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FEDERAL RESERVE BANK OF BOSTON RALPH E. FLANDERS PRESIDENT June 16,1944. Honorable Marriner S. Eccles, Board of Governors of the Federal Reserve System, Yi'ashington 25, D. C. Dear Marriner: In accordance with what will be my regular policy of sending you copies of any talks I might give, I am enclosing herev/ith manuscript of a talk on Federal taxation which I gave before the New England Council yesterday. TiJhile in introducing myself, I said I was speaking as Chairman of the Research Committee of C D and not as President of the Federal S Reserve Bank of Boston, s t i l l i t is not possible to completely dissociate m two capacities. y Sincerely, A. Encs. A FEDERAL TAX SYSTEM TO ENCOURAGE BUSINESS ENTERPRISE, PRODUCTION, A D EMPLOYMENT M An Address before t h e Hew England Council June 1 5 , 1944 The Committee f o r Economic Development has a s a major p r o j e c t t h e study of t a x p o l i c y for t h e p o s t - w a r p e r i o d . The problem was a s s i g n e d by t h e Committee t o our Research D i r e c t o r , Llr. Theodore 0 . Yntema, and h e , i n t u r n , engaged Dr. Harold M. Groves, P r o f e s s o r of Economics a t t h e U n i v e r s i t y of Tiisconsin, t o head t h e s t u d y , w i t h o t h e r t a x e x p e r t s as c o n s u l t a n t s . The r e - s u l t s of t h i s r e s e a r c h havo j u s t beon p u b l i s h e d by t h e McGraw-Hill Company i n a book by Dr. Grovos e n t i t l e d " P r o d u c t i o n , J o b s , and Taxes." This study i s t h e foundation of t h e Committee's forthcoming p o l i c y s t a t e m e n t on t h e same s u b j e c t . While t h e p o l i c y s t a t e m e n t of t h e C o m i t t e o i s based on t h e work of the research specialists, who tako full responsibility for thoir work, tho policy statement is the solo responsibility of the business group forming tho Committee. During the long period of discussions between tho economists and the business group, most of the differences of opinion have been ironed out, and the final differences will bo coraparativcly unimportant. Since tho policy statomont is not yet in i t s final form, What I am saying about i t hero is preliminary and unofficial, but will not, I a sure, m depart very much from the completed statement. A dangerous dilemma faces the post-war world as a result of tho enormous taxes w shall have to pay. o employment and production? H w can wo pay theso taxes without choking o H w can wo pay them without destroying tho taxable o income by which alone they can be paid? The increase in the national debt resulting from tho cost of recovery measures during tho depression, and the much larger added burden of interest on tho war debt, will require such heavy outlay that w aro faced with peacetime e federal oxpendituros of unprecedented sizo. To t h i s vdll bo added the incroased cost of maintaining an enlarged navy and standing army, and increased benefits for veterans. All of this adds up to around $20 billion in taxes, including social security—three times tho amount required before the war and six times tho amount required in the-twenties. The government vdll need to raise twice as much as total corporate profits in a good year* There is danger that i t s mistakes will more or loss automatically be big ones. In fact, unless wo dan doviso a tax system which permits high production and employment, wo cannot raise the required taxes-thero vdll not be income enough to tax. Throughout tho history of this country, the increase in job opportunities and tho improvement in tho scale of living has obviously como from the expansion of old businossos and tho establishment and growth of now ones. Few who have not studiod the matter or have, not experienced the effects of existing tax i policies realize the ho?«.vy repressive hand that our present taxation has laid on this normal method of expanding the income of tho wage earner and tho markets of agriculture* Business growth is financed in three ways. First, by the investment of venture capital in a new, untried but hopeful undertakingj second, by subsequent growth of tho successful undertaking, financed by plowing back earnings; and third, by floating new security issues on thu market. As to new vonturos, our personal taxes are such that, in combination with our corporate taxes, th.oy direct the funds of tho larger income groups away from rick-taking, expansive business undertakings into tho gilt-edgod securities c of established companies or, more unfortunately s t i l l , into tax-exempt securities, Until recontly, the second means of financing, by plowing i t s earnings back into tho expansion of i t s operations, was tho normal moans of growth of a well-managed businoss enterprise. Instead of paying the major part of thoso earnings back to stockholders, a good share of them was invested In new equipment, larger supplios of raw materials, and wagos for more men. And, of course, the new equipmont and the added raw materials, in turn, meant more wages for more men among the producers of these commodities. Under our present tax laws and, to a lessor extent, those in the immodiatoly precoding years, so largo a share of the earnings of a growing company wont into excess profits taxes that little or none was available for expansion, and increase of employment was thus heavily ponalizcd. This repression of expansion applied particularly to the small or middle-sized company which, under existing S.E.C. Regulations, had no effective access to the third means of raising funds, by new stock issues, even though the opportunities