be interested in a fair and regular return on his investment than to look to 3^ capital appreciation for a speculative return* A moderate excess profits tax will probably not reduce dividends suffi ciently to seriously and adversely affect the securities 35 market* The fact that even the repealed 90 to 95 per cent excess profits tax did not exert any conspicuous effect on the annual aggregate dividends paid during,the war years, as com- pared with those paid immediately prior to the war, 31 * Marion H. Gillim, The Incidence of Excess Profits Taxation (New Yorks Columbia University Press, 19*+5) , P* 6 3• 35 Loc. cit. 3^ The following table of excess profits tax paid and dividends paid for the years as indicated is compiled from Table p. 19, Preliminary Report of U. S* Statistics of Income. 19^-6-Part II. (Figures are in millions of dollars.) Year Excess Profits Dividends Paid in Tax Other Than Own _____________________________________ Stock______ 1937 - 7,51^ 1938 - 5,013 1939 - 5,7*7 19^ 37^ 6,089 19^1 3,359 6,701 19^2 7,852 5,607 191 +3 11,291 5,728 19*w- 10,^32 6,057 19^5 6,557 6,081 19b6 268 7,502 The violent fluctuations in the annual aggregates of excess profits tax paid are not at all matched by similarly wide 331 substantiates our contention and bears convincing testimony to the great weight given to the importance of regularity in dividend payments as a deciding factor in dividend policy* The importance of dividend regularity cannot be overemphasized. It cultivates a loyal and attached group of stockholders who 37 hold their stock for investment and not for speculation. It also creates a strong credit for borrowing in the open 38 capital market. Uncertainty and irregularity are not con ducive to sound financial policy of the corporation, for speculation is encouraged and its credit may be adversely 39 affected. , f The need for a stable dividend policy has been made all the more necessary today because of the extensive ^ (Continued) variations in the annual aggregates of dividends paid. Instead, the differences among the latter, in spite of the excess profits tax, remain within the range of normal differences in the annual amounts of dividends paid during the period immediately prior to the war (or 1937-1939)> pre sumably varying only with business conditions. This is not to deny that the excess profits tax, or any other tax for that matter, tended to exert a depressing influence on the magnitude of total dividend payments. But for the war years as Indicated in the above table, such influence, if any, was scarcely operative. 37 Arthur S. Dewing, The Financial Policy of Corpora tions (Fourth edition without footnotes; New York: The Ronald Press Company, 19^1), p* 515« Loc. cit. ^ William H. Husband and James C. Dockeray, Modern Corporation Finance (Chicago: Richard D. Irwin, Inc• , 19^) , p. 4-99. 332 * 4 - 0 public ownership of corporations," It is perhaps wrong and at variance with the economic conception of equity or venture capital for the investor to expect regularity in *+1 dividend disbursements. But the small and casual stock holder is likely to have a greater need for a regular divi dend and, more important to the corporation, the small stockholders may not appreciate fully the reasons underlying l j - 2 the abrupt cessation of dividend payments. In all proba bility, therefore, a moderate excess profits tax will not lead to a change in the stable dividend policy of the cor poration. Ordinarily, the tax will probably cut down some- r what the amount of retained earnings in order for the * * ■ 3 corporation to maintain a stable dividend policy. Once a L.O Ibid., p. $01. ^ Dewing, op. cit., p. $16. k-2 _____„ «... . . kp . Husband and Doekeray, op. cit.f p. $01. ifO "Yet it is known that the amount of profits retained after the payment of dividends tends to vary directly with the rate of profit— that is, the more profitable corporations tend to distribute relatively less of their profits or dividends than do the less profitable corporations. Regular payment of dividends are, of course, essential to the maintenance of corporate reputations upon the capital market and hence are apt to vary relatively less over time than the volume of prof its retained within the corporate system. By imposing a special tax,upon the latter it is clear the most profitable corporations are apt to pay a larger tax of this sort than the less profitable corporations." (Temporary National Economic Committee, Taxation of Corporate Enterprise (Monograph No. 9. Washington, D. C.: Government Printing Office, 19*+1), p. 88.) The relevancy and significance of our proposed excess profits tax in this connection are beyond question. 333 dividend has been fixed and designated as a ^regular1 1 divi dend, it possesses the tendency to be fully maintained under Mf all ordinary circumstances. Now, if the yield of securi ties be the sole determining factor of their value, as the proponents of the recognition of current value must insist, the relative stability and regularity of dividends paid thereon should assure their holders of a relatively stable value. The extent of their capital losses, if any, should be limited under the assumed circumstances. Besides, the knowl edge that any such capital losses realized eventually upon the sale of their stockholdings will be offset against their income from other sources under our proposed treatment of 1*5 capital gains and losses as ordinary income and deductions, so that the government will directly share in such losses to the extent of the tax otherwise assessable against such income 1*6 without the offset, will lessen the effect of such losses on 1*7 the investment incentive. In this connection, it should also be pointed out that , the stockholders may arrange in advance to L lL l . Dewing, op. cit., p. 5lo. ^ See infra, pp. ^03-^0 6. 1* 6 Under the present individual income tax provisions individual taxpayers are allowed to offset such losses against other income to the extent of capital gains plus $1,000 or net income whichever is the lesser. (Sec. 117(a)(10)(B;, Internal Revenue Code) * * ■ 7 See suora. Chap. V, pp. 277-289. 33^- have their losses realized in the period most advantageous to them taxwise. Theoretical and practical defects of current value theory. The current value theory itself is not entirely free of defects, however, from the standpoint of both principle and practice. In principle the untenable nature of the imputation and capitalization theory may best be exposed by assuming the current value of the enterprise to be less than its original cost on account of earnings prospect being not quite up to original expectations. From the point of view of either the accountant, the business man, the banker, or even the economist adhering to the capitalization theory, the enterprise is losing money. But according to the strict logic and application of this imputation theory, the enter prise is not only not losing money but breaking even. We grant, for the sake of argument, that excess monopoly profits may be eliminated by computing invested capital on the basis of the higher capitalized value, but then we are also forced to accept that losses due to the decline in earnings prospect may be wiped out by computing invested capital on the basis of the lower current value. In.fact, it may be possible that an occasional windfall would cause an enterprise to show excess profits subject to tax at times it is really losing money in the ordinary usage of the term. That this portion of the 335 conclusion resulting from a strict application of the current value theory cannot be countenanced by us or anybody else k-8 needs no further comment. A theory is defective if it cannot work both ways and the current value theory is there fore defective. In this respect the originals cost theory is definitely superior. A practical defect of the current value theory lies in the insurmountable difficulties to be encountered in the ascertainment of the appropriate appraisal values not only of tangible business assets but of intangibles as well. Even if the accountants protest against recognition of unrealized 50 gains is overcome, there still remains the problem of appraisal and its attendant difficulties. What is meant by "current value?" Since business assets, by definition, con sist of property acquired for use rather than sale and which will be ultimately consumed in the business, and since the value of intangible business assets, such as good will, attaches only to a going concern, for which no ready market exists, there is clearly no exchange value for such.business The business man. cannot consider himself as having just broken even, because on the basis of the lower current value of his business he has broken even, when that value is much lower than the original cost of his investment. see suora. p. 323, footnote 19. Some accountants, like Broad, May, and Paton seem to have swung to the side of the economist. 336 property in the sense in which the economists use that term. Capitalization of net earnings may be regarded by some as a proper measure of value, but as we have pointed out above, its use is not acceptable, to us, inasmuch, as it would nullify our attempt to get at excess profits by enabling the taxable enterprise to retain not only normal but also monopoly prof its. The difficulties encountered in appraisal at reproduc tion cost are too familiar to need any elaboration and the reader is referred to any text on.public utility rate regula- 52 tion for further information. Besides its inherent practi cal difficulties, appraisal is sometimes prohibitively 53 expensive and its results may be unreliable. Since the assessment of the excess profits tax is an annual affair, the adoption of any appraisal revaluation measure by the framers of the tax would spell, its downfall even, before it were put ^ May, op. cit., p. 88. 52 One of such texts is Jones and Bigham, pp. cit., pp. 209-239. 53 One author writes that appraisers must invariably produce enhanced values in order to justify his engagement and to support his computations he must make assumptions that are thoroughly unrealistic. (E. L. Kohler, Auditing. An Introduction LNew York: Prentice-Hall, Inc., 19^7J, P- 127.) Sanders also had occasion to allude to “The fantastic results of those engineering estimates eventually brought them into general disrepute." (Thomas H. Sanders, "Depreciation and 19h9 Price Levels." Harvard Business Review. XXVII, No. 3 [May, 19^9], 303.) The unreliability of appraisal needs no further comment from this writer. 337 into practice. Thomas S. Adams once testified: I think that no one thing so conduces to delay and complexities of tax laws as the necessity for valuations. . . . It would follow from that, then, that valuations should he omitted and eliminated wherever possible. The practical difficulties and uncertainties of determining value by appraisal constitute a strong case for using original 55 cost for invested capital purposes. Cost versus value: elimination of discrimination. Briefly restated, the problem here concerns two establish ments possessing identical current value and similarly situated in other respects with the only exception that one of them for tuitously underwent a taxable reorganization prior to the imposition of a permanent excess profits tax. Assuming that current value exceeds original cost plus accumulated earnings sind profits, one firm would base its invested capital on cost while the other would be entitled to use current value, which was now the new cost to the new stockholders. According to some economists, the former would be discriminated against by being required to use cost for invested capital purposes. ^ Hearings. Select Committee on Investigation of the Bureau of Internal Revenue, United States Senate, Sixty-eighth Congress, 192*+, p. 2 6 9, cited by May, op. cit., p. 107. ^ May, op. cit., p. 102. Gf course, May was not deal ing with cost for excess profits tax purposes, but the argu ment he raised is directly in point, in the opinion of this writer. But from the point of view of the firm, the residual clai mant, the return on investment, be it contractual or equity, is to be allowed or computed only on the actual amount of capital contributed, not on some fictitious inflated amount. In theory, this is the only proper point of view, that of the taxable unit. From the standpoint of equity and fairness in tax practice and administration, there is much to be said for using cost in all and every instance. Now, in the case of a taxable reorganization or any taxable transfer, the original selling stockholders or owners would have realized the gains accruing to their business and paid a tax on such gains and the new acquiring stockholders or owners would have contributed into the capital of the new business an amount equal to its current appraisal value, including that of all intangible values that might have accrued in the past. Since they had made capital contributions equal to the current value of the business, they were entitled to a return on such cost or “current value.** If current value were allowed for 56 J An example will suffice. An old corporation whose net worth was determined to be $1,000,000 was sold to an acquiring corporation for $2,000,000, the former’s current value, whatever that might mean. The capital of the acquir ing corporation was stated at $2,000,000, contributed by its stockholders upon incorporation. It is now entitled to figure its invested capital, at $2,000,000 which is the original cost of investment of its stockholders. The old corporation would have a gain of $1,000,000 on which it must pay tax. invested capital purposes in the absence of any taxable trans fer, the original owners would be enabled to derive a return on an increment in value on which they had not paid any tax* In place of the type of discrimination we mentioned above, there is now a new kind of discrimination under which some owners are allowed to earn a normal return on what they have contributed to the capital of the business while others are permitted to earn a return on a fictitious amount which they have not contributed and on which they have paid no tax* Which type of discrimination is more serious is a matter of judgment* In view of the time-honored principle of account ing, almost universally followed, that recognition of apprecia tion in the accounts must be preceded by realization and in view of the long-standing practice of income tax administra- 57 tion adhering to this time-honored accounting principle, the adoption of any new tax measure that disregards such principle and practice will, in the opinion of this writer, not only throw its administration out of harmony with that of other taxes but automatically check its successful execution by failure to observe such rule* There is nothing so inimical 57 One exception relates to the allowance to recover March 1, 1913 (the date the income tax.first went into effect) value without recognition of gain* (Sec. 113(a)(1*0 *) Another refers to gifts or transfer in.trust made before January 1, 1921* (Sec* 113 (a) (*+) requires the valuation of such trans- . fers at the fair market value at the time of the transfers*) 3*4-0 to a successful tax administration and so offending to the taxpayers’ sense of tax justice as to institute different sets of rules of solution for different taxpayers on the same set of tax problems* Conclusion. On grounds of generally accepted account ing principles, long-standing tax practice, and the practical difficulties of appraisal determination of current value, we strongly recommend the adoption of the principle of cost valuation for purposes of the computation of invested capital. The perennial vested interests may be adversely affected to some extent thereby, but there are many other mitigating factors as to render inadvisable any basic departure from cost valuation on that aceount alone. The alleged discrimi nation among firms is only apparent. For other arguments in support of cost valuation, see the discussion in the subsec tion after next. INVESTED CAPITAL AFTER FIRST YEAR OF TAX The increase in capital investment subsequent to the first year of the imposition of a permanent excess profits tax should, without exception, be included in invested capital at cost. Whether improved earnings prospects should call for a revaluation at current value for some future tax able year is not seriously open to question. There is no necessity of raising cost to current value when improvements in earnings prospects have already reached or passed the level of exempt normal earnings, for regardless of how valid the theory of current value is, when the level of normal earnings is reached, it is no longer necessary to consider the raising of cost to current value to preserve incentives to invest, venture, and work, or to protect any interest that 58 was vested before the tax was introduced. Prospective investors or owners of business enterprise will take the excess profits tax into consideration in evaluating its worth. TWO MORE ARGUMENTS IN SUPPORT OF COST VALUATION On the strength of long-standing tax practice and accounting principles we have rejected the current value con cept of invested capital in favor of the original cost theory. There are other arguments, however, to support our position which we have not seen fit to inject in our discussion until now and which we are to discuss hereinafter in this subsec tion. One of these arguments we had occasion to state briefly 59 above should now be expanded. It has to do with the business enterprise as the residual claimant in our residual claimant theory of excess profits. 58 Shoup, op. cit. T p. 8h- . 59 Supra, pp. 325-326, especially footnote 23. 3^2 The use of current value incompatible with the residual claimant theory of excess profits. The current value or the capitalization theory approaches the phenomenon of profits from the standpoint of the owner. Under the traditional theory of private property the owner has a theoretical as well as an exercisable legal right to appropriate all firm profits, whether these profits be normal or excess or monopoly profits and whether or not they are functionally attributable to him. It is therefore natural that a capitalization of such appropriable profits yields the value of the ownerfs right. This is still the situation prevailing in all unincorporated enterprises as well as in small and close corporations. It is inapplicable, however, to a vastly more important segment of the business world represented by the large corporation. This traditional concept is untenable in such a world, as we 60 belabored the point elsewhere in this study, for the legal owner is no longer able to exercise control over corporate profits and assets, though they may still have the nominal right to do so. The theoretical claim that capitalization of earnings will yield the value of the stockholdings can have reference only to the dividends the stockholders receive periodically at the pleasure of the corporate directors over whom the majority of them are unlikely to have control. Supra. Chap. Ill, pp. 132-1^3 3*e Capitalization of corporate earnings does not, a priori. yield the value of the total outstanding stock, in. view of the wide spread divorce of ownership from control, though such earnings 61 may still be indicative of the trend of such value. Regard less of how valid the principle involved may be with reference to the traditional theory of profits and property, it is incon sistent with our residual claimant theory of excess profits with the firm as the separate residual entity on which the tax is to fall. When this separate entity is maintained, the security quotations immediately become irrelevant in the determination of corporate profits, toward the earning of which such quotations can have no functional contribution. The dividend yield of corporate stock might be more indicative of the normal profits rate of a particular corporate entity if it were less subject to manipulation by the controlling 62 interest. Economically speaking, the owners of large as well as small enterprises do not possess a functional claim 63 to monopoly or excess profits, though the owners of such Stocks were sold on the market from 1871-1937 con sistently at about 72 per cent of their true value based upon earnings, which was 39 per cent above market. (Alfred Cowles, 35d, et al., Common-Stock Indexes, 1871-1937 [Bioomington, Indiana: Principia Press, Inc., 1938], p. H-3-) The policy of maintaining dividend stability exerts an opposite influence. ^ Supra. Chap. IV, pp. 222-230. 3M+ small enterprises do have both the legal and the actual right to appropriate them. It is with respect to the taxation of these unnecessary excess profits that we propose our taxing measure. It is to replace the traditional theory of profits and property which can no longer explain the economic phenomena brought about by the rising institution of the large corpora tion, that we have developed and formulated our own residual claimant theory of excess profits. From the standpoint of the firm as the residual claimant, the equity owners are no different from any other class of creditors and their share of the firm profits, necessarily imputed and computed under the existing institutional setup, bears the same characteris tics as the remuneration of any other contractual agent of production. The residue of profits, after allowing for the reward of all factors, accrues to the firm, the residual claimant. The excess profits tax we propose as an exclusive 65 business tax aims at taxing the firm on this residue. ■ As such, the title "excess profits tax*1 is, perhaps, not par ticularly apt, if it is not exactly a misnomer. The name 6 if Here the factors obviously do not include that of organization, or the firm. ^ The state, as encompassed in the factor of organi zation. under the broad definition of the term (supra, Chap. IV, pp. 2b6-2)+7), shares in this residue by way of taxation. 3^5 66 “residual profits tax” would be much more appropriate, 67 though in reality and practice they are one and the same thing. Actual experience with the invested capital method based on cost valuation. A tabulation of some statistics and computed percentages^ concerning the number of excess profits tax returns filed during the period from 19^1 to 19*+6, based upon both of the alternative methods of computing exempt normal profits, reveals the fact that an increasing number of corporations had found it advantageous to use the invested capital method based on cost despite the alleged serious defects of that method as maintained by economists. For all the years indicated increasingly more than 50 per cent of the returns were filed under the invested capital method. This corroborates Paul's remark that . . . although relatively the invested-capital credit was made less attractive and the average- earnings credit more attractive, more companies were using the invested capital credit. These percentage figures also attest to the fact that the use ^ In addition, the word “residual" is much less offen sive, provocative, and susceptible of moral implications (and, on account thereof, much more palatable to the business man) than the word "excess." ^ For one possible difference, see infra, p. 353• ^ Compiled by this writer and shown on page 3^6* 69 Randolph E. Paul, Taxation for Prosperity (New Yorks The Bobbs-Merrill Company, 19V 7), p. 79* 3»+6 N u m b e r of R e t u r n s’ * c Year Aggregate Invested Capital Method Average Earnings Method No. % No. % No. % 19*+1? 3 8 ,2 6 2 100 19,*+93 51 18,769 *+9 191 +2t ) 5*+,002 100 3 1, 86*+ 59 2 2 ,1 3 8 *+1 19^35 6 8 ,2 0 2 100 $ + ,3 8 6 65 23,816 35 19M+d 55,888 100 36,762 66 19,126 3*+ 19*+5® 52,098 100 35,831 69 1 6 ,2 6 7 31 19i +61 11,053 100 8, 1+80 77 2,573 23 * Data were obtained from JJ. S. Statistics of Income, Part II, for the years indicated* a Table 11, 2*+0-*+3. b Table 10, 302-0*+. c Table 10, 308-11. ^ Preliminary Report, Table 3, 18-20. e Preliminary Report, Table 3, 18-19* f Preliminary Report, Table 3, 17-18. of original cost for invested capital purposes did not and will not understate invested capital and "penalize** many investors in a majority of cases because of the relatively low level of earnings for most businesses even in a base period of con- 70 siderable prosperity. Adams1 claim that the invested capital Prosperous periods like that of the twenties can never be chosen as the base period, for that choice would negative any attempt at taxing excess profits. 3 ±7 computed under the excess profits tax provisions in effect during World War I fairly represented business capital entitled to normal return in a large majority of cases and only in about 15 per cent of the cases were there such * extreme aberrations as to accentuate the injustices of the 71 tax, is nearer to the truth than it first appeared. Another aspect of the controversy between the propo nents of original cost and those of current value, namely, depreciation, will be examined fully in subsequent subsection. Conclusion. On grounds of accounting principles, long standing tax practice, and the practical difficulties of appraisal determination of current value, we conclude by way of a strong recommendation for the adoption of original cost for purposes of the computation of invested capital in regard to the imposition of a permanent excess profits tax. CONTENTS OF INVESTED CAPITAL It goes without saying that proprietorship capital and common stock representing equity capital is to be included in invested capital under all circumstances. Question arises whether borrowed capital, rentor*s capital, preferred stock, and accumulated surplus should also be so included. ^ Thomas S. Adams, “Should the Excess Profits Tax Be Repealed?*1 Quarterly Journal of Economics. XXXV (May, 1921), 379. 3^8 Borrowed capital* From the standpoint of principle in agreement with our residual claimant theory of excess profits, borrowed capital must be excluded from invested capital and contractual remuneration, including interest and wages, must be deducted in arriving at residual profits. To impute to contractual agents of production normal earnings which may be either larger or smaller than the actual contractual remunera tion is not consistent with the principles of the residual claimant theory of excess profits, inasmuch as such imputa tion process exempts excess profits arising from the under payments of contractual agents of production from the tax and penalizes the enterprise for the overpayments of such agents. From the administrative and the technical points of view the conclusion is also exclusion. Exclusion entails administrative convenience. There will be no need to dis- 72 tinguish long-term and short-term borrowing and the intangi ble element of personal credit representing capital at stake in the case of owners of unincorporated enterprises need not 73 be considered. It further prevents borrowing idle capital 7b at low rates to attain evasion of the tax. In some cases 72 Accounts payable, for instance, did not come within the definition of “borrowed invested capital" under Sec. 719(a). 73 Shoup, 0£. cit.f p. 90. Ibid., pp. 91-92. assets and goods may be purchased with borrowed capital, the interest on which is hidden in the purchase prices, and hence is being deducted in computing net ineome either as cost of 75 goods sold or as depreciation (in part only)• The one positive merit of excluding borrowed capital from invested capital is the encouragement of venture and equity investment which is doubtless conducive to economic stability and has 76 always been regarded as sound financial policy. Rentor* s capital. The problem of rentor*s capital would not enter the discussion if the problem of borrowed capital is settled in favor of exclusion, as held above. We will, however, review the arguments for and against the 75 Loc. cit. When interest is merged with cost of goods sold and depreciation deduction, the inclusion of the indebtedness on which the interest is owing would produce a double deduction for excess profits tax purposes on account of such indebtedness: first, as interest and secondly, as part of the exempt normal earnings attributable to such indebtedness. 76 ( See Modern Corporation Finance by William H. Husband and James C. Dockeray (Chicago: Richard D. Irwin, Inc., 19*+^ ) pp. 793-791 N for a conscious policy of encouraging risk and venture capital through taxation. The one possible disadvan tage of excluding borrowed capital lies in the possible hard ship which exclusion might bring about especially to young, growing enterprises which must borrow heavily to take advan- tage of opportunities before they vanish. (Carl Shoup, “The Concept of Excess Profits under the Revenue Acts of 19l +G-191 +2, Law and Contemporarv Problems. X (Winter, 19**3) * 28-1 +2, reprinted in Viewpoints on Public Finance, edited by Harold M. Groves (New York: Henry Holt and Company, 19**7), P* 18*k) If this possibility should arise, it would be a problem for the relief provisions of the tax. 350 inclusion of rentor's capital, as if borrowed capital were taken into invested capital, to see whether there is any intrinsic merit in recognizing rentorfs capital. The problem arises as follows: long-term notes, say maturing in twenty years from the date of purchase of assets therewith, are includible in invested capital according to our assumption and the depreciation of the assets acquired with these notes is deductible in arriving at net income subject to the tax. But if the same assets were rented on a twenty-year lease, invested capital would not be increased by the execution of the lease, though the rent paid in the next twenty years would be deductible for excess profits tax pur poses. The inequity of the situation is serious only when the rent deduction is considerably less than the depreciation deduction plus the statutory percentage times the declining 77 balance of the notes over the twenty-year period. In order to eliminate this possible inequity, the present value of the twenty-year lease, obtained by capitalizing the stipulated rent payments over the same period, may be included in invested capital. Its inclusion would, of course, entail the disallow ance of the deduction for “that part of the rent paid over and above the part that is, to the owner, a return of capital, ^ That is, assuming other things being equal. 351 to cover the wear and tear on the equipment.w'7® it can be readily seen that such division of rentals into two hypotheti cal parts would lead to unnecessarily complicated technical problems and administrative headaches. Besides, it would introduce another souree of escape from the excess profits tax and therefore would be inconsistent with our residual 79 claimant theory of excess profits. Preferred stock. Inclusion of preferred stock would produce discrimination between raising capital by issuing preferred stock and that by issuing bonds or other long-term obligations, since we have now excluded the latter from the 80 concept of invested capital and the statutory normal rate is ordinarily higher than the interest rate on long-term 81 bonds. This inequitable situation may, however, be 78 f Shoup, op. cit•, p. 9 8. This disallowance is justi fied on the theory that the rented equipment would now be regarded essentially the same as the assets bought with bor rowed money. 79 Since the complicated treatment would be resorted to only when it would produce a lower tax. American experience has indicated that there was a noticeable tendency for corporations to retire bonds by new issues of preferred stock as a result of the exclusion of borrowed capital under the provisions of World War I excess profits tax. “Report of Committee on Federal Taxation, “ Pro- , ceedines of National Tax Association. 1919j PP* 359-360, cited by Shoup, op. cit., pp. 94-95. According to Husband and Dockeray (op. cit.. p. 72), industrial preferred are typically 6, or 7 P©** cent stocks; public utility preferred carry rates of 5 and o per cent; and 352 eliminated by requiring that preferred stock be included at its stipulated rate of dividend. Furthermore, to require the inclusion of preferred stock at its stipulated rate of dividend possesses the merit of being in accord with our residual clai mant theory of excess profits. Finally, the inclusion of preferred stock at actual dividend rate will do away with many technical difficulties involved in case of exclusion since much preferred stock contains strong doses of common- 82 stock element. Accumulated earnings and profits or surplus. In strict compliance with the principles of our residual claimant theory of excess profits, accumulated earnings and profits or surplus, except to the extent that such surplus represents the undis tributed normal profits, are not includible in invested capital. However, arguments are legion in favor of the inclu sion of all accumulated earnings and profits. This writer is of the opinion that it is a wiser course to permit recognition (Continued) railroad stocks are concentrated at ** and 5 per cent. Accord ing to the same authors (op. cit., p. 338), money rates on high-grade industrial bonds varied from 5•Ob to 2.^3 per cent in the period of 1925-191 +0. (The authors' figures were based on data furnished in Base Book and Current Supplements. by Standard Statistics Company. Shoup, op. cit., pp. 9^-95. It is understood that in case no rates are stipulated, the statutory rate is to be used. 353 of accumulated earnings and profits for invested capital pur- 83 poses for the following reasons. For the new, young, and growing enterprise the disallowance of surplus for invested 8 lf capital purposes might be disastrous. For all enterprises the actual determination of normal profits exempt from tax may require a large margin of error to insure the equitable ness of the tax and that portion of the accumulated earnings and profits over and above the undistributed normal profits may be just the cushion needed for this purpose. Even though security values are not likely to be much affected and much less likely to be determined by past earnings, the size of accumulated earnings and profits of an enterprise may indicate its ability to withstand the onslaught of a business recession 85 or depression. This fact alone may have some bearing in the determination of normal profits. Lastly, the objection to the tax from the side of business may be softened more by the inclusion than by the exclusion of accumulated earnings and profits. The problem of the technical computation of accumulated ^ This represents the only instance where the residual claimant theory of excess profits and our proposed tax measure are not in perfect harmony. Supra. pp. 326-327* ^ Supra. Chap. Ill, pp* 175-180, passim. earnings and profits is in general similar to that in eonnec- 86 tion with income tax administration. One of the disputed points in regard to the computation has been settled by the United States Supreme Court in the South Texas Lumber Co. case, 333 U. S. **96, 35 A.F.T.R. 15?6. It has to do with the inclusion of the deferred profit on installment sales for invested capital purposes. Section Mf(b) of the Internal Revenue Code permits the reporting of the gain from sale of real and personal property on the so-called installment basis, that is, instead of having to return the entire gain from such sale as income for the year of sale, the taxpayer is allowed to return as income only that proportion of the install ment payments actually received in that year or any year subse quent thereto which the total computed gross profits bears to 8 7 the total selling price. The question involved in South Texas Lumber Co.. supra, is this: Is the taxpayer entitled to include the entire gain as part of the accumulated earnings and profits for invested capital purposes when he has availed himself of the installment basis of reporting gain under Reg. 112, Sec. 35«7l8-2(a)s "In general, the con cept of 'accumulated earnings and profits' for the purpose of the excess profits tax is the same as for the purpose of the income tax." The term "selling price" should be replaced by "con tract price" in order to be technically correct. But ordinar ily, in the absence of assumption of liabilities on the assets sold, selling price and contract price are one and the same thing. 355 Section In holding for the Commissioner the Supreme Court denied the taxpayer the use of the unreported gain as part of the accumulated earnings and profits and approved a long-standing income tax regulation of the Commissioner in connection with the determination of earnings or profits for income tax purposes. Reg. Ill, Sec. 29*115-3, prescribing the proper method of computed accumulated earnings or profits, provides that, . . . the amount of such earnings or profits in any case will be dependent upon the method of accounting properly employed in computing net income. . . . a corporation computing income on the installment basis as provided in section M+ shall, with respect to the installment transac tions, compute earnings and profits on such basis. . . . The principle of this regulation is in perfect harmony with 88 existing accounting standards. From this it may be inferred that the accounting profession, the tax administration, and the highest court of the land are not very sympathetic to the economists claim that current values be used for purposes of 89 computing invested capital* Tax justice demands that such George H. Newlove, C. Aubrey Smith, and John A. Tsttiite, Intermediate A,ccounting (Hew Yorks D. C. Heath and Company, 1939), pp. ^15-^16. 89 ' The allowance by the court of the unreported or unrealized profit or gain resulting from the installment sale would have meant the effective use of current value (of the asset or assets sold on such installment basis) for invested capital purposes. 356 long-standing tax practice as embodied in the regulation cited 90 above be maintained without unwarranted modification. Intangible assets. The term “intangible assets” is defined herein to mean the intangible value of the business embodied in good will, trade-marks, trade-naraes, patents, et cetera. It does not include stocks and bonds. Our prin ciple of original cost convention does not permit the recog nition of the current value of any of the above-mentioned intangibles arising from the operations of the enterprise. Their invested capital status is conditioned entirely by the existence of acquisition costs at the time of purchase, incorporation, organization, or a taxable transfer or reorgan ization. There are exceptions to this rule with respect to good will and other property acquired prior to March 1, 1913, and December 31, 1920, provided Section 73^, relating to 91 inconsistent position, does not apply. The advantage to 90 This writer has had some personal experience with a tax case in which the inclusion of the unreported or unreal ized gains on the sale of practically all of the assets of a corporation would have not only wiped out all deficiency assessments by the Commissioner, but resulted in a refund, which, in the opinion of this writer, that corporation did not deserve. The South Texas Lumber Co. decision, supra, prevented this from happening. ^ Montgomery^ Federal Taxes— Corporations and Part nerships . 