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Form F. R . 131







Office Correspondence

Chairman Eccles


Date May 17, 1957

xMaleolm H. Bry;

In accordance with your note of April 29, I have given
considerable attention to the suggestion by Mr. Charles Taussig
and Mr, Rexford Tugwell regarding the modification of the undistributed profits tax. The original of that suggestion is
I am unable to convince myself that the proposal is
feasible or that it would be useful to a corporation needing
funds for expansion.
The inclosed memorandum does not exhaust the points that
could be made regarding the proposal. It does, however, deal with
the major financial aspects of the suggestion so far as a corporate
borrower would be concerned.


Form F . R . 131




Office Correspondence

D fP

C,hfAvmxn Eccles



Malcolm H. Bryan *

M i?, 15

Subject: Proposal of Mr, Taussig and
Mr. Tugwell for revision of
undistributed profits tax.

The proposal is that "a corporation requiring additional cash
for approved purposes such as additional working capital or plant
expansion" should be allowed to put its earnings into a 25-year issue
of 1 per cent Government bonds.

These bonds could be used to support

the corporation's note at a commercial bank, and the corporation's
notes, with bonds as collateral, could be rediscounted with the Federal
Reserve banks at par.

Borrowed capital for expansion could thus be

secured on the basis of notes to be amortized in equal annual installments.

The face of the corporation's loan would thus have a maximum

average length of 12 1/2 years.
I am not sure that I see all the meaning of this suggestion, but
the following points occur to me:

It seems to be assumed that member banks, because the notes

with bond collateral are to be discounted at par, would in fact lend
the par value of the bond collateral hehind a corporation's notes.
Such a conclusion, if it is intended, appears questionable.
The risk involved in a loan to a corporation with poor credit,
though somewhat diminished by the proposed plan, would by no means be

A bank, in regarding an otherwise risky loan, would be

With acknowledgments to Mr. Martin Krost and the inventors of
logarithmic tables.

May 17, 1957

Chairman Eccles - 2

forced to contemplate the possible necessity of relying on the bond
collateral to effect liquidation of the loan; and the collateral
would have a market value less than par.

At a yield rate of 2.80, a

25-year bond carrying 1 per cent interest would have an approximate
market value at issue of |68.

At higher yields, which may well occur

in later stages of the present recovery, the capital value of 25-year
1 per cents would correspondingly fall.
If a bank lent to the par value of the collateral, it might
be forced to absorb a loss equaling the difference between the market
value of the collateral and the principal of the loan.

The fact that

the bonds were rediscountable at par with the Federal Reserve banks
would not alter the situation, for a rediscounting member bank would
become an endorser on the note of the corporation and would assume a
contingent liability.

Default by the corporation would throw the loss

upon the discounting bank.
The only way to avoid the foregoing conclusion is to assume
that the Federal Reserve bank, by rediscounting at par, is to take the
loss involved in defaulted notes.

Under such a provision, however, it

may be concluded that any risky loan would be promptly discounted, and
the plan would amount to no more than a guarantee by the Federal Reserve
System of the credit of risky corporations.

This would in turn mean

that the System would, so to speak, be paying the undistributed profits
tax (via losses on bonds) for those risky corporations that were allowed
to retain earnings untaxed and failed later on.

Several aspects of this

Chairman Eccles - 2

May 17, 1957

proposition appear to transcend the usual functions of a central bank.
The safer conclusion all around is that the borrowing corporation, if its credit were such that it needed to adopt the suggested
method of financing, would be able to borrow somewhat less than the
market value of its bond collateral.

In view of bond yields


prospective, the figure might be in the neighborhood of #60 for each
#100 1 per cent bond.

With the present undistributed profits tax schedule in effect,

a corporation that could earn more than 2.18 per cent on capital
retained in its business could not afford to adopt the proposed system
of financing.
A corporation would have the choice of investing in Government bonds yielding 1 per cent annually or of paying the tax and
retaining its earnings for use as new capital. A corporation could,
under the present schedule of undistributed profits taxes, retain
100 per cent of its earnings by paying a tax of #20.50 per #100. It
would have #79.50 remaining for investment in its business.
Now, #100 invested in Government bonds would yield an annual
income of #1.00 and a tax remission of #20.50, realizable at the end
of 25 years. A rate of approximately 1.26 per cent on #79.50 will
yield #1.00 of annual income; and a rate of 0.92 per cent, compounded
annually at 6 per cent, will yield #20.50 in 25 years. Thus, a total
earnings rate of approximately 2.18 per cent on #79.50 of capital would
give a corporation #1.00 a year of income for 25 years, plus a realized
amount of #20.50 at the expiration of the period.

