A. Some countries levy no tax whatever on dividends received by individuals: Costa Rica, El Salvador, Finland, Haiti, Indonesia, Iraq, Ireland, Lebanon, Liberia, Paraguay, Uruguay, Venezuela, Guatemala, New Zealand, Nicaragua.

B. Other countries give credit on personal income tax for dividends received by individuals or corporate income taxes paid by the companies declaring these dividends: Argentina, Canada, Israel, Japan, United Kingdom.

C. Other countries tax distributed profits at a lower rate than undistributed profits, or exclude them from the corporate tax base: Belgium, Egypt, Germany, Greece, Portugal.

D. Other countries impose a penalty on company-retained profits: Cuba, Ecuador, Mexico, Norway, Union of South Africa.

THE CONTROVERSY:

THE INCIDENCE OF THE CORPORATE INCOME TAX

The vacillation in tax policy, with respect to corporate earnings and dividends experienced in the United States, is based in large measure on the uncertain incidence of the corporate tax. If the tax is absorbed by the corporation, then validity attaches to the charge of double taxation. If, however, the corporation does not absorb the tax, but rather shifts it forward to consumers in the form of higher prices or backward on workers in the form of lower wages, then double taxation, in the traditional sense of that term, is not at issue. At first glance, the determination of incidence would seem a simple problem. Such is hardly the case. The question is obscured by controversy of heroic proportions.

In the past, businessmen have often contended that a corporate tax simply represents a cost of doing business and, therefore, must be reflected in price. Although this opinion is a rather common one, the available evidence seems to suggest that the majority are of the contrary view-namely, that the corporate tax cannot be shifted. Regardless of the exact division of opinion, it is apparent that the prime actor in economic life, the businessman, can shed little light on this basic question.

Nor have the economists been able to clarify the problem. On the contrary, it seems that my colleagues have only added to the confusion. Traditional economic theory, as is often the case, does provide us with a rather simple solution. Briefly, price theory maintains that all firms establish prices at a point which maximizes profits (i.e., at a point where marginal cost equals marginal revenue). The imposition of a tax, therefore, would not alter this optimum price position, for a constant percentage reduction in profits would lower all possible profit levels proportionately. Therefore, the output-price level which was most favorable, relatively speaking, before tax would still be the most favorable, relative to other possible levels, after tax. On this basis, some economists have long held the view that the corporate tax could not be shifted and, consequently, was borne by the corporation.

Many economists, however, are not satisfied with this explanation. Some would argue that although the analysis is correct, it does not go far enough. Despite the fact that prices will not increase immediately, the tax would reduce the return on investment required to bring about continued operation and growth. According to this view, the tax serves to restrict investment, and consequently, produc

National Industrial Conference Board. "The Shifting and Effects of the Federal Corporation_Income Tax," vol. 1, New York, 1928, pp. 153-155; National Industrial Conference Board, "Effects of Taxes Upon Corporate Policy," New York, 1943, pp. 57-58,

tion. The ensuing reduction in supply, therefore, indirectly forces price to advance.

Other economists have argued that although the corporate tax would reduce investment, and consequently, supply, prices, in fact, may not increase. They point out that a decrease in investment demand not compensated for by an increase in consumer demand would result in a reduction in national income. Such a development would make declining prices a much stronger possibility.

In recent years, another approach to the question of incidence has been developed. Essentially, this approach questions whether corporations actually operate at a point which maximizes profits and tends to prevent shifting of the tax. The proponents of this point of view argue that the modern corporation may seek rather to set prices, and therefore profits, at a level which would maximize nonprofit objectives. Thus, corporations may aim

at limited rather than maximum profits in order to discourage potential competition, to restrain wage demands of organized labor, or to maintain customer good will. Or management, which typically has a small financial interest in the modern corporation, may want to limit profits in order to maximize its own benefits. So-called standard profits may be set with reference to (1) what it takes to attract outside capital, (2) what earnings are needed to finance planned expansion, or (3) what the company or comparable companies have normally earned."

In such situations, where the corporation attempts to fulfill objectives other than profit maximization, the imposition of a corporate tax or the increase in the existing rate may induce forward shifting. This result could follow, since each firm would be reasonably certain that competitors would tend to treat the tax burden as an expense item. Since many obstacles to such price increases exist and vary greatly from firm to firm and from industry to industry, only in rather unusual circumstances would such forward shifting be complete.10 Thus, according to this view, although forward shifting is possible and in many industries probable, the exact degree of shifting is largely uncertain.

