to spend collectively through Government. In the real world it may be essential to balance off a handicap with an advantage. But so long as this privileged tax position exists we cannot be sure that a distortion in the allocation of our capital resources will not emerge. Another question is whether the high and highly progressive personal income-tax rates unduly choke off investment in risky ventures. The high-income people, according to this argument, are the only ones who can afford these risks. The heavy tax rates make the possible net gains after taxes moderate and provide incomplete assurance that the Treasury will participate equally fully in the losses. Therefore, assets such as tax-exempt municipals loom relatively more attractive to these investors. And the tax-exempt feature is more attractive to precisely those on whom society ought to rely for its most venturesome capital. 3. Do corporate income taxes correspondingly reduce the amount of retained earnings? It seems clear that the volume of gross retained earnings (before depreciation changes) is a limiting factor on the size of a corporation's total capital expenditures even if theoretically projects whose rate of return substantially exceeds the cost of money must be excluded. This reflects the generally recognized preference for internal financing particularly by manufacturing corporations. An unresolved question is, of course, the extent to which corporate income taxes result in less corporate income after taxes (dividends plus retained earnings). The answer derived from pure economic theory is clear-corporate profits taxes are not passed on in the form of higher prices or lower wages. Therefore, corporate income taxes correspondingly reduce corporate income after taxes. But there is enough contrary sentiment in the business community to suggest that the answer is less clear cut. Even the statistics are inconclusive. Corporate profits after taxes in 1950 were 9.2 percent of national income, not significantly lower than the 9.5 percent in 1929-this in spite of the fact that corporate profits taxes absorbed 14 percent of before-tax profits in 1929 and 45 percent in 1950. By 1953, however, profits after taxes were down to 5.6 percent of national income. For 1955 the figure will be roughly 7 percent, with taxes taking about half of corporate profits. These data suggest that the question of whether corporate profits taxes reduce dividends and retained earnings cannot be given a simple "Yes" or "No" answer. The more fruitful approach must be to explore when and under what circumstances retained earnings are lower than they would otherwise be because of profits taxes. It is reasonable to suppose, for example, that the immediate impact of a change in taxes probably is at the expense of dividends and retained earnings, with retained earnings reflecting most of the change. It is probable that the capacity of businesses to adjust to profits taxes weakens as the tax burden becomes relatively heavier. What is true of a tax taking one-fifth or one-quarter of profits may not be true for a tax taking half or more of corporate income-particularly if high marginal rates are involved, as was true with the so-called excess-profits taxes. The Treasury does now share more fully in losses. An individual may carry his (unincorporated) business losses back 2 years and forward 5. And for a corporation losses on one operation are, of course, consolidated into the income statement for the company. Losses from a corporation's ownership in another corporation, where the income is not consolidated, can only be offset against capital gains. One dimension of this problem is the overstatement of profits and therefore profits taxes because of the tax treatment of depreciation charges. The response of businesses to accelerated amortization suggests that capital outlays are influenced by tax policy with respect to depreciation. This problem has been moderated by the change in the Revenue Act of 1954 which does permit some more flexibility in handling depreciation. But it does not take care of the understatement of costs and overstatement of earnings and taxes because of a higher price level. This understatement has been estimated at $5 billion for businesses, and capital consumption allowances on a current cost basis have been estimated as much as 35 percent higher (for 1949) than the figure actually used in the national-income accounts. If capital outlays are sensitive to depreciation policy, it does not make sense to pursue a policy which actually does not account for the full current cost of production. 8 4. Does our high and highly progressive tax structure reduce the amount of national income being saved? If so, it probably means some less investment since the volume of capital outlays is not completely unrelated to the flow of savings into the capital markets. The logic of the case suggests that our tax structure ought to work in this direction. Our present tax system is heavier on the highincome groups than on those with lower incomes. We also know that society's savings come importantly from those with higher incomes. Therefore, it seems to follow, our highly progressive tax system ought to work in the direction of reducing total saving. The empirical evidence as usual is a bit inconclusive on this matter. A shortage of savings should be reflected in relatively high rates of interest. Yet interest rates are lower than the preprogressive income-tax era. (But this is not conclusive because our tax system may have reduced the demand for capital even more than the supply.) Moreover, there is reason to believe that the structure or the progressivity of the tax structure (as