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F r F R 11
o m . . *-

BOARD OF GOVERNORS
FEDERAL

RESERVE

SYSTEM

Office Correspondence
To

Chairman Eccles

From

Date

October zr, 1957

Malcolm H« Bryan
>77
'3




Subject:

This memorandum limits itself to t r general points:
io
1. Arguments for the modification of the undistributed
profits tax on small corporations and, temporarily,
on all corporations• These notes ignore considerations against such a procedure, because the opposing
considerations have already been presented in a separate
memorandum by Mr* Currie.
Z.

Comments against attempting to modify the capital gains
tax for the purpose of securing an immediate improvement
of the business or market outlook.

F r F R. 11
om .
3

BDARD OF GOVERNORS
FEDERAL

M^ffice

RESERVE

SYSTEM

Correspondence
Date October 27, 1957

To

Chairman Eccles

From

Subject:

Malcolm H» Brym
The proposals to stimulate private expenditure for plant and equipment by modification in the undistributed profits tax at this time are
two in number:
1* A more liberal exemption designed to assist the bulk of small
corporations by allowing the exclusion of, say, #15,000 from earnings
subject to the tax*
2. A provision that companies in the year 1958 may make plant and
equipment expenditures (in excess of depreciation allowances) and may
distribute such expenditures as a deduction from income subject to the
tax in the years 1958-59-40.
In brief, the reasons that could be brought forward in support of
the foregoing changes (aside from other slight revisions unrelated to
the present business outlook) are as follows:
1. The tax places a premium on corporate financing by means of
capital issues and other credit facilities and, in comparison, a penalty
on financing by the retention of earnings. Small corporations usually
find the use of the capital market either expensive or impossiblej and
their other credit facilities (and means of avoiding the tax through
stock dividends) are often inadequate. A revision of the tax in favor
of small corporations is thus indicated in any event, and whatever
stimulation of expenditures as might be secured by revision at this
particular time would be to the good in view of current business prospects.
2. Corporations in general, as was originally argued in support of
the tax, are probably less reluctant to finance expenditures for expansion
by money taken from earnings than by money obtained through the capital
market. Generally speaking, a corporation would probably need to foresee
a greater profit margin before financing through the capital market than
before expanding from earnings. A relaxation of the tax would probably
result in some plant and equipment expenditure that would not otherwise
be made.




(a) If the relaxation of the tax were temporary, say for
projects undertaken within six months or one year, a
premium would be placed upon more or less immediate
expansion expenditures by those companies that fore-

Chairman Eccles - 2

October 27, 19S7

see a probable near-term necessity for expansion*
With business receding, a stimulation of private
expenditure in this direction would, if achieved,
be helpful to the economy and to the Government.
3, A tax that tends to compel the use of the capital market, whatever
may be the long-run outcome, is questionable in a period when the capital
market is uncertain and erratic* The decline in security prices, over and
beyond other direct and important effects, has practically precluded stock
issues for financing purposes; and the bond market is disturbed* In such
a situation a tax penalty on expansion from earnings is in a measure simply
a penalty against expansion*
4* The rapid increase of business in the last quarter of 1956 and
the first quarter of 1957 seemed to reveal a real lack of effective capacity
in many phases of the economy* The result was the accumulation of big backlogs of orders and a rapid upsurge of prices, which tended to choke down
demand and produce a fluctuating operation of the economy* Unless business
utilizes the present and prospective lull to expand capacity at those points
where under-capacitation appears, we shall have missed an opportunity to
avoid a disorderly rise of prices when the cycle moves upward again. It
may be guessed that conditions of full employment and more adequate consumergoods production will in the next several years, especially in view of shortening hours and a more adult distribution of the population, require a considerably greater expansion of productive capacity than was typically true of the
twenties.
5* After a deep depression in which the classes that receive the bulk
of dividends have made large cuts in their customary standard of expenditure,
it is probable that additional dividends paid out because of the undistributed
profits tax are quickly laid out by dividend receivers in repairing their
customary expenditure standards, and it is probable that this expenditure
will be undertaken more immediately and completely than if the money received
in dividends had been retained by the corporation paying them* However, at
the present stage of the business cycle, when the chief dividend-receiving
classes in the economy have probably repaired their customary standard of
expenditure, it is questionable to what extent additional dividend payments
actually cause additional consumption* At the present time they are likely
to become savings (less tax accruing by reason of the distribution) and,
because of various factors in the capital market at the moment, to become
idle balances. It is possible that corporate management, as contrasted with
the investing classes that largely receive dividend payments, would be more
willing to expend money at this time than those who receive the additional
dividends forced out by the undistributed profits tax*