Stated in another manner, the undistributed profits tax would

need to be #64.12 per tlOO in order to make the suggested plan a feasible
alternative for a corporation with a 6 per cent earning rate.
The magnitude of the loss involved in financing in the fashion
proposed in contrast with retained earnings can be illustrated as follows:

May 17, 1957

Chairman Eccles - 2

Let us assume, for instance, a corporation earning 6 per cent
on capital. It lends #100 to the Government for 25 years at 1 per cent.
At the end of 25 years, it receives back the capital sum of #100, plus
interest accumulated at the rate of #1.00 per year, which should be
compounded annually at the 6 per cent earning rate. The total sum at
the end of 25 years would be #154.86. Actually, the sum would be slightly
less than that amount because of tax charges on the earnings attributable
to accumulated interest; but this factor is ignored in order to make the
most favorable showing for the plan.
The sum of #154.86, then, has a present value of #55.88, if
discounted at 6 per cent, which has been assumed as the average earning.
In short, a corporation that can earn 6 per cent on its capital could
afford to take #55.88 immediately rather than #154.86 at the end of 25
years. (The sum of #100 - #55.88 equals #64.12.) The loss in terms of
present value is the difference between #55.88 and #79.50, which is #45.62.
The foregoing points can be turned around into terms of annual
loss or into terms of total capital loss at the end of the 25-year period
involved. For example, if a corporation can earn 6 per cent on its capital,
its earnings will be #4.77 annually on each #79.50 remaining to it after
it has paid a tax of #20.50 on each #100 of undistributed earnings converted
into new capital. Since the corporation will receive #1.00 of annual
interest if it chooses to invest #100 in Government 1 per cents, it will
have an annual loss of #5.77 per #100 for 25 years. When #5.77 is cumulated
at the assumed rate of earnings, namely, 6 per cent, there is a total loss
of earnings during the period of #206.85, which, when adjusted for the
initial difference in capital value (#100 minus #79.50), gives a net
capital loss of #186.20 at the end of the period.1/
The question arises, Is not the foregoing capital loss offset by
the earnings of the corporation on the loan from the bank secured by bond

The answer to the first question can be implied by asking a

second, Why take the loss in the first place?

Why not finance the cheapest

However, the point can be further examined.
Generally speaking, a corporation that profits by borrowing money

must have an earning rate greater than the interest rate.

A corporation

that borrowed at 6 per cent and earned 6 per cent, as in the preceding
assumptions, would have no net loss or gain from the borrowing phase of


The same result can be obtained by compounding #79.50 (#100 minus tax)
at 6 per cent for 25 years and #100 plus #1.00 cumulated at 6 per
cent for 25-years.

Chairman Eccles - 2

its operation.

May 17, 1957

That would be true whether it could borrow only |60 for

each $100 bond, as the writer thinks likely, or the full par value of

The loss resulting from a loan to the Government, as measured

against retention of its earnings and the payment of the tax, would
stand unreduced•
In the case of a corporation with a 6 per cent earning rate, there
would need to be an annual profit, as previously demonstrated, of #5.77
on its borrowing to equal the annual loss for each $100 of funds invested
with the Government.

Should the writer1s assumption that the corporation

can borrow in the neighborhood of #60 on each #100 bond be correct, a
corporation would require a difference between its earning rate and the
rate of interest paid on its loan of more than 6.2 per cent.

Thus, if

the corporation could count on earning at the rate of 6 per cent annually,
and could borrow $60 on its 1 per cent bond, it would need a negative rate
of interest on its loan to make the procedure more profitable than a
straightforward retention of earnings in accordance with our present undistributed profits schedules.
In the unlikely event that the corporation would borrow a full
$100 on each $100 bond, and its earnings were 6 per cent, it would need
an interest rate of 2.25 in order to make its earnings on the #100 borrowed
equal to its annual loss in comparison with retained earnings.

It must be

noted that the $5.77 annual loss on the bcaad-investinent method as against
the retained earnings method of financing new capital would be increased
pari passu as the assumed earnings rate of the corporation were increased
above 6 per cent.

Chairman Eccles - 2


May 17, 1957

For a corporation in need of cash, the simpler and more satis-

factory procedure for acquiring an equal amount of capital would appear
to be the retention of 60 per cent of its earnings.

Under the present

rates of the undistributed profits tax, 60 per cent of earnings can be
retained by the corporation for a tax charge of #9.70 for each $60

On the assumption that the amount of the tax is borrowed at 6

per cent, the annual charge against the #60 retained would be approximately 58 cents in perpetuity, which would in turn represent somewhat less
th8n a 1 per cent annual charge against the capital thus secured.

If it

should be objected that perpetuity is too long a time, then the whole
cost, including the principal of the tax and interest on it, could be
amortized in 10 years at an annual charge against the retained capital of
slightly more than 2 per cent.

This figure will ordinarily be much less

than the cost of borrowing an equivalent capital sum.
Perhaps it is not amiss to remark at this point that the cost of
retaining earnings under the undistributed profits tax is frequently

While it may certainly be agreed that the imposition of the

tax creates a cost for capital secured by retained earnings, the tax is
not a recurrent charge against the capital but is a once-and-for-all

The cost of the tax must be prorated over the period for

which the capital is to be used.

Unless the capital requirement is for a

brief period only, the retention of earnings is still entirely practicable
from a cost standpoint.

The language of the proposal contains the words "approved purposes."

The determination of what purposes, if any, shall be approved purposes is

May 17, 1957

Chairman Eccles - 2

one of the crucial points in the current discussion of the undistributed
profits tax.

If we could determine what should be approved purposes, the

tax schedule could be fairly easily and directly adjusted to permit untaxed expansion in those directions.
Moreover, the language of the proposal contains the following

"The Federal Reserve to have the right to deny re-discount

privileges where the proceeds are to be used for purposes outside of
their regulations."

That might very well entail policing by the Federal

Reserve banks.

"In times of over-expansion, Federal Reserve could discontinue

re-discount privileges altogether."
The history of disputes regarding the existence of actual or
threatened "over-expansion" is such that this provision would appear to
impose an additional burden of omniscience on the Board of Governors.
Perhaps, however, the omniscience of the Board of Governors is an unavoidable assumption in the long run.