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10:00 A.M. EDT

Statement by
Henry C. Wallich
Before the
Committee on Ways and Means
United States House of Representatives
Washington, D.C.
Wednesday, June 25, 1975

10:00 A.M. EDT

Statement by
Henry C. Wallicr.
Before the
Committee on Ways and Means
United States House of Representatives
Washington, D.C.
Wednesday, June 25, 1975

It is a great pleasure to address this distinguished
Committee on the subject of taxes and capital formation.

I do

so purely in my personal capacity.
There is widespread concern that the United States is
approaching a period of capital shortage.

More capital for

investment will be needed in the future than has been in the

Savings to finance this investment, on the other hand,

have been diminishing.
Fortunately, the demand for capital is likely to increase
by only a small margin.

Business investment, which in the past had

averaged approximately 10-1/2 per cent of GNP, probably will have to
average 11-1/2 per cent in order to provide needed jobs, protect the
environment, assure health and safety of the labor force, and meet
energy needs.

Meanwhile the capital requirements of homeowners and

-2of various types of urban construction may diminish thanks to
declining population growth, and less investment in inventory
may be needed as inventory control methods improve.
The supply side of capital, on the other hand, presents
more serious difficulties.

The continued ability of the individual

saver to supply capital equal to a historic 4-5 per cent share of
GNP, to be.sure, does not call for serious questioning.

The ability

of corporate business, however, to contribute to the flow of savings
has been hurt by the diminishing share of corporate profits in the
GNP and by the deteriorating quality of these profits.

Taking demand

for and supply of capital for the private sector as a whole, a
deficit very probably is ahead.

To this private capital deficit

there may well have to be added a deficit in the accounts of State
and local authorities.
The Federal Government therefore will play a decisive role
in balancing the demand for and supply of capital.

If the Federal

Budget produces a sufficient surplus, this will offset private plus
State and local deficits.
been forestalled.

An over-all capital shortage will have

If the surplus is too small or if, as has

happened before, the Federal Budget is in deficit, we shall confront
a shortage.
The corporate sector suffers, in addition to its weakened
earnings, from serious financing constraints that may impede
financing of investment even if adequate savings are available.

-3Corporate liquidity has been drained.

The capital structure of

corporations has deteriorated, with debt rising relative to
equity, and short-term debt rising relative to long-term debt.
Both conditions could be remedied by a variety of measures that
would improve corporate cash flows and enable corporations to
improve their capital structure.

Among them are such familiar

proposals as an enlarged investment tax credit, depreciation
facilities more realistically recognizing inflation, an outright
cut in the corporate tax rate and, at the individual taxpayer
level, adjustment of capital gains taxes for inflation and a
reduction in the capital gains rate for longer holding periods.
All these techniques have advantages.

They mostly share the

disadvantage, however, of reducing the Treasury's revenue and of
shifting the distribution of income in the direction of greater
inequality, or at least of partly reversing a move toward greater
equality that may have occurred.

A loss of Treasury revenue,

besides, means more Treasury borrowing and to that extent does
not help resolve the capital shortage.
If we want to avoid a loss of revenue and a shift in
the income distribution, it would still be possible to improve
the capital structure of corporations and facilitate financing.
This could be done by removing or reducing the bias in favor of
debt as against equity that is a familiar feature of the corporate
tax system.

Two methods are available:

-4(1) To eliminate the deductibility of interest payments
by nonfinancial corporations and so to tax net operating income
(income after depreciation but before interest) instead of, as
now, net income (income after depreciation and interest). The
tax rate then could be lowered substantially without losing
(2) To make dividends deductible, the same as interest,
and therefore to tax only retained income, at a rate substantially
higher than the present rate.
Of these two approaches, I regard the first -- taxation
of net operating income —

as preferable, because the second is

essentially a tax on undistributed profits which would require a
number of complex provisions to keep it from becoming detrimental
to capital accumulation and growth.

For the implementation of

the tax on net operating income, two methods are available in
order to avoid the severe impact on corporations with above-average
debt that would result from sudden non-deductibility of interest,
even at a moderate rate.

These are:

(1) To phase in the change over a number of years, a
growing fraction of interest paid becoming nondeductible over time
and a growing fraction of dividends being taxed at the reduced
(2) Application of the tax change to debt and equity
issued after enactment.

-5Method (1) (phasing in gradually) exerts only limited
pressure toward more equity financing in the early years and for
that reason seems less desirable, even though it has administrative

Method (2) would immediately end the existing bias

in favor of debt financing.

It poses administrative difficulties

because in effect there would be two tax rates, one on old debt
and equity and another on new.

Regulations would have to be

written with a view toward closing the obvious loopholes that
such a situation presents.
Financial intermediaries, whose principal business
consists in receiving and paying interest, could be covered by
either alternative only by means of complex arrangements and it
seems preferable to give them entirely separate treatment.


would seem appropriate also in view of the lack of uniformity of
the present taxation of financial intermediaries.
The foregoing tax changes would improve the structure of
corporate capitalization and thereby ease corporate financing.
They would not, by and of themselves, increase the supply of saving.
The number of devices that have been suggested to increase saving
is large, and most of them have been so thoroughly discussed that
there is no need here to pass them in review.

As noted already,

they share for the most part the defect of making the distribution
of income more unequal.

Among those that would have the desirable

effect of pushing the economy in the direction of greater equality

-6is the type of plan which tries to convert employees into

Here again, a wide variety of models have been

In my judgment, such plans are desirable if they

meet the following criteria, in addition to giving the individual
employee a share in the flow of corporate profits:
(1) An increasing flow of equity funds for the firm,
(2) A tax arrangement that allows firms to treat
contributions made on behalf of its labor force as part of tax
deductible wages, even though these contributions were made in
the form of stocks,
(3) Diversification of holdings for the benefit of the
stock-owning employees, to reduce the risks of particular stock
(4) Protection against excessive concentration of
voting power in the hands of any particular group,
(5) Ability of the stock-owning employee to sell his
stock, subject to some minimum holding period.
I believe that plans of this kind deserve examination
as part of the effort to increase the supply of capital.