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F«rm F. R. 131



ce Correspondence
Chairman Eccles


February 17, 1956,

Fiscal Program

Lauchlin Currie

I am afraid that this Is longer than I had anticipated* I felt, however,
that you should have as many aspects of the matter as possible brought
to your attention before you approached the Treasury* In particular I
hope you will consider carefully the question of exempting debt retirements from the tax* It would be very helpful if you could find time to
run over this and either aark the sections or make comments that will
serve as a guide for the preparation of the short memorandum*


I - Bearing of Fiscal Program cm Business Recovery.
The Board of Governors has a peculiar interests/fend responsibility
for general business conditions. Since the fiscal policy of the
Government has such a direct and important bearing on general business
conditions the Board of Governors has, perforce, a keen Interest In
the fiscal policy* During the past three years the Federal Government,
by disbursing more In the form of income to people than it has collected
from Incomes In the form of taxes, has been Increasing the national money
income and has been the chief factor In bringing about the degree of recovery achieved to date. In the fiscal year 1935 we estimate the Govern-*
ment9s net contribution to the national Income at #2 billion* in fiscal
19S4 at #£»5 billion} and fiscal 1955 at fS.S billion. With the loss of
processing taxes and the payment &nd partial spending of the bonus the
contribution for fiscal 1956 mill be the largest yet. These figures are
minima. They do not include any secondary expenditures arising from
Government expenditures, and all taxes, with the exception of
taxes, have been deducted from expenditures In arriving at these figures,
even tho there are good grounds for believing that much of the corporate
and individual income tax revenue would not have been spent If It had
been left in private tends.
There are numerous indications that the effect of the net Income*
Increasing expenditures of the Federal Government are at last resulting
In a stimulation of net lncome~increasing expenditures on private account.
Expenditures for plant,equipment and construction are Increasing. It Is

highly questionable, however, whether sueh expenditures are Increasing at a sufficiently rapid rate t > carry the whole load of recovery*
Liquidation is still proceeding and the flow of money is still being
obstructedtoythe piling up of idle cash in the accounts of large
corporations* More specifically, it is doubtful if recovery would
not be seriously impaired ££ the Federal Government balanced its
budget in fiscal 1957 and made no contribution to the increase in
the national income* On the other hand, the private net income«increasing
expenditures have increased sufficiently to permit the Government to
reduce its contribution* Thus, from the point of view of general
business recovery the proper course would appear to be a reduction
of the Federal deficit in fiscal 1957, and not a balanced budget*
This should be achieved through an increase in revenues rather than
a decrease in expenditures*
IX - Paftwlr P f a f f


The argument most frequently urged against a continuance of a
Federal deficit is that such a condition leads to "inflation". If
inflation is characterised as a period when the monetary demand for
goods and services of all kinds outstrips the communityfs ability to
produce more so that costs and prices rise, it is obvious how a deficit
at such a time would Increase inflation* When* however* there is
enormous slack in the productive machine as at present a deficit
merely enables some of the slack to be taken up* From this point of
view Federal borrowing and spending in a depression is very little

-3dlfferent from private borrowing and spending* It is apparent,
therefore, that it is not a deficit in depressed times that is
to be feared but rather onlcr in prosperous times* Since it appears
beyond the bounds of probability that full productive capacity
will be utilized in 1957, Government borrowing in that year would
be no more inflationary than private borrowing*
It is often held that a deficit engenders farther deficits*
This, again, Is only true at a time of rapidly rising prices* In
a time of depression the reverse Is true for two reasons* In the
first place, a substantial part of the expenditures are attributable
to the depression and will decrease as business revives* Secondly,
by increasing the national Income £ax revenues are increased* The
lag, which may be serious if Government costs are rising rapidly,
is not serious when recovery is orderly and Is characterized by the
absence of rapid price rises*
One further point remains* A deficit entails borrowings and,
in so far as banks subscribe for new bonds out of idle reserves,
new deposits are created* It is conceivable that a volume of deposit
currency may be built up in this way that will be excessive at a later
date* The danger of this in the present circumstances does not
appear great* So far : o the effect of Government financing has been
to contribute to a restoration of the volume of means of payment
wiped out in the course of the depression* In view of many factors
which will not be entered upon here^ a further expansion of three or
four billion dollars of deposit currency should not prove to be

