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BOARD OF

GOVERNORS

•r yÍ
fE
FEDERAL »¿SERVE SYSTEM

Office Correspond^a<5e
To

Chairman Ec pies

¿r

Frrrm Mr» Honkins and Mr#4ius grave

Date^L^jfe
Subject:

Preliminary Study for
Chairman1s presentation

The present is a strategic time for formulating a sound
program for meeting the long-term needs of small business» Small
businesses at present are prosperous, but small business as a type
of enterprise is under serious pressures•
As long as we have taken the individual approach, we have
dealt only with the surface aspects and fringes of the problem« During
the depression, it was assumed that if we could only pump out more and
more credit to small business borrowers, all would be well» We conceived
of the problem in terms of credit and relief. Circumstances now permit
us to take a more rounded approach.
When we speak of small business, we have something else in
mind besides smallness in the business size* We have in mind the independent individual enterprise, which is usually small» It is fortunate
for the economy that, along with the growth of a few thousand large
business collectives in the last half century, enterprises of the individualistic type remain very numerous, about three million in number.
The small businesses have Hiueh to do with preserving competition,
with adding variety to the standard of living, and with supporting
independent consmunities. Also they tend to develop the type of individual that backs his own judgments and has the spirit of enterprise
and venture. The more bigness we have — big industry, big government,
big labor — the more we need such individualistic offsets as small
business, small farming, and independent professional life. It may
be, in the last analysis, that democracy depends upon the maintenance
of an adequate amount of individualism. If a democratic government
had to subsidize individualism to keep it alive, it would only be
subsidizing its own foundation.
This type of enterprise has tremendous vitality. We need
not take an alarmist view. Many small businesses that disappeared
during this war will revive, and more will be founded as demobilization
proceeds. This process is already on; since May, 19i|i|* the number of
business births has exceeded the number of discontinuances» After
dropping from 3*398,000 in September 191+1 to 2,8l|0,000 in December,
19i4.3# "cf total number of business firms was 2,9$Q,L\QQ last September
fbe
and undoubtedly exceeds 3*000,000 today. This phenomenon would be
gratifying if the environment could assure that the new business births
would not be compensated by a rise in business deaths»




Chairman Ecoles

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Small business
is especially important to employment»
In 1939 eight million wage-earners and two million proprietors were
employed in enterprises having less than 50 workers each, which was
about equal to the total employment in all concerns having 1,000
workers or more« Perhaps we need not be especially alarmed by the
fact that from 1939 to the end of 19U3* employment in the less-than50-worker concerns declined by 1»7 per cent, whereas employment in the
more than 1,000-worker enterprises increased by 95 P e r cent» This
wartime distortion will tend to rectify itself if only the conditions
are right» But conditions are not right in certain basic respects,
and we cannot have either the desired restoration of individualism in
enterprise, or full employment in the nation, unless conditions are made
favorable for the small enterprise»
What, then, is the small business problem? /There are financial
problems, but these are a visible symptom only» We may^reach behind the
financial problems and ask: Why, in a nation that has abundant investment capital, should small business have difficulty in commanding capital?
Why, in a nation that has vast credit resources, should small business
complain of unfavorable differentials in credit, especially term credit?
Taking an historical view we may ask: Why did the problem of small
business become serious during the 19P0fs when investment capital was extremely active? Why did small business do reasonably well before the first
World War, when credit was scarce and high priced^but encounter trouble
during the present war when credit was abundant? Jm
Technological basis of the problem
The basis of the problem, it seems to me, is not financial,
but technological. Invention, during the 1 9 t h Century, provided small
machines to supplement the work of individual craftsmen; the sewing machine,
the linotype, the typewriter, small woodworking and metalworking machinery,
and the like» Small business seized upon these small-unit machines and
still utilises them in the lines where mass production has not extended»
But in recent years, these machines have become more refined and more
costly, and in addition, the mass producing type of machinery has been
vastly developed and applied» As a result of both these trends, the
minimum capital requirement for successful operation in nearly all
fields of enterprise has considerably increased» It has become increasingly difficult to start a new business on a small scale, or to continue
in business, unless the capital investment is fairly large»