19*+6-V7 (New Yorks The Ronald Press Company, 19^7)» II, pp. 379~382. 357 the taxpayer of “stepping up the basis'* at the date of acquis ition will not be so great, however, in the case of depreci able property, such as patents and other intangibles with a limited term or life, since depreciation allowance after 92 acquisition will reduce accumulated earnings and profits. Inadmissible assets. It is for the sake of the preven tion of tax avoidance through the accumulation of "inadmissi ble assets" that the exclusive liability side approach to invested capital gives way to the asset side approach. Sec tion 7 2 0(a) of the repealed excess profits tax defines ‘ Inad- .missible assets" as consisting of stock in any corporation except a foreign personal-holding company and stock which is not a capital asset and of certain government obligations the 93 interest on which was tax-free. The exclusion of borrowed ^ Ibid., p. 3 8 0. It should be noted that the stepping up of the basis at the date of acquisition or reorganization will always work to the advantage of the taxpayer, inasmuch as invested capital is thereby increased than it otherwise would be. The quoted passage (paraphrased), however, merely refers to the comparative advantage of stepping up the basis of nondepreciable intangibles and depreciable intangibles. Even then, the comparison stated in the test is not conclu sive, for depreciation on depreciable intangibles reduces taxable income while nondepreciable intangibles do not. No attempt will be made here to render a full comparison, as a conclusive statement on this topic is not pertinent to our discussion and the issues involved are far too complicated to be amenable to handling within a footnote. 93 An election is allowed the taxpayer by Sec. 720(d) to treat such government obligations as admissible assets, pro vided it includes such tax-free interest in income. 358 capital for invested capital purposes eliminates much of the problem, since now it will not be advantageous taxwise to resort to borrowing to carry tax-free securities. The inad missibility of stock in domestic corporations, however, still applies. It effectively prevents the same amount of stock from double reckonings once in the invested capital of a parent corporation and second in that of the subsidiary or 9b subsidiaries. Furthermore, since dividends from domestic corporations are not fully subject to the tax through the 85 95 per cent dividends received credit, the disallowance of domestic stockholdings from the computation of invested capi tal is again justified. The problem of inadmissible assets relating to individ ual proprietorships and partnerships and other unincorporated businesses will be much more difficult to solve than that relating to incorporated businesses. To prevent the carrying of stocks and bonds as business assets which belong personally to the proprietors and partners, thereby improperly swelling the amount of invested capital and augmenting exempt normal profits, a way must be devised either to eliminate such stocks ^ In case of consolidated returns by parent and sub sidiary companies, intercompany stockholdings must be elimi nated. (Montgomery1s Federal TaxesT op. cit., pp. 7b7-7b9«) ^ Sec. 26(b). 3f?9 and bonds entirely from invested capital or to include them at their actual yield. To equalize between incorporated and unincorporated businesses, the same may have to be required of the corporations, even though it is the general rule that all the assets of a corporation are ordinarily considered business property. II* THE DETERMINATION OF THE STATUTORY RATE M. NORMAL PROFITS Introduction. We are not here concerned with the mechanics or the process of the determination of the statutory rate of normal profits, or with the determination of the actual rate itself. Only the principles involved in the derivation of the statutory rate will be discussed. As we mentioned above, appeal to the base-period experience has no place in the framing of a permanent excess profits tax and therefore the percentage return on invested capital must not require base-period experience for its determination. The percentage return or the statutory rate of normal profits, according to one author, has been derived primarily from general observa- 96 tion by or common sense approach of the lawmakers. **The basic problem is, of course, how to apply general observation ^ Shoup, f , The Taxation of Excess Profits I,” p. 360 or common sense to get a reasonable percentage."^ It is interesting to note that none of the percentages used in the excess profits tax provisions in the past were arrived at by large-scale statistical study. Legislatures of most coun tries assumed that something in the neighborhood of 8 to 10 98 per cent was appropriate. With regard to American experience 99 the 8 per cent statutory rate was set a little high as com pared with the level of earnings of a majority of business corporations during their base-period years. ^ Shoup, loc. cit. 98 Loc. cit. The statutory rate declines slightly as the amount of invested capital increases. (Supra, Chap. II, p. 77*) 100 Supra, pp. According to Monograph No. 12, of the Temporary National Economic Committee, profits after taxes accruing to stockholders for the period from 1909 to 1937 provided a rate of return which, based upon contemporane ous book values of their equities, ranged from 5 to 7 per cent. (Profits. Productive Activities, and New Investment (Washington, D. CT: 19^1)Y p* 23*) The 8 per cent statutory rate was obviously a bit high. Another possible criterion for gauging the excessiveness of the 8 per cent statutory rate may be the 5 per cent average yield of common stock for the 67 years from 1871 to 1937» as obtained by the Cowles Commis sion for Research in Economics. (Alfred Cowles, 3rd, and Associates, Common-Stock Indexes. 1871-1937 (Bloomington, Indiana; Principia Press, Inc., 193°), p. 4*1.) The results would not have been comparable, since the 5 percent was obtained by comparing cash dividend payments to stock prices, had it not tallied well with the Temporary National Economic Committee's 5 to 7 per cent. In other words, other things being equal, the book values of stockholders' equities were good indicators of the market values of their stockholdings. 361 FACTORS AFFECTING DERIVATION OF STATUTORY RATE In spite of this general observation or common sense approach to the determination of the statutory rate of normal profits, there are, among others, a few relatively important principles which must be considered in order that an equit able scheme may be developed to equalize the differences in the economic situations in which the various taxable units find themselves. These principles have been discussed else where in this study and will therefore be presented here again only in summary form with the exception of the first of such principles. Effect of unlimited liability. The subjection to the tax of all incorporated and unincorporated business enter prises whenever they meet the income requirements calls for a consideration of the effect of unlimited liability on the determination of the statutory rate of normal profits. Appar ently under the theory of unlimited liability an individual proprietor’s entire private wealth, whether devoted to busi ness or not, is subject to appropriation to pay his business debts. The question arises whether only those personal assets devoted to business use or the entire personal assets at stake on which the statutory rate is to apply. One solution to this problem is to set the invested capital of unincorporated busi nesses at an arbitrary amount, roughly 50 per cent above the 362 amount actually engaged in business operations unless other personal assets not devoted to business use are smaller than the 50 per cent."*^ The administrative difficulties to be encountered on this score alone are likely to be overwhelming. Small businesses sometimes do not keep adequate records upon which a correct amount of business assets, let alone personal assets, may be ascertained. Proprietors are apt to make no distinction between his business and personal assets. Since there are numerous unincorporated business units, no suffi- 102 cient attention can be given to all eases of laxness. But the exclusion of personal assets of the proprietor or proprietors which generally constitute an important con sideration in obtaining business loans from banks and creditors would seem to be inconsistent with the theory that only assets used in business operations may be included for invested capi tal purposes. In other words, the assets, say, personal resi dence and bank savings, may be personal, but since they are part of the consideration for granting a business loan by the bank, they may be considered as being used in business and the proprietor should be entitled to Include them for invested Shoup, "The Taxation of Excess Profits III," Political Science Quarterly. LVX, No. 2 (June, 19*+1) , 227-228. 102 Ibid., p. 228. 363 103 capital purposes. Their inclusion would further tend to lessen the harsh effect of the exclusion of borrowed capital for the small, growing businesses. To prevent the abuses likely to arise from the inclusion of personal assets, the filing of consolidated returns by affiliated enterprises 10*+ should be made mandatory. In order to receive the bene fits from the inclusion of personal assets, the small pro prietor may be required to maintain accurate records regarding 105 tnem. The following summarized statements represent this writer*s common-sense approach to a final solution of the perplexing problem of unlimited liability in connection with a permanent excess profits tax: 1. The invested capital of unincorporated businesses ^ jjjq inclusion for invested capital purposes on equitable grounds of personal assets instrumental in obtaining bank and other credits was suggested to this writer by Harold N. Finkel, partner of Finkel and Finkel, C. P. A. Even though this represents another aspect of the problem of unlimited liability concerning unincorporated businesses, this writer considers it as possessing sufficient merit to warrant separate statement. loJ+ Mandatory consolidated returns in case of Inclu sion of personal assets when affiliated enterprises are involved were also recommended by Mr. Finkel. 105 -pkis should not work undue hardships on the pro prietor, especially when the specific exemption is set at a relatively high level, for those proprietors affected would have considerable accounting to do for their other business assets anyway. 36»f should generally be based upon capital actually contributed to and used in business operations. This is in conformance with our residual claimant theory of excess profits. But when firm credit position is enhanced by the possession by its proprietor of personal assets of considerable value, the usefulness of these assets to business operations cannot be gainsaid and their inclusion for invested capital purposes may be permitted. Accurate records must be kept as a pre requisite for inclusion. In case of affiliated enterprises, consolidated returns may be required to prevent the abuse of the privilege of inclusion. 2. The specific exemption of the excess profits tax must be set sufficiently high as to reduce the administrative difficulties to a minimum in respect of the taxing of small 106 unincorporated business enterprises. 3. For those unincorporated businesses which are sub ject to the tax despite the level of exemption, the statutory rate of normal profits should be adjusted to reflect the rela tively greater degree of risk involved in operating an unin- 107 corporated business than an incorporated business. Effect of size of enterprise. The height of the 106 Infra, pp. 1* 18-1*21. Supra. Chap. IV, pp. 2^1-255* 365 statutory rate varies inversely with the size of the enter- 108 prise. Effect of loss offsets. The degree of availability of or ability to benefit from loss offsets should be considered in setting the height of the rate, which should also vary 109 inversely with the size of the enterprise. 7 As a complemen tary measure, the loss-offset mechanism should be so devised as to benefit small business to a larger extent than it did enjoy under that of the repealed excess profits tax. Risk and the statutory rate. It is to be noticed that among the above list, risk, commonly regarded as an important factor in the determination of the statutory rate of normal profits, is conspicuous by its almost total absence. But if the reader has thoroughly familiarized himself with the dis cussion in Chapter V, supra. he will immediately be aware of the fact that the degree of risk, as a correlate of size and loss offsets, is implicitly considered when these latter two objective manifestations of such degree of business risk are dealt with. The repealed wartime excess profits tax dealt with risk and size by providing for a gradual reduction in the statutory rate of return on invested capital as the latter 108 Supra. Chap. V, pp. 289-299* *^9 Supra. Chap. V, pp. 278-289. 366 110 increased in amount. The rate of reduction may be set somewhat steeper when the ability of large enterprises to avail themselves of the benefits of loss offsets is also taken into consideration. Administratively, the manipulation of the rate of return in accordance with the objective standard of the amount of invested capital lends itself to standard and general treatment. Admittedly, it does not solve all the problems regarding business risk. But when the tax rates are moderate, even this defect of the tax may not entail serious consequences. If remedy is insisted upon, special relief provisions must be resorted to as stated above. This “safety valvef l of the excess profits tax can deal not only with the risk problem of established businesses but with the more urgent considerations of a new, growing enterprise. The subject of relief under any system of excess profits tax is important, difficult, and indispensable, especially when the rates are high. Its administration is even more difficult and time-consuming. III. MISCELLANEOUS TECHNICAL CONSIDERATIONS Certain technical problems raised by the imposition of a permanent excess profits tax and the principles involved in their solution will be discussed hereinafter. No attempt will 110 Sec. 71^. 367 be made, however, to answer all of the questions which may arise, even if that were possible. These problems center around nine major topicss depreciation; percentage depletion; capital gains and losses; accounting period and income aver aging; loss carry-over; specific exemption; the rate structure; revenue and administration; and suggestions for integration. DEPRECIATION Accounting for depreciation based on cost. Accounting for depreciation is an orderly procedure, consistently applied, designed to appropriately apply the cost of productive facili ties having a useful life of more than one year to the fiscal periods during which they are expected to be useful. The pro vision for depreciation has no direct reference to "the purely physical processes of decay, deterioration, et cetera, although physical changes may be in whole or in part responsible for economic extinguishmentAs such, the depreciation reserve should not be construed as to signify a section of surplus or a fund of liquid resources available for replace- 112 ment. As stated above, the purpose of depreciation account ing is to assign the cost of plant to operations, and hence 111 W. A. Paton, Advanced Accounting (New York; The Macmillan Company, 19*fl) , p. 2^6. 112 Ibid., p. 273. 113 to revenues, in an orderly, reasonable manner. 368 The economist»s challenge. This concept of cost depre ciation has been preached and practised by accountants for the last century or so. But recently, rising prices and the cor respondingly reduced purchasing power of the dollar in the postwar era have led to the clamor for the abandonment of this traditional cost approach to depreciation in favor of the recognition of replacement value as the proper basis for accounting depreciation of fixed assets. The issue is not exactly new. Many accountants who had sanctioned plant asset write-ups during the twenties, only to be blamed later for thus being responsible for the general downfall during the ll*f thirties, probably know what is involved in this basic change in accounting procedure better than most of the pro ponents of the change. Testifying before the Flanders Committee of Congress, Slichter maintained that corporate profits had been overstated during the period from 19^5 to 19*+8 by approx imately $16.5 billion.1' 1 ' ' * The amount of the overstatement 113 Ibid.T p. 272. llH- Thomas h. Sanders, “Depreciation and 19*+9 Price Levels,*’ Harvard Business Review. XXVII, No. 3 (May, 19^9) * 30^. Hearings. before a Subcommittee of the Joint Com mittee on the Economic Report, Testimony of Sumner H. Slichter. T.flmnnt University Professor. Harvard University. December 6, 19^8, "cited by John W. Welcker, “Divergent Views on Corporate Profits,” Harvard Business Review. XXVII, No. 2 (March, 19*+9)* 255. 369 was attributed by Slichter to the rise in cost of replacing inventories and fixed assets, which the accountants were said not to have taken sufficiently into account in computing prof its, The failure to take cognizance of such rise in cost was, according to Slichter, due to the slowness of the accountants in developing accepted procedure for dealing with permanent changes in the price level. Many in the accounting profession, either of their own belief and understanding of economics or influenced by the apparent logic behind the economist’s theo retical argument, have also questioned the adequacy of deprecia tion based on cost to cope with the changing purchasing power of money. With no intention to quarrel with anyone in par ticular, this writer wishes to examine this replacement cost concept of depreciation from the point of view of both theoretical validity and consistency and practical appliea- 116 bility. Il6 The discussion to follow is confined exclusively to depreciation accounting. Accountants' use of the "last-in, first-out" method of costing inventories has tended to blunt the charge that their strict adherence to cost in respect of inventories has resulted in the overstatement of corporate profits. (For a seconding view, see K, Lacey, "How the Last-in First-out Principle Encourages Economic Stability," Journal of Accountancy. LXXXVII, No. 3 (March, 19^9), 200-05*) According to one author, however if Lifo is intended roughly to match current costs against current income, it is necessary that an extension must first be made of the practice to set up reserves for replacement, so as to provide for all cases of inventory liquidation. (Samuel J. Broad, "The Impact of Rising Prices upon Accounting Procedures," Journal of Accountancy. LXXXVI, No. 1 (July, 19^8), l1 *.) In other words, strictly speaking, 370 The replacement cost concept: the theory. A more understandable account of Slichter's theory is contained in Sanders' “Depreciation and 19**9 Price Levels," cited above. 118 According to this theory, to which Sanders agrees, economic income is determined only when current costs have been charged at current price levels against current dollars of gross 119 revenues. A variety of this theory argues that for pro ductive enterprise earnings cannot be considered as economic income unless and until they have been charged with the pro vision for the cost of replacing materials and equipment used 120 up in the process of production. A corollary of this latter version of the theory stipulates that “the depreciation allowance is adequate only to the extent that it provides a fund for the replacement of new efficient equipment of an 121 equal economic value." Thus, (Continued) Lifo is based on cost, not replacement cost, allowing the more recent or current cost of inventory purchases to be cost out first. Lifo inventorying is therefore not equivalent to replacement cost inventorying. ■^7 Supra, p. 3 6 8, footnote ll1 *. Sanders agrees in theory only. When it comes to practical application of this theory, his views veer toward opposition. See infra, p. 390, footnote 165* Sanders, op. cit., p. 295- Broad, pp. cit., p. 11. Dewing, pp. cit. T p. 379* (Italics supplied.) . . . the depreciation allowance must be adjusted from year to year in accordance with the purchasing power of money so that the fund, gradually accumu lated by successive income allowances through the years, shall be adequate to buy the replacements, even though the cost, through rising prices, has been greatly enhanced.122 So much for a statement of the theory itself. It appears to this writer that the concept of economic income as envisaged by the proponents of the replacement cost con cept is extraordinarily succinct and unusually definitive, considering the elusiveness of the term “real" or "economic" income as understood by economists in general and consider ing the vast amount of literature devoted to its discussion. The economic, income, defined as net business earnings after current costs have been charged at current price levels against current dollars of gross revenues, does not corres pond at all to the definitions of the same term as advanced by Fisher.To the extent that the decline in the purchas ing power of money has not been given effect in determining net income, the latter still is not "economic" income in the true sense of the term, as put forth by Fisher, even though 122 Dewing, loc. cit. These statements were made in connection with an exposition of the economic definition of depreciation. Dewing's own views on depreciation accord with those of the accountants. (See ibid.. p. 3 8 1.) 123 i r v i n g Fisher, "Income," Encv clooaedia of Social Sciences, VII (New Yorks The Macmillan Company, 1932T, 372 such net income is arrived at in accordance with the replace- 12k- ment cost concept. Anyone who has had the occasion to read through Hicks' chapter on income in his Value and Capital 125 knows how difficult it is even in theory to define income. Economic income is a subjective concept, dependent on the *1 o A particular expectations of the individual in question. On the contrary, accounting profits are strictly objective and historical. If the accountant would follow what Fisher advises him to do, that is, to "set up ideal standards and reckon potential as well as actual income" and to smooth out irregularities by use of reserve accounts, sinking funds, and 127 other devices, he would not be practising accounting, an objective procedure of income determination, but would be engaged in prediction as to what income ex ante should be at the end of a certain fiscal period. Since economic income Another economist's view in this respect is of interest. "In measuring income so conceived, there can be no axioms or self-evident truths, for business income is an Intellectual concept which is not unique but may be, and indeed is, given different meanings, at different times, in different countries, or for different purposes." (George 0. May, "Postulates of Income Accounting," Journal of Accountancy. LXXXVT, No. 2 [August, 19^8], 108.) J. R. Hicks, Value and Capital (Oxford: The Clarendon Press, 1939)? pp. 171-181. 126 Ibid.« p. 177. 127 Fisher, op. cit.« p. 62^. 373 and accounting profits are not one and the same thing, it is doubtful whether the concept of economic income should ever serve as the criterion of determining accounting profits, especially when its own nature is susceptible of many differ ent interpretations. Lest this writer should be accused of being a perfectionist in matters economic which happen to meet with his disapproval, he wishes to add that the accountant has never claimed that accounting profits coincide with eco nomic income in the short run. One of the basic assumptions or postulates of accounting is the stable value of the dollar over which neither the accountants nor anybody else has any control. The best approach to a "stabilized accounting0 128 would be through the use of index numbers, not by way of the replacement cost approach. But the difficulties encoun tered in adapting index numbers to accounting procedures and the intrinsic weaknesses of any index number and its compila- 129 tion are notorious and there seems to be little likelihood 130 of widespread adoption of this method, i p8 Advocated by Henry W. Sweeney, Stabilized Accounting. (New York: Harper & Brothers, 1936). Seligman Coo, cit. T p. 6 2 9) also considers index numbers as being a means to bring capital appreciation under income taxation. See, for instance, "An Inquiry into the Reliability of Index Numbers" by the Research Department, American Insti tute of Accountants, a memorandum republished by Journal of Accountancy. LXXXVII, No. b (April,. 19^9) , 312-319. See also Hicks, ©£. cit.. p. 175* W. A. Paton, editor, Accountants1 Handbook, third edition, p. 810. 37^ The replacement cost concept: its defects. Theoreti cally speaking, the economic principle of keeping capital intact by charging operations with fictitious replacement cost of fixed assets is accepted normally as a standard of income measurement only when the whole national economy is under consideration. Differences of opinion exist even among economists as to the proper application of this principle to 131 individual business. And the accountant admittedly has only his clients* individual businesses, not the whole economy, as his charge. TShat is more important and to the point is the fact that the maintenance of physical capital by adequate depreciation charges based upon replacement cost is, by the very nature of the economic logic behind it, a long-run con cept, not particularly amenable to short-run application. Marshall writes that “supplementary cost must generally be covered by the selling price to some considerable extent in the short run. And they must be completely covered by it in 132 the long run. . . .“ So, even if the plant is not Lacey, 0 2. cit.. p. 205* 2 Alfred Marshall, Principles of Economics (Eighth edition; London: Macmillan and Co., Limited, 1920), p. 360. (Italics supplied.) (See also, infra. Chap. VIL) “Supplementary costs*1 are defined as including “standing charges on account of the durable plant in which much of the capital of the business has been invested. • . .“ (Loc. cit.) Depreciation is apparently included. 3 75 maintained in the short run, there is no reason to believe that it will not be so maintained in the long run* In the absence of the so-called "permanent changes in the price level,1 1 the ups and downs in the price level over the cycle will in large measure average themselves out and any remain ing differences will generally be of comparatively minor importance* It follows that the propriety of cost deprecia tion under such circumstances should not be impugned and the superiority of the replacement cost concept is subject to considerable doubt* This line of reasoning, however, still does not answer Slichter*s charge when permanent changes in the price level 133 are involved. Presumably, the ups and downs will not average out, the difference being maintained by the permanent changes which will outlast the cycle* Economists like Slichter are vague about the real nature of these so-called "permanent changes" and the accountant would like nothing better than to be general and vague if he could afford to do so in connection with income and tax figures. It is easy for anyone who has acquainted himself with Slichter*s arguments to associate "permanent changes" with lasting changes in 33 it is to Slichter*s credit that he was much more careful in his assumption of "permanent" changes than some accountants who subscribe to the replacement cost theory, but have only temporary price level changes in mind* 376 replacement costs or values and there is considerable basis for this interpretation in view of our discussion of two of 13^ his followers. The reply is, however, that changes in replacement costs are not synonymous with changes in the pur- 135 chasing power of the dollar. Even if we grant an adjust ment in depreciation on cost by reason of a permanent decline in the purchasing power of money, there are still no theoreti cal or practical reasons to rely on replacement values as the only gauge of the extent of the purchasing power decline. There are a thousand and one causes for the “real** replacement values to differ from period to period. It would be most difficult to isolate changes in replacement values caused by. the decline in the purchasing power of money from those brought about by some basic economic or engineering factors. The fact 136 that asset replacements are seldom made in identical units tends to accentuate the already difficult situation. Now, who is to determine that the current price level adjustments will perpetuate themselves? The determination involves long-range forecast and prediction of which the Sanders, “Depreciation and 19^9 Price Levels,1 1 and Welcker, “Divergent Views on Corporate Profits.“ 3-35 Herbert E. Miller, “The 19^8 Revision of the American Accounting Association's Statement of Principles— A General Appraisal," Accounting Review (January, 19^9), ^5* Loc. cit. 377 accountant is generally not expert. It is not their respon- 137 sibility to predict permanent price level changes. They were advised of such Mpermanent" changes in the twenties and took action to give effect to such changes, but they were blamed for the downfall in the thirties as being unduly opti- 138 mistic. Granting, for the sake of argument, that current price level adjustments are likely to last, and there are 139 valid reasons for this conclusion, there remains another serious weakness in the replacement cost concept. When per manent price level changes are assumed, or say, when prices rise 50 per cent permanently, the- depreciable assets involved 37 Robert H. Montgomery, ' ‘ Accountants Should Not Be Expected to Forecast Future,” Journal of Accountancy. LXXXIV, No. 6 (December, 19^7) > *+60. Supra, p. 3 6 8, footnote llH-. Despite the hazards of prediction, this writer is of the opinion that there appear to be grounds for holding that the American economy has reached a new plateau, so to speak, on which level it will remain for a long time to come. Two of the more fundamental causes are the existing national debt of $255,000,000,000 (Los Angeles Times. September 8, 19^9, Part I, 26:5) with no immediate prospect of any large-scale reduction and the fundamental change in outlook as to the role of the government in the national economy since the New Deal or the last depression. Among other contributing factors are the mounting military expenditures for national defense as long as the strain in Russo-American relations is not eased, ECA programs, U. S. obligations under the North Atlantic Pact, and the near-permanent dollar crisis of Great Britain. It is fairly certain that though the height of the price level some five or ten years from now may not remain where It is today, a return to prewar price level will be permanently forestalled. 378 have presumably undergone a permanent 50 per cent appreciation T_ IxQ which to all intent and purposes, represents monetary income. One of Seligman's objections to taxing appreciation as income lies in his apprehension that opposite changes in the price lk-1 level later may wipe out any appreciation recognized earlier. This apprehension is now removed by the assumption of permanent price level rises. The taxation of appreciation logically follows. But the point is that to have included appreciation as income would have eliminated Slichter's charge of profit overstatement, since now the higher depreciation charges against income would have been offset by additional income 1^2 credits arising from appreciation. Most of the proponents Georg Schanz in 189*+ and Robert M. Haig over two decades later held that income is measured by "the money value of the net accretion to one's economic power between two points of time." (Seligman, op. cit.. p. 6 2 8.) Hicks' income ex post is arrived at in a similar way. (Hicks, op. cit.. p. 179.) Edwin R. A. Seligman, "Income Tax," Encyclopaedia of Social Sciences. VII, 629. 1^2 economist's objection to crediting income with appreciation due to a permanent rise in the price level lies in the argument that no real economic gain accrues from a purely monetary appreciation in asset values and hence, no economic income results. As long as real income is not increased, the proposed income credits sire improper. (Jacob Viner, "Taxation and Changes in Price Levels," Journal of Political Economy. XXXI (August, 1923), *+98.) See also A. C. Pigou, A Study in Public Finance (Third revised edition; London: Macmillan & Co., Ltd., 19^9)» PP« 159-160.) In other words, no taxable income results as a result of monetary appreciation. But the query is: would there be any realized gain if an item of real estate, a lot for instance, which 379 of the replacement cost theory among the accounting profession, however, cannot be taken to task in this respect, While they would be willing to base depreciation charges upon appreciated asset values, they would insist upon the return to operating income of the excess of depreciation based upon appreciated l*+3 values over that upon cost. However, should the economist lU-o (Continued) cost $1,000.00 some twenty-five years ago, but which now has a market value of $5,000.00 because of permanent changes in the price level, were sold for $5*000.00? Strict adherence to the economists theory, as presented above, would dictate that no gain be recognized for taxation purposes. However, the government, the business man, the banker, or the accountant would recognize a gain in this respect of $*+,000.00. (This writer knows of no competent accountant who would argue, as the economist does, for nonrecognition of gain in this case.) This has been the way of recognizing gain since the income tax was first introduced in 1913* Any divergence from this rule would not promote an equitable enforcement of the tax law. Unless a uniform treatment of all such cases were adopted, the recognition of current replacement values for deprecia tion purposes would seem perforce to involve a similar recog nition of monetary appreciation for purposes of income deter mination. 1**3 For example, see Accountants * Handbook. 3rd ed., pp. 8l5-8l6. In this connection this writer notes with con siderable regret Paton*s recent change of position on this issue. As recently as April, 19^8, he advocated an account ing treatment of appreciation directly in agreement with the economic view that capital appreciation does not constitute income. This new method of depreciation accounting permits appreciation to be either formally or informally recognized through equity adjustment, but under it net income is to be charged with replacement cost depreciation without further adjustment. (William A. Paton, ’ 'Accounting Procedures and Private Enterprise," Journal of Accountancy. LXXXV, No. b (April, 19^8), 289-290.) In other words, the excess of depreciation based on replacement cost over that of original cost is not returned to income. Paton's argument is that the 380 concede to this position, his charge that corporate profits were overstated from 19^5 to 19^8 -would immediately vaporize. The association of the notion of the replacement fund with accounting provision for depreciation further weakens the replacement cost concept. According to this notion, the provision for depreciation should be adjusted from time to time for changes in the purchasing power of money so that a fund, gradually accumulated by successive income allowances 1J+ through the years, will be adequate to buy the replacements. Even erstwhile accountants who have later turned corporate executives, have become oblivious of one of the most important principles of accounting that accounting reserves do not, of. themselves, provide actual cash funds for any specific purpose unless when matched by the creation of special funds. One such example appeared recently in a prominent professional journal in the form of a letter to the editor by a former public accountant who hassince been associated with the comp troller 1s department of a large firm. The relevant portion ^ (Continued) net income arrived at according to his new method is more use ful to the management and the investing public. Why this should be so is not clear, especially when it is remembered that operating cost arrived at under both Paton*s and the eonven-' tional methods is identical and according to him (supra, p. 368, footnote 113, and infra, p. 3^2, footnote 1^8). One of the main objectives of accounting for depreciation based upon replacement cost is the correct reporting of cost. Supra. p. 371* of this letter reads as follows: 381 Because, in perfect conformity with accounting principles, they had “sold*1 their assets— bought with 100-cent dollars— on the basis of depreciation charges on a scale down to 50 cents or less, while at the same time they would be confronted with the necessity of replacing said plants at costs which would involve the provision.of large amounts of additional capital. It is conceded that the cost of raising.additional equity 1^6 capital for replacement purposes is extremely high nowadays and many business men are unwilling to incur such high cost if the funds can be saved out of current earnings• But the point is that if it is the choice between additional funds for replacement of worn-out assets and cash funds for the payment of dividends that is confronting the business men, a llf7 surplus reserve or even an income appropriation, ' clearly earmarked as such, will be sufficient for the purpose, even though there is no more guarantee under this method than under provision for depreciation based on cost that funds will be 1 ^ G. E. Hawkins, "Management Expects More of Account ants Than Record-Keeping: Accounts Kept on Cost Basis May Hot Be Adequate," Letter to .Editor, Journal, of Accountancy. LXXXVIII, No. 2 (August, 19^9), A-lV— A-l5. Sanders, ojo. cit.. p. 298. Professor Woodbridge is of the opinion that the pro vision for the excess of replacement cost over original cost may be taken care of by an appropriation of net income to be determined without any consideration of fictitious replace ment cost. He also believes that direct income appropriation may eventually prove to be the solution to the problem of inflated replacement costs of fixed, assets. 