excessive for a period of relatively full employment. Moreover, if
necessary the volume of excess reserves can he cut down and the hanks1
portion of subscriptions to new Issues be reduced.
As opposed to these arguments, however, most be set the psychology
leal one. If people believe that a succession of deficits is inflationary then it cannot be doubted that they furnish a background against
which a succession of inflationary Incidents may precipitate a runaway
situation. This danger might be lessened if it were clear that
progress toward a balanced budget was being steadily made.
I U rfifftflflfttaffflfFylttrtL r g t i r a fBfl ^ffldJttiygp,ftgffifl19g7i
For the fiscal year 1937 receipts, exclusive of processing and
social security taxes, are estimated to amount to $4.4 billion* This
represents a conservative estimate and probably underestimates the
revenue. It seems probable that social security taxes will be the object of litigation and if paid will be held in escrow pending a Supreme
Court decision. On the expenditure side the picture Is not clear.
If benefit payments of $577 million, social security payments of #600
million, and relief payments of $1.1 billion are included and debt
retirements are excluded, the expenditure would amount to $6.2 billion,
or a deficit of $1.8 billion. It seems logical that benefit payments
or their equivalent will not aggregate such a high figure on a revised
basis, since for one thing farm prices and farm incomes have increased
substantially from their low points. It is also possible that an
adverse Supreae Court decision would lead to no payments on social

-5security account* In any case it is unlikely that social security
payments would continue to be made unless specific and earmarked
taxes are paid* If, therefore, we deduct social insurance payments
the deficit will be $1*3 billion*
Provision for relief, on the other hand, is unquestionably too
low at $1*1 billion* In fiscal 1935 the amount spent on ordinary
and drought relief aggregated $1*9 billion* Taking into account
the intervening period of recovery, it would appear reasonable to
asstrae the cost of relief in fiscal 1957 will be no greater than in
fiscal 1955* If, therefore, we add an additional $800 million to
relief payments, our estimated deficit would then become $2*1 billion*
Of the anticipated expenditures of $6*5 billion, receipts would amount
to $4*4 billion, or 68 per cent* If these guesses are approximately
accurate the budget could be balanced In the succeeding year or years
by an increase in receipts of $1 billion and a reduction of relief
expenditures of $1 billion*
Although time has not been available to make a careful estimate,
such work as we have been able to do indicates that on the basis of
a national income of $80 billion the present tax rates would yield
at least $5§ billion dollars* Probably the yield would be larger*
This figure excludes any revenues from processing taxes or their
equivalent, social security taxes, or payments under the Guffey Act*
It qlso excludes the revenue from miscellaneous taxes which Is estimate
ed will amount to $160 million in fiscal 1957, and takes no account
of repayments to HFC or other Government lending agencies whose activities enter directly into the budget* Since, with the national income


at #80 billion the cost of relief should be at least cut down by
$1 billion from our estimated $2 billion for fiscal 1957* it would
seen a conservative guess that over $1 billion would be available
for debt retirement*
One factor that should be kept in mind in discussing fiscal
policy in an upswing of business activity is the lag in Government
revenues* Thus in any fiscal year returns from individual and corporate income taxes arise from Incomes earned from six months to a year
IV - Are additional taxes necessary or advisable?
Taking into account on the one hand the new taxes imposed during
the depression* increased rates of taxes* various administrative changes
relating to depreciation allowances and capital losses* and repayments
to the RFC* etc*| and on the other hand* the probable decreased need
for expenditures* it appears fairly certain that a continuance of
recovery and a rise in the national income to levels approximating the
late Twenties would bring about not only a balanced budget but also
permit substantial retirement of debt* even if no new taxes are imposed.
As opposed to this line of argument it may be urged that It is
based largely on guess work and in addition Ignores important psychological factors* It may be years before the national income increases
to #80 billion* Expenditures Instead of diminishing may increase*
The psychological effects of a long-continued series of deficits mey
be very bad.
On the whole it would appear advisable to take a middle course*
Introduce some new taxes which would not constitute too greftt a drag

on the recovery movement In 1957 and yet would have a reassuring effect
and would provide against possible unfavorable developments in expenditures and receipts not given proper weight above*
V - Possible new taxes.
Excise taxes» particularly on food stuffs.