Chairman Ecoles

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For example, in former years a man in the contracting business
could bid successfully for contracts, and perform them successfully, on a
pick and shovel basis, with very little need of capital* Today, in order
to find work and compete, a construction firm must have costly bulldozers,
*
heavy trucks, machine-drills, and other expensive equipment« In former
>
years in the lumber industry, even the largest trees were cut down by axes, t
logs were coasted down to water, sawmills were fairly simple, and finished
lumber was dried in the sun* These conditions still obtain in the Southeastern
lumber industry, but West Coast lumbering today is a matter of power-driven
logging, J i l ! . i hy railroad, elaborate sawmills and kiln drying of finished
jfgag>
lumber, ¿JEB-Pumei ¿mar« a beot •ougar, refinery might reprosont as -little -ao$500,OQQ in ua^jilal, 1ml
llial ludaj —
th% ¿aiaimiuu lUTtfblMgiil
-inr-aiuuiid $Q,50Q,00CElI This
situation has, of course, varied considerably among different industries, but
even the small corner store today must have its refrigeratioij. plant, and the
small beauty parlor its elaborate electrical devices.
This higher capital requirement has had the effect of discouraging
venture• The higher capital requirements have meant higher overhead costs
and fixed charges. The higher costs have required a larger volume of
business, and created a more rigid break-even point. The necessity for
larger volume has involved an expansion of the market, and the break-even
point has required a broadly spread market so that the fluctuations in one
area would be compensated by the fluctuations in another. This, in turn,
has increased sales costs and required larger amounts of working capital. ^
Finally, the larger the enterprise, the greater the meaning of the adjective —
^isk1* in the term w risk capital11. Investment funds; in turn, have preferred
the enterprises with the broadest market base^in order, as it has been generally
assumed, to reduce the risk.
Opportunity for a threefold attack
Nothing can be done to reverse the technological trend• Large
enterprise represents one type of progress, and we cannot turn back the clock»
But the process has had certain byproducts which, it seems, are not essential,
and can be c h a n g e d S m a l l enterprises as well as large can be technologically
efficient in their fields« and many of them are so. But as a general condition the small business has a deficient contact with the findings of modern
technology, while the large enterprise has thorough-going contact» This
seems susceptible of r e m e d y T h e small business has a sharply fluctuating
earning position, but the ups and downs generally average up with time; the
taxation system, however, has failed to gear itself to the fluctuating incomes
and has placed a penalty against venture investments and risks
As to
investment, there seems no valid reason why, in creating elaborate mechanisms
for supplying the capital needs of 5 V e r
of .American enterprises, it
should so completely have neglected all institutional provision for the 95
per cent. Insurance, finally,has failed to provide protection behind the
extensions of credit in the area involving risk. In summary, small business
has lacked certain facilities essential to the proper conduct of business
under modern conditions, and the problem on its practical side comes down to
that of designing and providing the necessary facilities. Under the




Chairman Ecoles

-h-

circumstances of general neglect that have existed, it is remarkable that
independent enterprise has managed to survive.
Some elements in the small business problem are doubtless beyond
reach* But at least facilities can be established, and it would probably
pay the government to establish them, in view of the desired contribution
of small business to freedom of enterprise and to employment.
I, The Technological approach
The first item in such a program would be a facility for small
business in better touch with modern technology and, in general, with the
best management information and technics of every type. The big organizations have their own laboratories, some 2200 in number, and large companies
and associations covering the major portions of their industries are
constantly represented at the National Bureau of Standards» The larger
businesses also have their own economic and marketing experts and staffs.
Hot only is the small business unable to support such services, but its
management often does not know where to write for the most reliable type
of information of the desired kind.
What is here suggested is that one central place be established
within the government, to which the small business may send in a query on
any difficulty connected with management, that is hampering its efficiency.
The queries might deal with technological problems, production "bugs,11
sources of needed materials, use of byproducts, methods of personnel administration, accounting standards, market opportunities — any matter within
the accepted range of management problems. The central query bureau would
not directly answer these queries but would serve as a clearinghouse and
source-finding agency. It would have to build up cooperation with all
scientific and economic agencies of government, technological societies,
universities, any private organizations that would consent to help. The
task would be to run down the sources of the needed information and put
the small business directly in touch with those sources, leaving the rest
to th'e small business itself. An informational clearinghouse service of
this type seems an appropriate function for the Department of Commerce.
Much scientific information and wknow-howtt is public and open, and publicminded agencies would work for small business if they had the chance.
The nucleus of this idea already exists, having been developed
in private banking circles in 1936, by a Buffalo banker in cooperation
with the National Research Council of the National Academy of Sciences»
The system developed by this bank was adopted by the Smaller War Plants
Corporation when General Johnson was its Director, and applied to problems
of small plants in war production. A much more extended use of the same
system seems entirely practicable, especially if it had no connection with
a government lending agency.




Chairman Ecoles
II.