382 available if a special fund is not created at the same time. There is no great sense in upsetting the convention of cost depreciation on the ground that it will not provide adequate funds for replacement, at the same time without any assurance that the end sought will be attained by so doing. Paton, in an article extremely favorable to the replacement cost con cept, had the following to say regarding the "fund1 1 idea:. Advocates of adjustment of depreciation under present conditions have made too much of the point that charges based on recorded costs are inadequate to provide for replacement at current prices. Depreciation charges, like other costs, don*t "pro- vide1 1 anything. The main objective in setting up any cost is the correct reporting of costs and of net earnings. Funds are provided by the flow of receipts from customers and the amount of that flow— assuming competitive operation— is only indirectly affected, if at all, by cost reckonings and assign ments. . . . Moreover, the ultimate cost of replace ment is not known, and is difficult to estimate, particularly where facilities may not be replaced in kind* The matter of real concern, on. .which atten tion should be concentrated, is the proper reporting of the cost of using existing facilities and of the amount of net earnings. Such reporting furnishes a general guide for those charged with financial administration, but should not be confused with either broad or specific fund pro grams.14' 0 In practice, depreciation reserves are seldom funded. Avail able funds are immediately expended for expansion or working Paton, op. cit.. p. 289. (Italics in the original.) The same interpretation of depreciation reserve is contained in Paton*s Advanced Accounting, supra, p. 367, footnote 112. A related issue having to do with the availability of funds for dividend purposes when the books of an enterprise show a surplus, has been discussed elsewhere in this. work. (Supra. Chap. Ill, pp. 176-179.) 383 capital without intention or accumulation for specific pur poses, In 1939j for example, accumulated depreciation in the whole of the United States amounted to $18,5 billion or some four times the aggregate cash balances of all domestic l*+9 corporations. It needs no further elaboration for the reader to see that the "fund’ 1 aspect of the replacement cost concept does not hold true either in theory or in practice. There exists yet another theoretical-practical defect of the replacement cost theory that needs to be raised. Under' this theory we have to know what is meant by "maintaining plant and buildings intact." There are, at least, two inter pretations, but the one which is pertinent to the economists concept of replacement cost holds that "maintaining plant and 150 buildings intact" means maintaining these assets as new. ^ Now, in order for the costs of the assets concerned to diverge widely from current replacement cost, they must presumably have been acquired many, many years ago at the relatively low 151 prewar prices. For buildings and plants their structures 1^-9 "The Depreciation Dilemma," Fortune. XXXIX, No. 1 (January, 19*+9)» 68. The fact that cash balances were smaller than depreciation reserve does not prove conclusively that there were no funds accumulated for replacement purposes, for the reserves, if funded, might have been.carried in the form of marketable securities. Lacey, op. cit.. p. 205. Our interpretation here is in accord with the economic depreciation as defined by Dewing, suora. p. 320. The other interpretation, the accountants ver sion of plant maintenance, is discussed.in Broad, pp. cit., pp. 17-19. By the same token,, assets of short life expectancy 38*f may have been erected over thirty or forty years ago. In order for these assets to last out their normal life expectancy, it is unavoidable, as an engineering fact, that growing sums of expenses in the form, of repairs and maintenance will have to be incurred especially toward the latter years of their use. As one author puts it, depreciation is a correlate of 152 repairs or maintenance. But when.depreciation of fixed assets is based upon the replacement cost, as the economist understands it, the theoretical reference is made to such assets as new on which the cost of repairs and maintenance is normally very nominal. In actual practice the replacement cost concept is of significance only with reference to assets acquired years ago, as reasoned above, on which the cost of repairs and maintenance is expected to be and normally is high. And it is not known whether the increase in cost of repairs and maintenance would not be large enough to equal roughly, the excess charges to income brought about by basing deprecia tion on replacement cost. The above situation represents a practical, as well as theoretical, point which the theoretical ^ (Continued) do not constitute the proper reference for the application‘of the replacement cost theory. Continual.replacement of these assets will bring their, cost closer to or more in line with the current price level. ^2- Dewing, op. cit.. p. 389. 385 economist has not foreseen and for which he also is not pre pared* Generally speaking, when a business enterprise acquires a new office building or undertakes the construction of a new plant, it does so only in the expectation that its future business will benefit from the investment* It is only fair and logical that the cost of the replacement should be spread over the future period during which the new assets are 153 expected to be of service. It is illogical to argue that the profits of some prior period during which such new replace ments are not even in existence should be called upon to bear part of this fictitious cost of non-existent plant* Biough's pertinent and cogent comment on this point is quoted verbatim below: True, it is recognized that if it is possible to demonstrate that a plant has. permanently lost its value it is proper to write off its cost, but this can hardly be relied upon to support a charge to income before the plant Is completed to provide for possible loss that is as yet only speculative. If, at the time the plant is constructed, inefficiencies, shortage of materials, and labor practices run the cost higher than is believed to be normal, it must still, be assumed that the company has weighed these costs and found them worth while for the benefit of 153 Ttie i0gic iS even more forceful if it is remembered that one of the fundamental postulates of accounting assumes an indefinite existence of the business enterprise. (May, on. cit., p. 109.) Fisher*s concept of capital calls for the capitalization of a permanent stream of periodic income at some appropriate rate. (Fisher, ojd. cit., p. 623*) 386 the future. Otherwise, the construction would hardly be undertaken. It would seem to follow that if the plant is built it is expected to con tribute its full worth to future revenues and that its costs should therefore, be fully charged to the periods it will s e r v e . From the point of view of the association of cost, or dis utility, with economic benefit, or utility, to depreciate fixed assets on the basis of replacement cost simply means an erroneous assignment of their cost over time. The replacement cost theory; a temporary “final verdict.1 1 For reasons stated above and many other considera tions, including accounting consistency and possible public misunderstanding of the significance of financial statements if the traditional cost procedures were upset, the American Institute of Accountants, the oldest and most prominent accounting profession, representing the certified public 155 accountants, and the American Accounting Association, rep- 156 resenting the accounting teaching profession, have openly voiced their opposition to any basic departure from the Carman G. Blough, “Replacement and Excess Construc tion Costs.“ Journal of Accountancy. LXXXIV. No. (October, 19^7), p. 336" 155 Committee on Accounting Procedure, “Depreciation and High Costs,*1 Accounting Research Bulletins. No. 33 (New York: American Institute of Accountants, December, 19^7)• 156 American Accountings Association, Accounting Con cepts and Standards Underlying Corporation Financial State ments— 19^8 Revision (Chicago; American Accounting Associa tion, 19W. 387 traditional cost depreciation. In a more recent reaffirmation of its previous position, contained in a letter to its members, the American Institute of Accountants maintained that unless inflation has proceeded so far that original-dollar costs lose their practical significance, no basic change in the present accounting treatment of depreciation will be con- 157 sidered, This reaffirmation of the Institute1s position on depreciation came upon the heels of a survey, conducted by it during the latter half of 19^8, among the various business and professional groups, comprising corporate executives, bankers, economists, teachers, and others, who could be expected to be interested in the subject, to sound out their reactions to the proposed basic change in depreciation account- 158 ing. To many the results of the survey were shocking, 159 Economists were the only group that favored the change. Among business men and bankers, the position was 3 to 1 against 16 such a basic change. The controllers were against the change. 157 Committee on Accounting Procedure, in letter to the members of the American Institute of Accountants, dated October lb, 19^8, George D. Bailey, "Relationship of Accounting to Other Factors in Accurate Reporting of Inflationary^ Incomey" Journal of Accountancy. LXXXVI, No, 5 (November, 19^8), 366. Ibid.. p. 367, only by the margin-of 7 to if. Loc. cit. 388 Since then, the clamor for basic revision of accounting pro- 161 cedures has died down* In this connection it is interest ing to note that the last straw that broke the back of the proponents of the replacement cost theory, which is alleged to benefit business enterprise in general during a period of 162 "permanent rises” in the price level, was supplied by busi ness men themselves, in spite of the urgings of the econo- 163 mists* The replacement cost concept and excess profits taxa tion. To begin with, the replacement cost concept is incon sistent with our residual theory of excess profits, inasmuch as depreciation charges based upon fictitious replacement cost 161 Since then, change was either opposed or advised against in ‘ ‘ The Depreciation Dilemma," supra, and "Quick Depreciations Tax Relief for the 1950*3?" Business Week. February 5, 19^9 • In a letter to the presidents of corpora tions having securities listed on the New York Stock Exchange, dated January 10, 19^9, Emil Schram, President of the Exchange, officially endorsed no change in the computation of net income which is to be determined in accordance with generally accepted practice at the present time. When permanent price adjustments are downward, no benefit whatever accrues to business. This is one of the most potent reasons which must have convinced the business men of the futility of any change. l6 3 We have already seen Sliehter*s testimony on this side of the Atlantic. On the other side, see an adapted ver sion of an article in The Economist. London, June 12. 19**8 by Journal of Accountancy. LXXXV.I, No. 5 (November, 19^8) > 381. 389 will conceal and understate profits, thus causing periodic excess profits to escape the tax. This result follows naturally from our definition of excess profits as being the residual profits remaining in the firm after all factors of production, excepting, of course, the factor of organization, have been rewarded with their respective shares of the total product, the imputed share of the owner being computed on the cost of his original commitments. Aside from its basic inconsistency with our profit theory, the replacement cost concept also is objectionable on many other practical and theoretical grounds peculiar to income and excess profits taxation. Theoretically speaking, the fiscal concept of income, in general, is not governed by the economic concept of income, though the former is, of 1614 - necessity, rooted in the latter. Since taxation affects directly the well-being of the people, the fiscal concept of income, in order to be serviceable, must necessarily be more compact, definite, and practical than its economic- counterpart. It must be objective and ex post« instead of subjective and ex ante. In this respect, even though the replacement cost concept constitutes only_ one aspect of the problem of deter mining economic income, its subjective and ex ante nature can Seligman, o p. cit. T pp. 628-629. 390 hardly be gainsaid. The burden is on those who propose its introduction to reconcile this fundamental theoretical con flict in economic outlook. Foremost among tax considerations from the practical standpoint is that of equal treatment to all taxpayers con cerned. If the business group were permitted to keep its capital intact during periods of price adjustments, other groups, including owners of government bonds, of rented pri vate dwelling houses, and of other property, and above all, the low-income group with considerable bank savings in the aggregate, would be justified to ask for allowances to main tain their economic capital intact before they arrived at 165 their taxable income. Even if depreciation were to be based upon replacement cost, the excess of replacement deprecia tion over original cost depreciation would become a cost of operations only on the assumption that the price increase had 166 brought to the business a gain.which-would be subject to tax. An additional and related consideration involves the taxation * 1 Z n of monetary appreciation which we discussed above and which Sanders, op. cit.. p. 299. This is in substantial agreement with the position we have taken in respect of the computation of invested capital upon the original cost of investment, supra, p. 325* Ibid.. p. 300. In other words, replacement cost depreciation might be recognized for excess profits tax pur poses only on the condition that capital appreciation be brought under the tax at the same time. See the next sentence. 167 Supra, pp. 327-329 and 376-330. 391 would more than deprive the taxpayer of any practical benefit supposedly to be derived from the adoption of the replacement 168 cost depreciation. Depreciation procedures based upon principles similar to those of the wartime accelerated depreciation or amortiza tion of emergency facilities have been suggested as another possible solution to the problem of high replacement cost. Under the principle of accelerated depreciation assets would be amortized over a period considerably shorter than their normal life expectancy. Not much benefit would accrue to business, however, if stable tax rates are to be maintained over the years, the rate structure is moderately progressive, and no more than cost is taken into consideration in arriving 169 at the periodic amortization. Besides, one possible 168 As we maintained elsewhere, supra. pp. 376-380, the increase in income through the recognition of capital apprecia tion for tax purposes could easily wipe out any benefit from increased depreciation charges. Besides, during a period of declining prices even though there are economic as well as international factors that will-.tend to sustain the national income at a high level for some time to come, the height will not remain as great as we have experienced in the last two or three years and eventually the level of national income will tend to fall (cf. supra. p. 377, footnote 139)? Depreciation charges would be lower on the basis of the then lower replace ment cost, despite the fact that such lower replacement cost might have wiped out all the previously taxed gains through appreciation,*then regarded as “permanent.” 169 That is, the total amounts of depreciation under current accounting and the proposed procedures will be equal. If the rate structure is stable and mildly progressive, the 392 aftermath of such a procedure introduced at the present timb may be a powerful stimulus to investment, coupled with “addi tional demand for goods and services that in the short run at 170 least would be directly inflationary.“ Furthermore, accelerated depreciation may not help young, new enterprises which are not expected to be very successful during their first few years of operations* Loss offsets through allowance 171 of loss carry-overs may remedy part of this defect and the extension of the recovery exclusion provision to depreciation (and depletion) may also be of advantage under conceivable 172 circumstances. Conclusion* For both theoretical and practical reasons as stated above, the replacement cost theory of depreciation ^ (Continued) advantage of the proposed procedure is, indeed, doubtful, inas much as most fixed assets are retired before they reach the limit of their life expectancy and the loss deduction upon the retirement plus accumulated depreciation reserve will yield the same tax benefit as under the proposed procedure* 170 ftjhe Depreciation Dilemma,“ op. cit*, p* 68* 171 Infra* pp. *f 08-^l8. 172 The recovery exclusion provision is contained in Sec. 22(b)(12)• Reg. Ill, Sec. 29.22(b)(12)-1(a) excludes depreciation and depletion and amortization from the applica tion of this recovery exclusion rule. But there is no logical reason why depreciation and depletion should not be brought within the purview of the recovery exclusion provision. 393 accounting has no place in our proposed permanent excess prof its tax. Another reason which has not been mentioned in our discussion of depreciation but which was made one of the prin cipal reasons for rejecting current value for invested capital purposes is the difficulties likely to be encountered in the determination of such value by appraisal or otherwise. The expensiveness and unreliability of appraisal rule out its general adoption in any system of taxation. PERCENTAGE AND DISCOVERY DEPLETION Introduction. The principal reason for selecting per centage and discovery depletion as a topic of discussion is that the allowance of the deduction for depletion computed on 173 17** a percentage basis or on the basis of discovery value without regard to cost gives rise to fictitious cost deductions and therefore results in hidden excess profits which will legally be permitted to escape taxation* This is in direct conflict with our residual claimant theory of excess profits. Since 1925 depletion of oil and gas wells has been based upon 27 1/2 per cent of the gross, or 50 per cent of the net, income from 175 oil and gas properties whichever is less. Most mines are ^■73 sec. ll**(b)(3) and (**■)• Sec. ll**(b) (2) • Paul, Q£. cit., p. 306. 39^ now allowed depletion on the basis of discovery value, though some mines are permitted to compute depletion on a percentage 176 basis. The original intent of these special depletion pro visions was to provide an incentive “to stimulate production and protect the prospector or wildcatter who risked drilling 177 in unknown territory." As these provisions now stand, their operation furnishes “a discriminatory subsidy in favor of an established industry" which,is now in firm financial position far beyond the need of special government help. The effect of this subsidy is to shift a part of the community tax burden unjustifiably on to the shoulders of other segments of 178 the economy which may be less able to bear that burden. The inequities of percentage depletion. The nature of the second reason for selecting the topic will, be evolved in the following discussion. As we had occasion to point out 179 elsewhere in this study, percentage depletion works primarily 176 See Secs. lllf(b)(2) and (*0 3-77 Paul, op. cit., p. 305* 17^ Ibid.T pp. 306-307. The.inequity is even more glar ing if it is remembered that the deduction for depletion on the percentage basis does not stop when the property has paid for itself, inasmuch as Secs. lli f(b)(3) and C1 *) allow such deple tion to continue as long as there is production. According to Paul (ibid., p. 306), on the average the allowance for oil has consistently run about six times the actual depletion sustained on actual cost. 179 Supra. Chap. Ill, pp. 162-163, footnote 166. 395 for the benefit of the large oil, gas, and other mineral corporations. Coupled with the allowance of deductions for intangible drilling and development cost in the case of oil gas operators or corporations is complete. We will demonstrate below how this result comes about and our discussion will be confined to oil and gas operators and percentage depletion only, for they are probably the most favored beneficiaries of these provisions. As one author puts it, “The inequity of the depletion allowances is somewhat mitigated by their being limited to 181 50 per cent of the net income before depletion, . . ,u This view is correct only when the inequity is thought of as the result of a comparison between the industries which enjoy the benefit of such depletion allowances and those which do not. But within the industries entitled to such benefit the 50 per cent limitation works to the disadvantage of the small operators who are supposed to be protected by such percentage depletion provisions. Together with the election to deduct the intangible drilling cost, the tax disadvantage of these small operators would be complete, were the two-year loss and gas operators, the tax advantage of the big oil and 180 Reg. Ill, Sec. 29.23(m)-l6(b). 181 William Viekrey, Agenda "~ ressive Taxation (Hew York: The Ronald Press Compa: . . , p. 117. 396 carry-over provisions not in existence, 182 As a general proposition, the small prospectors or wildcatters drilling for oil incur losses in their first years of operations even if they suceeed in locating oil. The intan gible drilling costs constitute the one most important item of expense in such operations. Under Reg, 111, 29.23(m)-l6(b) they are permitted either to capitalize such costs or to expense them and the election once made is binding on all subsequent years. In anticipation of substantial income to come from their oil deposit in the future these small operators cannot afford to capitalize such intangible drilling and develop ment costs in their first years of operations for two related reasons. (1) Capitalisation now would mean capitalization in all future years of profitable operations. (2) Though such 183 capitalized costs are recoverable through cost depletion, the allowance of percentage depletion without considerations 184 of cost comes virtually to this: as compared with electing to deduct such intangible costs, capitalization loses to its 182 Tllis ^iter speaks from however little experience he has had in respect of the preparation and review of income tax returns involving percentage depletion on oil properties. 183 Reg. Ill, 29.23(m)-16(b)(2). Except when cost depletion amounts to more than depletion deduction computed on the percentage basis. (Sec. 114(b)(3).) elector such capitalized costs, provided there is stiffi cient gross and net income from the oil property for this result to come about and we have assumed that in regard to future operations of the small operators to start with* Since capitalization is unattractive, the alternative is to expense such intangible drilling costs. For the small wildcatters to do that in their first year or two of operations would almost 186 certainly result in net operating losses. No deduction for depletion based upon the percentage basis is now allowable since the 50 per cent net income limitation rules out such depletion deduction. One argument in favor of percentage depletion has the following to say on the subject: True, it can be pointed out that from profitable wells or mines using percentage depletion much more than cost can be recovered as a deduction, but that is not the whole story. What about the many, many wells and mines upon which great amounts of money have been spent in exploration and development which prove to be commercially unworkable or dry holes? True enough, if you have other income with which to offset this loss, you may secure a deduction if you take it at the right time, but the sad part of the story is that it is too often the case that there is ^ This is so because the election to expense gives its elector the right to deduct both such intangible costs and depletion deduction on a percentage basis. The deduction of the costs will not affect the amount of the depletion deduc-r tion until the 50 per cent net income limitation applies, which is more likely, to happen among small than large opera tors. Here, this writer speaks from however little experi ence he has had in this matter and.also from deductive reason ing. 398 not taxable income available with which to offset these losses.1°7 The rebuttal lies in the fact that even in the case of wells which in later years prove profitable depletion deduction for the first year or two based upon the percentage basis is likely to be lost for the reasons stated above. As to the loss off sets, it is clear that only the large operators can benefit much from contemporaneous offsets, since they are likely to have taxable income available for that purpose. But the point is that the percentage depletion provisions are supposed to protect the interest of the small prospectors and wild catters. On the contrary, the operation of these provisions inures primarily to the benefit of the large oil corporations whose established financial strength puts them beyond the need for special government subsidy. Furthermore, the benefit flow ing from the income tax provisions to the large oil corpora tions and the tax disadvantage of the small operators do not stop with percentage depletion, the election to deduct intan gible drilling costs and contemporaneous offsets. As we mentioned above, the tax disadvantage of the small operators would be complete, were the two-year loss carry-over ^ W. L. Hearne, “Depreciation, Depletion, and Research and Development Costs.1 1 in How Should Corporations Be Taxed? by the Tax Institute (Hew York: Tax Institute, Inc., 19*+7) > p. 157. 399 provisions not in existence. Here again, the small ones lose out. Under Sec. 122 the net operating losses sustained by these operators during their first year or two of operations may be carried forward to offset income for the two succeed- 188 ing years. It goes without saying that the uncertainties in profit prospects of small operators are generally great and there is considerable reason to doubt whether there will be sufficient income for the succeeding two years to absorb such 189 carried-over losses. Even if there is sufficient income for the two succeeding years, the adjustment called for by Sec. 122(c) and/or Sec. 122(d)(1), to limit the amount of the deduction for depletion to that based on cost for the taxable years in which the net loss originates as well as for the taxable years to which the net loss is carried, literally wipes out any conceivable benefit for the first three or four years of operations that may accrue under the provisions allow ing percentage depletion to the small operators whose interest they were intended to protect. At the same time the benefit accruing to the large We will ignore the two-year loss carry-backs for three reasons: (1) by small operators we usually mean new operators; (2) the principles involved are similar; and (3) for our proposed excess profits tax only loss carry-overs are recom mended. Here is one instance where the loss carry-over period may be lengthened to accommodate these small operators. This will be dealt with more fully in a later subsection. 3+00 operators under the same provisions has been extremely gener ous. Such large operators ordinarily have many sources of income and the gains from some will be offset contemporaneously by losses from others, as stated above. But since percentage depletion is based upon “gross income from the property during 190 the taxable year1 1 and a large oil corporation may have acquired interest in several separate oil properties, the losses from some properties may be offset against the gains from other properties without affecting the corporation^ privilege to compute the 27 1/2 per cent depletion from these latter properties through the 50 per cent net income limita- 191 tion. Similarly, the deduction for intangible drilling costs on new properties on which losses are likely to occur no longer affect percentage depletion on established proper ties. Loss offsets will be contemporaneous, the excess of percentage depletion over cost depletion need not be eliminated, 192 and no loss of interest will be suffered. All these advan tages are- not present in the case of carry-overs by small operators. 190 Sec. llh(b)(3). 191 iphe losses sustained from new properties are not taken Into account in arriving at the net income of old ones. ^ 2 See also supra. Chap. Ill, pp. I6O-I63, footnote 166. **01 Practical remedies* The above contrast brings out in bold relief the inequities of the percentage depletion and other related provisions as they affect small and large enter prise within the industries coming under such provisions, in addition to the discrimination such provisions engender against other industries which do not enjoy special legislative favors. Besides tax inequities, these provisions introduce new adminis trative difficulties. It is not always easy to tell, for instance, just at what stage of processing the product should 193 be priced for applying the depletion percentages. The mean ing of “property** as used in computing percentage depletion has been the subject of extensive court reviews. But it is not always easy to redress tax injustice and eliminate administra tive difficulties. The problem of vested interests immediately presents itself when the elimination of percentage depletion 195 is proposed. Any corrective measures in this respect must be gradual and proceed with caution. A Treasury proposal in 19^2 suggested an alternative depletion provision which would have permitted percentage depletion to stripper wells, marginal ■^3 geQ Reg. ill, Sec. 29.23(m)-1(f) for an understand ing of the difficulties involved herein. Consult Montgomery1 s Federal, Taxes. 19^-6-47. pp. 830- 832, for a summary of the more important court decisions in connection herewith. ■*■95 Vickrey, op. cit., p. 119. b02 mines and also to discoveries of new pools and newly dis- 196 covered mines. In all other cases, the basis for depletion computation should presumably be cost. A more gradual process 197 of correction has been proposed by Vickrey. According to this author, in the case of discovery depletion, discovery values already set up on the books are allowed to be depleted until they are exhausted. All new bases for depletion should be confined to cost or actual outlays for purchase and for development. A practical way of dealing with percentage deple tion, apparently with an eye on vested interest, would be to consider some arbitrary percentage of past depletion allow ances as offset against prospecting expense and to deplete the remaining prospecting expense or acquisition cost, if any, out 198 of future production. In any event, to allow-percentage depletion to continue indefinitely on presently known deposits until they are exhausted would be far too great a concession to make to the benefited industries, especially the large producing units within such industries. Paul, o£. cit., p. 306. The effectiveness of this proposal is doubted in view of discussion in the text above• Vickrey, ojd. cit., pp. 119-120. 198 Yicicpey mentioned other ways of dealing with the problem, but none of them appears to this writer to be very practicable. b03 CAPITAL GAINS AND LOSSES The problem. It should be pointed out at the outset that only business capital gains and losses fall within the scope of our discussion here. Under the existing income tax code, besides gains and losses arising from sale of capital assets such as stocks and bonds held in connection with busi ness, gains and losses from involuntary conversion and from the sale or exchange of certain property used in the trade or business and held for more than six months are accorded the status of capital gains and losses only if such gains and 199 losses aggregate in net gain. The problem is: Should these capital gains and losses be subject to our excess prof- 200 its tax? Arguments for excess profits taxation of capital gains. The reason for the exemption of long-term capital 201 gains from the repealed wartime excess profits tax may be detected from the following quotation: If a capital gain accrues to a corporation, it is usually because the prospect of income from 199 Sec. 117(j)• The repealed wartime excess profits tax exempted these gains from tax under Sec. 71lXa)(1)(B) and Sec. 711(a) (2)(D). Gains from sale of capital assets held for more than six months. the assets, considered either severally or in com bination, has improved, as, for example, through a fortunate shift in market demand coupled with monopo list ically competitive power. To tax both the present value of this improvement in prospect and, later, the full amount of the increase in income as excessive (by disallowing inclusion of that present value in invested capital) is to create an inconsistency of a kind that does not apply equally to the ordinary income tax.202 This position is subject to question. Let us assume that the present value of the improved income prospect is represented by the value of business assets and business good will com- \ bined, A sale of business assets at their market value with out selling the business and the replacement of these assets will cause the gains to realize and to be includible in invested capital, as well as maintain the same profit level as before the sale and replacement without showing excess profits, provided the increase in surplus earnings is not 203 withdrawn or distributed as dividends in the meantime. Normal profits will prevail from then on. Neither inconsist ency in treatment nor double taxation of the increase in value due to the same improved earnings prospect can happen under our proposed excess profits tax. A sale of good will cannot be effectuated without 202 Shoup, op. cit.T pp. 23^-235. 203 <£^ ,3 withdrawal or distribution as dividends of such gains will create entirely different issues which should not concern us here, anyway. ko5 selling the business to which it is attached. To tax such good will upon the sale of a business also does not give rise to an inconsistent position as stated in the above quotation. According to long-standing practice, realized gains are taxed in the year of realization. Part of the past good will repre sented by portions of excess profits earned in the past would have been taxed under the levy and there is no reason to leave the remaining balance of such excess profits (to materi alize in the future) untaxed as it was exempt under the repealed excess profits tax. To exempt it from tax is tanta mount to a permanent moratorium on taxing such gains, inasmuch as the vendee of the business is now entitled to compute invested capital on the current value of the business, or the price it paid for the business, which will earn normal profits from the date of acquisition onward. Furthermore, to exempt such gains from tax is. inconsistent with our position taken in arguing for the use of original cost for invested 20k capital purposes. For these grounds, consequently, this writer is of the opinion that capital gains arising from sale of business property or of business itself should be brought within the definition of excess profits and taxed as such. Relief. Special treatment, however, has been urged for 2Qif Supra, p. 338. *+06 taxing such long-term capital gains, for they accrue, in most cases, over a long period of time and to bunch in one year’s income what has accrued over a long period will result in higher tax than it would have been if the gain had been taxed 205 bit by bit as it grew. The current provisions taxing such gains at a flat, effective, maximum rate of 25 per cent is arbitrary and illogical. A more logical treatment would bear similar characteristics to that contained in Sec. 107 govern ing the special taxation of compensation received in lump sum for services rendered over an extended period of time. Groves proposed an averaging-feature to iron out income irregularity in the taxation of capital gains, provided parity treatment is given to capital losses and both such gains and losses should be taken into account in arriving at the decedent 206 owner’s tax liability. (Another aspect of gains and losses arising from the sale of business property will be discussed in the subsection immediately following.1 ') Paul, on. cit., p. 271* Harold M. Groves, Financing Government (Revised edition; New York: Henry Holt and Company, 19*+6), p. 182. ^07 ACCOUNTING PERIOD AND INCOME AVERAGING Accounting period. The adoption of a twelve-month tax accounting period, while equitable to most business enterprises, may sometimes work hardships to some whieh experience irregular profits. This is especially true when the tax rates are high 207 and graduated. There are three alternative methods of dealing with income irregularity. One is to make the account ing period longer than twelve months. In order to afford any real relief by this method, however, the accounting period 208 would have to be made considerably longer. To do so would 209 not only contradict business experience and practices, but 210 also entails a delay in income tax collections. In any event, the longer the accounting period the greater the objec tions on grounds of administrative and business inconvenience, for tax returns would be left open and tax liabilities unsettled for long periods of time. ^ Norris Darrell, "How Long Should the Accounting Period Be for Corporate Income Tax Purposes?0 In How Should Corporations Be Taxed.? by the Tax Institute (New Yorks Tax Institute, Inc., 19*+7), PP» 135-136. 208 Ibid.f p. 138. 2^ Corporate as well as other business reports and accounts are customarily rendered on the twelve-month basis. 