distinct from its absolute magnitude) may affect the flow of savings less than had been thought." For whatever the reason, however, there is evidence that the ratio of total national savings to national income has undergone a modest secular decline. A trend of the ratio of total national saving to national income for the period 1897-1929 would give an average ratio of 13.1 percent for the years 1946-49, compared with the actual figure of 11.2 percent.10 This conclusion is also suggested by the data on the increase in productive wealth, which show smaller increases relative to the increase in the labor force in recent decades than was true for the early part of the century. Realistic Depreciation Policy-A Summary, Machinery and Allied Products Institute, 1953, p. 19; Raymond W. Goldsmith, A Study of Saving in the United States, vol. Í (Princeton University Press, 1955), p. 31. The fictitious element in profits represented by understating costs of materials charged against sales is allowed for in national-income data by the inventory-valuation adjustment. This logle should be extended to the understatement of profits from present depreciation policy. Richard A. Musgrave and Mary S. Palmer, The Impact of Alternative Tax Structures on Personal Consumption and Saving, Quarterly Journal of Economics, August 1948, pp. 475-499. 10 Raymond W. Goldsmith, A Study of Savings in the United States, vol. I, op. cit., p. 82. This is the concept of savings excluding consumer durables. If purchases of consumer durables are included in savings the gap is smaller though still present. The denominator of the ratio is actually net national product rather than national income. Since depreciation charges were too low in 1946-49, net national product is probably overstated and the "true" savings ratio understated, which might account for a substantial part of the gap. The most reasonable conclusion, therefore, seems to be that the ratio of national savings to national income or product is slightly lower now than in the latter part of the last century or the early part of this one. But the decline has not been severe, and we cannot rule out the possibility either that it is an optical illusion reflecting imperfect data or that it would have occurred in the absence of the changes in our tax structure. 5. The view that heavy taxes impede capital formation has some support from theoretical analysis." The theory of investment implies that a firm will undertake all capital outlay projects from the most profitable down to those whose rate of return is just equal to the cost of money. If the cost of money (e. g., interest on debt) is fully deductible as a cost in computing taxable income, a business income tax should not restrict private investment. The tax affects both the cost of money and the rate of return equally. A project whose rate of return exceeds the cost of money on a before-tax basis will also exceed the cost of money on an after-tax basis. The imposition of the tax narrows the gap but does not eliminate it for any project. It is pretty clear, however, that the actual decision-making process does not reflect quite this precise a calculus. The actual outcome of any new venture cannot certainly be known at the outset. The penalty on those particular personnel who make or recommend these decisions may be particularly severe if a project proves unwiseconsiderably more severe than foregoing projects that might have been profitable. These considerations may help to explain the real-life fact that most capital budgets stop considerably short of all projects whose probable rate of return exceeds the cost of money. This problem may take the form of the requirement that a certain spread between the cost of money and the probable rate of return must exist before the project be undertaken. The imposition of corporate income taxes, even if the cost of money is deductible, will then eliminate certain projects if we visualize this gap to be a certain number of percentage points of return.12 And capital outlays would thereby be adversely affected. If the cost of money for financing capital outlays is not fully deductible for tax purposes, the imposition of a business income tax will clearly reduce private investment. The after-tax probable rate of return on projects is lowered by more than the net cost of capital. Thus marginal projects which would just have been undertaken no longer qualify for the capital budget. And there is reason to expect that projects with a longer expected life would be particularly adversely affected.13 " The literature on this subject is quite extensive. Cf.: E. Cary Brown, Business-Income Taxation and Investment Incentives in Income, Employment, and Public Policy, Essays in Honor of Alvin H. Hansen (New York: Norton, 1948), pp. 300-316; Evsey D. Domar and Richard A. Musgrave, Proportional Income Taxation and Risk-Taking, Quarterly Journal of Economics, May 1944, pp. 388-422; Richard Goode, Accelerated Depreciation Allowances as a Stimulus to Investment, Quarterly Journal of Economics, May 1955, pp. 191-220. Cf. also the various studies by J. Keith Butters and colleagues on the effects of taxation. 13 For any firm the supply curve of funds is almost infinitely elastic. And the slope of the schedule of the marginal officiency of capital is negative. Therefore, the slope of the supply curve on an after-tax basis remains unchanged (but its level is lower) while the level and slope of the schedule of the marginal efficiency of capital are reduced. Therefore, the requirement of some fixed premium for the rate of return beyond the cost of money will, of course, reduce investment. 