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AIR MAIL
SPECIAL DELIVER!

April 22, 1942

Dr. Simeon £• Leland
Department of Economics
University of Chicago
Chicago, Illinois
Dear Sim:
If I understood you correctly yesterday, lir* Eccles discussed
with you over the telephone the joint memorandum to the President*
Apparently Mr. Eccles raised a question as to whether the proposed
tightening of the excess profits tax by lowering the capital ratio
credit might not be a step in the wrong direction• You wanted us
to answer immediately by wire. I felt, however, that this is such
a complicated subject that it would be better to write a letter.
Accordingly, I wired Mr. Eccles last night that we would answer his
question by air mail.
In order to answer Mr, Eccles1 question, it is first of all
necessary to determine what changes in the taxation of corporate
profits would be a step in the right direction. Only then it is
possible to determine whether the specific proposal moves in the
right or wrong direction. The group who drafted the joint memorandum apparently was of the opinion that a basic modification in the
determination of excess profits would be desirable, but that such a
fundamental change is not feasible at the present time. If I
interpret the statement in the joint memorandum rightly, it implies
a criticism of the present method of determining excess profits.
The present method relies predominantly on the base income method.
Under this method, tax liability is made dependent partly on what
a corporation happened to earn in a base period. Corporations
which happened to have relatively high profits in the base period
are favored, and corporations which happened to have low profits
are penalized. The invested capital method for determining excess
profits is fundamentally a relief provision in favor of the taxpayer under the present and the proposed statute. The weakness of
this method of determining excess profits made it necessary to
increase the normal income and surtaxes on corporations in order to
raise the amount of money allocated to corporate taxes.
I as under the impression that the group would have favored an
arrangement by which some compulsory use would have been made of the
invested capital method in order to catch corporations which had




Dr. Simeon E. Leland

- 2 -

April 22, 1942

high profits in the base period; that it would have preferred to
graduate the tax not in accordance with the absolute amount of
profits but in accordance with the relationship between excess profits
and normal profits; and that it would have favored a somewhat lower
income tax and surtax on normal profits than that proposed by the
Treasury.
If this interpretation of what would have been desirable is
correct, then it apparently follows that the proposed modification is
not a step in the right direction. By lowering the invested capital
credit, more corporations will be brought under the average income
method which seems to be the opposite of what is held desirable.
This is apparently the point that Mr. Eccles has in mind.
After thinking it over, I personally believe that the specific
proposal of lowering the invested capital credit may not be a step
in the right direction but it is not a step in the wrong direction
either. It would be an improvement within the framework of the
present law. The use of the capital ratio method at the option of
the taxpayer does not accomplish and does not even approximate the
objectives of those who favor the basic use of the capital ratio
method. Under present law, the capital ratio method is mainly used
by corporations with high capitalization (and often excessive
capitalization) which make substantial earnings but whose earnings
are still low relative to their invested capital. Thus, in 1940
United States Steel did not pay any excess profits tax and will pay
relatively little under present legislation. The railroads increased
their profits substantially because of war business, but are practically exempt through use of the capital ratio option.
A statistical analysis of the 1940 excess profits returns, which
showed no excess profits tax liability, permits the conclusion that
it was mainly the larger corporations which claiiaed tax exemption
on the basis of the capital ratio method. These statistics are not
entirely conclusive because the breakdown of size is made according
to excess profits "deficit classes* and not according to the size
of the corporation. I am enclosing the figures for your personal
information.
Lowering of the invested capital credit would narrow this relief
provision and would bring under the law corporations with high
capitalization which have increased their earnings above the base
period. This measure will certainly not sjove in the direction of a
shift from the taxation of war profits to the taxation of excessive
profits. In this sense, it is not a step in the w right u direction.
If we are compelled, however, to use the present framework of taxing
profits (whether we like it or not) we imist see to it that this




Dr. Simeon E. Leland

- 3 -

April 22, 1942

method is used as equitably and effectively as possible. The
specific proposal which Mr. Eccles discussed rfith you is only an
attempt to restrict possible misuse of a relief provision in the
present law. As such, it would be an improvement of the present
law and the present Treasury proposals.
There is no doubt that this narrowing of the capital ratio credit
may create hardship in particular cases. Two measures to minimize
such hardship are contemplated. First, it is proposed to start
the capital ratio credit at 6 percent for the smallest corporations
and gradually reduce it to U percent for the largest corporations.
Second, it is planned to establish a Board of Referees for examination of hardship cases. (The Treasury has already proposed such a
board to deal with extraordinary conditions in the base period.)
ne have been informally advised by the Treasury that further
modifications are under consideration. If the top rate of 100 percent
proposed in the joint memorandum should be adopted, an attempt will
be made to graduate the tax according to the rate of excess profits
rather than the absolute amount. In this case, two rate structures
must be enacted: one for the base income method, one for invested
capital method, Randolph Paul would like to make the rate structure
under the capital ratio method more attractive than under the income
method. This favoring of the capital ratio method would be a step
in the right direction. It is very doubtful, however, whether he
will be more successful with this than with his earlier attempt to
lower the percentage of average base period earnings applicable in
computing the excess profits credit, — which was proposed for the
same purpose.
The above technical details could not be set forth in the brief
memorandum to the President. They were contemplated when it was
decided to recommend a "tightening of the excess profits tax" proposals.
I saw in the morning papers that the Chicago Sun ran a story
saying that the President is determined to eliminate entirely the
average earnings method. This comes as a great surprise to everybody
here and we still doubt it. Unfortunately, it looks now as if the
voluntary savings method will be given a trial. The bad thing about
this is that if the result is not satisfactory at first, the plan
presumably will not be given up right away; rather it is likely
that an attempt will be made to make it work by using more coercion.
We heard in the Treasury that practically all the Secretary's
advisors, except those directly responsible for t-he voluntary savings
campaign, favor the "universal" savings program and expressed this
preference to the Secretary.




Dr. Simeon £• Leland

- U -

April 22, 19-42

lith best -wishes,
Cordially yours,
#v Wei don «N*i**aJ, Weldon Jones
Assistant Director in Charge
of the Fiscal Division

Enclosure

cc Mr, Eccles via air
special delivery




NONTAXABLE EXCESS PROFITS T X RETURNS, FOm 1121, WTtR NORM*Ir»TAX
A
NET HOOK OF $100,000 O 07m AND/OR EXCESS PROFITS CREDIT OF
R
$250,000 O O E RECEIVED IN T E BIHEAU T R U H D
R TR
H
HOG
R 2 , 1941
Number of returns by selected types and options and by
adjusted excess p r o f i t s d e f i c i t classes
(Adjusted excess p r o f i t s d e f i c i t classes and money figures i n thousands of d o l l a r s )

Adjusted excess p r o f i t s
deficit classes
Under 5
5 under 20
20 under 50
50 under 100
100 under 250
250 under 500
500 and over
Total

copied
4-21-42




Invested
capital

Method of c r e d i t computation
Income
General
Increased
Total
average
earnings

58
140
233
288
488
426
522

207
407
389
276
269
119
90

98
212
187
126
127
67
43

109
195
202
150
142
52
47

2.155

1.757

860

897