210 Unless some pay-as-you-go scheme, based on inter mediary tentative accountings, was adopted. (Darrell, loc. cit.) 1*08 Income averaging and loss carry-over compared. An alternative device to overcome the tax disadvantage of income irregularity is the adoption of some averaging scheme whereby "the payment of the tax for each year would be based on an average of the annual incomes and losses over the cumulative 211 life" of the business or over a moving period of years. One shortcoming of a straight moving average method has to do with the assessment of heavy taxes based on previous high incomes in years when the income has sharply decreased, so that, collection is difficult and hardship to the taxpayer 212 results. Besides, in so far as business losses are con- 213 cerned, averaging is not as effective as a loss carry-over. To begin with, a loss carry-over immediately relieves the . business taxpayer of tax until the carry-over is completely exhausted, while the eventual recoupment of the same loss 21*+ under the averaging device usually takes too long. Admin istratively, a loss carry-over is much simpler to handle than either averaging or loss carry-back. For business enterprises 211 Ibid.T p. 139. For a more complete discussion of some of these averaging devices, see Vickrey, op. cit.. pp. 172-197; Henry C. Simons, Personal Income ^Taxation (Chicago: University of Chicago Press, 193^), pp.l?*f-15?5 also Groves, pp.. cit., p. 206. 212 vickrey, pp. cit.. p. 169. Darrell, pp. pit., p. 139* 2lIf Ibid.. p. I*f0. *f09 it is generally agreed that the carry-over system for busi ness losses is the best means of alleviating the inequities resulting from the rigid adherence to the twelve-month account Pi 5 ing period in income administration, ' LOSS CARRY-OVER There are, however, numerous problems in connection with 2l6 the actual designing of a loss carry-over system. Three or four of these will be discussed here. Loss carry-overs and loss carrv-backs compared. The first problem is to assess the comparative merits and demerits of both loss carry-backs and loss carry-overs. Loss carry backs entail the unavoidable refund claims and keeping open tax returns for past years, which add to administrative burden pi 7 of the tax. There is also the temptation for prolonging the Ibid.. p. Ik2. Darrell's assertion applied only to corporations. But this writer cannot see why it does not apply to other unincorporated businesses as well. 216 The term “loss carry-over'1 here refers to both net loss and insufficiency in normal profits. Technically, they are known as net operating loss carry-over and the unused excess profits credit carry-over. This definition of the term “loss carry-over" (without distinction between the two separate carry-overs) will facilitate the discussion to follow. The net operating loss carry-over is covered by Sec. 122 of the Internal Revenue Code and the unused excess profits credit carry-over by the repealed Sec. 710(c) of the same code. 217 preparation of a separate refund claim is more of a technical problem than the mere carry-over of the loss for the year to the return for the following year in arriving *flO liquidation of an enterprise in order to make use of both the net loss and the unused excess profits credit carry-backs to 218 gain refund of prior years* tax. Generally, a system of loss carry-back is unnecessary under a permanent excess profits 219 tax. But since losses are usually and commonly suffered by businesses in their final year of winding up operations and since carry-over provisions are no longer available for a business already liquidated or on the verge of liquidation, equity would seem to demand that loss carry-back for one year 220 be allowed to the business for its final year of operations, ^ (Continued) at net income. (For requirements of refund claims, see Montgomery^ Federal Taxes, 19*+6-*f7. II, pp. 976-977*) The Commissioner may disallow the claim and under Sec. 3772(a)(2), no suit for recovery may be begun before the expiration of six months from date of filing such claim. The disallowance may be based upon certain technicality in the form or legal require ments of the claim not having been met and upon the ground that the claim is not filed on time under Sec. 3 2 2(b)(6). Recovery by suit is always costly. No interest on the final refund for the period from the due date of the return for the year to which the loss was carried back to the date of filing the claim, will be allowed. The delay in granting refunds has been considerably reduced by the enactment of Sec. 3780 accel erating the refund procedure. (See supra. Chap. II, pp. 80-81.) 218 Decisions involving these issues either fully or partly in favor of the taxpayer where there is no evidence of intentionally protracted liquidation are Acampo Winery & Distilleries. Inc.. 7 TC 629 (A), in respect of net loss, and Wier Long Leaf Lumber Co. . 173 F* (2d) 5*+9j in respect or unused excess profits credit. 219 Shoup, op. cit. T p. 2*K>. 220 Loc. cit. U-11 unless there is evidence pointing to undue delay or prolonga tion of the liquidating process for purposes of obtaining refunds through carry-backs. Length of carry-over period. The length of the carry over period is a subject of considerable controversy and no final conclusion can be drawn until some definitive research has been made as to the effect of carry-over periods of vari ous lengths upon American business enterprises and upon the 221 revenues under projected tax rates. Various authorities have their own suggestions as to the probable or "optimum1 1 222 length of such carry-forward period. It is this writer’s opinion that the period should not be less than five years but, in no event, more than eight or ten years. Under the present system of carry-back and carry-over for income tax purposes, the business is allowed an equivalent of five years 223 during which its losses may be offset against income. Under the proposed carry-forward system for a permanent excess profits tax, the period should not be less than five years by all means. For administrative reasons, subject to Darrell, op. cit.« p. lk-5* 222 For some of these authorities, see Darrell, loc. cit., and footnotes. 223 ne- { . offsetting years are four only, since the loss year is counted among the five years. *+12 modification, the period should not be longer than eight years, in no event longer than ten years* The principle governing the determination of the length of the carry-forward period has been well stated as follows: The period should also be one within which it would normally be expected that an existing enter prise which falls upon hard times could make up its losses if its business is worthy and is to be continued. Above all, it should be one calculated as sufficient to enable new and promising ventures to utilize their initial losses, thereby encourag ing the development of new, independently owned enterprises and removing the discrimination in favor of established concerns with far-flung and diver sified interests which can currently utilize losses from new ventures against profits from other branches of their business.224- This principle is in substantial agreement with the position we have consistently taken so far in this study. The concept of adjusted loss. By virtue of the opera tion of Sec. 122 the carry-back and carry-over of losses are limited broadly to that portion of the net loss which repre sents roughly the accounting loss of the business for the 22? loss year. The various limiting adjustments are specified Darrell, op. cit., p. IMS. There are many instances, to be sure, where the income tax net loss differs from the accounting net loss either in amount or in the manner the two loss figures are arrived at. The use of “accounting loss” is to express this writer's disfavor of the term “economic loss" or some such terms used by many tax writers (e.g., Darrell, op. cit., p. l1 ^) to indicate the net loss carried back or over. The in Sec. 122(d), especially paragraphs (1) , (2), (*+), and (5), the last mentioned paragraph having application only to unin corporated business. Without embarking upon a technical dis cussion of the operation of these provisions, it may be pointed out that under the recommendations made by us in respect of the determination of the taxable net income, as set forth in the earlier subsections of this section, adjust ments called for by paragraphs (1) , (2) , and (*+) will no longer be necessary in order to arrive at actual accounting loss sustained by the business availing itself of the loss carry-over provisions. Paragraph (1) dealing with percentage depletion will be rendered superfluous by our recommendation 226 that depletion be computed on the basis of cost. To dis pense with the adjustments with respect to percentage deple tion will, in turn, do away with many of the injustices, as 227 we discussed in detail above. Our emphasis on the deter mination of income according to accounting principles carries 225 (Continued) adjective “economic" makes one think of many economic factors entering into the determination of real economic profit or loss, which are not considered at all in arriving at either the taxable net loss or the accounting net loss. “Accounting loss** is closer to the real meaning of income tax net loss than “economic loss.“ 22^ Supra, p. *+02. Suora. pp. 393-^03. hih the inferrible suggestion that all income is taxable, there being no tax-exempt interest, thus doing away with the adjust ment under paragraph (2). The adjustments in regard to capital gains and losses under paragraph (*+), to the extent that they affect business capital gains and losses, are inapplicable when such gains and losses are, respectively, taxable and deductible in full: in arriving at net taxable income, as we 228 proposed above. Composition of loss sub.iect to carry-over. The ques tion of the content or the composition of the net loss forms the last topic of our inquiry. It Is agreed that trading losses are subject to the net loss offset provisions, but should losses incurred on the sale or exchange of business property, either in the course of trade or business or upon liquidation, be considered a part of the net loss which is to be carried over (or back for the final year of operations) to offset profits of other years? Since the issuance of I.T. 3711, CB 19*+5> 162, in 19^j the Bureau of Internal Revenue has steadfastly held that loss on the sale of property by a person who is not a regular trader or dealer in such property is not incurred in a trade or business and therefore may not be carried back or over by such non-dealer to offset taxable income of other 228 Supra, pp. 1*03-^07. bl 5 years. And. the courts have consistently upheld the Bureau*s 229 position. Recently, however, the courts have somewhat 230 relaxed the Bureau's ruling. That is: only an individual's loss on sale of business property to liquidate his business may not be carried back or over and there is no such restric- 231 tion on incorporated businesses, J Besides this illogical application of Sec. 122, the restriction is without justifi cation from either the standpoint of the history of the net operating loss provisions or from that of legislative intent behind Sec. 122, currently in effect, allowing the carry-backs 232 and carry-overs. Leaving aside the technical discussion of the history of and the legislative intent behind Sec. 122, we are here mainly concerned with the logic of this Qee Pettit, et al. v. Commissioner (CCA-5; 19*+9), Prentice-Hall Federal Tax ServiceT 19*f9T VT Para. 72,7^3; Lazier v. U. S. and Perry (CCA-o; 19M-8) , P-H Federal Tax Service. 19^+8. V, Para. 7 2, 6 3 0; Foreman v. Harrison (DC, 111*, 19^8),79 F. Supp. 9875 Joseph Sic, 10 TC IO9 6; and Hartwig N. Baruch, 11 TC 9&. language of the circuit court [CCA-51s decision on Pettit y. Comm., supra] implies that the carry over would have been allowed if there hadn't been a liquida tion of the business. For example, if an individual business man sells a machine at a loss and buys another, the loss could be carried over or back." (Editorial comment by TAX Checklist. 191+9 Ed.— 7 (June 2b, 19^9) * by the Research Institute's Tax co-ordinator, Research Institute of America, 1.) Loc. cit. 232 pranj. Scott, "Losses on Sales of Business Property as Net Operating Loss Deductions," Journal of Accountancy. LXXXVI, No. 3 (September, 194- 8), p. 219. *H6 restriction on the application of Sec. 122 and the discrimi nation it has brought about against the unincorporated small business, as compared with the incorporated enterprise. Mere consistency in treatment would require us to argue for the inclusion in loss carry-over of loss on sale of busi ness property. Loss on sale upon liquidation is usually indicative of the low earnings capacity or prospect of the business, as compared with original expectations or with the level of earnings in general and conversely, gain on liquida tion signifies a high earnings capacity and prospect, as com pared with the general level of earnings. Since we have recommended the full taxability of gains arising from such sale and consequently the full offset of these gains against 233 any net loss carry-overs, we are theoretically bound to hold for the full deductibility of the losses and consequently their offset against income of other years. The Commissioner^ ground that such losses are not incurred in a trade or business of an individual is illogical since the same criterion as to . . w < * the carry-over or carry-back of such losses does not apply to those incurred by corporations. The discrimination placed on the small unincorporated business by this restriction on the carry-back of loss on sale 2^3 Adjustments called for by Sec. 122 accomplish vir tually the same things. *+17 of business property is especially harsh, in view of the many tax advantages already enjoyed by the large incorporated busi ness. Small business is the hardest hit, inasmuch as the large corporation just does not liquidate in the sense and manner that small business liquidates. Why this special restriction should be imposed to hamper small business increas ing its tax disadvantage as compared with large business, is beyond the comprehension of this writer. He, therefore, urges the allowance of loss upon a liquidating sale of business property to be carried back for one year under our proposed permanent excess profits tax. Conclusion. In conclusion, this writer wishes to point out that the net loss carry-over is, in his opinion, probably the most important single leverage in any system of business taxation based upon business net income. It lessens the effect 23 of any tax on business risk. It smooths out the more extremes of income irregularity, thus affording some tax 235 relief on its own. If its actual operation is perfected, Sunra« Chap. V, pp. 277-289. 2^5 A carry-over period of ten years will probably be more than sufficient to cover a business cycle and irregular profits of some years will be reduced considerably by the losses carried over from other years. In tax practice, the existence of excess profits can be determined only with refer ence to the normal long-run period, as we mentioned elsewhere. (Supra, Chap. IV, p. 2580 But loss carry-overs will eliminate, to some extent, some of the defects inherent in the imposition of an annual excess profits tax. *+18 it may equalize to a great extent the differential tax advan tages as enjoyed respectively by large and small business.2^ It allows the growing enterprise to retrieve out of current profits, tax-free, some of its unavoidable losses sustained in its infancy. To accomplish all these economically desir able results, it is yet simple to administer, much more so than income averaging, or even loss carry-back. Tax framers may do well to devote their time, energy, and resources to work for its perfection. SPECIFIC EXEMPTION Reasons for flat income exemption. Despite the utmost care and exactitude devoted to the framing of a permanent excess profits tax, there are bound to be unforeseen defects and shortcomings in the tax scheme that will detract, to the delight of the opponents of the tax, from its claim to dis tributive justice and administrative efficiency. Especially when the rates are high and graduated and where discriminative treatment is called for but only general over-all treatment is available, the injustices done or the operational difficulties encountered may be such that irreparable damage may be done. To avoid the occurrence of such eventualities as far as possible and to keep down to a minimum such distressing situations Supra. Chap. Ill, pp. 160-163, Chap. V, pp. 277-289, and text above, passim. calling for special treatment, various cushions, so to speak, are provided in the levying provisions of the tax to absorb or lessen its adverse effect on business* Specific exemption is one of such cushions* The repealed wartime excess profits tax provided a specific exemption of $10,000 for most corpora tions except mutual insurance companies other than life or marine which were allowed a special exemption of $50,000. For peacetime operation the flat exemption of $10,000 is too low, especially when unincorporated businesses are included within the scope of the tax* Even though the residual claimant theory of excess profits and the principle of the separate enterprise entity are equally valid and applicable in the case of small business as well as in the case of the large corpora tion, as has been argued above, we also recognize the close relationship and the practical correspondence between the small enterpriser and his business* To prevent hardships from arising out of a strict compliance with these principles, a high exemption, leaving out most small enterprises from the imposition of the tax, is considered highly desirable. Fur thermore the drift of our discussion so far undoubtedly con veys the impression (at least, that is what this writer intends to convey) that if a permanent excess profits tax produces any adverse effect at all, small and medium business is going to be affected more adversely than large business. This is so with respect to risk, efficiency, ability to benefit from k-20 the relief provisions (such as the loss carry-over provisions) of the levying act, and many other pertinent issues at stake, as we have discussed hereinabove. Again, the small unincor porated business has the institutional disadvantage of unlimited liability thrust upon its owners, which has prompted one author to argue for an arbitrary 50 per cent increase in 237 computed invested capital for all unincorporated business. One way to eliminate the extremes of tax differentials between large and small business is to provide a flat exemption for all enterprises at such a level that the small firms will benefit more from the flat exemption amount than the large concerns, thereby partially balancing out the tax advantages enjoyed by the latter. To a high degree of efficiency in the administration of a permanent excess profits tax, a high specific exemption is almost indispensable. It is administratively impossible for any tax assessment and collection agency to deal with numer ous • individual as well as corporate excess profits tax returns without some minimum income standard below which no excess profits tax returns are required to be filed. Since the OO Q burden of the tax, as we have analyzed elsewhere, will in the long run fall on the consistently high monopoly profits, Supra. pp. 361-362, footnote 101 Supra. Chap. 3TV, p. 269. k-21 which will be earned primarily by large corporations, it is against the interest of the national treasury and against efficient administration to shift administrative vigilance from its primary target to some piddling and unrewarding enterprises whose excess profits, if any, will be small and will consist mostly of competitive efficiency profits and, to a minor degree, windfalls. Recommendations. For the aforestated reasons, a mini mum specific exemption of $50,000 should be allowed. A high specific exemption, however, entails difficult problems of its own and we have space here to mention just one of them. Since the split-up of an integral business enterprise into several smaller units, each of which would presumably be entitled to one $5 0 ,0 0 0 specific exemption, the excess profits tax liability of the affiliated group under the same control might be cut down considerably and at times total avoidance 239 of the tax might be accomplished thereby. Unless compul sory consolidated return is required under such circumstances,' there does not seem to be any effective means of combating tax avoidance in this respect. This loophole of the tax measure Sec. l*fl(c) allows only one specific exemption for an affiliated group filing a consolidated return. pU.fi For problems arising from the election to file con solidated returns, see infra, pp* l +31-1 +32. must be closed, by further technical study k-22 BATE STRUCTURE In principle, there is little basis for rate graduation 2bX in a permanent excess profits tax system, A given dollar of profits above normal either provides or does not provide a necessary incentive for further economic endeavor. Regard less of the amount of excess profits, anything above normal is supposedly unnecessary for the maintenance of investment incentive and may be taken away in taxes without impairing production. In practice, however, the problem is not that simple. Rormal profits are difficult to define, even more difficult to compute. Risk and efficiency act as factors con stantly varying in our effort to arrive at such normal profits. Size and the ability to benefit from miscellaneous levying and relief provisions of the tax tend to modify whatever level of normal profits computed without consideration of these modifying factors. A new and growing enterprise cannot be expected to be satisfied with the same level of profits as an established one. The ability to pay tax is directly related 2b2 to the size of the business enterprise. Small business has greater need to retain business earnings for purposes of Shoup, oj3. cit., p. 2*f3. Sunra. Chap. Ill, pp. 153-167• ^23 2*+3 expansion than large business. All of these factors have some bearing in the determination of exempt normal profits and indirectly point to the difficulty of knowing precisely where the dividing line between necessary and unnecessary 2M+ profits is. As we said elsewhere, precise knowledge is impossible under any system of taxation and therefore the lack of it should not be allowed to invalidate the effectiveness of an excess profits tax. To give effect to all these factors bearing upon the final determination of exempt normal profits, it is considered preferable to raise a given revenue under the proposed permanent excess profits tax by a rate structure graduated in accordance with some objective standards indicat ing the possible correlation between these standards and excess profits. The best indicator is, in the opinion of this writer, the percentage of excess profits to invested capital and the 2^-5 rate should be graduated accordingly. The initial rate should be considerably higher than the existing 33 per cent j. Keith Butters and John Lintner, Effect of Federal T^xes on Growing Enterprises (Boston: Harvard University, 15457, 2lfif Supra. Chap. Ill, pp. 108-109 and l^-lW. 2^5 Shoup, 0£. cit., p. 2V3. Shoup mentioned five possible manners of graduation: by blocks of absolute amount of net profit, by absolute amount of invested capital, by per centage of net profit to invested capital, by absolute amount of excess profits, and by percentage of excess profits to invested capital. He considered the last type of graduation the best of the five. l f21 + corporate income tax rate, considering the fact that no specific exemption and statutory normal profits are allowed in income tax computation. The terminal rate should in no case be higher than 75 per cent, considering the maximum effective rate of 85.5 per cent of the repealed wartime excess profits tax. These conclusions are indicative, however, more of this writer's conviction on these topics than of his inductive reasoning and are therefore subject to modification whenever warranted by statistical findings of a definitive sort. REVENUE AND ADMINISTRATION Revenue prospect. In accordance with the concept of the cyclical budget and with the factor of "built-in1 * flexi- 2h6 bility, a permanent excess profits tax will produce widely varying revenue yields over the business cycle. This lack of revenue stability, as we mentioned above, should not be urged against the tax, inasmuch as it is imposed for its theoretical harmony with the cyclical budget theory. Lack of revenue stability should not be thought of as lack of productivity. It is probable that even in lean years the tax would supply a revenue altogether worthwhile. "In our vast country it seldom or never happens that all sections and all industries move together. . . . There will always SupraT Chap. Ill, pp. 9^-102, passim. b25 21+7 be some excess profits tax.*1 Any prediction of exact annual yield, however, is difficult to make, as the factors 21+8 to be considered are too many for us to try to study herein. Indicative of the yield of our proposed tax under conditions of relative prosperity are Secretary Vinson*s estimate of $2,500,000,000 as being the cost for repealing the wartime excess profits tax imposed by the Second Revenue Act of 2 1 + 9 19^0, and the probable yield of $^-, 3 0 0, 0 0 0 ,0 0 0 as antici pated by President Truman from his proposed excess profits tax during the pre-election days in 19^8, A permanent peace time excess profits tax productive of revenue from upwards of two billion dollars annually during prosperity is nothing to be slighted. Administration. Most of the attacks on the proposal to levy a peacetime excess profits tax have been aimed at the 250 administrative difficulties it is likely to engender. Some of the difficulties are admittedly serious, though not insur mountable. Some are superficial only. Representative of the 2i+^ Adams, "Federal Taxes upon Income and Excess Profits,1 1 p. 22. Some of these factors are the level of national income, the relative prosperity of the various segments of the economy, price level, and so on. Sunra. Chap. II, pp. 81-82, footnote 1 2 8. 250 These difficulties have been exaggerated according to information obtained from Treasury sources. (Temporary National Economic Committee, Monograph No. 9* P* 121 and foot note 2 thereon.) h26 latter is the argument that "a court decision might reopen 251 thousands of returns.'* This statement was advanced in furtherance of the movement to repeal the V/orld War I excess profits tax. It is to be expected in a democracy that litiga tion will be resorted to for the settlement of issues arising from the administration of any tax especially during its infan cy. At first, court decisions will conceivably affect the returns of many taxpayers simply because they are concerned with issues and principles applicable generally. As time wears on, decisions will likely be confined to issues arising from some particular situations not generally applicable. This is exactly what we may expect in levying a permanent excess profits tax. After it has been in effect for some time, the likelihood that a court decision might reopen thou sands of returns is slight. There are many other such superficial arguments against the tax on administrative grounds. The intricacies in the determination of net income in a complex industrial society 252 may serve as another example. The one real difficulty in 251 Kenneth J. Curran, Excess Profits Taxation (Washington, D. C.: 19^3)» p. 93. 252 Ibid., p. 127* We do not have to concern ourselves with this problem, inasmuch as under our proposed tax the net income for excess profits tax purposes will be arrived at in the same manner and in accordance with the same principles and rules as the net income for income tax purposes. administering a permanent excess profits tax lies, in the opinion of this writer, in the determination of the taxpayer’s 253 first-year invested capital. Even this difficulty may not amount to anything like a serious indictment of the tax, as it once did during World War I, inasmuch as the experience with the tax during the past two wars should have enabled both the taxpayer and the administration to more successfully deal with any problems that may arise from a re-imposition of the tax. The relief provisions of the tax may be another source of administrative difficulties. But in view of the high specific exemption and moderate rate structure we have recommended, it is doubtful whether they will continue to cause as much difficulty as the relief provisions had under the repealed wartime excess profits tax. The elimination of the computation of normal profits by appeal to base-period experience will have done away with any relief provisions similar to Sec. 722. And that is a real relief in itself. SUGGESTIONS FOB INTEGRATION Technical superiority of excess profits tax over existing corporate income tax. We have criticized the present federal income tax on corporate and individual income for 253 For a discussion of the difficulties invo'lved herewith, see Curran, oja. cit., pp. 127 ff* effectively taxing the same dividend distributions twice, first, as corporate income and then, as individual income 251 * when that income is distributed. From the point of view of the corporation as a separate and distinct entity detached from its legal ’ ’owner,1 1 corporate income should be taxed to the corporation as an economic entity. But from the same standpoint of separate entity the owner is classed in the same position as that of the contractual creditor and any distribu tion to the former should be allowed as a "deduction” from corporate income before any tax is applied, inasmuch as inter est paid to the contractual creditor, occupying virtually the same economic position as the owner, has always been allowed as a deduction for corporate income tax purposes. As we said elsewhere, to tax the corporation as a separate entity but fail to apply the theory of separate entity consistently so as to allow dividend distributions as a deduction from gross income, remains to be a serious theoretical objection to the 255 existing federal corporate income tax. There is no such theoretical objection to the imposition of a federal excess profits tax, for both in theory and in the mechanics of tax computation normal profits, representing the share of the total 251 * - See supra, Chap. I, pp. I-1 *, and Chap. Ill, pp. 1^0 lU-l, footnote 110. Loc. cit. *f29 product going to the owner, which will be distributed in the long run if not in the short run, are always allowed to be deducted before the tax applies. Relation to Sec. 102 surtax. The imposition of an excess profits tax would render superfluous the current Sec. 102 surtax on corporations improperly accumulating sur plus. Since the repealed Sec. 102(d)(1)(D) allowed income subject to the wartime excess profits tax as a credit against the income subject to the Sec. 102 surtax, the same provision should be revived when our proposed excess profits tax is introduced. If it is thought that the penalty surtax is now superfluous, the entire Sec. 102 may be stricken out. The net result of the imposition of an excess profits tax is that 256 only the normal profits of a corporation will not be sub ject to the higher tax. Since normal profits will generally be distributed in the long run, the penalty surtax on cor porations improperly accumulating surplus loses its present significance. The problem that remains to be'solved has to do with the taxation of the normal profits exempt from the excess profits tax. Here is where proper integration between the proposed tax measure and the existing income tax provisions exerts itself. Plus the specific exemption of $50,000. H-30 Withholding and credit of tax. The issue involved cannot be explored in full in this study. This writer will make a few suggestions as to how the problem may be solved. A withholding tax of around 25 per cent may be levied against the exempt normal profits plus the specific exemption, at the corporate level. This will permit the government to tax such profits at their source without any loss of revenue through diffusion of income. Gross dividend distributions without reduction for tax withheld in the hands of individual stock holders will be included in their gross income for personal income tax purposes, but a credit of 20 per cent (only) of the 25 per cent corporate tax against the personal tax finally determined may be allowed. A full credit up to 25 per cent, the rate at which corporate normal profits were taxed, is not recommended. The difference is to be used by the govern ment to defray extra expenses incurred in administering the 257 withholding and credit provisions. For corporate account ing purposes, it may be necessary to set up two surplus accounts to record debits and credits to both accounts aris ing from the transactions relating to normal profits and those relating to excess profits, both remaining after tax. 2^7 Sec. 2 6(b) allows a dividends received credit of only 85 per cent for the. amount of dividends received by a corporation from other domestic corporations. 4-31 Uninc orporated businesses. For unincorporated busi nesses the portion of profits which is subject to the excess profits tax will not again be taxed under the personal income tax. Business normal profits will, of course, be included in gross income subject to the latter tax. In case of large incomes, it is not only possible but probable that the appli cable personal income tax rates may be higher than the corres ponding excess profits tax rates. SOME IMPORTANT TECHNICAL PROBLEMS NOT FULLY DISCUSSED Owner1s salary allowances for unincorporated businesses. The guiding principle in the determination of the owner*s com pensation for unincorporated business is reasonableness. Of course, reasonableness is a relative term and its degree varies with the amount of net income of the business as much as with the ability and acumen of the owner. The principal employees* salaries may serve as an indication of what the salary allow ance for the owner should be. The “opportunity cost'* aspect should also be examined. We do not have space in this study to go into all determining factors. Consolidated return. The principle of separate enter prise entity of business enterprise, distinct and apart from its “owner," applies just as much to various business interests controlled by the same “owner." There is no valid reason why the excess profits of one affiliated enterprise should be ^32 allowed to be offset by losses incurred by another of the affiliated group in the determination of the excess profits tax liability of that group. These arguments seem to argue against consolidation. But the entity theory of consolidated 258 statements for accounting purposes seems to apply equally well for taxation purposes. Tax avoidance through the split ting of an enterprise into smaller units to take advantage of the specific exemption allowance may also be forestalled by the requirement of compulsory consolidation, even though loss offsets among the group may be achieved at the same time. The beneficial effect of such offsets on entrepreneurial decision may be a redeeming feature of such compulsory consolidated return. Relief. The need for relief provisions is a relative one. It is relative to the care with which the tax measure is drawn, the statutory rate of normal profits, the height of the tax rates, the level of the specific exemption, and other factors. Passing over the matter of legislative care in devis ing the tax, we can see that the need for relief under our proposed excess profits tax system is not as great as under ^ As proposed by Maurice Moonitz, The Entity Theory of Consolidated Statements (Chicago: American Accounting Association, 19^-^ See also Randolph E. Paul, Taxation for Prosperity (New York: The Bobbs-Merrill Company, 19^7)j pp. 372-373. Also supra. Chap. Ill, p. 156. ^33 the repealed wartime excess profits tax. The level of the specific exemption as recommended by us is five times that of the repealed measure. The average rate of the tax stands at about 63 per cent, as compared with the effective 85 per cent (approximately) rate of the wartime tax. For the small busi ness on which our present interest is primarily centered, the high specific exemption of $50,000, the longer period of loss carry-over, the improved system of such loss carry-over, and other differential tax benefits in its favor should render any large-scale general relief provisions unnecessary, except in particular instances. One of such instances relates to the small unincorporated business with the attendant institutional factor of unlimited liability. It is difficult to allow for the greater risk-bearing due to the institutional cause of unlimited liability in the levying statutes. A better way to achieve the same end would be to set up a special board devoted strictly to hearing and granting relief to worthy hardship cases. The statutory normal rate may be increased to suit individual needs. Business assets, however, may not be revalued at current market for the simple fact that such revaluation is inconsistent with our residual claimant theory of excess profits. The exempt normal profits should be com puted as provided in the statutes. CHAPTER VII THE INCIDENCE. AND EFFECT OF A PERMANENT EXCESS PROFITS TAX Introduction* The economic validity of most of our major conclusions reached in the foregoing chapters with respect to the taxation of business excess profits depends upon one of the most fundamental assumptions we have so far implicitly made regarding the excess profits tax: that the burden of the tax rests with the business enterprise taxed as a separate and distinct entity and is not shifted forward to the consumer in the form of increased prices, sidewise to the wage-earner through wage reductions, or backward to the stock holder or the owner in decreased dividends or normal returns* Without this assumption as to the incidence of the tax many of the arguments advanced in support of an excess profits levy would be either literally untrue, or deprived of much of their logic, strength, persuasiveness, and conclusiveness. For instance, if the major part of the tax burden is shifted to any or all of the three groups mentioned above, our claim that the excess profits tax is exclusively a business tax on busi ness enterprise as a separate entity cannot withstand the charge that it, just like any other tax on business, is levied but for the convenience and expediency of tax collection and administration without any.merits of a separate business tax ^3^ ^35 1 as we have maintained elsewhere. Why busy ourselves with any theoretical and economic justification for a special tax on business as a separate entity, knowing that in the end either the consumer or somebody else other than the business itself will pay for that tax? Furthermore, prospective evaluation of the equitableness of a proposed tax measure would not be possible without some knowledge about its probable incidence. To the extent that it is shifted to the consumer, the wage- earner, the owner, or all three, the excess profits tax par takes of the shortcomings of the sales tax, the payroll tax, and/or a partial income tax on what is known as “normal 2 profits.” Finally, as we have argued elsewhere, without the assumption of nonshiftabilityour line of reasoning apropos of the relative abilities of business enterprises to pay taxes, the minimization of the depressive effect of the tax on the investment incentive, and the effect of the tax on investment, saving, and consumption, would not have carried ^ See supraT Chap. Ill, pp. 183-185* o Richard Goode, “The Corporate Income Tax. and the Price Level,” American Economic Review, XXXV, No. 1 (March, 19*+5) i **1» Goode did not mention the shortcomings of a par tial income tax on normal .profits. As we know, the sales tax and the payroll tax are regressive in character and suffer in the lack of justice in tax distribution according to the ability-to-pay theory.. A partial income tax on normal profits tends to restrict capital supply, to the affected industry or firms• ^36 as much conviction and conclusiveness as it now has.