The approach through taxation

The second approach to the small business problem is in the
tax field. This is a matter about which there has been much discussion and much pussy footing of the real issue. Adjustments in the law
are needed to eliminate certain provisions which are especially detrimental to small enterprise, but this is not enough. To do the job well
we must formulate the tax law to give the small business unit direct
encouragement and preferential treatment. I shall consider this briefly
with regard to (l) the excess profits tax, (2) the corporation income tax
and (3) the personal income tax.
(1)

Excess Profits Tax

I am in accord with the recent proposals of the Joint Committee
for Internal Revenue Taxation and the Treasury Department for raising the
specific exemption under the excess profits tax from $10,000 to $25,000.
This will reduce the number of excess profits tax paying corporations
greatly and will do much to render investment in the smaller business
unit more attractive. Similarly, small corporations will profit from the
accelerated carry-back and amortization provisions included in the Committee
proposal.
For the duration of the war this will be a satisfactory arrangement, but what shall be done thereafter? There is a tendency in current
tax discussions to consider the excess profits tax as a tax to be discarded
immediately, once the last shot is fired. I disagree. Some reduction in
business taxes will be possible and helpful, but we should not give all the
benefit to the corporations with excess profits. Elimination of the excess
profits tax, while retaining corporation income tax rates at their present
level, would give the greatest tax relief to those who need it least. This
would be a tax differential unfavorable to the smallest corporations.
Instead, I should favor a gradual reduction in both the excess
profits and corporation income tax rates. We may well consider a further
increase in the excess profits tax exemption later onr I t may be menExonei
in this connection that the excess profits tax after world War I was continued through the income year 1921, or for three years after the cessation
of hostilities. Surely there is likelihood of large profits to some
enterprises in the early postwar yejirs, and these should not be -permitted
to go tax free,
mjJUjl^g
(2)

Corporation Income Tax

Among various adjustments that need be made in the corporation
income tax, the treatment of dividends and of losses are of particular
importance to the small corporations.




Chairman Ecoles

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Under present and prewar practice, equity capital is taxed
under the corporation income tax, and again, under the personal income
tax, when distributed in the form of dividends. Income from fixed debt
forms, on the other hand, is not taxed at the corporate level, interest
payments to bondholders being taxed but once, under the personal income
tax. The resulting discrimination against income from earning capital ^
is serious, particularly for the small enterprise which needs new capital.
Numerous schemes have been proposed to give tax relief to equity capital.
I should prefer to give the relief at the corporate level, and exclude
from taxable income such part of corporate profits (or a fraction thereof)
as is distributed in the form of dividends. This would take care of
the problem of double taxation and, in addition, would exert a healthy
pressure for the distribution of dividends. Also, it would be a good
deal simpler than some of the other methods which have been suggested*
To protect small corporations in need of funds for capital expansion, it
might be well to provide that some minimum amount of retained income, say
#50*000* receive the same favorable tax treatment otherwise given to
distributed profits.
Adequate provision for carry-over of losses is again vitally
important to the small corporation, which is not in a position to spread
its risks over a wide variety of ventures and which is likely to have a
more fluctuating income. The small firm can be less certain that its
losses may be charged against other taxable income than its bigger competitor. If a 5 or 6 year period for the carry-forward of losses is
allowed, combined perhaps with a 2-year carry-back period, this disadvantage
of the small firm will be reduced.
Apart from these provisions which would make for a general
improvement in the corporate tax structure, I believe that special relief should be given to the small corporations. This should be done
either by granting a substantial exemption, or by providing some progression in the rate schedule. Also, the possibility of giving small corporations the option of paying taxes under the partnership form should be fully
explored.
(3)

Personal Income Tax

The great mass of truly small business units, however, are
unincorporated. Their tax problem therefore is under the personal, rather
than the corporation^ income tax. From a social point of view these are
the very units which it is most important to encourage. But at the same
time the technical problems of providing encouragement under the personal
income tax are the most serious.




