Any unneutralities that may arise in the application of the personal income tax are inherent in the distribution of income. Thus, as levied on the smaller incomes, the tax chiefly burdens consumption, and as levied on the larger ones, investment. But since the aggregate of the smaller incomes greatly exceeds that of the larger, most of the collection is and must be from this source. In 1956, the amount of adjusted gross income below $8,000 was 68.6 percent of the total. Below $10,000 it was 78.3 percent. The corresponding percentages of the total of income taxes paid were 49.5 and 59.9. The personal income tax, therefore, is collected in the main from money that would otherwise be used for consumption.

And here I should add that the full effect of my recommendations would be to increase the percentage from that source. For I am proposing that the upper rates of the personal income tax be repealed. That portion of the rate schedule, which reaches a maximum of 91 percent, is unrealistically high. The rates included stimulate the conversion into capital gains of what would otherwise be dividend or entrepreneurial income, the taking of compensation in the form of stock options and pensions after retirement, and other dodges. On the other hand, such rates discourage the making of taxable investments for the purpose of earning an income. Consequently, they yield comparatively little revenue, and are productive chiefly of ingenuity in developing avoidance devices. I think that the 91 percent rate and all others down to 65 percent should be removed from the statute. Thus, I am suggesting a maximum of 65 percent. A schedule stopping at that upper limit would, in my opinion, be much more likely to be effective than the present one, would be less discouraging to investment, and would satisfy all reasonable requirements of fairness. The $4 billion or less of additional revenue required could be distributed in approximately proportional fashion over the income scale, thus preserving the degree of progression.

8

A basic question remains: Why take $5 billion from the sum paid by corporations for the purpose of adding some $4 billion to that paid by individuals? Or, as expressed otherwise, why increase by $5 billion income largely devoted to investment, at the cost of decreasing by almost the same amount income largely devoted to consumption? What advantage is to be served by the transfer?

Investment and consumption are essentials of economic progress. Investment is one of the key factors of production. Except as there be additions to machinery, plant, and other instrumentalities of production, the rate of economic progress would decline. Consumption, on the other side of the relationship, is equally important. The products of the economic process must be used up if warrant is to be found for its continued operation. Full stocks but no sales, bulging warehouses but no deliveries, stall the apparatus of production.

Such a complementary relationship as exists between these essentials suggests that at times one and then the other may need stimulation, depending on the current economic situation. And in the required judgment and its implementation lie much of the art of fiscal

7 "Statistics of Income, Preliminary Individual Income Tax Returns for 1956," U.S. Treasury Department, Internal Revenue Service, p. 11.

8 This is believed to be a conservative estimate of the need, assuming the adoption of the proposals made here.

are

management, including the setting of appropriate tax rates. We however, not considering that problem here, but the long time one of the regular or ordinary tax relationships that should apply.

At least three powerful arguments support the case for less emphasis on taxing investment and more on taxing consumption. First, even after a reduction of the rate of the corporation income tax to the proposed 40 percent, investment would still be discriminated against. A 40-percent rate is high by all precedent, as well as because of the practice of double taxing nearly all of any dividends paid. Second, the volume of investment is small as compared with that of consumption. In the first quarter of 1959, gross private domestic investment was being made at the annual rate of $70.2 billion, while personal consumption expenditures were at that of $300.5 billion. An additional burden of $4 billion on consumption, or only 113 percent, would have small adverse effects. On the other hand the addition of $5 billion of largely investment funds, or 7 percent of the total, would have a substantial stimulating effect on investment. Third, the position often taken in economic writing that consumption should be favored taxwise as against investment does not support the purpose intended to be served. By such a policy the most that could be accomplished is a temporary increase in consumption that would result in sufficient investment to be sustained. Surely this would be an indirect, weak, and faltering way of attaining the end sought. On the other hand, the removal in considerable measure of a discrimination against investment would offer a positive encouragement to greater investment with a consequent larger production and growth of consumption.