for profit might bo obviously good. A security issue of $500,000 is too small for tho complicated and expensive procedure now required. The big, es- tablished company, on tho other hand, has free access to the security market and can expand, by this third mothod. and the Our prosont tax laws restrain the now, the small, growing organizations, and tend to loave expansion as a porquisite of the largo, established ones. Another unfortunate tendency, in companies of all sizes, has boon in the direction of financing by debt as against equity; or, in simpler languago, by borrowing on bonds instead of by the sale of stock. debt is not taxable as coming out of profit. coming out of profit. Interest on bonds or other Dividends on stock are taxable as There is, therefore, a tendency toward a typo of corporate financing which puts hoavy fixed charges on the business, whether timos are good or bad, whether operations are at a profit or at a loss. This unfortunate ten- dency tends toward bankruptcy in depressions and contributes to tho instability of our economy. Of course, the extremes of the s i t u a t i o n s described above are made i n evitable by the height of war t a x e s . But only a small p a r t of the damage i s inevitable in properly devised peace-time taxes, and i t i s the purpose of our study to find ways in which we can avoid serious mistakes in going from war to post-war taxes. In view of the conditions described above, we make the following recommendations for changes in corporato taxes. -—) Repeal the excoss p r o f i t s tax. "While clearly j u s t i f i e d as a war measure, we arc convinced t h a t the rotcntion of t h i s t a x aftor tho war, evon a t reduced r a t e s , would havo disastrous effects on national production and employment. Tho present oxcoss p r o f i t s tax i s a coiling tax on gross p r o f i t , since v i r t u a l l y a l l p r o f i t s above tho 1939 levels for most concerns arc appropriated by the government. What strong incentive i s thero to do business beyond the 1939 lovolT — Vp( ou In addition to boing exceedingly repressive for businoss entorprisc as a whole, we havo soon how i t places growing cempanios with small c a p i t a l basos and unsatisfactory past earnings a t a sorious disadvantage compared with old established businesses which have either a s a t i s f a c t o r y rocord or a largo c a p i t a l baso. As such, i t i s c l e a r l y in opposition to the objective of promoting a dynamic and expanding economy, with i t s increased markets and employment. Reduce corporate income taxoi to a level equal to tho post-war normal withholding tax rate for individual incomes. Tho wage earner, as well as the stockholder, has a definite stake in those two proposals. By leaving corporate p r o f i t s l i g h t l y taxed, thoro is not only an opportunity for more dividends and easy expansion, when expansion i s indicated; t h a t expansion offers more and b e t t e r job opportunitios. The tax r e l i e f also w i l l permit lower prices for the things tho wage oarner buys. Indood, the case has been strongly arguod that corporato taxos arc not paid by tho corporation, but aro reflected in prices paid by tho customers. W boliovo this statement to bo too o strong, and arc particularly concerned with tho effect of those taxos on tho expansion of employment. Yet thorc remains, without question, an opportunity for favorable uffecta on prices. Reduce double taxation by frocing from corporate taxation those profits paid out in dividends, or by leaving the stookholdor free of the normal tax on dividends on "which the normal tax has boon paid by tho corporation. With tho corporato tax and the normal tax on personal incomes equalized, this proposal is intendod to avoid tho inequitable and repressive system of double taxation of dividends which we now have. fect. Noither of the solutions abovo is per- From the standpoint of simplicity, we prefer the payment of the normal tax by the corporation on i t s entire earnings, and tho remission to the stockholder of the normal tax on the dividends received. Business income should be allowed to carry forward losses to apply againirt"subsoquont oaraings for a period of six years. As a temporary moasuro, w also recQinnond th"at o the existing privilogcTTf applying post-wo.r losses against current excess p r o f i t s b c o x t e n do d to cover a period of three years after tho war. i ^ • The theory of taxing income sololy on an annual basis of accrual has placed a substantial premium on regularity of income. By failing to make allow- ance for business incomes which by thoir vory naturo fluctuate from substantial losses in one year to substantial gains in another, i t has resulted in a heavier tax burden ovor a five or ten year period for such irrogular inccmos than for incomes which arc stable. Frequently this situation causes the payment of taxes out of capital rather than out of actual net income. There is nothing sacred about an annual tax basis to justify such inequality. Moreover, this method of taxation creates a particular hardship for new small enterprises ifhich, in gonoral, tond to have considerably greater irregularity of income than those of largp, well established businesses. G The importance of this fact has boon recognized in current federal taxation which permits the carrying forward of one year's losses to be applied against the income of the second. Wo believe that considerations of equity and the objoctivo of stimulating venture capital require a substantial broadening of this principle. In addition to the proposal that the privilege