Chairman Ecoles

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Proposals have been advanced to provide some credit under
the personal income tax for funds which are invested in small business
units. But I fear that this would involve serious problems of tax
evasion. A more feasible approach perhaps would be to give some
favorable treatment under the personal income tax, not for amounts
invested, but for income derived from investment in business units with
assets of less than, say $50,000» This credit might be given along the
lines of the old earned income credit, or rather the old earned income
credit might be reintroduced and be supplemented by a credit for income
from small enterprise» Such a provision without doubt would greatly
increase the attractiveness for investment in small business units to
those who have to pay high surtax rates» It would thereby somewhat
reduce the progressiveness of the tax structure, but would be most
effective in attracting capital into small business from exactly those
sources best in the position to assume the risk of investing in small
firms» While a plan of this kind would undoubtedly involve difficulties,
it should be given serious consideration»
III. The financial approach; (a) Equity investment
The third major problem is that of a direct attack upon the
problem of supplying adequate capital and adequate credit for small
business» Tax adjustment would help the restriction of equity investment
in small business indirectly, but some new form of investing institution
is also needed» Traditionally, the individual small enterprise was
capitalized by the individual investor, and this unorganized source of
capital apparently worked with success until shortly before the first
World War» It is an interesting fact that community funds for the
capitalization of small businesses, in which local investors pooled their
funds for joint investment instead of taking individual risks, were
founded in a few localities between 1910 and 1916» Evidently, the risktaking individual was beginning to vanish at that time» Some of these
early community funds are still in existence and one, the Louisville
Industrial Foundation, founded in 1916, has become to some extent the
model on which the new small business plan of the Investment Bankers
Association of America is largely based» I am not fully in accord with that
plan» However, it is directed toward filling a gap in our investment
institutions that has never been adequately filled, and certain features
impress me as sound. The local investment company, directed by local business leaders and locally administered, is the best replacement for the
individual investor, and unquestionably better than any central or largescale investing institution, private or governmental. Local business
leaders know their localities and the enterprises in them, and community
patriotism is a force that should be brought to bear.
The plan is also sound in clearly recognizing that additional
outside funds will also be needed, by such local investment companies, if
the job is to be properly done. But there are other features of the I.B.A.
plan that are less convincing» The required eitride funds under this plan




Chairman Ecoles

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are to be borrowed direct by sale of debentures to the Federal Reserve
Banks, whereas it seems to me that the private investment market, or such
pools of private capital as the credit pools recently formed by commercial
banks throughout the United States, would be a more appropriate source»
The makers of the plan condemn government lending, then propose to borrow
government funds, which is inconsistent. Government funds should be the
last, not the first, resort.
Furthermore, this plan provides that a local investment company,
after investing in an equity of a local small business, may resell that
equity in the public market ~ a feature which might go far to destroy
small business itself» If the equity were resold to a competitor, to a
chain store concern, or to a large manufacturing company in search of an
affiliate, the independence would be gone and the investment company would
become an instrumentality of business concentration» This by all means is
to be avoided» The Louisville Industrial Foundation has never resold
its paper, but has held it for amortization by the benefited enterprise.
Finally, there is a considerable question whether such local
investment companies would develop a sufficient volume of investments to
enable them to live. A good many of them might fail» Their charges for
money and for business services apparently would be somewhat high, so that if
term loans from commercial banks were available, the proposed investment
companies,, particularly the smaller ones, could hardly compete with "banks»
However, small business urgently needs a type of institution that will
channel local investment funds back into each locality, and perhaps this
plan could be modified so as to eliminate its undesirable features and to
make it more workable»
The financial approach: (b) Credit
The credit problem of small business, finally, should be clearly
conceived of as one of stimulating the flow of private credit to small
business, as opposed to direct governmental lending. The great majority
of all banks are themselves small businesses, and government should encourage
them, not undermine them by its competition in the lAnding field»
Very many small businesses have satisfactory credit relations
with their banks and for them no credit problem exists» But we want that
number to increase» The problem is how to bring the commercial bank loan
further over into the area of the marginal credit risk» The commercial
banker is not a risk-taker by training or profession, and if he were,
his responsibility to his depositors would act as an inhibition» Ifet
the banker is identified with his community, knows its problems and
exists to serve its enterprises» The problem, accordingly, comes down to
finding some means of enabling the banker, without undue risk to his
depositors, to broaden the scope of his credit operations and assume
greater risks.