^ With these words of introduction we proceed to a review of the traditional theory of incidence, preliminary to our discussion of the incidence and effect of a permanent excess profits tax. i« m incidence It was generally held among economists down to 1927 that the incidence of a tax on net income, is not shifted hut remains where it was first imposed. Representative of this school of thought was Edwin R. A. Seligman whose standard work on the shifting and incidence of taxation should be 5 familiar to all. While there are numerous works dealing with the subject of the incidence of the income tax, very little has been written on the incidence of an excess profits ^ See suura. Chap. Ill, pp. 186-188. L. Duncan BlackT The Incidence of Income Taxes (London: Macmillan and Co., Limited, 1939), p.""!?. ^ Edwin R. A. Seligman. . The. Shifting and Incidence of Taxation (Second edition, revised; New York: Columbia Univer sity Press, 1902), the fifth edition of which appeared in 192o under the same title, but was not available to this writer when this chapter was written* However, some passages of Seligman*s later work pertinent to our discussion were freely quoted by Gillim (see footnote 6 on the following page) in his book on the incidence of excess profits taxation. A compari son of these passages with the corresponding parts in the earlier edition indicates that Seligman* s views on incidence remained substantially, the same in 1926. as they were around the turn of the century. 1*37 6 tax until recently. However, we will proceed from a review of the theory of incidence with regard to a net income tax in order to acquire the necessary background for the discus sion of incidence in connection with a permanent excess profits tax* SELIGMAN*S THEORY OF INCIDENCE OF A GENERAL INCOME TAX Theory of tax shifting. According to Seligman, whether the shifting of taxation is possible or not is primarily a 7 question of prices. Since in the long run cost governs price, the tax must evidently at first be regarded by the producer as an increase in the cost of production in order 8 to be shifted through prices increases. If the tax is an addition to the cost of producing the article, price must rise, for otherwise profits will be curtailed and the produc tion of the article will diminish. Failure to raise the price will entail the following two results: 6 In 19^-5 the first comprehensive and exclusive treat ment of the incidence of excess profits taxation appeared under the title. The Incidence of Excess Profits Taxation by Marion H. Gillim (New York: Columbia University Press, 19^5)• According to Gillim, the only, essay dealing exclusively with the subject, prior to his own, appears to be a chapter. “Has the Excess Profits Tax Raised Prices?” in David Friday’s Profits. WagesT and Prices (New York: Harcourt, Brace and Company, 1921), PP* 192-206. ? Seligman, og. cit.. p. 179. 8 Ibid.. P. 180. b38 . • • either producers will gradually transfer their capital to untaxed industries, or, even if the transfer of capital is impossible because it is firmly fixed in the industry, production will be curtailed by the crowding out of those who were previously on the very margin of profitable produc tion, while the tax will prevent the influx of any new capital.y In either case the long-run supply will decrease; and "this diminution, provided the commodity continue to be produced at all, will involve an increase of price. The burden of the tax is therefore shifted from the producer to the consumer. Nonshiftability of a general income tax. But Seligman argues that a general income tax willnot have either of the two effects and, hence, it will not be shifted* The reasoning proceeds as follows: unless capital can be invested more profitably elsewhere, it will not be transferred. As the general income tax reduces the profitableness of investment in all fields, the allocation of productive factors under competitive equilibrium prior to the imposition of the tax will not be disturbed afterward. Although the tax will reduce profits, it will not alter the. relative profitableness of investments in various businesses. ^ Seligman, loc. cit. 10 cit. Edwin R. A. Seligman. Studies In Public Finance (New York: The Macmillan Company, 1925)7 pp. 68-69. The quoted passage pertains to Chapter III— Income Taxes and the Neither can a general income tax crowd out those who were previously on the very margin of profitable production. A tax levied on profits cannot touch the marginal producer, for he makes no profits. Since the tax does not affect the cost of production at the margin and therefore does not pre vent the marginal producer from bringing the marginal product into the market, it cannot enter into the determination of 12 price. If price cannot be altered, the interest of the con sumer cannot be affected. It is the producer who bears the 13 burden of the tax, both immediately and ultimately. Seligman* s theory supplemented: the marginal unit argument. To complete the traditional theory of incidence, the marginal unit argument has been advanced. According to this theory, in addition to a marginal firm, there is for each firm a marginal or price-determining unit of production. Sir Walter Layton argues that any firm will continue to pro duce up to the point, . . . where the last unit of output makes no con tribution towards profit and therefore nothing (Continued) Price Level, originally an address before the Academy of Politi cal Science in the City of New York at its meeting, on “Wealth and Taxation,* 1 April, 192*+, appearing in the Papers and Proceed ings. XI, No. 1 (May, 192b), 3-23. 12 Ibid.. p. 73. ■ * • 3 Seligman, The Shifting and. Incidence of Taxation, p. 291. V K > towards the revenue of the State. This is the unit of production which determines prices, which should therefore be unaffected by a tax on those units which.yield some profit. On the same reasonr. ing, the amount of output should remain unchanged.1^ This is the point where marginal revenue and cost are equal 1*5 and we had occasion to_refer to its significance elsewhere. y This marginal unit argument ..supplementing the tradi tional theory of incidence_has .application .under conditions of both competition and monopoly. By the same reasoning as above stated, a general income tax on firms operating under conditions of monopolistic competition, or a partial income tax on monopoly, ceteris paribus. cannot be shifted, for as long as the marginal unit production bears no tax, the tax cannot prevent it from being, produced and brought into the market as the price-determining unit with.no tax addition. Production, therefore, will not be curtailed and price cannot be raised.1^ THE DEMAND SIDE APPROACH TO THE THEORY OF INCIDENCE Effect on demand ignored in traditional theory. It may be observed that the traditional theory of incidence approaches Tit From Minutes of Evidence Taken before the Committee (Colwyn) < 2 1 1 National Debt and Taxationf p. 177, Sec. 11, cited by Black, ag. cit., pp. 7-8. Supra, Chap. V, pp. 306-307. l6 Black, op. cit., p. b7» For more detail, see infra. p. Mfl the Incidence problem entirely from the supply side. To be sure, Seligman did devote some attention to the influence on incidence of the various degrees of elasticity of demand of 17 the particular commodities under consideration. But his concern in regard to the degree of the elasticity of demand has reference only to the relative ease with which price 18 may be increased without difficult adjustment in production. The effective demand is assumed to be constant, that is, the imposition, of the tax is assumed to exert no effect on demand through its income effect on the demand schedule. In other words, any effect the tax may produce on the demand side is ignored. Antonio de Viti de Marco1s theory. It is this complete disregard of the effect of the income tax on demand that Antonio de Viti de Marco deplored. He insisted that the immediate effect of a general income tax should be studied ^ Seligman, 0£. cit.. pp. 188-192. For instance, if demand is inelastic, as in the case of necessities and luxuries, effective demand will not decrease as a result of a rise in price due to the imposition of a tax (ibid.. pp. 189-191); where the price of a commodity before the tax has already reached the limit of the. effective demand, or where the commodity must be sold.at the.accustomed price or not at all, any attempt to increase the price would totally anni hilate the demand and the price cannot possibly rise.(ibid.t p. 191); and if the demand is elastic, as is the case with minor luxuries and of all comforts, the tax.will.be divided between the consumer and the producer (ibid.. pp. 191r?192). M +2 19 from the side of demand rather than of supply, No immediate effect of the tax on price can come from the side of supply, inasmuch as factors affecting supply taka time to work them- 20 selves out. The only immediate effect on price will be produced by the tax through its effect on the demand curves for all commodities and services, as now taxable individual incomes have been reduced. Another fault of the cost theory of incidence, according to De Viti, lies in its disregard of the effect on price of government expenditures. Since it is obvious that the government will^not spend the tax money in exactly the same way as the individual producers and consumers will, the effect on demand is apparent and the demand for some things will be greater than before the tax and for others smaller. These changes of demand, according to De Viti, will cert ainly cause changes in prices * The alteration in supply is made secondary, under De Viti*s analysis: supply is increased in those areas in which tax has been shifted.and demand has increased, while a decrease will be observed in those enter prises which have borne the burden, of the tax through ^ Antonio de Viti de Marco. First Princfples of Public Finance, translated by E. Marget (New York: Hareourt, Brace and Co., n.d.). This work is not available to this writer and the discussion of de Viti*s work in the text is based entirely upon Gillim1s summary.(op. cit.y pp. 1^-17)• Alfred Marshall, Principles of Economics (Eighth edition; London: Macmillan and.Co., Limited, 1920), p. 3^9, and also, supra. Chap. IV, pp. 209-210. M+3 suffering a decrease in the demand for their.products. Accord ing to De Viti, even a tax on monopoly profits will be shifted through changes in demand curves. The only exception to this rule occurs when the tax collection and. government expendi ture of the money do not, on the whole, affect the demand curve for the monopolists product. SYNTHESIS A possible reconciliation of the demand and supply approaches to an incidence theory may be sought in the differ-^ ence in time period on which, their respective proponents focus their attention. As Marshall, pointed out, the influence of demand on value dominates in. the short run while that of supply reigns in the long run. The cost approach of Seligman is necessarily that of the long run and is therefore appli cable only to a long-run view of incidence. . De Viti*s demand side approach has reference only to the immediate short run* It goes without saying that.the effect of capital transfer ence and the elimination of marginal firms, takes a long time to make itself felt ultimately in altered price structure, but the reduction in demand, over a wide range of the economy and the differences in private and public expenditure patterns due to the. imposition of a general income tax have almost immediate and uneven effects on the price structure. But this writer does not wish to convey the impression that W f factors on the supply side have no influence at all in short- run price determination or that factors on the demand side exert no pressure at all on prices in the long run. It is the relative importance of each,, as compared with the other, in price determination in the long run or in the short run that he is referring to. Both the demand and supply side approaches are legitimate and tested tools of analysis within their own proper time spheres and no one is justified to say 21 that one is necessarily right and the other wrong. SELIGMAN*S INCIDENCE GP A PARTIAL INCOME Conditions for shifting. Under the traditional theory a partial income tax will be shifted. A tax on the profits of some particular occupa tion must, in the long run, be shifted to the consumer, provided that the commodity continue to be produced at all. For if the tax.rests on the particular profits, the producers will be put at a disadvantage as compared with those engaged in other industries. There will be a gradual migra tion of capital to find the most profitable level, and the original industry will gradually be deserted. In the long run, therefore, either the tax will be shifted to the consumer or it will lead to a cessa tion of production. In the one case, consumers suffer through increase of price; in the other case, they suffer through destruction of consumption. But in no case will the burden ultimately rest on the permanent producer.22 This result applies, however, only under competitive conditions. 21 Black has attempted a synthesis of his own by study ing incidence from both the demand and the supply sides. (Op. cit.. p. *+2.) 22 Seligman, op. cit., p. 289. bb5 A partial tax on monopoly profits cannot be shifted. Since the monopolist theoretically has already charged the highest price which will bring forth the greatest monopoly profits, a tax on such profits cannot increase the price and must, there- 23 fore, fall wholly, on the monopolist. Black »s qualification. In the case of a partial income tax on monopoly, Black added the qualification that the above conclusion holds true only when the private factors of a 2b monopolist are in fixed supply. When the private factors are in variable supply to the production of the monopolized good, he may be able to transfer part of his supply of these factors to other lines of production. The cost he figures in his production or marginal cost curve for his labor and capital is now what they would yield him if employed in their most favorable uses outside the business. After the tax Is imposed, the cost he charges to each unit of labor and capital that he devotes personally to his business must be raised in order to yield him after tax a return equal to that .which he could get for them by employing them in the most favorable and untaxed alternative industry. The resulting rise in marginal cost 25 means a reduced volume of output and higher prices. 23 Ibid.. pp. 288-289. Black, op. cit., p. **7. Ibid., pp. **7-53. ¥*6 Explanations of the, nonshiftabllitv of the federal • corporation income tax. In practice, the federal corporation income tax may be regarded as a partial income tax, as it does not affect partnership or proprietorships. A study conducted by the National Industrial Conference Board reveals, however, that the tax is not shifted. Since the market price depends upon the expan sive and contractile character of this large volume tendered on the market around the no-profit point, it is obvious that the price is determined by the portion of the output, the production of which is not affected by the tax. The tax will not affect the expansive or contractile character of any por tion, because the product sold at a loss or at no profit is not subject to the tax, and the portion sold at a profit will still be profitable after a tax proportional to the profits is deducted.433 Hence, the corporation income tax appears to offer no new or 27 additional factor in price determination. This tends to contradict Seligman's conclusion as to the shiftability of a partial income tax. A possible explanation seems to be that the corporation income tax, coupled with the personal income tax, may be considered as constituting a general rather than 28 a partial income tax. Institutional impediments to large- National Industrial Conference Board, The Shifting and Effects of the Federal Corporation Income Tax (New York: National Industrial Conference Board, Inc., 192o), I, p. 137* 27 Ibid., p. 138. 28 Ibid.. pp. 22-23. 1*1+7 scale capital transfers are among the other explanations.2^ II. A DISSENTING NOTE OH THE.DEMAND SIDE APPROACH TO THE THEORY OF INCIDENCE As stated above, the traditional theory of incidence differs from, its modern version in its neglect of the immedi ate response of demand to the imposition of a tax. Further more, demand may be altered by government expenditure of the tax proceeds to the extent that the pattern of public spending may differ from that of private consumption. Effects of a general income, tax on demand and prices. The apparent effect of a general income tax at proportional rate is a reduction of all incomes by the same proportion as 30 the tax rate. But, as De Viti pointed out, a 10 per cent tax will not result in a 10 per cent decrease in the quantity of all goods demanded, lichen each, individual has. an income of only 90 per cent of its former size he will rearrange the relative shares of his income to be allocated to each expendi ture. Thus, an immediate effect on price will be produced by the tax through its effect on the demand curves for all commodi ties and services. But whether this means an increase or 29 Ibid.. p. 139. De Viti, op. cit.. pp. 153-15^j as cited by Gillim, OR* JSi£*> P* 15* 1 *1*8 decrease in the general price level or in individual prices depends on several variables, including, among others, the new pattern of private consumption after a general income tax, the pattern of government spending, elasticity of demand, and conditions of competition permitting entry. In giving effect to the influence of demand on price, it is important that the pertinent time period or periods with 31 respect to which that influence is studied be specified. It is conceivable that owing to the general reduction in income, an alteration in the combination of goods ordinarily consumed 32 m y have immediately occurred so that the.demand for certain goods is immediately increased. J The prices of those goods, 31 Ruby t. Norris , The Theory _ of Consumer * s Demand (New Haven: Yale University Press, 19^+1), p. 96, 32 Since it takes time to make a consumer break old habits or adopts new ones, it may be assumed that in the short run the consumption pattern of any individual remains constant. (Norris, o p. cit.T p. 97») As his income is reduced by tax, it is deductively probable that the existing demand for neces sities will be maintained within certain limits, but that for the high-priced luxuries will experience a decline. (Ibid.. p. 106.) No wholesale regrouping of substitutes is likely to take place in the short run. Furthermore, if the consumer dips into his savings to maintain, his customary consumption, no change in the combination of commodities may happen at all in the short run. 33 it is obvious that the ordinary process of tax shift ing does not operate in cases where the demand for the commodi ties has fallen off on account of the imposition of the tax. It should also be noted here that if savings are reduced to maintain short-run. consumption, no decrease in demand may be experienced at all. 1*1*9 low-priced necessities and luxuries, may experience a partial rise. Thus, a portion, of the tax burden on the net incomes of the firms which, produce them will in. the short run be shifted to the consumer in the form of higher prices. But is this occurrence an enduring phenomenon of the tax levy? The price rise will yield extra profits to the more fortunate firms, com pared with their contemporaries. If they operate under condi tions of free competition.where entry is free, competitors will step in and the increased supply will soon drive prices down 3^" again. Under conditions of monopolistic competition where customers* good will and the customary prices are important considerations, there may not be price increases even in the 35 short run and there will, likely be increased production in the long run. Thus, in the short run prices may rise under competition, as a result of the levy of a general income tax, but not under monopolistic competition where consumer good will.and customary prices prevail. But in the long run prices tend to level off with the possibility of returning to their previous level. Furthermore, the long-run effect of changes of income upon the Ok J The increased supply.may also come from increased production by the existing firms. 35 Norris, op. cit.. pp. 102-103. Also Albert L. Meyers, Elements of Modern Economics (Revised edition; New York: Prentice-Hall, Inc., p. 99 and Edward Chamberlin, The Theory of Monopolistic Competition (Third edition; Cambridge: Harvard University Press, 1939)> P* 108. k-5o consumption habits of the consumer may be a changed mode of life for some, but On the other hand, many categories of goods are so dissociated in the types of services they render that considerable shifts in income would in no way alter the relative esteem in which the alternatives are heId.3° On these types of services or goods the amount of income may have little if any effect upon their relative preferences. In this latter case a 10 per cent general income tax will reduce demand by roughly 10 per cent across the board. Tax shifting is difficult to accomplish under such circumstances. Possible effects of an excess profits tax on demand and prices. What we have been trying to stress hereinabove is the extreme uncertainty characterizing the possible conclusions as to the ultimate effect of the general income tax on price by approaching the.problem from the demand side, even granting the most favorable circumstances for its application. If this is the case with a general income tax, it will be even more so with an excess profits tax inasmuch, as an excess profits tax levied upon business income is likely to affect demand more 36 Norris, o£. cit., p. 123. 37 This conclusion may be modified by whatever effect reductions in savings and tax credits and deductions may have on demand in the long run, as suggested by Dr. Pettengill. bji slowly and indirectly than a general income tax.^ As we have maintained elsewhere, an excess profits tax. on business may affect consumer’s income only through reduction in cor porate dividends to the stockholders* There is some contro versy as to whether dividends will decline drastically or at all*. . Even if dividend payments should decline after some interval of time on account of the tax, these dividends gener ally represent a small portion of the stockholders* total income so that it will be impossible to predict the effect on demand. The differences in. circumstances as among stock holders, which an impersonal excess profits tax.cannot take into account, further tend to render impossible any tolerably 09 accurate estimation of the effect of the tax on their demand. Then, there are the possibilities that the tax may not reduce ^-0 corporate dividends at all, as we have maintained. As Gillira appropriately remarked, because of the aforementioned difficulties in estimating the effect of the tax on demand, ”it is likely that no adequate treatment can be given to the changes which undoubtedly will occur in demand as a result of bl the tax.” ^ Gillim, on. cit., p. 6 3. ^ hoc, cit. Supra. Chap* VI, pp. 330-333, footnote 3 6, and infra, p. *+96. ^ Gillim, oj>. cit.. p. 63. *f52 Balancing effect of government expenditure of tax proceeds. Besides, there is the factor of government spend ing yet to be considered* If the increased government spend ing attributable to the tax proceeds is taken into account, it may conceivably provide some sort of a rough balance 1*2 whereby the decrease in private consumption may be offset* The comments of Goode on the effect of the federal corporation income tax on the price level are pertinent here* According to Goode, the corporation income tax is likely to bring about an increase in the price level only if the net effect of the tax is expansionary* The expansionary effect is created by some economic units which are willing to draw upon their savings to maintain the pre-tax programs of consumption and investment* If the corporation income tax taxes amounts which would otherwise be saved, the depressing effects on aggregate money income arising from the reduction in planned investment caused by the tax will-be partially or wholly off- 1*3 set. Prices will rise only when the net of these counter balancing effects is expansionary, or when the net effect plus the effect of government spending is expansionary* Under ordinary circumstances private cons lamption and investment will ^ Ibid*, pp. 20-21. **3 Goode, ojb* cit* T pp. 55-56. hardly be expansionary after tax. It would seem logical to assert that unless the government undertakes a program of expenditure with a view to stepping up the activity of the economy, private and public consumption and investment after tax should not cause a great disturbance in the pre-tax price structure. The effect on incidence from the demand side is thereby considerably lessened. Conclusion. Because of the inconclusiveness of any study of incidence from the side of demand, due to the diffi culties in predicting the vagaries of the consumer, the unknown pattern of government spending, and the probability of striking a balance between the decrease in post-tax private consumption and investment and the increase in post-tax public consumption, and investment, the incidence study of a permanent excess profits tax, which is to follow presently, will.by-pass De Viti*s demand approach to it. The conventional supply-side approach will be followed, supplemented by an analysis of incidence with respect to the various time periods, III. THE INCIDENCE OF £ PERMANENT EXCESS PROFITS TAX The purpose of this section is to present a deductive analysis of the incidence of a permanent excess profits tax under conditions of monopoly, monopolistic competition, and pure competition. The most complete work on this subject is k-5h that of Marion H. Gillim, which we have had many occasions to M* refer to. Gillim dealt exclusively with the incidence of the excess profits tax with the repealed wartime model of the tax as his point of reference. As such, the book con siders primarily the incidence of only a temporary and partial excess profits tax, though there is also ample space devoted to a study of that of a general permanent excess profits tax 1+5 under conditions of monopoly and monopolistic competition. The modern concept of relating incidence to the various per tinent time periods with respect to which, any analysis of incidence may be carried out is employed throughout his study. The book concerns itself not only with the theoretical aspects but also the practical side of the incidence problem. It is exclusive as well as comprehensive. This writer has not been able to find much fault with, both his technique of analysis and his conclusions, though differences of opinion, duly noted below, exist. The discussion to follow will lean heavily on this accomplished work. A- THE INCIDENCE OF A PERMANENT EXCESS PROFITS TAX UNDER CONDITIONS OF MONOPOLY AND MONOPOLISTIC COMPETITION Definition of terms. The terms “monopoly** and ),)■ Sunra. passim. ^ Gillim, op. cit., pp. 1*+1-155» i+55 • ’ monopolistic competition’ * are used hereinafter in the same connotation and same way as Chamberlin has used them. The word • ’ monopoly*1 has reference to those market conditions which enable the producer or monopolist to have a relatively high degree of control over his supply. It is not intended to describe a condition in which control is extended to all substitutes so that a perfect monopoly, almost non-existent 1 + 6 in the actual world, is attained. Besides, there is always the limitation of a highly elastic demand over which the 1+7 monopolist can, at best, exercise only limited control. The term • ’ monopolistic competition” is employed to describe the various or numerous gradations, of both monopoly and com petitive conditions lying between the extremes of pure 2+8 monopoly and pure competition. It is permissible to include monopoly, “as ordinarily conceived and defined," in the cate gory of monopolistic competition, since the theory of monopoly 1+9 recognizes both monopoly and competitive elements. It follows that in our treatment of the incidence of a permanent ^6 Chamberlin, on. cit., p. 65. A perfect or extreme monopoly is reached only in the case of eontrol of the supply of all economic goods. (Ibid.. p. 6 3.) 1 + 7 Ibid., p. 66. The limited control may be exercised through advertising. ^ Ibid., p. 6 3. ^ Ibid., p. 68. partial excess profits tax the analysis under conditions of both monopoly and monopolistic competition, as distinct from those of competition, is lumped together. This simultaneous treatment is also justified from the point of view of the 50 mechanics of analysis, as explained in the footnote. THE MARKET PERIOD The market period defined. This study of the incidence of a permanent excess profits tax starts with the market period which is defined as r , a period in which the supply of a good 51 cannot exceed the stock already produced and on hand." As regards the length of this period, it may not be limited to any certain duration, but will, differ in accordance with the v In the short run under monopolistic competition, the average revenue (AR) curve, the marginal revenue (MR) curve, and the short-run marginal cost (MC) curve for the firm bear the same qualitative relation to one another as do the AR, MR, and the long-run MC curves under monopoly. It follows that the type of diagram employed to show the effect of taxa tion on price under monopolistic competition in the short run can also be used to show the effect on price under monopoly in the long run and. also under monopolistic, competition in the long run, if entry into the field is not absolutely free. In the long run under both monopoly and monopolistic competition the AR curve will not lie below the curve of the average total unit cost (ATUC). Also in the long-run analysis under both monopoly and monopolistic competition relevant cost curves are the long-run cost curves, as distinct from the short-run cost curves. Adapted from Elmer D. Fagan and Roy W. Jastram. "Tax Shifting in the Short-Run." Quarterly Journal of Economics. LIII (August, 1939), 576, footnote 9« Elmer D. Fagan, "Tax Shifting, in the Market Period," American Economic Review. XXXII, No. 1 (March, 19**2) , 72, foot note 1* **57 commodity or service under concern and the size of the market. “The period can be shortened, if the market considered is small. and the supply can be increased by importing the eom- 52 modity." Under monopolistic competition the reservation price of a seller becomes the actual price at which the goods 53 he produces are sold. In a sense, this seller of a differ entiated product is a monopolist in the determination of his own price. But the existence of close substitutes sets a “sharp limitation on the amount which he can sell at any given price he decides to set.“ Profit maximization in the market period takes into account at the same time the total maximum profits possible in both the market period and the short-run 56 55 period. Complete price interdependence between and among sellers and constant demand schedules are generally, assumed. Cost of production, exclusive of tax, is “ancient history" in 57 this market period, except to the extent that it may affect the producer*s reservation prices, since every producer would 52 Gillim, op. cit.. p. 73* ^ Meyers, o p. cit.. p. 119. ^ hoc, cit. 55 Fagan, pp. cit., p. 76. 56 Ibid., p. 72, footnote 2. 57 Ibid.. p. 7*+. 1*58 58 like to recover as much-of his cost as possible* Selling price may be below, equal to, or above cost of production in the market period. Incidence in.accordance with deductive analysis. Since the seller sets his own reservation price at which the buyers will determine how much they will buy, the price, will be set at that volume, of production where the.marginal revenue ob tained from selling an additional unit of goods in the market 59 period is the same for that in the short-run period. His maximum profits will be realized when the marginal revenue in each time market is equal to the marginal cost of the entire 60 output in both the market period and the short-run period. The relationship between the reservation price (in the market period) and the expected future price (in the short-run period) is expressed by the simple assumption that the former is equal to the latter less carrying cost, including interest and risk allowance.^1 The same relationship exists between marginal 5® Meyers, op. cit., p. 96. 59 Fagan, pp. cit.. p. 7 6* 60 Joan Robinson, The Economics of Imperfect Competi tion (First edition; Londons Macmillan and Co., Limited, l 9** 2), p. 181. ^ Fagan, pp. cit., p. 7 6. The validity of this expres sion of the relationship, in the opinion of this writer, suf fers in two respects: (l).the market-period, reservation price may be better stated as the expected future price less carrying **59 revenues of the two periods. This pre-tax distribution of output will not be disturbed by a permanent excess profits tax levied at a proportional rate. An excess profits tax with a progressive rate schedule may tend to disturb this 62 optimum allocation, but only to a very limited extent, as we shall see presently. Prices, therefore, will not rise much, if any, in the market period as a consequence of the tax. Possible deviations. The alleged deviations may be studied by dividing the products to be sold into two cate gories: perishable and durable. 63 1. Proportional, rate of less than 100 per cent. In (Continued) cost, not including interest, discounted to the market time, inasmuch as interest and risk allowance, usually reckoned as part of interest, are taken into account in the discount ratio as defined by J. R. Hicks in his Value and Capital (First edi tion; Oxford: The Clarendon Press, 1939)? p. l8£ and (2) unless the elasticities of the demand curves in the market period and in the short-run period are equal (which was not explicitly assumed, though might have been implicitly allowed for), equal marginal revenues will not produce equal selling prices. For a proof of the truth of this statement, the reader is referred to Robinson's Economics of Imperfect Competition, p. 3 6. Fagan, op. cit., p. 85* Fagan was dealing with a net returns tax. With respect to the incidence of a permanent excess profits tax, this conclusion should apply with equal validity. ^ Since our proposed excess profits tax taps excess profits at progressive rates, the analysis of its incidence under a proportional rate would at first sight appear incon gruous. It is the opinion of this writer, however, that to analyze the incidence of a permanent _.exe ess profits tax under . * f 60 the case of perishable goods, since deferring sales to future 6*f periods is difficult, if not altogether impossible, the right amount to yield the maximum current profits before the tax will still be the right amount to yield the same current profits after the tax. One exception to this rule is men- 65 tioned by Gillim. As the tax reduces the reward to a new entrant to the field without decreasing his risk of entering into competition with a small group of established producers, the latter, planning to sell more goods in the current market before the tax in order to protect their future markets, may 66 believe it expedient not to do so after the tax. Thus, current prices may be higher than they otherwise would be in absence of the tax. The durability of the products does not affect the con clusion reached in the case of perishables that a permanent proportional excess profits tax will not affect prices. But (Continued) both types of rate structure will afford a comparison of the results and conclusions under either type, which would not be possible if we confined our analysis to the progressive rate schedule. As will be seen, such comparative analysis reveals some theoretical weaknesses of the graduated rate structure, as compared with the proportional rate structure, which a one sided analysis would not bring to the surface. ^ For instance, modern refrigeration system may render some of the heretofore perishables relatively ndurable.“ ^ Gillim, 0£. cit.. p. 101. 66 Ibid., p. 102. b6l 67 according to Gillim, a durable and depleting good provides an exception in that the monopolist producers may, to some extent, control the speed with which the market will be saturated. The pre-tax allocation of the good between the present and future markets may be altered, after allowing for risk and interest, so as to yield a greater profit after the tax than.that which would, result from the existing dis tribution after the tax. The proportional tax rate may reduce the reward for the risk involved in..future sales to a greater extent than that attendant upon current sales, which will now 68 increase. The reduced probability of new competition after 69 tax may encourage, however, withholding of depleting goods. Which of the two effects dominate will, vary among individual cases, 2. A progressive rate schedule considerably short of the confiscatory 100 per.cent. What has been said of the incidence of a permanent excess profits tax levied at a pro portional rate under (1) is also applicable to that of a tax 70 levied at progressive rates. In addition thereto, the latter may have some effect on price by disturbing the pre-tax 67 Ibid,T p. 103. ^ hoc, cit. 69 Ibid., p. 10b. 70 Ibid.. pp. 10^-106. h62 allocation of the product between the pre-tax prices within 71 the present and future markets. This comes about as a result of the fact that taxing larger profits at higher rates, the progressive tax makes desirable the regularity of profits as well as the extension.of the profits over a longer period 72 of time. But the postponement of sales to achieve profit regularity, concluded Gillim, may be practised only when the 73 product is both durable and depleting, Coroments on possible.deviations. The aforementioned deviations from theoretical conclusions as to the nonshift- ability of a permanent excess profits tax in the market period were summarized from Gillim* s accomplished work. This writer does not attach much significance, however, to such possible deviations for the following reasons. One of the argument s on which Gillim based his conclu sion that the excess profits tax may cause current prices to be higher than they otherwise would be in the absence of the tax is that the tax, by reducing the reward to a new entrant to the field without correspondingly, decreasing his risk of 71 Fagan, o£. cit., p. 85. 