of carrying forward losses bo extended for a period of six years, we also recommend that the existing carry-back provisions of the excess profits tax bo broadened from two years to cover a period of throe years after the war. Since the existing privilege is incorporated in the excess profits tax law, special action will be necessary, if this tax is repealed after the end of the war. Since a significant part of re- convorsion costs end of losses during the transition period will be a direct effect of the war, we believe such action is desirable to make more equitable the ovorall burden of wartime taxation on corporations. The heavy burden of taxation on business expansion which is inherent in our tax system is mitigated by tho various suggestions just made, but the conditions are still far Ices favorable to an expanding economy than they wore a generation ago. V r therefore recommend that .e Tho present differential taxation of capital gains of 100 per cent subject to tax, on securities hold for six months and 25 per cent subject "to tax, on those y hold for a longer "period, should be retained^ There has been much theoretical discussion as to whether or not capital gains are income in the sonso that makes them logically subject to an income tax. There is the precedent that in England capital gains are not taxed unless it appears that they are depended upon for income. Without subscribing to tho theoretical objections to tho capital gains tax, and without depending on tho British precedent, wo urge rotantion of tho above policy as tho bost point in a modern tax structure at which to maintain a measure of the old conditions under which risk-taking and • vonturo capital received the reward necessary to bring them into action. -7It is true that the very simple form of the proposal will not distinguish completely between market operations as a source of income and the investment of money in productive enterprise. It is true also that it makes no distinction be- tween the securities of established enterprise and new securities issued for the establishment of new enterprise or for the expansion of older ones. An endeavor to draw these distinctions would lead to complications which would not be worth their cost. The thing to be desired is to get the liquid wealth of the nation & attracted to the expansion of American production and employment. This is a strategic point at which to remove the barriers to the desired result. After the close of the war, all federal excise taxes should be repealed, with the exception of those on tobacco and liquor. We are opposed in principle to all general sales taxes in the federal tax structure. Their impact is particularly severe on low income recipients, and hence, they have an immediate depressing effect on demand for consumption goods, whatever stimulation might arise from later expenditures of this tax money by the Government. They are the source of much annoyance, and are usually costly to administer. The same general arguments apply against most excise taxes levied on particular commodities or groups of commodities. Such taxes are not objection- able as wartime measures, but are definitely undesirable in times of peace. We propose, however, that excise taxes be retained on tobacco and liquor. These taxes are collected at the source and are cheap and easy to administer. arc not taxes on necessities and, therefore, can be avoided. They They are productive of an important amount of revenue with highly stable characteristics. I e Y believe it desirable to retain such an element in our tax structure in order to avoid placing too great a reliance on the income tax. The repeal of other existing excise taxes u8 suggested above will provide substantial relief after the war for the lower income groups. greatly will simplify the federal tax structure. In addition, it -aCongress should pass at once a resolution declaring that all future issues by state and local governments will be fully taxable. If a Constitutional amendment should prove necessary, appropriate steps should be taken. For many years we have been erecting a federal tax structure which, step by step, has tended to discourage the assumption of risks by enterprisers, and to promote a static capitalism. The refuge from high surtax rates afforded by tax- exempt securities may well be called the crowning arch of this structure. TThen, as at present, an individual in the top surtax bracket is forced to obtain a return of twenty per cent on an equity holding to give him a yield after taxes ecual to that on a two per-cent tax-exempt bond, the effect on incentives is obvious. The federal government has finally recognized this anomaly by making all of its current security issues fully taxable. The important remaining loophole still to be closed is that afforded by the exemption from income taxation of securities issued by state and local government agencies. Action should be taken at once in this connection, and without waiting for the end of the war. We are not willing to recommend the removal of the tax-exempt privilege from outstanding securities. Such a step would be inequitable unless compensation were paid to the holders of existing securities. This would be costly to the federal government and difficult to administer. Moreover, we do not believe such drastic action is essential to incentive encouragement. The present seems a very appropriate time for the action proposed. Outstanding debts of state and local governments have been substantially reduced since Pearl Harbor and are likely to undergo further reductions while the war lasts. After the