Despite the seemingly endless, and at times rather violent, controversy which has developed regarding the question of incidence, students of the subject have come to agree that the most reasonable assumptions are: (1) the corporation bears the tax entirely or (2) the corporation bears the major proportion of it, some minor proportion being shifted forward to consumers in the form of higher prices. Thus, the two major investigations of the effects of the corporate income tax undertaken since the end of World War II bear witness to this area of agreement. Richard Musgrave, in his recent study on the incidence of the tax structure, stated his assumption in the following

manner.

One factor is the assumption that two-thirds of the corporation tax is borne by the shareholder while one-third is passed on to the consumer. Thus one-third of the corporation tax is in fact treated as a sales tax, with a correspondingly heavier burden on the lower income groups. While I am not in a position to prove that this is the true ratio, I believe that theoretical reasoning as well as

Keith, E. Gordon, "Economic Impact of the Corporation Income Tax, Federal Tax Policy for Economic Growth and Stability," Joint Committee on the Economic Report, 1955, p. 660. 10 See Shoup, Carl S., "Some Considerations on the Incidence of the Corporation Income Tax," Journal of Finance, vol. VI, June 1951, pp. 187-196.

empirical observation renders this a much more defensible assumption than the standard textbook proposition that the corporation tax cannot be shifted except through its effects on capital formation."

Daniel Holland, in a more recent study for the National Bureau of Economic Research, based the greater part of his investigation on the more classic assumption.

In deriving the basic measures it is assumed that corporation income taxes are not shifted but constitute a burden on the stockholders, i.e., that the corporate income tax reduces by an equivalent amount what could otherwise have been distributed to stockholders. There is, of course, no unanimity of opinion about where the corporation income tax falls ***. That the corporate income tax rests on profits is probably still the most prevalent view among students of public finance (though other opinions are also strongly held).12

ECONOMIC EFFECTS OF DOUBLE TAXATION

As we have seen, our present method of taxing corporate income in the hands of the corporation and again in the hands of the stockholder results in a substantial amount of extra taxation. Since this burden of extra taxation is directed against the sensitive area of private investment, the economic effects of double taxation are bound to be of crucial import.

The first and most obvious effect of this double taxation of investment income is a reduction in the level of private funds which otherwise might have been available for financing economic expansion. The question now remains as to how this reduction in investment funds is allocated. Its impact may be felt at the corporate level in a reduction of undistributed profits, at the stockholder level in a reduction of dividend income, or more probably, to some degree at both levels. To the extent that the reduction in private investment funds is absorbed by the corporation, it is brought to bear on the retained portion of earnings which have traditionally been used to finance replacement and modernization of plant and equipment, as well as new capital projects. At the stockholder level, this reduction in the flow of funds to individual investors, particularly those in the higher incomp brackets, translates itself directly into a reduction in the level of personal savings. Such a development, of course, has an adverse impact on the economy's ability to finance new investment.

The very reduction in the rate of return on investment, of course, has important forward effects on future levels of capital formation. In the area of corporate investment, lower rates of return doubtlessly force management to eschew many high-risk projects which, more often than not, have the greatest growth potential. Typical of such projects would be investments in facilities to produce new products, where the probability of success is highly uncertain. With respect to the stockholder, of course, the lower rate of return on his investment might tend to increase his desire to hold cash, or to consume, relative to new investment uses. In this case, the future level or equity investment would be lower than would otherwise have been the case.

11 Musgrave, Richard A., "The Incidence of the Tax Structure and its Effects on Consumption, Federal Tax Policy for Economic Growth and Stability," Joint Committee on the Economic Report, 1955, p. 100.

12 Holland, Daniel M., "The Income-Tax Burden on Stockholders," National Bureau of Economic Research, Princeton University Press, Princeton, N.J., 1958, p. 6.