The arguments that

can be urged against such taxes are as follows*
(a) Thsy are regressive and inequitable. They bear most
heavily on the urban populations, which in many cases are worse off
than the farmers. Moreover, the poorer a person is the larger a
proportion of his income that is spent on the necessities of life.
If such necessities are taxed, the heavier, proportionately, are taxes
on the poor than on the rich.
(b) A tax on the necessities of life Is a political liability.
No matter how small it is It gives opponents a fine talking point and
becomes a scapegoat for any rise in prices.
(c) Excise taxes, of all taxes, have the most dampening effect
on business recovery. In so far as the Governytnt raises money by
excise taxes It is almost certainly decreasing private expenditures
by nearly the same amount. The same is not so true of corporate taxes
or taxes on the wealthy since, in a time of sub-normal business act-*
lvit^ there is more probability that the money would not have been
spent if it had not been paid in taxes.
gf Increased income tax rates.

Income tax rates on the very wealthy

are probably as high as they can be made. People with Incomes from $5,000

-8to $50,000 could very well pay higher rates but doubtless the Imposition
of additional taxes on such people would not be politically feasible at
S» The means which are here recommended to raise additional revenue
?re a tax on the undistributed earnings of corporations and the abolition
of separate income tax returns for husband and wife.

There are three

main arguments to be urged in favor of a tax on undistributed earnings.
In the first place, many wealtlgr individuals can cut down the amount of
their tax payments by leaving a substantial portion of their income with
the corporations they control. A tax would either force them to disburse
more of their income in the form of dividends and thus subject thep to the
payment of higher individual income taxes or, If they did not follow this
policy, their uncollected income would be subject to a higher tax than
at present. By means of such a tax the people who are benefitting the most
from the recovery would pay more of the necessary cost.
The second argument in favor of this proposal Is that it would discourage to some extent the uneconomic allocation of the community1 s productive resources. Salaried executives may, in many cases, be more interested in Increasing the absolute gross and net return than in Increasing
the rate of return on invested capital. It Is at present excessively
easy for them to do this by holding back a substantial portion of the
earnings of the year, reinvesting them in plant facilities. There would
be a m d j closer calculation of probable costs and returns on any new

investment if managements were confronted with the alternatives of
either paying much heavier taxes or asking the stockholders directly
for new money, or borrowing*
In the third place, if through the imposition of a graduated tax
on undistributed earnings corporations regularly disbursed a greater
proportion of their earnings in the form of dividends or taxes, one
source of disturbance in general business conditions might be lessened*
It Is probable that the flow of money would be more regular and there
would be fewer obstructions to that flow due to the lessened variability
in cash balances that might be expected to follow the penalizing of
undistributed earnings* Corporations could, It Is true, still build
up large cash holdings Y / borrowing, by the issue of stock, and by not [
using depreciation reserves for repairs and new equipment, but it is a *
reasonable assumption that they would be more reluctant to acquire balances in such ways than by holding back earnings*
The argument that would be urged against such a tax is that it
would militate against sound principles of business finance* It will be
said that a *properly* run business should not disburse all its earnings
but should hold back some in the good years so that it will be in a strong
position to meet adverse conditions when they arise*
This argument may be met in various ways* In the first place, it
rests in part on an analogy to individual finance, where it is obvious
that if all income is currently disbursed on consumer goods no capital
accumulation will be possible* A corporation, however, is not an individual but rather an instrument by means of which a group of individuals


engage In a productive enterprise. The importance of the distinction
from the present point of view is that if more money can be profitably
utilized by a corporation its owners can be asked to put it up.
Admittedly this does not apply so well to a privately-owned business,
since a heavy tax on undistributed earnings or on large individual
incomes would leave less money available for investment in the business.
This, however, is an Individual and not a social disadvantage. If the
business is very profitable the individual can either borrow or admit
new stockholders by selling stock. It would be most unrealistic to
assume that if Henry Ford had had to pay much heavier taxes the community
would not have been supplied with automobiles as good and as cheap as
they are at present. There is, In other words, no more reason for exempting Incomes from taxation which are not disbursed by corporations
but which are directly reinvested in plant or marketable securities than
there is for exempting incomes disbursed but used for the purchase of
stocks or the building of houses.
In the second place it is not the existence of a bookkeeping surplus
that enables a company to withstand adverse conditions but rather its
liquid position and the smallness of its indebtedness in relation to the
equity. A corporation can retire indebtedness and put itself in a liquid
position by Issuing stock as well as by holding back earnings.
On the matter of sound corporate financial policy, Dewing, one of
the leading authorities in the field, takes a middle ground on the
question of reinvesting earnings. On the one hand he points out the