72 Gillim. on. cit., p. 106. 73 Loc. cit. For an example of the tax advantage in postponing sales, see Gillim*s illustration on pp. 107-108. entering into competition with established producers, reduces the possibility of new competition, thereby making it unneces sary for the established producers to sell more goods in the current market to protect their future markets. There is at least one defect in this contention* We have noted else- 7h where that under imperfect competition the concept of 1 1 industry" is no longer valid} as a result, profits of exist ing firms are, at best, only a very distant and uncertain indication of the profit prospects open to new entrants. This is the case when prices are maintained by agreement or collu- 75 sion and when there is product differentiation. If the pre-tax profits serve as only a minor guide as to the profit possibilities of new entrants when entry is at all possible, under conditions of monopoly and monopolistic competition, the post-tax profits will have even less influence on entry deci sion. Under such conditions the_established firms will tend to have to continue to produce and sell_as many goods as they would otherwise do. This is true when.the tax rate is propor tional as well as when it is moderately progressive assuming an ordinary degree of profit regularity. Gillim*s argument that part of the tax will be shifted through less current ^ Sunra. Chap. IV, pp. 231-23l i. 75 Willard. L. Thorp, editor, Economic Problems in a Changing World (New York; Farrar & Rinehart, Inc., 1939)} p• 2o8. offering of goods for sale than otherwise would be, is there fore not entirely true. Gillim's opposite argument that current sales may be increased on account of the fact that the proportional excess profits tax may reduce the reward for the risk involved in future sales to a greater extent than that attendant upon current sales is, in the opinion of this writer, an illegiti mate manner of comparing the' degree of risk incident to the relative profitableness of current and future operations. Before the imposition of the tax, the producer will plan his production program such that the total capitalized value of 76 his prospective net receipts is the greatest. This value may be arrived at by discounting such periodic net receipts to the current market time, as we stated above. This discount process takes care of the interest as well as a part, at least, of the risk element in future operations. Even if there is extra risk involved, the discounted probable risk cost may be deducted from the applicable discounted net receipts to arrive at an aggregate value net of risk cost. The producer's plan will again be so scheduled that this value net of risk cost will be the greatest. A proportional tax, it can be easily seen, will reduce this capitalized value in the same propor tion as the discounted periodic net receipts after deduction ^ Hicks, op. cit., p. 195. 4-65 for risk, stretching, out from, the beginning to the end of the period under the plan. In other words, a proportional tax will, reduce future risk reward in the same proportion as current risk reward. There is a priori no discrimination against future risk reward as to cause an acceleration of current sales offerings. The case of depletable products is rather unique and is important whenever exhaustible natural resources are used in production. The extreme results contained in an example 77 given by Gillim are conceivable ..when the rate structure is steeply progressive, but not probable when.the rates are moderate. If producers of depletable resources wish to plan their production in such a way that profits over a period of years may be regularized in order to minimize the tax liability, they can do so only within certain limits set by current and probable future demand, general market conditions, and the very simple.consideration of security. In the actual levying of the tax provisions may be added so that undue withholding of production resulting from the imposition of the tax may be forestalled. Percentage depletion allowed by the Internal 78 79 Revenue Code might be one approach to the problem. Anyway, 77 See supra, p. 4-62, footnote 73* 78 sec. 114-(b) (3) and (4-), Internal Revenue Code. 79 Randolph E. Paul. Taxation for Prosperity (Hew Yorks The Bobbs-Merrill Company, 19*4-7), P* 305* The reader should 466 under a permanent excess profits tax withholding of produc tion, other things being equal, will, not work to the advantage of the withholding firm as much as it would, under a temporary tax. Other factors hindering tax shifting. The inadequacy of the legal provisions levying the excess profits tax should have no bearing on the incidence or shifting of the tax in the market period, since cost is disregarded in price determina- 80 tion in this period. The insufficiency of the statutory normal as compared with the theoretical normal profits need not cause us to revise our conclusion that in the market period the tax is not shifted, simply because of the fact that the shifting of the tax through price increases caused by capital transfers or the gradual elimination of the marginal producers in case of institutional barriers to transfers, on account of inadequate allowance for normal profits, can be effected only 79 (Continued) be reminded here of this writer*s disapproval of any statutory allowance of depletion based upon a percentage of gross income from property without regard to cost. (Supra. Chap. VI, pp. 3o8-402.) SO Except to the extent that past or current cost may influence the setting of reservation prices by the producers. One possibility is that sellers do not wish to spoil their market by offering goods at too low a price, usually not lower than their marginal prime cost. The levying provisions of our proposed excess profits tax would allow the seller to recover his marginal prime cost in the short run and much more. k6 7 in the long run* Furthermore, in the absence of concerted action, the firm attempting to raise its prices may have to consider the price policy of its competitors after the imposi tion of the tax even if attendant situations peculiar to it may augur well for a current price raise. Chamberlin1s small group equilibrium establishes the fact that after profits are maximized, the price and the volume being determined at the same time, each firm of the group will hold its price at the point of equilibrium, "because the ultimate consequences of 81 his doing anything else would be less advantageous." Besides, under monopoly, and monopolistic competition goodwill of the customer is important to any firm and may prevent that firm from raising prices for fear of antagonizing its patrons. Customary prices constitute another barrier to price increases. The effect of the excess profits tax on demand in the market period is ignored by virtue of relevant discussion elsewhere above. It may be argued, however, that a permanent excess profits tax on business may cause an immediate drop in the demand for producers' goods. Even then, no tax shifting is possible. Besides, "the result for any particular firm is Chamberlin, op. cit., pp. 100-101. (Italics in the original.) Only Chamberlin's conclusion as to the inter dependence among a small group of firms as to price policy is cited, for "the considerations relevant to competition between small numbers are much more generally applicable than might at first be supposed." (Ibid.. p. 10*+.) 468 indeterminate." Another possible factor conducive to tax shifting is found in the imperfect knowledge of the sellers regarding the maximum they may. charge to reap the maximum profits. Gillim states the proposition as follows: If he has produced and. planned to sell a stock of goods of greater volume than the most profitable amount at a price lower than the price which he can ask for a smaller volume of goods, the reduction of his profit by the tax. may be the factor which will cause him to hold some of his stock off the market and to raise the price nearer the one which will yield him the greatest profit.°3 The answer to this proposition is twofold: (1) the unstable price caused by uncertainty on the part of the seller will find its equilibrium point with or without the imposition of 84 the excess profits tax and (2) in case the original selling price is higher than.that which will yield the maximum profits at the proper volume, the tax. may lead him to examine the 82 Gillim,.©2. c£t., p. 118. 83 Ibid.. p. 120. QL. By trial and error the monopolist will eventually reach the optimum production and. price, irrespective of the tax. "Any change in price will.lower, his tax, it is true, but it does so only by lowering his income. The amount that remains after payment of taxes will be less at the new price than at the former one. Of course, if a monopoly puts itself upon a fixed profit per unit, as some automobile manufacturers are said to do, then it may oe that the imposition of an excess profits tax will produce an increase in price. But this is only because the monopolist had not pushed his advantage to its logical conclusion before." (David Friday, Profits. Wages« and Prices [New York: Harcourt, Brace and Company, 1920], p. 204.) i j - 6 9 possibility of lowering his price and thus increasing his 85 total.net profits, ' Under such circumstances the search for a more definite conclusion as to incidence will be deductively unprofitable, if not futile. The importance of the lone-period view of incidence. Even if a progressive excess profits tax may disturb the pre tax allocation of products for sale in both the current and the future markets, thus altering the prices in. the two markets in accordance with the changed volumes offered for sale, it is doubtful whether the market-period view that the tax may have been shifted is legitimate in the long run. It would seem that when allocation of products between markets in time is resorted to as another means of shifting tax burden, the long-run view which takes into account the shifting in both the current and the future markets is the only proper one. Withholding of products from the current market as a result of the tax may lead to higher prices than otherwise would be, but their release in the future market will lead to lower prices, offsetting previous price increases. The net result may be zero, i.je., no tax shifting in the long period, ^ jn other words, when uncertainty is brought into the discussion, a priori reasoning dictates that both sides of uncertain possibilities be examined and in absence of factual proof, no definitive conclusion can be reached on the issue as a whole. *+70 though partial shifting may be possible in the market period or the short run# For the theorist the long-run view of nonshiftability of the excess profits tax is of much greater significance than the short-run view# The touchstone of the pertinent merits of a permanent excess profits tax must needs be its long-run incidence, no matter how important its short- run incidence is to the practical business man. Conclusion. The inevitable conclusion from the fore going analysis is that no general price increase is expected in the market period as a result of the imposition of a per manent excess profits tax# The time is too short for any shifting to take place# Some shifting may occur in the area of durable and depletable products, or of commodities in the production of which some depletable and exhaustible factor or factors are required# However, in the case of a permanent excess profits tax with a progressive rate structure the desirability of reallocation of products between time periods is limited by the degree of control.the seller may have in regularizing his profit flow. To the extent he can control the regularity of his profits, reallocation is desirable# Ordinarily suchcontrol canbe effective only to a very limited extent# It may safely be concluded, therefore, that any excep tion to the above general, conclusion as to the nonshiftability of the excess profits tax in.the market period is confined to h71 an area so small and insignificant that we may ignore it entirely* THE SHORT PERIOD The short period defined. The next period with respect to which the incidence of a permanent excess profits tax will be discussed is the short period. This period includes suffi cient time to permit changes in output without alteration in 86 the scale of plant. “Fixity of the scale of plant is the 87 sine qua non of the short-run period. * * Additional charac teristics of the short-run period which need no elaboration are (1) no conversion of plant from the production of one 88 good to another and. (2) no new entry into the industry. This is the period in which productive equipment has not been adjusted to demand and if the supply is excessive, some of the equipment must remain imperfectly employed, since there is not time for the supply to be greatly reduced by gradual 89 elimination and by transfers to other fields of production. Variations in the particular income derived from them do not for the time affect perceptibly the supply; and do*'not directly affect the price of the 86 Fagan and Jastram, 0 0. cit., p. 562. 87 Loo* cit. 88 IMd.. p. 563. Marshall, op. cit.. p. 376. b7 2 commodities produced by them. The income is a This is the period in which price may be below the long-run cost of production with, prime or direct costs setting the 91 minimum price to be charged. Production will not be con siderably reduced if fixed or supplementary cost is not entirely covered. Deductive incidence. The individual firm will reach its short-run equilibrium when its marginal prime cost equals 92 its marginal revenue. Its short-run rate of output is the function of two variables: marginal prime cost and elasticity 93 of demand. In order for the price of the firm’s product to change on account of the imposition of a permanent excess Ibid.. pp. 376-377* (Italics in the original.) 91 Ibid., p. 360. Fagan and Jastram, op. cit.. p. 563* Since the firm’s prime cost must be covered in the short run, this marginal prime cost must lie either on or above the point of intersection of the marginal cost curve with the average prime cost curve. Price cannot fall below any point on the average prime cost curve in the short run, if production is to con tinue. (Robinson, pp. cit.. p. *fo, footnote 1.) ^ Fagan and Jastram maintained, (loc. cit.) that the two variables are cost of production and price. Since under monopolistic competition price itself is determined by the intersection of marginal- cost and marginal revenue and the elasticity of demand at the point of intersection, the latter is substituted for price in the text. (Robinson, pp. cit., p. 51 *.) *+73 profits tax at proportional or progressive rates, these two variable factors governing production and hence, price must somehow be affected. But deductively the tax does not affect either marginal prime cost or the elasticity of demand. As the firm will automatically push, its output to the point of equality of marginal cost and marginal revenue, the tax, whether proportional or progressive, does not in any case reach the marginal unit of production, on which there are no excess profits, and therefore, cannot prevent it from being 9^ produced. Since that unit marks the most profitable volume either before or after the imposition of the tax, the supply in the short run cannot conceivably be affected by the tax. As a consequence, there is no pressure from the supply or cost side to raise the price. From the demand side, we have made it clear elsewhere that a priori the tax does not directly affect either the intensity or the elasticity of the demand. Therefore, prices are not likely to rise in the short run as a possible result of the tax. Possible deviations. Gillim maintained that for the following reasons, akin and similar to those explained in connection with, the market period incidence, a permanent excess 9b Black, o£. cit., pp. b7k- profits tax will produce the following effects on price in 95 the short period: 1, The tax may encourage the postponement of the production of depletable goods. Firms will hold profits down to the statutory normal or to amounts taxable in the lower brackets; 2. The tax may discourage the postponing of the pro duction of depleting products by decreasing the reward for risk in the future period; 3* The tax may influence established firms to exploit to the fullest extent their monopolistic powers by raising prices after the tax makes new entry into the field more difficult; and k. The incentive to achieve the most profitable out put may be weakened by an excess profits tax. Comments on possible deviations. These alleged devia tions from the general conclusion that a permanent excess profits tax will not have any significant effect on price in the short period have been directly or indirectly disposed of in the preceding subsection regarding incidence in the market period. Gillim himself conceded that wno conclusions can be reached from the above analysis regarding the net effect of Qty Gillim, 0£. cit.. p. 125* b?5 96 an excess profits tax on price in the short period,” even though he started out to prove that there must be exceptions 97 to the general conclusion of nonshiftability. This writer feels justified in maintaining that a permanent excess profits tax can have no significant effect on commodity, prices in the short run, conceivable exceptions notwithstanding. Effect of tax on advertising expenditures. There is, however, an extra factor in the short period which must be considered: the indirect effect of the.tax on demand through its direct effect on advertising or selling expenditures. It is admitted that advertising affects demand also in the market period, £.£., advertising for retailers, and the effect of a permanent excess profits tax on the advertising policies of producing firms may extend far into the long period. The discussion to follow will, therefore, overlap both the market and long periods, though the short period serves as principal point of reference. Both the aggressive and the defensive types of advertising expenditures are included in our discus sion below. 1. A proportional rate of less than 100 per cent. A proportional excess profits tax will not affect an advertising 96 Ibid.. p. 120. 97 Ibid.. p. 12*f. plan, which contemplates the equality of one unit of current profits expended on advertising and the resulting additional unit of future profits, discounted to the current period. Since the proportional rate of the tax reduces current and future profits at the same rate, the relative attractiveness of current and future profits is not thereby distorted in favor of either. If the cost of advertising is deductible in in the calculation of the tax, the current mone- , tary sacrifice in profit devoted to advertising will be reduced by the same proportion as the qq increment to profit will be reduced.in the future. There are instances, however, where the levy of a per manent excess profits tax may increase or decrease the current volume of advertising expenditures. The uncertainty of the future reward in profits to be gained as a result of present advertising and the comparative certainty of severe reduction in current profits due to a high tax rate, according to Gillim, may encourage a producer to risk more current profits on advertising on the chance that future profits after payment of the tax may adequately reward him for current increased 99 advertising expenditures. The opposite situation takes place, as Gillim continues, where the imposition of the tax will reduce the prospective reward to new entrants without 98 Ibid., p. 127. *+77 altering their risk, thereby discouraging them from entering the field and at the same time leading the existing competing monopolists to reduce their defensive advertising expendi- 100 tures against potential new competitors. When the tax does effect a change in the amount of advertising, it may bring about a change in price. With the above exceptions, a proportional, permanent excess profits tax is unlikely to affect an advertising program designed only to increase demand within a given short period or beyond the scope of the current short period, Gillim. concludes.**"^ 102 We have, already commented unfavorably elsewhere upon Gillim*s argument of the deterring effect of the tax on entry by virtue of the reduction in prospective reward to new entrants by the tax without altering their risk. We will dis cuss presently whether a change in advertising expenditures will produce a price increase. 2. A progressive rate of less than 100 per cent. If the advertising program is designed only to maintain the existing level of profits in the future, argues Gillim, then the tax will not upset the equilibrium between present expen ditures and future profits, since both present and future 100 Ibid.. pp. 127-128. 101 Ibid., pp. 126-127. 102 Supra, pp. k62-l t-65. b7S 10^ profits can be expected to fall in. the same tax bracket, J But if planned current advertising expenditures will augment future profits to a point where the latter will be taxed at a higher tax rate than the rate at which current tax savings due to such expenditures are computed, Gillim continues, a progressive excess profits tax may discourage that plan of 10b advertising. Future demand, therefore, may decrease and future price will be higher than otherwise only if the adver tising would have permitted a more efficient scale of produc tion, Gillim concludes. Comments. Gillim*s argument that the reduction of advertising expenditures, as. a result of either a proportional or a progressive permanent excess profits tax,, may lead to a reduction in the price for the product in the short period is not convincing. This writer doubts if selling costs incurred for the benefit of future profits are proper addi tions to the short-run cost curve of the producer for purposes of price determination in the short period. If not, then the reduction in such selling costs for future benefits would not 103 Ibid.. p. 128. Log, cit. 10^ Ibid., p. 129. 106 Ibid.. pp. 128 and 129. ^79 be considered in short-run price determination and there is no logical relation, therefore, between the reduction in expense and price* Generally speaking, the indirect effect on price, if any, of the direct effect of the tax on advertising expendi tures always seems to amount to a pressure to reduce price rather than to raise price in the long run. The one excep tion mentioned by Gillim, is that the future price would be higher, in the absence of part of the advertising, only if the advertising would have permitted a more efficient scale of production, as stated above* Whether this exception is important in the long run or not depends partly upon whether production for the society as a whole is carried on at increasing, constant, or decreasing costs, ceteris paribus» For a relatively matured economy like that of the United States, production at increasing cost is the general rule, which means production beyond the extensive margin. On the whole, therefore, prices will not be higher in the absence of advertising expenditures on account of the tax, for any increased production due to advertising will have to be made at increasing cost. THE LONG PERIOD The long period defined. The long period in incidence study corresponds to the normal long, period with respect to 1+80 which the theory of normal profits has been examined.10^ This period is set long enough for the scale of plant to alter, allowing it to achieve its optimum, and most profitable output. In this period the amount of investment will change as the scale of plant alters. As far as entry is not absolutely impossible, at least under conditions of monopolistic competi tion, the change of plant capacity contemplates new entrants into the field. In the long period cost of production governs value or price. Unless price covers not only the direct cost, as it does in the short period, but also the conventionally 108 named fixed cost, production will be curtailed and supply will not be forthcoming, varying with the extent of the 109 deficit. Under monopolistic competition and in the long period equilibrium will be reached when marginal revenue curves of intramar.ginal firms intersect their long-run margi nal cost curves, with their average revenue curves lying above their long-run average cost curves, and the average revenue curve of the marginal firm (or firms) is tangential 107 Supra, Chapter .IV, pp. 215-219* The adjectival phrase “conventionally named“ is used on account of the fact that the distinction between variable or direct and supplementary or fixed costs is of significance only in relation to the short period. Since plant fixed cost may be varied in the long period, it takes on the same characteristics of variability in the long run as prime cost does in both the short run and long run. (Marshall, op. cit.. p. 3 6 2, footnote 1.) 109 Ibid., p. 360. b8l to its or their long-run average cost curvesWe will examine the incidence of a permanent excess profits tax in the long period under these fundamental assumptions. Deductive incidence. Since an excess profits tax reaches only the portion of profits which represents excess over normal profits necessary for the maintenance of invest ment, it cannot curtail production if it does not reduce the optimum scale of plant in the long run. This comes about in the following manner. Included at all points in the average cost curve is the minimum profit necessary to maintain the 111 existing firm investment and this minimum profit is allowed before the tax is imposed. And since price is either equal to or above the average cost curve at the point under concern, Note that these conditions do not by any means create a stable equilibrium in the long run, as one remembers Hicks* comment that “under monopoly the stability conditions become indeterminate . . .*< (On. cit. T p. 8 3.) It is conceivable that the marginal revenue curve cuts the marginal cost curve at a point on the decreasing segment of the latter curve and price may still be above the average cost curve at that point. Under such conditions any rise in demand will upset whatever equilibrium position that has been reached without the inherent tendency to restore the original equilibrium. One of the three stability conditions for firm equilibrium as expounded by Hicks stipulates that marginal cost must be increasing at the point of equilibrium. (Ibid., p. 80.) 111 Chamberlin, op. cit., p. 77* ££• Robinson, op. cit., pp. 92-93* **82 112 the tax can reach only surplus profits or rent, which has no significance in price determination for the simple reason that it is itself determined by price* As marginal revenue equals marginal cost at the point of equilibrium, the tax cannot reach the marginal unit of output and hence, cannot prevent it from being produced as long as the tax is levied short 113 of the theoretical rate of 100 per cent. In other words, the scale of production is in no way affected by the imposi tion of the tax in the long run* As cost of production governs value or price in the long run and such cost, in theory as well as in tax practice, includes the imputed normal profits necessary to maintain production and investment in the long run, a permanent excess profits tax, whether levied at a proportional or progressive rate, cannot be shifted through price increases, for it does not reduce the economic reward lib necessary to a continuing supply of all factors of production. As one author put it, the tax is levied not on the causes but 112 Rent and monopoly profits are similar, according to Otto von Mering, The Shifting and Incidence of Taxation (Philadelphia: The Blakiston Company, 19**2), p. 77* But see infra, p. **88, footnote 127* See supra, Chap. V, p. 306. Also, supra, pp. **39- kbO* ll1 * jkQ residual share of the factor organisation may be reduced to any amount without affecting its supply* (Supra, pp. 2**9-25Q. ^83 on the result of price and therefore cannot be shifted Possible deviations. The conclusion regarding the non- shiftability of a permanent excess profits tax in the long run is valid, according to Gillim, only under the assumptions that the legal valuation of invested capital equals that of 116 the owner and that the firm's income is not characterized 117 by extreme fluctuations. To the extent that these condi tions are not met in the actual world, the tax will be shifted by a contraction in capital supply in the industry affected and a consequent eventual rise in prices. We will examine these possible deviations below. Tax shifting brought about by the differences between *j n Q legal and “owner's1 1 valuation of invested capital. It is rare and at best coincidental that the legal valuation of invested capital exactly equals the economic valuation, or Edwin B. A. Seligman, "Income Tax" in Encyclopaedia of the Social Sciences (New Yorks The Macmillan Company, 1932), p. 6 3 7. Seligman's "income tax" is in general similar to our proposed excess profits tax, as may be seen from the following quotations "Such a general tax on net profits can never be shifted. If profits represent the surplus above cost of pro duction, a general tax on this surplus cannot influence the cost of production. " (Seligman., The Shifting and Incidence of Taxation, p. 291.) Gillim, ojq, cit., p. l*+2, 117 Ibid.. p. 1*1-9. For a large corporation there may not be any economic owner. (See supra. Chap. Ill, pp. 132-l1 ^,) 1 + 8 3 + supposedly the "owner1s" valuation. In the absence of con clusive statistical proof, it is a priori unassailable to presume that the chances for the legal valuation to exceed the economic valuation in amount are about as great as, if not greater than, those of the opposite situation. It is admitted by Gillim that when the statutory invested capital exceeds the economic or “owner*sM valuation, a permanent 119 excess profits tax cannot affect prices from the supply side. Any influence or pressure to raise prices must come from the demand side indirectly through its effect on the income of the consumer or through changes in “the cost of materials .which are produced by firms operating under other conditions 120 in which the price does change because of the tax.” And we have stated our reasons elsewhere for not attempting to analyze the incidence problem from the demand side. Since we have urged the use of original cost of invest ment for invested capital purposes, the differences between the legal and economic valuation can result only when cost does not fairly represent the value of invested capital* We have 121 cited elsewhere, however, two authorities whose views on Gillim, o p. cit.T pp. 13+1-13+2, In case of rough equality, as regards the invested capital of new firms organ ized through acquisition of some predecessor business, the tax will likewise exert no effect on prices. (Ibid.. p. 13+2,) 1 2 0 x , o c . c i t . Supra. Chap. VI, pp. footnotes 69 and 71* *§■85 the matter of capital valuation may be inferred as to support the claim that cost fairly represented the value of invested capital in a majority of cases under the past administration of the emergency type of excess profits taxation* This leaves us with only the minor and exceptional cases to con sider, where approximate correspondence between the legal and economic valuation is not found. 122 123 According to Gillim, if the owner's valuation exceeds that of the government or cost, what he considers as 12> 1 + normal profits may be reduced by the tax* When there is a 125 tax on capital gains, the owner cannot escape the tax by 126 selling his business. He will, therefore, suffer a capital Gillim, cit., pp. 1^2-lW. 123 ye wiil use the term without the quotation marks in this connection for the convenience of presentation. In order to have this result realised in practice, Gillim would also have to assume a very high, prohibitive, or even confiscatory tax rate* Capital gains will be taxed as ordinary income under our proposed permanent excess profits tax. (Supra. Chap. VI, pp. *+ 03-^0 6.) If the present owner can sell his business free of capital gains tax, he will not suffer any loss of capital and the purchaser will not have any excess profits tax to pay In the future, for presumably the price the latter pays for the business will approximate its value and that price, being the cost of investment in the business by him, will be accepted as his basis for invested capital purposes. However, the present owner may not always be able to sell his business at the price he asks for, even in the absence of an excess profits tax. Besides, the psychological effect of the imposition of the tax **86 loss. But this is not the only cause of realizing a debase ment in capital value. The difference in legal and owner valuation will produce different production costs on account of different depletion, depreciation, and insurance expenses. In the case of depleting resources, the owner*s valuation of his own business will be sympathetically lowered by the lower legal valuation because of the reduction in revenue attribut able to the marginal unit which he has come to regard as normal profits. This lowered valuation will entail lower depletion and insurance charges, thus bringing down the owner’s esti mated curve of long-run marginal, cost. But this may nbt be interpreted as leading to increased production in the long run. If the tax, the capitalization of which reduced the cost attributable to the marginal unit, is included in marginal cost, the original position of the optimum long-run production and hence, the original point of maximum profits will remain undisturbed. The case of depreciation produces a different result. The owner’s valuation of reproducible assets subject to depreciation will not be lowered on account of the tax on normal profits attributable to the marginal unit of production. 126 (Continued) will tend to depress its value even further, though theoreti cally the purchaser will buy free of any future excess profits tax liability and therefore the seller has no reason to lower his offer. k-8? But the failure of legal provisions to permit depreciation to be based upon the higher current cost of replacement will cause the owner to raise his estimated long-run marginal cost curve sufficiently high so that there will be enough profits left over after the tax to pay for the increased cost of replacement* In that event, production will be reduced and the long-run price will be higher after the tax* Implicitly, the excess profits tax is considered to have thus been shifted* Comments on tax shifting due to valuation differences» Differences between legal and owner *.s valuation of invested capital may be due to either temporary or permanent factors* By temporary factors are meant those variations in the pur chasing power of money which will not long last and tend to balance each other out in the long run or over the business cycle* As we are now discussing about the long-run incidence and effect of the excess profits tax, these temporary differ ences can have but a neutral influence in determining the long-run incidence and effect of an excess profits tax* Valuation differences due to improved profit prospect. The case of appreciation due to improved profit prospects of a growing enterprise, which may be brought about by the acquisi tion of monopoly and monopolistic powers, has vastly different implications, Gillim*s argument in respect of the capitaliza tion of improved profit prospect proceeds as follows: hQQ The original owners who made the initial invest ment in the firm may have enjoyed profits exceeding the normal level of profit in competitive enterprise. The firm, once established, will have a sale valua tion capitalizing its potentiality for producing excessive profits. Its sale value and, if it is incorporated, the value of its stock may be based more upon expected profits than upon the paid-in value of invested capital, A firm may thus come to have a value tending to transform excess profits into rents. If statutory normal profits are computed on the amount of paid-in capital, then profits not regardejjl^s excessive by the producer will be subject The theory of the transformation of excess profits into rents is unacceptable to us, with the possible exception in connec tion with stockholders who have purchased corporate stocks at prices taking into account the capitalizing of such excess profits. In addition to the objections to valuation based upon current market we raised in the preceding chapter, there is no valid business and financial reason to maintain that a t o business enterpriser, receiving profits at the rate of 50 per cent on his original investment of $1,000,000 on account of his profitable monopoly trade, as compared with competitive return at 5 per cent on an original.investment of $10,000,000, is not enjoying excess profits simply because he has been receiving the same higher 50 per cent profit rate for years and his Investment has come to have the value representing the transformation of such excess profits into rents. The Gillim, op. cit.. pp. 1^2-1*+3* enterpriser would be immediately richer by #9,000,000 if he sold his business at its current value of #10,000,000, the #9j000,000 representing the present worth of the periodic excess profits he would be receiving over a long period of time, if he retained his business. It seems idle to this writer to argue that this enterpriser is only just as well off economically as the other receiving 5 per cent on his investment of #10,000,000, Furthermore, there is the matter of negative rents to resolve. 