Double taxation tends to discourage equity financing in another important way. When a corporation distributes earnings to stockholders in the form of dividends, it cannot deduct such payments in computing its taxable income. However, when the same corporation pays interest to its bondholders the amount is deductible. Thus, the management will tend to prefer debt-financing to equity-financing, as a result of our current tax treatment of corporate and dividend income. Needless to say, the increase in debt financing is an undesirable development. It tends to decrease the flexibility of corporations, thereby making them more vulnerable in periods of depressed economic activity.

The operation of our current tax policy with respect to corporate income has at least three major adverse effects on economic growths. It decreases the availability of investment funds, depresses incentives to invest, and distorts the method of financing corporate expansion.

The concern with economic growth is hardly an academic one. On the contrary, in my opinion, it is one of the most important problems facing the Nation today. The best summary measure of economic growth is per capita gross national product in constant dollars, the Nation's aggregate production of goods and services relative to population, after adjustment for price changes. A perusal of such figures for the United States reveals a period of virtual stagnation in per capita product over the period 1955 to 1957, inclusive, while 1958 experienced an actual decline in this summary measure of economic wellbeing. Not only has our recent experience been relatively poor in terms of itself, but it suffers severely by comparison with the pattern of growth exhibited by other industrialized countries in recent years. As shown in the table below, for the period 1950-57, the United States experienced the lowest growth rate in per capita product of the countries listed.

Index numbers of per capita gross national product at constant prices

Source: United Nations, "Statistical Yearbook," 1958, New York, 1958, p. 431.

Furthermore, our recent growth experience is most disquieting when viewed against the rate of economic advance implied in official Soviet statistics. Although comparable gross national product figures have never been systematically developed for the U.S.S.R., official estimates are available for net material product.13

13 Net material product: the total value of material goods and productive services produced by the economy in the course of the year. Economic activities not contributing directly to material production such as public administration and defense, personal and professional services, and similar activities are not included.

Over the period 1950-57, the per capita net material product of the Soviet Union, in constant prices, increased by approximately 80 percent.14 These estimates, of course, are open to serious statistical objections and should be viewed with a healthy suspicion. Nevertheless, the very magnitude of the increase is startling. Certainly, even after rigorous critical review, the major part of the increment must be real. In short, the U.S.S.R. poses a very serious economic challenge to the free world. It requires a vigorous and creative response on the part of the United States if we are to survive.

The forces responsible for economic growth are many, diverse, and complex. One of the primary determinates, of course, is the level and rate of growth of investment. Generally speaking, experience shows that if a nation devotes a greater proportion of total production to investment uses than do other nations, it will tend to achieve a relatively higher rate of growth in total prouction. This fact is graphically depicted in the accompanying chart.15 The arrangement of the observations indicates that countries which experienced relatively more rapid growth in gross national products over the period 1950-57, tend to be those in which gross investment was comparatively high. Therefore, our efforts should be directed toward creating a climate that will encourage investment, particularly private investment. By no means, do I wish to suggest that our current tax treatment of corporate and dividend income is solely responsible for our disappointing rate of growth. However, our present practice of taxing the sensitive process of private investment at high discriminatory rates is doubtlessly an important part of the problem. It is imperative, therefore, that Congress seek a more positive method of obtaining revenues, a method that will be conducive to greater equity and economic growth.

METHODS OF INTEGRATION

Numerous methods designed to eliminate the burden of double taxation have been advanced over the years. Despite the seemingly endless variations presented by such methods, there are three basic approaches to the problem. Although they have been widely publicized, it might be well to review them here briefly.16

Approach No. 1: Elimination of the corporate income tax

Without doubt, this is the most direct and, in the opinion of some, the most desirable solution to the problem. If corporations paid out all earnings, then the elimination of the corporate income tax would insure that the income generated by the corporation would be ultimately taxed in the hands of stockholders at normal and surtax rates. This would completely eliminate double taxation of corporate income, thereby fulfilling the requirements of equity. Furthermore, this approach would eliminate the corporate tax as a factor in management decisions, remove the current bias against equity financing, and would assuage the fears of those who believe that the tax is, to some degree, shifted forward.

14 "The U.S.S.R. in Figures," Central Statistical Administration, Council of Ministers of the U.S.S.R., Moscow, 1958. 15 Made available by William Butler. vice president, Chase Manhattan Bank.

16 For an excellent and more detailed analysis see: Goode, Richard B., "The Postwar Corporation Tax Structure," Treasury Department, Division of Tax Research, 1946.