13 E. Cary Brown, op cit., p. 301. Accelerated amortization helps to neutralize this adverse effort. 45007 0-59--11 In the real world, of course, the cost of money is only partially deductible. Interest on debt is an expense which can be deducted before arriving at taxable income. But for business generally sound financial management requires that considerably less than all requirements for new money be met by debt financing. For all manufacturing corporations at the end of last year, long-term debt accounted for only $19 billion of the $134 billion of permanent investment. For public utilities the ratio is somewhat higher, but even here it is generally considered to be unwise for debt to account for more than one-third to one-half of total capital. The remainder is equity capital and the "cost of money" for equity capital is not, of course, deductible for tax purposes. If we make the reasonable assumption that as a matter of financial policy businesses will want to retain essentially the present capital structure, debt financing can then be a source of substantially less than half of total new capital requirements. It then follows that for only a minority of new capital requirements is the "cost of money" deductible for tax purposes. This seems to be the policy businesses have actually pursued. For all corporations permanent investments from 1945 to 1952 increased $138 billions, of which an increase in long-term debt accounted for only $40 billion or 29 percent. This did, however, raise the share of long-term debt in the capital structure from 20 percent in 1945 to 24 percent in 1952.14 V It may be useful to summarize the four basic points covered in these comments. 1. Maintaining a high rate of private investment is important to our economic welfare not only in order to avoid unemployment but also because a rising amount of capital invested per worker is one of the primary sources of our high and rising productivity and standards of living. 2. Taxes can serve as a stimulus to private investment. Tax effects are not all adverse. 3. The weight and progressivity of our tax structure also impede private investment in numerous ways. The availability of funds may be altered. The equilibrium amount of desirable capital outlays may be reduced. The structure of the tax system may considerably alter the pattern of allocation of our capital outlays. 4. The weight of theoretical reasoning and empirical evidence suggests that the rate of private investment has been moderately reduced in recent decades relative to the earlier period when the share of the national income going to the tax collector was lower. 14 U. S. Treasury Statistics of Income, pt. II, 1945 and 1952. These figures are for corporations filing balance sheets. IV. IMPACT OF FEDERAL TAXATION ON MANAGEMENT AND ENTREPRENEURIAL EFFORTS AND ON TYPE OF REMUNERATION; EFFECTS ON LABOR SUPPLY AND PROFESSIONAL SKILLS IMPACT OF THE FEDERAL INCOME TAX ON LABOR FORCE PARTICIPATION CLARENCE D. LONG, Johns Hopkins University 1. THE PROBLEM Is the tendency of people to be in the labor force1 influenced by the size of their own or their families' incomes and by the fact that they must give up an appreciable part of those incomes as a tax? Economists and others have differed widely in their speculations on this question. There are those who have argued that the lower the income retained (because of a tax or other reasons) the less the incentive to work, especially in the case of a progressive tax which takes larger percentages of a high income than of a low income. There are others who have held that the lower the income retained, the greater the need to work, in order to earn enough after tax to maintain a desired living standard, or to save enough to provide for the future or to retire. There are still others who have pointed to the many noneconomic reasons for working-rank, fame, power, an altruistic mission, companionship, convention, love of work, or habitand have urged that income and taxes on income would have little or no influence on the decision to enter or leave the labor force. How are we to proceed on the basis of these speculations? Perhaps the safest course is to begin with the assumption that the answer cannot be discovered from mere analysis of human motivation. Even if people were motivated solely by the incomes they could retain— their decision whether or not to work (as their incomes were reduced by a tax) would depend on how the individuals value income in rela In the United States the labor force is currently defined as the sum of all persons who are reported by the Census to be employed or unemployed during a certain specified week. The employed category covers all persons 14 or older who have jobs or businesses for pay or profit. Specifically, it includes wage and salary employees, supervisory employees at all levels, employers, self-employed persons, and it even includes unpaid family workers such as wives or children who labor in the family store or on the family farm provided they help produce a salable product or service. It also includes employees of non-profit-making enterprises and Government agencies. The unemployed includes persons 14 and older who have no job or business of the above-mentioned sort and are seeking such employment during the survey week. There are many things that are less than satisfactory about this concept from an economic point of view, and a full discussion of them may be found in a monograph now being prepared for publication. (The Labor Force Under Changing Income and Employment. National Bureau of Economic Research, Inc.. 1955 mimeographed, chs. 3 and 4.) It is not believed that these defects are such as to impair the results of the present study. |