war, however, public construction needs are almost certain to cause a considerable expansion of those debts. Furthermore, current low interest rates provide an excellent opportunity for refunding short-term issues on a taxable basis. -9The net effect, in our opinion, would be that the volume of tax-exempt securities within five years after the war would be small in relation to total outstanding public debts. Their influence on incentives, therefore, would be relatively unimportant. As already indicated, the post-war budget, even without provisior for debt retirement, will run somewhere around $20 billion. This.will be true whether we have a Democratic or a Republican administration, and even in the case that the nation's finances are in the hands of highly conservative legislators and administrators, of whatever party. The problem of raising money for this unavoidable budget is going to be painful. Because it is most favorable to the expansion of profitable, productive employment, we are proposing to place the principal burden for raising the postwar budget on the personal tax structure of the income tax. c This is logical as well as desirable, since all taxes are ultimately taxes on persons, whether levied on corporations, sales, imports, or what not. Putting the burden on personal taxation is, therefore, realistic, as well as being socially favorable. The postwar budget cannot be balanced with this main dependence on the personal income tax unless there are a very great number indeed of highly paid i wage earners to pay their share. This is a fiscal necessity, as well as a social desirability. The following policies are bused on the above general conclusions: Present personal exemptions should be raised by repeal of the Victory tax, but with income tax exemptions " maintained at approximately the present levels. The present combined withholding tax of 22 per cent should be replaced with a single normal tax at a moderately lower rate. Tha level should be raised at which surtaxes begin to apply. -10As set forth previously, the new normal rate should fix the level for the corporate income tax. Although it is not now possible to predict exactly what the postwar normal rate should be, it is clear that it will have to be much higher than the prewar normal rate, but probably can be somewhat lower than the present combined rate of 22 per cent. A level of personal exemptions close to those now applicable for income taxes, other than the Victory tax, will also be required. In this connection, it is important to observe that individuals with incomes of less than $5,000 received in the aggregate $116.7 billions in 1943, or about 82 per cent of total personal incomes of |142 billions. On the other hand, total incomes of those who received $5,000 or more amounted to only $25.3 billions. Although the pattern of income distribution will change in some respects after the war, no really great changes appear to be in prospect. Consequently, a substantial tax contribution will continue to be required from income groups receiving less than $5,000 a year, if postwar revenue requirements are to be met. Nevertheless, an adequate withholding rate combined with current personal exemptions, should permit a lifting of the level at which surtaxes begin to apply. At present, a family of five is exempt from income taxes (except for the Victory tux) on income up to £>2,25O. Thus, if surtaxes started at a moderately higher level, the net effect would be that income taxes for the great majority of all individuu.1 taxpayers would be covered by the normal withholding tax. Some form of income averaging for tax purposes should be available to individuals as well as to corporations. We therefore recomiaand that individuals be granted the right to obtain tax rebates at the end of every fiveyear period by the use of some averaging device. We believe that tax relief should be provided for those with widely fluctuating incomes. Such individuals are frequently required to pay much higher taxes over a period of years than those- with equivalent stable incomes. -11One possible method to accomplish this would be to provide for refunds to individuals to the extent that taxes actually paid during a five-year period exceeded some given percentage (perhaps 110 per cent) of what such taxes would have been if the aggregate income had been spread equally throughout the period. The object of using a figure such as 110 per cent would be to limit refunds to •those who had been seriously affected by income fluctuations. Pending a comprehensive study of the problem of business fluctuations, we are unable at this time to suggest means by which they may be kept under close control. trol. Indeed, it is not yet clear to what extent they can be kept under con- It is clear at this stage, however, that we have certain tools of control which we must learn to use. If these tools are misunderstood and misused, or even if they ore neglected, they may easily become active factors in generating booms and depressions. One of these tools, and an essential one — though by no means the only one — is the tax system adopted. A specific tool of control is provided by the volume of money taken out of the economy for the payment of taxes, particularly if applied to the retirement of bonds held in the banks. If this volume is heavy during an inflationary period, it tends to restrain inflation and thus acts favorably. If it is heavy during a deflationary period, it tends still further to deepen' the depths of deflation. If, therefore, a tax system were designed solely from the standpoint of controlling the business cycle, it would doubtless provide for variations in rate which would apply drastically high taxes as inflation appeared, and decrease taxation during the deflationary period. This latter v/ould not merely decrease the liquidation, but would, as well, allow larger margins for spending and'business revival, both on the part of individuals and businesses. 