Chairman Eccles - 4

October 27, 19S7

II. Alteration of the capital gains tax for the purpose of securing a
current improvement in business or in the security market is a doubtful
expedient, and an alteration is made more doubtful by very important
considerations unconnected with immediate business prospects.
1* An adjustment of the capital gains tax of sufficient magnitude
to create real enthusiasm in the business community would necessitate
substantial additional taxes from other sources. It is difficult to
determine what group of taxpayers could properly be asked to assume the
burden from which capital gains would be relieved, and it is difficult to
see what equivalent revenue sources could be levied upon without an equal
or greater impact on the economy.
2. In view of the deterioration of current business prospects, a
tax device expected to be of much assistance should place a premium on
immediacy of results. How the capital gains tax could be satisfactorily
adjusted to provide such a premium on immediate action is not apparent.
(a) Perhaps a temporary permission to average for two or
three years gains made on additional purchases would
cause some immediate buying of securities. Such a
provision, however, would instantly acquire so many
administrative complexities, and would involve so
many inequities, as apparently to preclude its use.
Because of administrative factors and equity considerations (neither of which is here listed), an averaging
device would apparently need to be of general application in the form of a provision not specifically
temporary. And in view of the general points made
here, especially Ho. 5, the writer would not be inclined
to advocate a permission to average gains.
3. A considerable class of security owners, including large security
owners, is now free to purchase additional securities in case they believe
the market outlook is encouraging and want to do their own averaging. If
they have unrealized losses they can acquire additional securities and, as
the market moves up, close out their holdings at whatever point their
losses equal their gains. So far as the purchase of additional securities
is concerned, they are not frozen out of the market on the buying side by
a long price decline that piles up unrealized losses.
4. An argument for the forwarding of losses can be made on the ground
that large owners of securities who have currently realized losses would
be tempted to purchase on the present market by the knowledge that their
currently realized losses could be offset against future gains. This




Chairman Eccles - 4

October 27, 19S7

argument is not entirely without merit, but the opposing considerations
are probably of greater weight•
(a) The fact that there is no advantage in liquidating
securities, unless the taxpayer has offsetting gains
within this year, probably means that important blocks
of securities are being held off the market at this
time*
(b) A permission to forward losses would place a very
great premium on reali zing losses by means of sales
in the market. To the extent that such realized sales
were not immediately matched by equal purchases, the
market would be injured rather than assisted; and at
least a certain number of security holders would be
tempted to realize losses and then to stay out of the
market for a time until they were quite clear regarding the market direction, so that the net gain would
be problematic*
(c) To the extent that a loss-forwarding provision were
taken advantage of by realizing sales that were simply
offset by equal purchases, the market would neither be
injured nor aided. Purchases would be exactly offset
by sales; and the Government would have lost a large
revenue for no purpose*
(d) Either the averaging of gains or the forwarding of
losses would introduce serious inequities into the
tax system in comparison with the treatment of earned
income under the individual income tax and would be a
source of serious discontent to other classes of taxpayers.
5* The maintenance of a capital gains tax virtually intact is vital
to any long-run program for a broader distribution of wealth and income
in the United States*