'What happens when enterprise return of #200,000 per year on an original cost of investment of $5,000,000 has clearly dipped below the competitive 5 per cent on account of a long-run decline peculiar to the enter prise? Would anyone argue that no loss were suffered by the enterpriser, for now the enterprise value were only 128 $*+,000,000 and the $200,000 annual return would still amount to a competitive 5 per cent on an investment value of $*+,000,000? Even if the economist would argue that no loss occurred, the business man would not. Now, to carry the theory of imputation or rent transformation into its logical conclu sion, we would run into a highly ridiculous situation which contradicts all common-sense or even economic approach to the problem of monopoly and monopolistic practices* If excess profits were transformed into rents, virtually every monopoly 128 $200,000/5$ = $*+,000,000. in the United States could be earning competitive normal profits. The magic theory of imputation would solve the problem of monopoly profits overnight by a reorientation of the public’s outlook from monopolies and excess profits toward competition and normal profits. After all, if monopo lies were receiving only "normal profits," they would be just as economically harmless and well off as competitive busi nesses, irrespective of their illegal practices. Unless this logical and yet absurd conclusion of the imputation theory were acceptable, the enterpriser receiving a 50 per cent return on his investment would still be considered as enjoy ing excess profits, though in a smaller amount after tax, as long as the excess profits tax does not "confiscate" such excess through a 100 per cent rate. He would then still be receiving more than normal profits, though revenue attribut able to the marginal, unit of production would be just normal, no more or no less. The tax, therefore, cannot influence price, for (1) normal profits of the marginal unit is not affected and (2) since the privileged monopoly still enjoys some excess profits after tax, no long-run capital transfer from it to a less privileged competitive enterprise will 129 result. ■*■29 yon Bering maintains that a tax on rent cannot be shifted and "the result is the same whether or not the tax is equal for different rents." (Op. cit., p. 78.) But, "it must *+91 Mitigating differences between economic theory and tax practice. In economic theory the aspect of the loss of capital value, due to the inevitable imperfections in the tax device, assumes importance by virtue of the fact that what has come to be regarded as normal profits on the marginal unit will be made subject to the tax which is supposed to exempt such normal profits. But in order for this loss to assume the importance attributed to it in respect of incidence study, the economic principle that permanent capital appreciation, representing largely goodwill due to improved profit prospect, constitutes economic income must first be implemented in practice. In other words, practical taxation must adopt the esx ante view of economic income, subjecting prospective capital apprecia tion to tax on the same basis as any ordinary income, before the theoretical importance attached to capital loss finds itself in the actual world. But income for business, account ing, and taxation purposes has always been regarded as ex post in character and does not include unrealized or prospective (Continued) be conceded, however, that the possibility of changing to a less privileged production which still affords more than average profit decreases the range within which taxation actually affects only rent (in the sense just defined as surplus over opportunity cost).’ * (Ibid.. p. 79*) Our first quotation argues against Gillim*s theory that an excess profits tax on rent will influence price, but our second supports it in an indirect and roundabout way, as can be easily seen. **92 capital appreciation. This basic difference in economic view point, it seems to this writer, must account partly for the confused state of affairs as they exist in the theory of incidence of excess profits taxation. The more important con sideration in this respect, however, is the divergence between the theoretical and the practical treatment of unrealized capital appreciation. Hicks writes, The capital value of the individual’s property at the beginning of the week is an assessable figure; so is the capital value of his property at the end of the week; thus, if we assume that we can measure his consumption, his income ex post can be directly calculated.*30 The value of capital at the end of the period, as determined according to Hicks* theory, will, presumably become the basis for planning for income ex ante for the coming period. In so doing, however, periodic capital appreciation (or deprecia tion) is automatically taken into income, which the profits tax on the basis of ex ante income determination presumably should reach, and capital value at any time, therefore, repre sents either the capitalization of prospective income stream or past capital accumulation, through the recognition of periodic appreciation for tax purposes. Under such assump tions the failure to allow invested capital to be computed on the basis of current appraisal value is not only illogical in Hicks, oj>. cit., p. 179 ^93 theory but quite disastrous in practice, inasmuch as now the excess profits tax is permitted to affect the same profits twices (1) when such profits were discounted to yield the increased capital value for tax purposes in a prior period or periods and (2) in the period or periods during which such previously capitalized profits materialized. But in tax practice, as well as business and account ing procedure, though cost is used as the basis for invested capital computation, the income subject to tax is also com puted on the same cost basis. Unrealized capital apprecia tion is seldom, if ever, recognized as taxable income. Under such procedures excess profits are taxed according as they are realized periodically without their "premature” taxation through taxing periodic appreciation. And under the same set of procedures invested capital is properly computed on cost basis for two related reasons: (1) just as in the case of recognition of capital appreciation economic surplus or excess profits are taxed once when invested capital is computed on appraisal value, such excess profits are taxed but once under a cost-based invested capital, and (2) to allow invested capi tal to be based upon appraisal value without taking into income the appraisal increase is to allow a certain amount of excess profits attributable to future periods to escape 131 the tax. In other words, tinder both methods of Invested capital computation the same excess profits are taxed once only, but in different periods. Since our concern now is the long-run incidence of the tax, the two methods are expected to produce the same long-run results. The inevitable conclu sion is that since the normal profits of the marginal unit production is not reduced by our proposed tax, computed either under the value-based or under the cost-based invested capital method, the tax cannot be shifted in the long run, as Gillim would like us to believe. 4 situation which needs remedy. As stated above, the situations wherein the failure to heed the capitalization of excess profits may result in some capital losses involve stockholders who had purchased stocks at market values, in' the determination of which the established earning power of the corporation ms taken into account, m this connection the reader must first be reminded that any tax is bound to have some ill effects on some vested interests. How, to follow our main theme, to remedy such an undesirable result 131 This second situation would produce its own deviating effects on tax incidence based upon a recognition of capital appreciation for invested capital as well as excess profits purposes, inasmuch as differential treatment is allowed different taxpayers, some of which may not have to pay tax on their excess profits, thus possessing a tax advan tage over the others. 1+95 it might be suggested that the market values of the stocks be 132 used as the proper basis for invested capital purposes. As stocks are customarily sold at about three-quarters of 133 their "true" value based upon their earning power, there might yet be excess profits left over for the tax to apply. But, unfortunately, this procedure is undesirable in itself. It violates the separate entity of the enterprise, especially the large corporation. From the enterprise point of view the stockholder holds a status similar to that of the contractual creditor and there is no logical reason to recognize market value in respect of the holdings of the former without recog nizing those of the latter. Furthermore, the market value of stocks rarely represents the stockholder's capital commitments to the corporation. Functionally speaking, such value can make no productive contribution to the earning of corporate 13*+ income, though it is indicative of such earning power. Then, there are administrative difficulties to consider in basing invested capital on security quotations of the relevant 132 Actually suggested by William E. Butt, "A Permanent Excess Profit Tax," (an unpublished Ph. D. dissertation, Yale University, 1931)» PP* 359-366. 133 Alfred Cowles, 3rd and Associates, Common-Stock In dexes . 1871-1937 (Bloomington, Indiana: Principia Press, Inc., 19W, ?T53. Supra» Chap* VI, p. 3^3* ^96 13 5 136 stocks* As we have admitted elsewhere, no effective general, practical remedies to correct this phase of the 137 excess profits tax have yet been devised. Some vested interests are bound to be adversely affected. Even then, the effect of this r *unavoidable" capital loss, due to the imposition of an excess profits tax, on the long-run supply of capital may not be as tangibly serious economically as might otherwise be assumed. As long as the tax rates are moderate and the corporation is allowed to earn not only normal.but some excess profits in addition, and as 138 long as relatively stable dividends are maintained, there is reason to believe that the ordinary genuine corporate investor is not likely to be alienated by the incurrence of 139 "conceptual" capital losses from the securities to which they have become accustomed. As the tax affects business Sunra. Chap. VI, pp. 317**3 1 +7, Passim. Supra. Chap. VI, p. 329* 137 por other mitigating factors, see supra. Chap. VI, pp. 317-3l *7, passim. •*•38 gee supraT Chap. VI, pp. 329-33^ for proof. 139 p0p ^ e investor who is not interested in realizing on capital gains, but who is definitely concerned about a stable dividend income, the market value of the stock he holds will not be too much of a concern to him. Until the loss is finally realized through a sale (and before then there are always chances of its being made good by further market improve ment), the loss remains conceptual to him. 1*9 7 enterprise in general, the profit differentials after tax among the affected enterprises may not be seriously disturbed so as to cause a reshuffling of the investment portfolios. As regards the incentive factor pertinent to prospective or potential equity investor, a later section will be devoted to its treatment. Other issues. We will not comment upon Gillim1s discus sion of the issue of depletion, since his conclusion is more in favor of increased volume of production and lower prices than vice versa. Gillimrs argument for tax shifting in respect of the issue of depreciation is based upon the failure of the statutory valuation to allow for the higher replacement cost of depreciable assets. For obvious reasons, we will dispose of this issue by referring the reader to Chapter VI for a l*+0 detailed presentation of our position on this point. fax shifting in case of income irregularity. Gillim argued that if the tax does not allow for irregularity in income, it may remove, as excess profits, income which will not appear excessive when it is averaged over a period of years. Capital loss will be incurred if the tax through insufficient allowance for irregularity reduces income below the expected ql+O Supra. Chap. VI, pp. 366-392. *+98 Ibl level over a period of years. According to Gillim, insuffi cient allowance for income irregularity may promote industrial concentration which, we have seen, furnishes insurance against 1**2 profit uncertainty. None of these undesirable consequences of the excess profits tax, however, will arise under our pro- l*+3 posed tax measure. Our carry-over system will, in the opinion of this writer, prevent taxing, as excess profits, income which may not appear excessive when averaged over a period of years. Our system of declining statutory normal lip+ l i j - 5 profit percentages and progressive rate structure, while they are not designed to break up existing corporate giants, certainly will not be conducive to further industrial concen tration. Gillim*s tax shifting due to income irregularity is hereby dismissed. Long-run incidence; conclusion. As in the market period and the short run, the long-run incidence of a moderate permanent excess profits tax will rest in an overwhelming majority of cases with the business enterprise on which the Gillim, op. cit., p. 1^-9* Suora. Chap. V, pp. 289-299« Supra. Chap. VI, pp. Supra. Chap. VI, pp. 359-386. ^*5 Supra. Chap. VI, pp. ^21-M-2*4-. tax is levied. Capital loss due to the imposition of the tax may be incurred only by the stockholder who has acquired stock in the taxed corporation at market values consistent with its established earning power prior to the imposition of the tax. Even then, the ultimate effect of the loss, may not involve any serious reduction in the supply of equity capital, as long as dividends are not greatly reduced. The refutation of and the discussion of various factors which mitigate against Gillim*s argument that valuation differences may result in tax shifting are carried out, admittedly, below the theoretical level, i.e., practical tax matters and tax practice are employed to redeem the imperfections of the levying provisions. This procedure is not considered unreason able, inasmuch as Gillim*s argument was itself based upon such pract i ca1 imperfe ct i ons. B. THE INCIDENCE OF 4 PERMANENT EXCESS PROFITS TAX UNDER COMPETITIVE CONDITIONS Gillim*s conclusions as to the incidence of a permanent excess profits tax under competitive conditions are that the lb6 tax will not be shifted in the market period, in the short 1^6 Gillim, op. cit., p. 77* 5oo lM-7 l*+8 run, or in the long run. To be sure, there are various factors conducive to tax shifting, the two most important of which are, as expected, some-imperfection of the tax and the lack of sufficient allowance for income irregularity which cause it to fall upon profits that are truly normal profits. For mitigating factors, however, the reader is referred to the discussion in preceding pages in regard to the same matters under conditions of monopoly and monopolistic compe tition. As the study of incidence of an excess profits tax under competitive conditions has not been considered of any great importance for both theoretical and practical reasons stated above, the subject will not be pursued any further, IV. THE LONG-RUN EFFECT OF 4 PERMANENT EXCESS PROFITS TAX ALLOCATION OF INVESTMENT We have alluded above to the improbability of any extensive reallocation of capital investment among various industries if the tax does not seriously disturb the profit 1 *>0 differentials among industries. As one author maintains, Ibid. j p* 81. llf8 Ibid.. p. 92. Loc. cit. Supra, pp. ^90 and b96-k97. 501 a tax on rent or monopoly or excess profits cannot be shifted ■whether or not the tax is equal for different rents or excess profits reaped by different taxpayers with the qualification that the range within which the tax actually affects only rents or excess profits is decreased by the possibility of shifting to a less privileged alternative enterprise or employment which still affords more than average profit or 151 income after tax. Unless the tax is so imperfectly designed that the final tax burden is so discriminating against certain enterprises or industries as to outweigh the advantages of their differentiating factors of monopoly and monopolistic 152 value, the existing pattern of investment will be maintained. The mere existence of monopoly and monopolistic advantages and practices should serve as a constant reminder of the artificial means and devices whereby the existing firms will be protected from potential competitors. Large size, characteristic of monopoly enterprises, is not at all conducive to capital with drawal, simply because it almost always costs more to withdraw 153 from than to remain in operations. The reduced degree of risk through consolidation works against shifting to a more remunerative but, on that account, a more hazardous independent ■*■51 see supra. pp. ^O-^l* footnote 129* Gillim is of the same opinion (op. cit.. p. 153*) Supra. Chap. IV, p. 2 3 6. 502 enterprise. To be sure, there will be minor adjustments among industries as a result of the imposition of a permanent excess profits tax. But deductive analysis, as has been carried out 151* so far, as well as inductive statistical findings, lends credence to the conclusion that no extensive capital readjust ments will occur on account of the tax. THE VOLUME OF INVESTMENT Supply side considered alone. If only changes from the supply side are considered, there is the possibility that the aggregate of investment may be reduced by the imposition of an excess profits tax. This result of the tax is brought about by the reduction in the reward to investment while the risks of 155 investment are not reduced, as Gillim maintains. ^ The logic behind this argument is, however, subject to serious doubt in view of our finding elsewhere that an adequate system of loss carry-overs will render the tax relatively harmless as far as 156 risk-taking is concerned. Since consolidation and large ^ We refer to Epstein's study (supra. Chap. IV, p. 2 3 6, footnote 93). Aware of the fact that Epstein's study was confined to observations on the trend of profits and com parisons of profits among industries, we, nevertheless, believe that his conclusion as regards the difficulties of withdrawing capital, once sunk, applies in this instance. ^55 Ginim, op. cit. T p. 153* 156 Supra. Chap. V, pp. 277-289, and Chap. VI, pp. **07- **18, passim. 503 size reduce risk-taking, large size is usually associated with monopoly, and the degree of the ability of business to avail itself of the loss carry-over provisions is usually higher with respect to large business than small business, any argument of excessive reduction in risk reward by the tax, the burden of which will fall primarily on the relatively ’ ‘ riskless'* giants, should be subject to serious doubt and thorough examination, if it is not to be dismissed as being untenable. Gillim. mentioned the possibility of the tax preventing an expansion of plant to a size consistent with the maximiza- 157 tion of long-run profits. Since the tax reaches the incre ment to profit to be obtained upon attaining a more profitable scale than the existing one, further increase in scale toward optimum production will be discouraged. The rebuttal to this argument has been presented elsewhere in this chapter. Gillim himself also recognized three counter-arguments against his own views incentive for increase may still remain because large size insures against loss? greater efforts may be made and greater risks taken by a producer who sets out to earn a fixed amount of profit, in order to acquire enough profit to leave him that amount after the tax? and the welfare of the 157 Gillim, op. eit.T pp. 153-155* 5014- economy is not necessarily reduced because of the discouraging effect of the tax on expansion, since maximum profits under monopoly and monopolistic production are never earned at the 158 point of lowest average cost. Demand side considered. If we take the demand side into consideration in studying the long-run effect of the tax, consumption and investment, may be reduced because of the tax. Consumption and investment in this connection include those of industrial enterprise as well as those of individuals who have a financial stake in the taxed industries. Unless either the industrial enterprise or the individuals are willing to draw upon their savings to maintain their pre-tax consumption and investment, the volume of investment will decline in the long run and unemployment will be the result. But as we have 159 stated elsewhere, if we approach an analysis of the inci dence of any tax from the demand side, we should also take into account the effect on incidence of government spending and/or investment. As soon as we do that, the possibility of striking a balance between the decrease in private consumption and investment and the increase in public spending and invest ment looms large. To be sure, there may be some readjustments 158 Ibid., p. I5*f. ^59 Supra. pp. ^50-^53 505 among industries subject to the tax, but in the long run the total volume of investment in the economy should not suffer great reductions, CONCLUSION On the whole, the long-run effect of a permanent excess profits tax on the total volume of investment is rather unim portant and insignificant• There is the possibility that the tax reaches such portions of excess profits which would have, been saved if not taxed away. This factor, coupled with increased government spending, is expansionary and may result in a larger volume of investment in the long run. There may be some minor reallocation of investment among affected indus tries on account of the imperfection in the tax device, but the extent of such reshuffling of investment will be restricted to a very small area of the economy. A moderate tax with high exemption will leave a pre-tax enterprise or industry still the preferable one after the tax. Restricted entry under monopoly and monopolistic competition and the cost of capital withdrawal combine to prevent any large-scale reallocation of investment. The long-run effect of the tax on risk and effi ciency and hence, on the volume of investment and its reallo- 160 cation was discussed in detail elsewhere and has been Supra, Chap. V, pp. 275-315 506 repeatedly reviewed in connection with incidence study made in this chapter* Further separate cognizance of it is considered unnecessary. 1* £HE EFFECT OF 4 PERMANENT EXCESS PROFITS TAX OS THE INVESTMENT INCENTIVE The effect of a permanent excess profits tax on the investment incentive will normally affect the investment decisions made by business management as well as those made by the investing public at large. In these days of the dearth of venture or equity capital the importance of a study of the effect of our proposed measure on the investment incentive cannot be overemphasized. From the point of view of the society, "Without venture capital, growth andprogress cannot long continue in a free-enterprise economy." From the point of view of the enterprise, an inadequate supply of ven ture or equity capital will tend to force it "to resort, far beyond the limits of sound policy, to debt financing instead 162 of equity financing." A permanent excess profits tax would 161 "Venture Capital," Fortune. XXXIX, Part 1, No. 2 (February, 19^9), 81 * - . Economic Progress: Tax Revision and Capital MarketsT a report of the New York Stock, Exchange (New York: October, 19*+7), cited by Stanley I. Miller, "The Equity Problem," Harvard Business Review. XXVI, No. 6 (November, 19^8), 671- 507 not be in harmony with the best interest of our economy to the extent that it should produce a deterring effect upon the investment incentive and hence, the supply of venture or equity capital* Again, it needs to be emphasized that it is the whole picture, not segments of it, that is important and should be kept in mind. Our analysis to follow will be carried out under both the headings of small and large business on account of the distinctly different types of problems involved. SMALL BUSINESS The problem. New, small business enterprises in their initial stages usually have been and in the main are financed by the savings of their owner-managers and by the latter*s 163 relatives and close acquaintances. Owing to the complicated 16^ and costly process of equity flotation, small, growing com panies have regarded retained earnings as their ma^or source 165 of funds for financing expansion. In this respect, it may be laid down as a general rule that retained earnings are 1 3 Charles Cortez Abbot, "The Availability of New Equity Capital,1 1 American Economic Review. XXXII, No. 1, Part 2, Supplement (March, 19^+2) , 132. 164 - LO Ibid., p. 139. J. Keith Butters and John Lintner, Effect of Federal TflYftg on Growing Enterprises (Bostons Harvard University Press, i<m, p.~£n 5 08 more important for small, growing enterprises than for large, established corporations. Since the social importance and desirability of the formation and expansion of small new busi ness in a system of free enterprise have generally been con- 167 ceded, the restrictive effect, if any, of our proposed tax on the incentive to form new enterprises and expand existing ones deserves our closest attention. General effect of taxes on the formation of new enter prise. Paradoxical though it may seem, tax considerations seldom dominate decisions to undertake small, independent ventures. According to a wartime investigation of the tax problems of the then young and developing aircraft industry, the critical decisions of the founders of new independent enterprises are likely the reflection upon their emotional : drives, rather than the product of rational conduct on which 168 most economic analysis is based. This statement is by no means a negation of the profit motive. To the contrary, profit potentialities must be good before these businesses 169 would be started at all. But in the developmental stage Loc. cit. See infra, pp. 510-511* Ibid. . p. 27« Also “Incentive— In Reverse,'1 Nation's Business. XXXII, Ho. 2 (February, 19^), *+2. Butters and Lintner, op. cit.. p. lb, 169 Loc. cit. 509 of the new enterprises the promoters are seldom guided by- profit considerations. They will execute their plan of pro motion, even though the opportunities for profit, objectively 170 considered, are not good. Once the development was under way they are 1 1 * determined to go through with it come hell or 171 high water,1 r * Fortunately for scientific and economic progress, the character of these promoters is such that they frequently take this kind of attitude. But the above conclusion does not imply that taxes do not restrict the amount of personal funds available to the prospective organizers of new enterprises. Since personal funds or savings of the promoters and their close associates are usually depended upon for the financing of a new business at the early stages of its developmentj personal income taxes tend to reduce the amount of such funds or savings available for investment, but do not significantly affect their willing- 172 ness to invest in it. It is their ability, not their desire, to start a new enterprise that is affected by high taxes• As far as outside capital is concerned, it does not Butters and Lintner, loc. cit. 171 Ibid., p. 15. 172 Ibid., p. 2*f. 510 become an effective means of financing new ventures until they have developed to a point where they give real indica- 173 tions of being potentially profitable. Besides, the pro moters are usually reluctant to share their control with outsiders over a project believed by them to be possessed 17k of a great potential value. Vftien it finally becomes possible and necessary to obtain external financing for com mercial production, high, personal income taxes may exert an adverse effect upon the willingness of the outside investor 175 to invest in the business. General effect of taxes on expansion. Available evi dence indicates that retained earnings are a more important source of funds for small, rapidly growing firms than for large, established corporations, as stated above. . . . the retained earnings of profitable small corporations constitute on the average a much larger percentage of their net worthT and incidentally also of their total assets, than do the retained earnings Ibid. T p. 16. 17lf Loc. cit. 175 An actual case was related in Abbott, ojg. cit., pp. 135-136. But Abbott's remark indicating that he was of the opinion that the capital gains tax has a deterring effect on the availability of outside capital is at odds, in content, with the statement by Butters and Lintner that the relatively low tax rates on capital gains “strongly stimulated the inter est of venturesome investors. . . .” (Op. cit.. pp. 25-26.) A support for the latter view may be found in Millert op. cit.. p. 677. 511 „ „ 176 of large corporations. The effect of high taxes on internal expansion through rein vestment of earnings is summarized below: 1* High corporate and personal income taxes, as com pared with a low tax, place severe restrictions on the rate of expansion that a growing enterprise can finance from its 177 retained earnings. The level of the tax rate is, of course, the principal factor in bringing about large reductions in the amount of retained earnings. 178 2. The double taxation of corporate dividends serves as a temptation for small corporations to pay larger salaries than they can ordinarily afford in order to obtain the dedue- 17' tion for purposes of the determination of net taxable income. Butters and Lintner, op. cit.. p. 6 3. (Italics in the original.) Ibid.. p. 70. This result is obvious. According to one study of such effect on the growth of one aircraft manufacturer which for a six-year (1923-1928) period under review was paying income taxes at an average rate of about 12 per cent, a hypothetical rate of ^0 per cent would have held its growth to approximately *+0 per cent of that actually attained in the same period, if we assume it could not obtain funds for expansion purposes in any other way. The aircraft manufacturer was Douglas Aircraft Company. (Ibid.. p. 80.) Double taxation may be considered a form of high taxation from a mathematical point of view. Abbott, op. cit. T pp. 137“138. Salary deductions are subject, however, to review and adjustment by adminis trative authorities. 512 Another effect of the double taxation of corporate dividends is the inducement on the part of business companies to resort 180 to debt financing, resulting in unsound capital structure. 3* Since profitable small firms on the average earn a higher rate of profits and retain a larger percentage of their earnings than do profitable large firms, a high flat- rate corporate income tax would restrict the internally financed growth of small firms more severely than that of l8l large firms. b. The differential taxation under the existing cor porate income tax of the profit increment between $25,000 and $50,000 for small firms whose total profits do not or are not expected to exceed $50,000 diminishes their incentive to earn that increment more than that of large firms whose total 182 profits amount to more than $50,000. The effect of our proposed tax on the formation and expansion of smallt growing business. Strange as it may seem, our proposed permanent excess profits tax will produce very little restrictive effect on either the formation or the growth of new, small business firms. The tax patently cannot engender 180 Ibid.. p. 137. - 1 Qi Butters and Lintner, op. cit.. p. 70. See supra. Chap. X, p. 3. 513 any adverse influence on the promoter in deciding to start a business in view of the finding that his decision usually reflects his desires to vindicate his own “idea” and to be his own boss more than his rational conduct. According to another analysis, under the present tax structure a new pro motion must promise, quickly, an annual return of 15 or 20 per cent in order to be attractive to persons of moderate 183 means. Whichever of these viewpoints is correct, our pro posed measure will ordinarily allow approximately a 17 per cent return to a capital investment of $5 0 0 ,0 0 0 before the 181 * tax applies. For profits amounting to less than $50,000, no tax applies in any event. That the specific exemption of $50,000 has the effect of equalizing the differential effect of the tax on the reten tion of earnings for expansion purposes for both small and large business can be easily understood. Under our proposed measure the double taxation of dividends as well as differen tial taxation is eliminated. With the former also goes the temptation to secure large salary deductions and finance growth through debt. The exclusion of borrowed capital for invested ^ Charles C. Abbott and Eugene H. Zuckert, “Venture Capital and Taxation, 1 1 Quarterly Journal of Economics f LV (August, 19^1), pp. 067-6 8 2, cited by Abbott, op. cit., p* 1 3 5, footnote 1 7* i au. Specific exemption of $50,000 plus 7 per cent on $5 0 0 ,0 0 0 equals 17 per cent of $5 0 0 ,0 0 0 invested capital. 51b capital purposes tends to negate, in part, the temptation of debt financing. In general, our proposed measure positively 18 5 encourages financing through equity investment. In con clusion, our proposed tax will not adversely affect the incen tive for small venturers either to start new business or to expand their existing ventures. LARGE BUSINESS The problem must be examined from two points of view: the point of view of the corporate management and that of the investing public. It is obvious that the corporate management must first, in the light of pertinent economic factors, decide upon a certain expansion program and the means to finance such a program, before the outside investor, institutional or individ ual, will be called upon either to extend the credits or to contribute equity capital. In case of reinvestment of retained earnings, no external funds will be solicited at all. Possible effect of tax on managements decision to expand. It is ordinarily accepted that the capacity of a firm to expand tends to vary directly with the rate of 186 profits. Any tax, including our proposed permanent excess See supra. Chap. VI, p. 3**9j footnote 7 6. Robert B. Pettengill, Price Economics (New York: The Ronald Press Company, 19^8), p. *+61. The statistical findings of Monograph No. 12 of the Temporary National Economic 515 profits tax, which reduces profits, will, according to this view, exercise a deterring and restrictive influence on the corporate management to undertake expansion projects. But detailed statistical study has revealed that a positive cor relation between the rate of profits and that of expansion holds true only if corporations limit themselves or are t limited to expansions which can be financed from internal 187 sources. If corporations do not limit themselves or are not limited to expansions which can be financed from internal sources, then the relation between their rates of asset expan sions and their rates of profits need not tend to be a positive one. In fact, there is a tendency for corporations with the lower profit rates to be in greater need of external financing during periods of rapid industry expansion and great pressure 188 for the introduction of new technologies. Statistical findings of Temporary National Economic Committee Monograph No. 12, For the oil industry, high profit (Continued) , v ■ Committee (Profits. Productive Activities, and New Investment. [Washington, D. C.: Government Printing Office, 19^1J > P* 91} also reveal that in the oil industry, for most of the years from 1927 to 1938, there is an apparently” positive relation between the rate of return and the rate at which assets were expanded. (But for the real tendencies and conclusions which are diametrically different from the apparent ones, see the discussion to follow.) ^■8^ Temporary National Economic Committee, Monograph No, 12, p, 99* 188 Ibid.. p. 10G. 516 rates, in and of themselves, have not been guarantees of high rates of asset expansion and similarly, low profit rates, in and of themselves, have not placed any rigid curbs upon the 189 rates of asset expansion. A given rate of profits has been associated with different rates of asset expansion which had occurred for different years during the period from 1927 to 1938* This lack of positive correlation between rates of profits and those of expansion has been attributed to the finding that the rate of asset expansion associated with a given rate of return has depended largely upon the rate of change in the volume of business, the relations of the volume of business to physical capacity, a rapidly changing technology, 191 and prices. Also, among corporations in the same industry for the same year differential asset-expansion rates are largely the result of their differential abilities to expand their respective volumes of business. As a corollary, changes in the differential asset-expansion rates from year to year must result largely from changes in the differential abilities of the same corporations to expand their respective volumes of 192 business. In addition, production and price controls, 189 Ibid., p. 9*f. ^9^ Ibid., pp. 9**—96. 191 Ibid.. p. 96. ^•92 XiQc. cit. 517 voluntarily adopted or otherwise, have produced the effect of lowering the effectiveness of the profit rate further in determining differential expansion rates in the oil industry, except during the periods of marked expansion to new high 193 levels of output. As regards the relation between the rate of profits and the rate of expansion in physical property, like land, buildings, and equipment, necessary to maintain or expand physical capacity to produce goods and services, in the iqij. industries surveyed, the underlying conditions again govern whether any relation at all exists. In general, the rate or the amount of property expansion at a given rate of return has been greater, the greater the utilization of capacity and the greater the necessity and opportunities for the introduc- 195 tion of new technologies. The effectiveness of the profit rate in determining differential property-expansion rates in the oil industry over a period of years has depended upon the amount of expansion financed from external sources. When expansions over a period of years have been financed from external sources, the influence of the profit rate has been 193 Ibid.T p. 98. oil, steel, automobile parts and accessories, and chemicals. Temporary National Economic Committee, op. cit.. pp. 112, 122, and 123. 518 relatively low, indicating a loose relation between the profit rate and the desire and ability to obtain funds from those 196 sources* The same conclusion holds true in the case of the steel industry, though the data there are not quite so 197 clear on this point* From the findings of the Temporary National Economic Committee presented above in summary form, it may be concluded that the level of output and the pressure upon business for the introduction of available.new technologies, rather than either the amount of profit income or the rate of return on capital, have been the major determinants of the level of capital expenditures of groups of companies in the same indus try and hence, of business as a whole. Effect of our proposed tax on management * s investment decisions* As long as general business conditions call for expansion and the financing of the expansion is to be obtained from external sources, the rate of profits will not be the principal consideration of the corporate management in decid ing upon the desirability of such an expansion project. This is not to say, however, that the rate of profits exercises no influence at all* The significance of the above conclusion 196 Ibid.