Chairman Eccles

The technique of the V-loan system, which has provided 9~l/2
billion dollars1 worth of credit on the high-risk margin of war production,
provides the answer to this problem. No system ever devised in history
for extending the margin of the bank credit risk without risk to depositors
has ever worked as successfully as the system that was installed by
Presidential order in March 19^42, and implemented by Regulation V. Under
that system, banks accepted war production credit risks that could not
possibly have been accepted in any other way, and with rare exceptions
those credit risks proved sound. To credit applicants that were fundamentally
acceptable, the plan permitted the authorization of much larger aumd in
credit than could otherwise have been provided. The private initiative of
bankers was not invaded, and business on its part found bankers exploring
new means and methods of extending credit, rather than denying or unduly
restricting credit. It would be detrimental indeed if, at the very
beginning of the readjustment period, the credit mechanism that has created
the most favorable small business credit situation on record should be
indifferently flung aside.
The Y-loan plan was not a new plan. It was a development of a
credit plan adopted by Congress in 193U*
adding section 13b to the
Federal Reserve Act. That legislation authorized the Federal Reserve
Banks, within somewhat narrow limits, to make loans to business and industry,
and also, within the same limits, to make commitments in regard to loans
made by banks and other lending institutions. While the limits themselves
went far to hamper the purposes of the act, the experience demonstrated that
the commitment feature was superior to the direct lending feature, or to
the participating loan feature, in practice. The commitment proved unexpectedly popular, so that i . per cent of all 13b loans and more than 50 per
|0
cent of the total amount of credit authorized proved, after 6 years1 time^
to be commitments. When the war came, shortly after Pearl Harbor, the
President authorized the procurement agencies to make similar commitments,
naming the Federal Reserve System as the administrating agency.
The commitments in question are known as deferred participations
or "take-out** agreements. A bank or other private lending institution sets
up, makes and services the loan. But before doing so, the bank may apply for
an agreement with the Federal Reserve Bank of its district, under which
agreement the Federal Reserve Bank stands ready to take a participation in
the loan at some later time, if requested by the bank. Ordinarily, if all
goes well, the bank will keep the entire loan until it is retired in due
course. But if trouble threatens, t h ^ a n k may ask to be taken out, up to
the proportion stipulated in the earlier agreement. In that case the
Federal Reserve Bank purchases the stipulated percentage of the loan.
What was formerly a bank loam now becomes a loan in participation, and
if loss actually occurs, the Federal Reserve Bank takes its stipulated
percentage of that loss. For this assurance that it can rid itself of part
of a losing transaction if it desires, the bank pays a part of its interest
receipts to the Federal Reserve Bank as m premium or fee.




Chairman Ecoles

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Private initiative and enterprise in banking are fully preserved
under this commitment plan. Certainly the independence of banks was not
invaded in lending 9*5 billion dollars under Regulation V. From 3 billion
to 3~l/2 billion dollars in war production loans has been outstanding from
commercial banks at all times since the beginning of 1943* More than half
of this amount has been represented by V-loans. On June 30,
when
15#153#000,000 of war production loans were outstanding, $2,06li,000,000
or 66 per cent were V loans. This does not resemble an invasion of the
banking function. Rather, it greatly increased the volume of profitable
bank loans.
The plan was equally beneficial to small business• Although the
V loan protection was open to enterprises of every size, the record shows
that 62 per cent of all V loan borrowers were small manufacturing and
construction enterprises with less than #500,000 in total assets. To
these small war plants the commercial banks under this protection loaned
|835i 000,000, sm amount many times as large as was loaned by any government
agency directly to small war business. The average amount of credit extended
to these smaller enterprises was generous; the very small concerns, with
less than $50,000 in total assets, received an average V loan authorization
of $96,900, while the slightly larger enterprises with assets between
$50,000 and $500,000 received an average V-loan authorization of 11+09,700.
The effectiveness of the commitment plan in assuring small business of
adequate bank credit has been demonstrated beyond all question by the V-loan
experience.
It would be a serious blow indeed to small business in the reconversion period if this form of guarantee behind its credits were discontinued. Rather, the plan that worked so successfully in war should be applied
to the credit needs of the postwar period. But the V-loan system at present
is beginning to lapse. The system applies, legally, only to war production,
and is disappearing piecemeal as war loans are paid up and retired. Foreseeing a year ago what this lapsing of the V-loan system would mean to the
credit rating of small business, the authors of the Baruch-Hancock report
recommended the extension and adaptation of the V-loan plan to the bank
credit relations of small business after the war. A bill embodying this
recommendation was prepared, and introduced into the Senate by Senator
Wagner and intg the House by Representative Spence.
This bill has been
reintroduced
the present session of Congress, but so far without
action. Meanwhile, small enterprises, retiring from war production, are
due to suffer a decline in credit rating at their banks because the
partial guarantee behind their credit risks is removed. Some* protection
can be afforded under the old 13b, hut the former unworkable limits remain.
-I regard the passage of the Yfagner-Spence bill as the central item for
meeting the financial problem of small business, and believe it should be
passed without delay.
Summary
The small business program, then must be three-fold --„central
system of technological and managerial information that small business can
readily use, readjustment of the tax system so as to favor independent



Chairman Ecoles

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enterprises and ventures, and the continuance of the V-loan method of
extending the credit margin of coinmercial banks. Some new form of
capital investment institution is also needed. No item in this program
amounts to the coddling of small business, and none invades private
enterprise. Small business has every right to the existence of the
normal facilities that would tend to put it on an operative par with
big business, and it is to the interest of government to establish
those facilities. If we merely provide equal opportunity to small
business, we can probably depend upon it to seize upon that opportunity.