advantages of this procedure to a young and comparatively unknown
company and mentions that an uninterrupted dividend record
enables a corporation to borrow at lower rates. On the other
hand* he discusses the danger of uneconomic overinvestment
and points out the possible injustice to stockholders arising
from this fact. He cites a study of a number of cotton mills*
half of whom depended on earnings for new money and half expanded
by issuing new stock and bonds. In twenty-one years the market price
of the stock of the latter group appreciated considerably more than
that of the former.
Still another argument that might be urged against the tax
proposal under discussion is the inequality of the burden it would
impose on different types of companies. On the one hand are those
very large companies which already have large holdings of cash and
securities and have In addition ready access to stock and bond
markets for new money if needed. On the other hand are those smaller
companies whose resources have been severely strainedfcythe depression* whose stock has a small market* who find it difficult to
borrow* and hence who have to rely heavily on undistributed earnings
to reduce loans and build up their liquid resources. A tax on undistributed earnings would penalise such companies relative to the
financially strong companies.
This objection* which appears to be a legitimate one* might be
met at least in part by graduating the tax according to the absolute
amount of undistributed earnings rather than according to the


percentage of net earnings undistributed. For example* the first
hundred thousand dollars of undistributed earnings could be exempt
or subject to a lover tax and progression could proceed rapidly
It would appear that a graduated tax has several arguments in
its favor. In the first place it would compensate for the greater
difficulty the small man has in raising new money for expansion.
Secondly it would make the tax politically more popular while diminishing very little its effectiveness. As opposed to this is the
fact that graduation would make the tax more complex and difficult
to administer. This objection is not as strong as it would be if
the principle of graduation were not applied to so many other taxes,
including the corporate income tax itself.
VI - Should the tax be initially levied on undistributed corporate Incomes for the calendar year 1955 or for the calendar year 1936t
To levy it on undistributed income in 1935 would be to make it
retroactive, which Is always unpopular. This, however, could be
avoided in part by le^ijgthe tax on the earnings of 1935 which were
undistributed by the end of 1936. This, however, would entail further

If repayments of debt were included in distributed

income certain companies which had retired debt would gain. There
would also be inducement to retire further debt in the latter part of
1936. If debt retirements were not included in distributed income
there would again be inequality of treatment in the case of companies


that retired debt but would not have done so if the tax had been in
Til - Should earnings devoted to repayment of debt (in existence
when the tax is initially imposed) be exempted from a tax on undistributed
l f . Arguments fort
a* 3y encouraging the reduction of indebtedness one of the factors
contributing to the jrlolence of a depression would be diminished. A
heavy volume of indebtedness contributes to the violence of a depression
in two different ways* In the first place it means a correspondingly
heavy volume of fixed charges, which in turn entails an inability to reduce costs as prices and volume fall* In the second place, a heavy volume
of indebtedness forces the adoption of very conservative policies on a
downswing* Efforts are made to accumulate cash to meet maturities and
all expenditures that can be are postponed*
b* Sound financial policy calls for the retirement of debt out of
earnings* Unless debt is retired out of earnings it is doubtful whether
it will ever be retired* An adequate depreciation policy merely maintains
the property intact* It does not enable the property to be kept intact
and also pay off the indebtedness outstanding against it* Unless provision is made for retirement of debt the corporation cannot borrow on
as advantageous terms and may even find it difficult to borrow at all*