« P- 113. 19' 7 Ibid. * p. 122, footnote *f. 519 in respect of excess profits taxation is simply thiss if the underlying conditions, such as the volume of business, the relation of business volume to operating capacity, changing technologies, and commodity prices, are conducive to corporate expansion, a moderate excess profits tax which allows the state to share in the success of the project but does not deny the undertaker the right to enjoy a substantial portion of the fruits of his effort will not engender a deterring or restric tive effect on the management in deciding upon expansion. The Temporary National Economic Committee findings also substantiate our earlier statement that an excess profits tax will not pre vent any firm from achieving the output at which its marginal cost and marginal revenue are equal, provided the volume’of 198 business warrants it. There are other factors making for corporate expansion despite taxation^of excess profits. The assurance that'losses resulting from either an expanded volume of existing business or a new promising venture can be offset against the relatively predictable profits of the existing business tends to reduce the risk involved in undertaking the project. The effective participation in such risk by the government has been discussed 199 in full elsewhere and need not be elaborated on again* See supra, Chap, V, pp. 306-307* Supra, Chap. V, pp. 277-289* 520 Moreover, the management of our large corporations is often not guided primarily by the profit motive in some of its decision-making* When ownership is separated from active management, profits can no longer be considered as a return for the dynamic function of creative business leadership* The weakening of the profit motive may result in the substitution by the top management of personal gain for the profits of the enterprise as a criterion in decision-making.^*^ Boulding writes of such a situation in the following terms: [if the business man is] extremely ambitious, anxious to be the 'captain1 of a large and important concern, interested in the prestige and power that come from the control of a large business, it is probable that up to a point he would wish to expand, his business even at the cost of smaller profits.201 If this is true of the owner of a large business, it should be more true of the top executives of our large corporations. The effect of an excess profits tax under such circumstances is unique. According to Boulding, the negative elasticity of the supply of enterprise brings the point of tangency between its indifference curves representing the supply of enterprise and the parabolic total profits and net profits curves beyond 200 Robert Aaron Gordon, Business Leadership in the Large Corporation (Washington, D* C.: The Brookings Institu tion, 19^5)jp« 338. Kenneth S. Boulding, "The Incidence of a Profits Tax," American Economic Review. XXXIV, No. 1 (September, 19^)} 568. 521 202 the point of maximum profits. Paradoxical as it may seem, this results in a greater volume of output with an excess 203 profits tax than without it. If “the pleasures of power 2 0 * f r are worth some pecuniary loss” to the business owner, they probably are worth a lot more to the top executives of the large corporations. The effect, if any, of our proposed excess profits tax on management’s decisions to expand in this respect 205 is beneficial. The adverse effect of a permanent excess profits tax. The adverse effect of a permanent excess profits tax on cor porate expansion to be financed by retained earnings must now be recognized. The tax, as well as any other tax for that matter, reduces the amount of such earnings made available for purposes of increasing productive capacity. Even here, there are many mitigating factors. As a general rule, the relative ease with which large business may obtain external Ibid.. p. 569. (See diagrammaties.) 203 Ibid. T p. 570. 20lf Ibid., p. 569. Ibid., p. 570. “By the mysterious alchemy of human nature, not only is the whole burden of the tax absorbed by the business man, but he drives himself to further efforts that positively benefit the rest of us: the burden is a carrot in front of his nose rather than a load on his back. “ (Ibid.. pp. 570-571.) 522 funds to finance its expansion project does away with the need for internal financing. Again, the divorce of ownership from control in the case of the large corporation may result in the ill-considered or faulty investment of retained earnings 206 yielding submarginal returns. In fact, one author proposed 207 the socialization of such earnings, A moderate excess prof its tax has, at most, the tendency to force the corporate management to look to the outside capital market for means of financing its expansion programs, which is beneficial in this connection. Besides, the decision to undertake property expan sions through internal financing has been found to coincide roughly with the acuteness of the need for new capacities and 208 for the introduction of new techniques. The importance of the underlying conditions for expansion is again manifest. Effect of tax on investment decisions bv investor. The management's decision to expand is usually followed by its decision as to the means by which the expansion project is to be financed. It is a more conservative financial policy to Robert Weidenhammer, "Causes arid Repercussions of the Faulty Investment of Corporate Savings," American Economic Review. XXIII, No. 1 (March, 1933)> 36, See also supra, Chap, III, p. 170, footnote 185. 20^ Ibid.. pp, 39-1 +0. See also supra. Chap. Ill, p. 182. Temporary National Economic Committee, Monograph No. 12, p. 113* issue equity stock. Since any tax tends to reduce corporate profits available for equity stock dividends, the tax has been held to exert a deterring effect on the private investor in making up his mind as to whether or not to purchase the risky security. As a general argument, high taxes have been held by many financiers as being responsible for the small pur chases of equity stock or venture capital. In this respect, some explanation must be supplied to account for the abnormally slow increase in equity capital since 1929. According to one economist, the industrial plant at the end of 19V 7 represented less than 8 per cent more equity capital than at the beginning 209 of 1929- Between 19^6 and 19^7 corporations spent $26.7 billion on plant, equipment, inventories, and extending credit to customers. Only $*f.l billion came from the sale of securi ties to the public, of which only one third came from the sale 210 of stock. Inasmuch as this happened right after the 19^5 repeal of the wartime excess profits tax, high corporate taxes, especially the wartime levy, do not furnish an explanation for 211 the small increase in equity capital. Many theories have been advanced to explain the investing public*s aversion to 209 sunder g„ Slichter, “Are Profits Too High?” Atlantic- Monthly. GLXXXII, No. 1 (July, 19^8), 32. hoc, cit. Slichter admitted this (ibid., p. 3*0. equity investment. Individuals ordinarily save for security 212 rather than for capital gains. The high cost of raising capital by offering equity issues must have prevented frequent 213 financing through such issues. The institutionalization of savings has accounted for a large share of the responsi bility for small equity capital increases, since most banks, life insurance companies, and investment trusts shun equity 21*f investments. Financial aid provided by governmental agen- 215 cies since the New Deal is another explanation. An insti tutional reason has been advanced elsewhere in this study that the separation of ownership from control has enabled the controlling interest and management to finance plant improve ment and expansion programs through plowing back surplus 216 profits, rather than through the regular capital market. There are undoubtedly many other explanations for the reluctance of the investor to purchase equity shares. Deduc tively, our proposed excess profits tax does not seem to be among them. The double taxation of dividends has been advanced 212 Slichter, loc. cit. 213 Thomas H. Sanders, “Depreciation and 19^9 Price Levels,*1 Harvard Business Review. XXVII, No. 3 (May, 19^9)» 298. 2llf Abbott, op. cit.. p. 130. 2“ ^ Loc. cit. 216 Supra, Chap. Ill, pp. 170-175. 525 by many as being the explanation* Irrespective of the sound ness of the argument, our proposed measure eliminates the undesirable feature of double taxation* The moderately pro gressive rate schedule should not reduce profits after tax to such an extent that dividends would have to be drastically reduced eoextensively. As long as a relatively stable rate of dividends can be maintained, and we have shown that it will 217 be in all probability, the market price of equity shares need not fall sufficiently, as a result of the imposition of our proposed tax, as to nullify the positive encouragement of our tax to the management to seek new capital through equity issues. The prospective investor has no logical reason to shun equity issues, other things being equal, for the effect of the tax on corporate earnings and dividends, if any, will have been taken into account in arriving at the market price of the shares that he purchases* Even if the management decides upon outside credits to finance expansion, the probable effect of our tax will be the encouragement of an unsound capital structure, as mentioned above, and the imposition upon future earnings of a relatively fixed charge for interest. But it will produce little posi tively restrictive effect on the incentive of the investor to. invest. After all, new credits are new capital, even though Sunra. Chap. VI, pp. 330-33*+-, footnote 36. not new equity capital. In conclusion, there does not seem to be sufficient deductive evidence to indicate that our proposed excess prof its tax will restrict the future supply of equity capital from the investor's point of view, other things being equal. Basie economic and institutional factors, other than high taxes, have furnished the principal explanations of the reduced supply of equity capital since 1929• CONCLUSION Our proposed permanent excess profits tax will produce little tangible effect on the investment decisions of small as well as large business. The incentive of small venturers to start new business or to expand their existing enterprises is not adversely affected at all, simply because the tax is so designed as to exclude them from its application, unless they are unusually successful. Since the underlying economic conditions, such as the volume of business, the relation of business volume to operating capacity, changing technologies, and commodity prices, are the principal and fundamental deter minants of the desirability of corporate Investment and expan sion, the corporate management's decisions to invest and expand will be affected but slightly by the presence of a moderate tax, as long as those fundamental conditions are favorable to such a course. The tax, however, does produce an adverse effect 527 on the management's investment decisions which require the financing of the expansion project through internal sources or reinvestment of retained earnings. But the relative ease with which large business may obtain external equity funds tends to mitigate against the unfavorable effect of the tax on management's decision in this respect. High costs of equity flotations may also deter the management from financing expansion through equity issues. But it still can look to the bond market for capital funds; therefore, the effect of the tax in this connection lies in a less conservative capital structure of the corporation and a relatively fixed charge for interest against future corporate income. If we ±ould take cognizance of the existence of governmental lending agencies with "cheap" funds ready to help private industry in its financial straits in this connection, even this defect of a capital structure may be obliterated. The alleged restrictive effect of the tax on corporate expansion is obviously over stated. It is admitted that many investment programs would not have been undertaken if the management had had to look to the capital market for funds. But we would like to stress again the social desirability of forcing the corporate manage ment of the large corporation to look to the capital market for expansion funds, the mechanisms of which will serve as a sort of "check" on the soundness of the investment project against the background of widespread divorce of ownership from control. We have examined the issues involved in this respect in a preceding chapter and no repetition is deemed necessary here. The overexpansion in the twenties by the large corpora tions, contributing, in part at least, to the depression in the thirties, may be advanced as another argument for heavy taxation of corporate net savings, though the issue is not so important at the present moment. The finals argument on this point has also been put forth in a preceding chapter. In a relatively matured economy unbridled expansion by the cor porate giants usually means more economic concentration and consequently, greater monopolies and larger monopoly profits. In view of the present policy of the government to prevent this from gaining momentum, some reduction in corporate retained earnings will be conducive to the successful admin istration of this policy. Whether the welfare of the economy will be adversely affected by discouraging further expansion of the large corporation is debatable and cannot be answered conclusively and definitively until further statistical study has been made. Deductively, however, from the point of view of the consumer, the outcome may not be as black as it has been painted. The fact of the relative productive ineffi ciency of the large corporation, as discussed in a preceding chapter, seems to point to the conclusion that if the small and the medium-sized business is allowed to expand and grow, within limits, of course, as they would be under our proposed 529 permanent excess profits tax, the future consumer will be benefited more in the way of lower prices than otherwise would be. The prospective private investor does not seem to be directly affected at all by the tax. It will probably reduce somewhat the market price of the equity stock he is to pur chase, but apparently does not have any perceptible direct influence on his incentive to invest if the yield is not effectively reduced below those from alternative sources. II* final CONCLUSION A final word must be added to conclude this rather prolonged discussion and analysis of the incidence and effect of excess profits taxation. It is true, as Gillim maintains, that unless the theoretical assumptions attendant upon any academic treatment of Incidence and effect are met in the actual world, the theoretical conclusions as to the incidence of an excess profits tax will be invalidated. We have recog- nixed the truth of this statement, but at the same time we have disagreed with the opponents of the excess profits tax that" it is the issue at stake. We do not deny that actual situations may differ from analytical assumptions, but we question whether the actual deviations are, on the whole, serious enough to invalidate theoretical conclusions in toto. We can conceive of imperfections in the levying provisions 530 and inadequate allowance for income irregularity which will render the tax sufficiently discriminating against certain producers in isolated instances as to lead to situations conducive to tax shifting, but we cannot conceive of any wholesale resultant tax inequities, inasmuch as the excess profits tax we propose is moderate with a high income exemp tion level and a generous loss carry-over system, We have already seen the virtually complete nonshiftability of the tax in the market and the short periods. The issue at stake is, therefore, whether in the long run the tax burden may be shifted in a sufficient number of instances, compared with the total number of enterprises affected, as to warrant the assertion that the theoretical conclusion is invalidated. In other words, it is the long-run over-all picture of the inci dence and effect of excess profits taxation that is the real issue at stake. We have analyzed the problem from the point of view of the consumer, the present stockholder "owner,1 1 the small ven turer, the corporate management, and the prospective investor. Our conclusion is that on the whole price increases will not result in the long run from the imposition of the tax, though there will be price increases as well as price decreases in certain isolated instances, brought about more by the inevit able imperfections of the tax measure than by anything else. Government spending is a balancing or equalizing factor in this respect* The stockholder “owner1s“ loss of* capital resulting from the tax is minimized by a stable dividend policy of a majority of corporations, provided he is a real investor not looking to capital gains for a return on his investment* The effect of capital loss is further diminished by his knowledge that any such capital loss realized eventually upon a sale of his holdings will be offset against his income from other sources under our proposed treatment of capital gains and losses as ordinary income and deductions for income tax pur poses, so that the government will share directly in such losses to the extent of the tax otherwise assessable against such other income without the offset. In this connection, the ability of the stockholder to control the time of realiz ing such capital loss so as to reap the maximum benefit from the offset constitutes another mitigating factor. The small venturer will not be affected by the tax, simply because the tax is so designed as virtually to exclude him from its appli cation. Since the principal considerations of the management of large corporations in deciding upon an expansion program are the underlying economic conditions conducive to expansion, rather than taxation, our proposed tax will have but a slight influence on its final decision. The tax may reduce the market price at which the prospective investor will purchase the equity issues, but other things being equal, it need not pro duce any deterring effect on his incentive to invest in such 532 securities. We have not tackled the incidence problem from the point of view of labor. There are arguments that the excess profits tax is passed on to the worker in the form of either reduced wages or smaller wage increases than otherwise would be. That these arguments are obviously untenable has made us shun the labor aspect of the incidence problem. Sinde wages are allowed as a deduction from the excess profits taxable income before the tax is imposed, there is no logical reason why wages should be reduced. If the employer were looking to the difference between the reduced wage payment and the additional tax payment for gain, assuming a less than 100 per cent tax rate, that would be a perfect argument for levy ing a 100 per cent excess profits tax. The other argument that wage increases would be smaller in case of the tax than otherwise has been vitiated by the fact that organized labor has been one of the most vociferous proponents for a peace time excess profits tax. Since wages are part of the cost of production, their increase will go to raise the existing price of the product and there should not be any great reduction in profits provided demand remains relatively strong at the higher price. This latter possibility is largely a matter of the purchasing power in the hands of the consumer and the increased purchasing power in the hands of the worker due to wage increases will, on the whole, sustain approximately the same demand at the higher price. Another argument of the opponents of the excess profits tax that the tax encourages waste and extravagance may boomerang in connection with their argument of the labor incidence of the tax on account of the logical fact that the tax should make any grant of wage increases that much less painful to the enterpriser. In con clusion, it is not incorrect to say that the shifting of the tax to the worker, if any, will, be very slight, indeed. All considered, the long-run incidence of a permanent excess profits tax falls primarily on the business enterprise affected. There may be some shifting in isolated instances. But these minor exceptions should not render invalid our, con clusion as to its long-run nonshift ability. That the burden of the tax rests with the affected enterprise constitutes one of the most important, if not the most important, basic assump tions underlying our theoretical treatment of the theory of excess profits taxation in the preceding chapters of this study. The importance attached to this conclusion is explained in the opening paragraph of this chapter. CHAPTER VIII SUMMARY AMD CONCLUSION I. SUMMARY OF THEORY THEORETICAL BASES OF PERMANENT EXCESS PROFITS TAXATION The residual claimant, theory of excess profits. A pro posed reformulation in respect to the theory of excess profits taxation is found in. the residual claimant theory of excess profits. This theory permits a practical equating of excess profits with residual profits of an enterprise, arrived at by the deduction from Income of all contractual costs and expen ses and of the imputed remuneration of the so-called "owner.1 1 This new concept of excess profits is corollary, however, to the recognition in the theory of distribution of the factor of organization or firm entrepreneurship as the residual claim ant. The fact that excess profits over and above cost of pro duction, including the "owner1s" remuneration for his services and capital, cannot be functionally attributed to him necessi tates a sort of conceptual "reservoir" to become the, recepta cle of these unimputable profits. This conceptual "reservoir" has as its actual counterpart the modern giant corporation which is, in every sense of the term, an economic entity by itself. This concept, however, is equally valid in respect of small enterprise, though less apparently so because of the appearance of close relationship and the close correspondence 53^ 535 between the 1 1 ownerM and his business. Its theoretical valid ity lies, in turn, in.that of the theory of firm entrepreneur ship or organization. The firm, in its broadest definition, as the intangible aggregate of business property, business personnel, and public services, derives its superimposed existence from the organiza tion of these tangible economic units in the ordinary conduct of business. Entrepreneurship has been identified with the function of the owner-capitalist as the sole factor responsible for decision-making, risk-bearing, innovation, and co-ordination. We have argued thoroughly why this identification is incomplete and, above all, incorrect. Practically every employee of any business has had to make decisions one time or another, to bear the risk of losing his job, to improve upon existing business methods or procedures, and to co-ordinate his work with those of his fellow employees. And yet, he is remunerated in theory as well as in practice only with wages or salary. The creditor's capital is subject to the same risk of loss as that of the "owner1 ' but to a lesser degree. But it is the same risk of loss none the less and he is entitled to ^interest only in theory as well as in practice. It logically follows that if the "owner" performs no more than these same functions, he is entitled to the same salary and interest of perhaps different amounts, but not to a special class of earnings called "excess profits" or "surplus profits." Functionally, these profits cannot be imputed to any single economic factor of production, 1 1 owner" or otherwise. They are earned by the firm as a factor of production and for that reason belong to the firm. The firm organization, as a whole, is entitled to these profits prior to their appropriation by the legal "owner." Firm entrepreneurship, it would seem to this writer, supplies the most logical explanation of why the factor of firm organization constitutes the residual claimant in the division of the total product. The impersonal existence of organization will be maintained as long as the normal rates of return are earned by the other tangible fac tors of production. As the residual, claimant, the factor of organization has no normal rate of return, nor does it possess any normal supply price in the long run. The theory of normal profits. The recognition of the factor of organization as the residual claimant in the theory of distribution relegates the concept of normal profits to a mere criterion or a guide in the determination of the "owner's" imputed share of the total product. From the standpoint of the firm organization, the "owner's" normal profits constitutes but another category of the firm's cost of production and are to be deducted to arrive at its share of the product. The residual profits which never become a part of the cost of production or enter into the price of 537 that product are now, with minor exceptions, synonymous with excess profits, as the term is ordinarily understood in excess profits taxation. Fiscal basis for business_ excess profits taxation. As the broad definition of organization encompasses the produc tive functions of the government as contributing to business prosperity, or more directly to business profits, these public functions certainly deserve to be remunerated out of surplus profits. The state may be considered either as in partnership with private business or as part of the impersonal organiza tion or the total productive machinery in earning business profits. Thus, the state partnership theory constitutes the fiscal basis for a permanent business excess profits levy. The impersonal-ability theory furnishes another ground for the same levy. Once the factor of firm organization is separately recognized, it has a definite measurable impersonal ability to pay tax, relatively speaking, because of the simple fact that the government is conceptually a part of that factor of organization and its contribution to business success should be recaptured by it to defray the cost of such contribution. Principles of tax distribution. In the attempt to recover, through taxation, a part of the cost of government, the state must observe the established canons of tax justice or equitable tax distribution. The criterion that the 538 investment incentive must be preserved as much as possible for the good of the economy finds its precepts more nearly com plied with by the imposition of a permanent excess profits tax than by the levy of a business income tax. The surplus or excess profits have a peculiar ability to bear moderately heavy taxation without any damaging effect on the investment incentive. In this respect, an excess profits tax is superior to an income tax. The greater ability of larger business units to avail themselves of the intended tax benefits con veyed by the levying statutes, their greater ease to obtain new capital through established financial markets, the rela tively smaller degree of risk characterizing their operations, and other factors point to a high degree of desirability to tax supernormal profits at progressive rates. The principle of the relative abilities to pay of business enterprises as separate taxable entities, which abilities to pay are trans lated into the sense that a heavier tax burden, on large busi ness will entail a smaller deterring effect on the investment incentive than a similar burden on small business or a tax burden imposed at the same proportional rate on both large and small business, will thus be complied with. The relative nonshiftability of a permanent excess profits tax levied at moderate rates insures that the conclusions drawn from the above analysis of the theoretical superiority and fairness of the excess profits tax under the assumption that the tax I 539 is an exclusive tax on business are not subject to extensive modifications and adjustments on account of the shifting of the tax burden. II* SUMMARY OF SALIENT FEATURES OF PROPOSED MEASURE The main provisions of the proposed permanent federal excess profits tax correspond closely to those of the repealed i excess profits tax of World War II. The reformulated theoret ical bases of the tax have, however, brought about certain changes in some of the provisions of the repealed measures, which will, be duly noted in the following outline of the pro posed permanent federal excess profits tax. SCOPE OF TAX The proposed tax reaches only excess profits attribut able to capital used in the course of business, regardless of the form of organization under which the business may be con ducted. Wages, salaries, some part of broker’s and agent's fees, professional fees, and farming income are not within the scope of the tax. If 50 per cent of business earnings have been attributable to equity capital over a specified number of years, the percentage may serve as an administrative guide In borderline cases. INVESTED CAPITAL Valuation. Cost is the only valuation basis for 5*fO invested capital purposes. The maintenance of the separate entity of the taxable enterprise requires that the “owner” be rewarded on the basis of their actual capital commitments at the time of acquisition by the enterprise. Transfers between stockholders or “owners” that do not go through the enterprise and any nontaxable transfers involving enterprise property cannot be recognised for invested capital purposes, even though such transfers are made at values higher or lower than enter prise acquisition cost. Exclusion of borrowed capital. In.conformity with the separate entity of the taxable enterprise and the residual claimant theory of excess profits, borrowed capital on which the rate of interest is contractually determined cannot be considered as a part of invested capital on which the exempt normal return is to be imputed. Inclusion of preferred stock without fixed rate of return. Preferred stock with a fixed rate of dividend return should not be included in invested capital, though the computed dividends accruing thereto, whether paid or not, should be deducted to arrive at the taxable excess profits net income. Preferred stock without any fixed rate of return may be included in invested capital. Inclusion of common stock and/or “owner1s“ capital. Common stock and/or “owner’s9 capital represent at any time 5^1 the original cost of the Mowner’sM commitments or investment, plus or minus any subsequent capital additions or reductions. This is the invested capital proper. Inclusion of accumulated earnings and profits. This •writer recommends, on practicaX grounds, the inclusion for invested capital purposes of all earnings and profits retained by the enterprise, even though to reckon that portion of such earnings and profits as may be attributed to the firm organi zation may appear to be inconsistent with the principle of separate enterprise entity. Intangibles. Ho restriction on the recognition of intangible enterprise assets possessed of acquisition costs is recommended. Inadmissible assets. Adjustments should be made for invested capital purposes for assets not used in the active conduct of business though held in connection therewith. STATUTORY RATES OF EXEMPT NORMAL PROFITS A schedule of declining statutory rates of exempt normal profits, varying inversely with the amount of invested capital, such as provided in Sec. 71^ of the repealed wartime levy, is recommended. These rates should remain constant without change unless a change is specifically granted by the special board of relief after hearing. 5k2 INCOME DETERMINATION The determination of the taxable net income (and hence the taxable excess profits net income) follows closely that under the existing federal income tax provisions with, among others, the following exceptions: Elimination of percentage or discovery-value depletion. The allowance of the deduction, for depletion computed upon the percentage-of-income or discovery-value basis without regard to the cost of mineral properties is clearly inconsist ent with the residual claimant theory of excess profits. Besides, the percentage depletion provisions favor the large and established operators more than the small and new enter prises. The elimination of these provisions granting special tax “subsidy" to certain industries is a "must" in any per manent excess profits tax measure. Capital gains and losses. Capital gains and losses should be considered as ordinary income and ordinary deduc tions in arriving at taxable net income. There is no theoreti cal reason why such gains should not be subject to excess prof its taxation, inasmuch as their nature is not much different from that of windfalls. LOSS CARRY-OVER An adequate system of loss carry-over to replace the 5^3 existing two-year carry-back and carry-over provisions is indispensable to a fair and equitable measure of permanent excess profits taxation. The exact length of the carry-over period is to be determined by further study. Prom the stand point of administration, the period should not be longer than eight or ten years. Losses incurred in the sale of business assets should constitute a part of the net operating loss sub ject to the carry-over provisions. Liquidation losses may be carried back for one year. SPECIFIC EXEMPTION A relatively high specific exemption, around $50,000, is recommended for all enterprises. Even though the residual claimant theory of excess profits and the principle of the separate enterprise entity are equally valid and applicable in the case of small business as in the case of large corpora tions, as we have argued, we also recognize the close relation ship and the practical correspondence between the small enter priser and his business. To prevent hardships from arising out of a strict compliance with these principles, a high flat exemption, leaving out most small businesses from the imposi tion of the tax, is considered highly desirable. The high exemption also tends to reduce administrative difficulties to a minimum. Special study, however, should be conducted to devise means to prevent tax avoidance through the reduction in the existing size of business RATE SCHEDULE The rate schedule should be progressive in accordance -with the varying percentages of excess profits to invested capital. The minimum or initial rate should be considerably higher than the prevailing 38 per cent corporation income tax rate. Though the steepness in rate graduation and the maximum or terminal rate may be redetermined in accordance with revenue requirements, a constant rate schedule is highly recommended as being in conformity with the theory of the cyclical budget and the concept of built-in flexibility. SOME TECHNICAL PROBLEMS YET TO BE DEALT WITH Salaries of proprietors, partners. managers. and offi cers. The salary scale for proprietors, partners, and mana gers and officers of close corporations must be determined in order to arrive at the taxable excess profits net income. Reasonableness of all salary deductions furnishes the guiding principle in fixing such a scale. Consolidated returns. One way to overcome tax avoid ance through separate returns by taking advantage of the specific exemption of $50,000 is to require all enterprises owned or controlled by the same interest or interests to file consolidated returns. By so doing losses of some enterprises within the consolidation would be permitted to offset gains or 5^5 profits of others. In good years consolidation would produce more revenue because of graduated tax rates, but in bad years the opposite might be true. Consolidation raises the diffi cult Issue of loss carry-over within the consolidated entity. All of these difficult issues cannot be treated in this study. Relief. A special board should be created to hear and grant relief to worthy cases. Variations in the statutory rate of exempt normal profits may be granted by the board after careful consideration and study. Ho general relief, however, is recommended. III. CONCLUSIOH Our analysis of the incidence and effect of the per manent excess profits tax as proposed herein has indicated that the economic consequences of the tax are relatively unpronounced. Its effect is negligible in the short run and, on the whole, certainly limited and inconsequential In the long run. Isolated instances of capital transfer in the long run, as a result of the imposition of the tax, are admittedly unavoidable, but the over-all economic picture after the tax should remain approximately the same as before the tax. The economic relationships among various business enterprises affected need not alter so drastically that extensive and pro longed adjustments are necessary before economic equilibrium is reached again. In a relatively matured economy such a result of a permanent excess profits tax should normally he expected. As we argued elsewhere, the burden of the tax nor mally. would fall on large enterprises with established monopoly and monopolistic powers and advantages, leaving the competitive fields relatively untouched. A moderate and well-designed tax measure should not alter the relative economic positions of the various monopolies and monopolistic firms affected as existed before the imposition of the tax. And there is even less reason to believe that it should leave them worse off after the tax than firms operating in the competitive fields. Capital transfers under such, circumstances would be strictly limited to cases suffering from gross inequities arising from imperfections of the levying provisions and should, therefore, result in no great and extensive readjustments in the economy as a whole. Also, in a matured economy the relative import ance of new and growing enterprises may reasonably be presumed to be small. The oft-repeated argument that the excess profits tax penalizes enterprise and risk, especially the new and young ventures, cannot therefore stand close analysis under conditions of economic maturity, even if we grant that owing to imperfection, the tax may conceivably affect young enter prises in isolated instances. The degree of the fairness and 5b 7 desirability of a permanent excess profits tax seems to bear a direct relation to that of eco