12 The difficulty with using the tax system positively as a means of controlling the business cycle is most obvious at the time when it most needs to be applied: namely, when an inflationary curb is needed. In the first place, the increased taxation must be applied more quickly than is possible by legislative enactment; and in the second placej if it is left by law to administrative discretion, the extreme unpopularity of the required moves would make the process politically unfeasible. We are, therefore, making the following recommendation in advance of a thorough study of the other tools of control, and with the knowledge that the results of that study may lead to putting more dependence on variable taxation. In such case, we may have to accept the variable rate (or, alternatively, the variable base) in spite of the great difficulties in administration. Wo propose that the federal tax system be revised to provide a balanced budget at an average high level of employment and national production. The level at which the budget should be balanced will require careful study. It must be neither too high nor too low. If the point of budget balance is set too low, taxation will tend to have a repressive effect before our desired level of production and employment is reached. If it is set too high, the budget will not be balanced over the business cycle, and we trill have a continuously increasing debt. We desire neither the ono condition nor the othor, but an intermediate position which will maintain us at the required high levels, on a selfliquidating basis, rather than on the basis of indefinite and cumulative deficit financing. At this point we run head-on into our dilemma. If tho kinds «nd rates of taxes are to be low enough to oncourago business expansion and employment, they can only balance the budget if the national income is high. From tho best figures as to postwar budget, tax rates and tax returns, applied to the tax program we have 13 been describing, it would seem the only safe rate of net national income we can plan for in the postwar world will be around $140 billion* Several independent calculations which have been made indicate that at the 1943 price level, this income will be achieved with 55 million peoplo gainfully employed at 40 hours a week* Above and below this level we may expect our economy to alternate but with- out destructively serious fluctuations. We recommend to Congress and the Treasury the establishment of a stable income tax structure^ within which rates may bo adjusted without re^~" quiring radical new legislation* It is recognized that one Congress cannot bind another* If, however, a tax law is drawn up, having a coordinated structure directed toward high employment and production in addition to a raising of the required revenue; and if, furthermore, such a tax structure is comparatively simple and equitable, there will be less temptation for successive Congresses to change the structure itself* Tax legislation has become a serious burden on Congress and its committees* Anything which lightens that burden should be appreciated by successive Congresses* As suggested, we do urge that rates bo stabilized eventually, so that this element of the conditions affecting business and employment will become established, so that in turn business confidence can support business enterprise* Business confidence needs to be defined* It is often considered to bo a psychological factor affecting businessmen and keeping them vibrating between jubilant optimism and blank despair. This is a better definition of the psychology of speculation in securities and commodities than it is of productive business* Business confidence, in the lattor field, can be simply defined as a reasonable hope of profit* As such, business confidence is absolutely essential to the ex- pansion of productive employment, and the various proposals of this document are directed to that end* 14 This group of tax proposals is not complete. Other items will require attention to make a well-rounded federal tax policy. But those are the most important proposals so far as concerns business confidence and expansion and a high level of productive employment. Let us revert once more and finally to the difficulties of the balanced budget in the postwar world. It is confidently believed that the pro- posals made will balance the budgot, and it is also confidently believed that they will permit business enterprise and high employment. Permit is the word to use; they will not guarantee those blessings. At the outset of this talk the dilemma was stated: that unless wo set our mark high in employment and production, we would have to have a tax system which would prevent us from reaching high employment and production on a balanced budget. The solution of the dilemma lies in attaining and maintaining that high level of national income of around $140 billion. Those tax proposals pernit reaching this goal, but the actual attainment will have to be made by the individually vase activity and enterprise of the whole mass of American businessmen, employees and farmers. The postwar world can be a success only as it is supported by the cooperation of all of us. Ralph E. Flanders 30 Pearl Street Boston, Massachusetts