C g i t r l If the property is being fully maintained presumably
there is no impairment in the security of the debt* If the
debt is retired out of net earnings the stockholders are increasing their equity just as though they had used net earnings to


extend plant. Since equity is being increased in both cases earnings
should be subject to the same tax. If a corporation's business is
declining so that it does not need as much capital plant it can devote
its depreciation allowances to the reduction of debt. If a corporation can use all the plant it has but no more it can ask its stockholders for new money If it wishes to reduce its debt rather than take
the stockholders1 undistributed earnings for this purpose. In the case
of holding companies where there are no depreciation allowances, and
stockholders wish to increase their equity by retiring corporate debt
out of earnings, such earnings should be subject to the same tax as if
they had been distributed and used by the stockholders to pay off personal
security loans. In both cases stockholders1 equity has been increased.
Since the debt in both eases was incurred for the purchase of stocks it
can be liquidated in both cases by the sale of stocks.
c. If repayments of debt are taxed it may discourage borrowing.
At present an investment will be undertaken if it promises to pay bond
interest and amortization plus something for the owner of the equity.
If repayments of debt out of incomewere taxed, amortized investments would
have to yield enough to pay interest and the tax as well as the amortization of the loan itself, or else enough to enable it to be financed by
the sale of stock. A large volume of savings is restricted by law or
custom to investment in high-grade bonds. A considerable portion of these
funds is now uninvested because of the scarcity of such bonds. If the
supply of such investments were further reduced it would mean that an even
larger portion of such savings would remain uninvested.

-15(d) In the ease of outstanding bond issues whose indentures
call for sinking fund provisions injustice would be done by not
exempting earnings demoted to this purpose.
Comment* The objections raised in c. and d. might be
avoided if the corporation distributed in dividends all of its

net earnings and then raised new money for sinking fund purposes
by issuing stock. The stockholders1 equity would be increased along
with the issue of the new stock.


Argents against.
a. Encourages liquidation and militates against full recovery.

Exemption of earnings used for debt retirement from the undistributed
earnings tax would encourage liquidation* Wealthy individuals could
add much more to their equity by causing corporations to retire their
debt in this way than by using earnings for the purpose of expansion.
Disbursements of corporations on wages and materials must increase very
greatly if we are to achieve full recovery and yet such an exemption
as is here discussed would militate against such an increase in disbursements. It may very well be the case that our chief difficulty
in the future will be to get people to borrow enough to absorb current
savings. A very large portion of savings can only be invested in
fixed-income yielding securities but the number of issuers of such
securities may steadily decline. Even in the f20fs most business corporations were retiringratherthan increasing indebtedness. In a few
years the Federal Government will doubtless be retiring rather than
increasing debt. Many States and municipalities have reached their


debt limits or are in other ways prohibited from borrowing. After
the experience of recent years utilities may very well rely more on
stock issues than bond issues for new money. There will be many
more obstacles in the way of an increase in security loans than existed in the past. At the present moment it would appear that the
one big field for an expansion of borrowings is in construction, and
it is doubtful whether the demand will be sufficient to absorb the
steadily increasing supply of savings. The eventual solution of this
condition if it should arise would be the continuance of very low
interest rates which would both encourage borrowing and cut down
savings. It will take some time, however, before lenders become
reconciled to low Interestratesand they may hold idle cash and wait
for a rise. Although doubtless the transition can be made it will take
time and in the meantime no additional incentive is necessary or should
be provided to encourage business to reduce indebtedness. If earnings
are taxed heavily when held in the business or disbursed to individuals
there is a better chance that such earnings will be spent on current
goods and services than if they are turned over to investors in a
l t i sum in repayment of debt.
b. An exemption for retirement of debt would be inequitable.
It would enable those individuals who own shares in companies at,present
heavily indebted to increase their equity and, hence their principal,
to a much greater degree than if thgy were in companies having no
indebtedness. It is true that on the downswing the existence of heavy
Indebtedness meant greater losses. On the upswing, however, the existence of heavy Indebtedness constitutes a leverage factor which should


make the net earnings of such corporations increase more rapidly than
those having no debt. Thus investors In heavily Indebted corporations
wiU gain on two counts in the upswing. In the first place* their net
earnings will increase more rapidly andf In thessecond place, more of
their income will be available for increasing their equity. In effect
the ixeaptlon would penalise companies which have been conservative in
the past and give a bounty to those which have gone heavily Into debt.
c. If retirements of debt were exempted from a tax on undistributed
earnings this would reduce the resultant increase of Government revenues
to a negligible amount. Instead of paying out earnings in the form of
dividends which would be subject to surtax, corporations would simply
retire debt whenever they could do so.

February 17, 1956