And now may I conclude by discussing briefly the problem of the small corporation, and the question of graduated rates. There is, I believe, a case for the lower taxation of the small corporation, in order to offer some encouragement to the enterprise in the crucial beginning years. But that case is limited. I doubt if any concessions should be given on income of more than $25,000 or $50,000. This brings me to the matter of graduated rates. Á scheme of graduated rates was proposed by President Roosevelt in 1935, but Congress did not enact it into legislation. There are two fundamental objections to graduated rates. First, the incomes of the stockholders do not necessarily correspond to the sizes of the corporations in which they own shares. Poor persons may own stock in large corporations and rich persons in small. To treat the corporation income as that of an individual, and then to subject it to progressive rates of taxation, would be to disregard the fact that such income is, through the ownership of the shares, a composite of the incomes of the stockholders. An artificial person, a construct of the law, is not to be treated as a natural person. Second, the graduated taxation of corporation income would introduce a dangerous precedent. The scale of rates might be carried to harmful extremes as it has been in the personal income tax.

9 Survey of Current Business, June 1959.

47060-59-pt. 349

CORPORATE INCOME TAX RATES

George Terborgh, research director, Machinery and Allied Products Institute

Mr. Chairman and gentlemen of the committee, I am deeply appreciative of this opportunity to discuss the effect of the corporate income tax on the American economy. My own studies in this field have been concerned entirely with the effect of the tax on investment and capital formation, and I shall therefore limit this presentation accordingly.

I. INTRODUCTION

The effect of taxes on the process of saving and investment is an important question for any country interested in economic progress, but it is doubly so for the United States today. For the object of progress is no longer simply the improvement of our standard of living; it is also the maintenance, and if possible the enhancement, of our international position.

With your indulgence, I should like to quote some observations on this point in a previous statement to this committee: 1

We start from the proposition that the American economy is not growing fast enough. We are not speaking of the current situation, or even of the last couple of years, but rather of the average growth rate evidenced by its performance over the past decade. This is something more than 3.5 percent annually in total output, something like 2.5 percent in output per worker.

Under ordinary circumstances, this rate of progress might be deemed quite satisfactory. Indeed, it compares favorably with earlier periods of our history. But the present circumstances are not ordinary. We are in deadly competition, militarily and economically, with a country that has sustained in recent years, and seems likely to sustain for some time ahead, a growth rate approximately twice our own.

We hardly need comment on what this means for our prestige before the world. If the Soviet Union can manage to outpace us so dramatically for another decade, it will be hard to convince even our friends that the Communist economic system is not the wave of the future. Neither is it necessary to stress the implications of this situation for our ability to compete with the Soviets in military and related expenditures. If they continue to gain on us in production, this competition will become progressively easier for them and harder for us.

The reasons for the rapid gain just referred to are of course complex, and we have neither the time nor the competence to attempt an assessment of their relative importance. One factor is clear, however. The Soviets devote a far higher proportion of their national output to productive capital formation than we do. Whatever else may be involved, this is basic. For nothing is more important over the long pull than the expansion and improvement of productive facilities. The moral for the United States is obvious. If we hope to step up our rate of progress to something nearer the Soviet tempo, we are going to have to provide both the financial wherewithal and the incentive for a higher rate of productive investment.

This is of course not the only aspect of our international position affected by the rate of investment. Unless it keeps pace with the rise of productivity in the leading industrial countries of the free world

1 Testimony of the Machinery and Allied Products Institute, Jan. 10, 1958.

as it has not done in recent years-the United States will find itself competing in neutral markets with increasing difficulty, and will experience a growing penetration of its own markets by foreign suppliers. It behooves us on this account as well (not to mention the obvious advantage of a more rapidly rising standard of living) to review the impact of our tax system on saving and investment, and to do so with a seriousness commensurate with the gravity of the issue.

The present study

I hasten to say that the present study is something far less ambitious than a review of the entire tax system. It can be described rather as a contribution to such a review. For as I have indicated, it is concerned only with the effect of the corporate income tax on productive investment.

It is quite obvious, of course, that this tax does not operate in isolation from other elements of the revenue system. Not only does it interact with other levies; it relieves them of part of the load they would otherwise have to carry. This means that any appraisal of the net effect of the tax on investment must take account of the effect of raising the revenue in other ways. It is of course the difference between the two effects.

Since this difference can be derived only by appraising the effects separately, such an appraisal seems to be the logical next order of business. Unfortunately, the alternatives to the corporate income tax are legion, and it is impossible to do more here than consider them in general terms. My real task is to analyze the effects of the corporate tax itself.

II. THE QUESTION OF INCIDENCE

It is imposisble to get very far in this analysis without raising the question of the incidence of the tax. Who ultimately pays it?

A generation ago it was widely assumed by economists and students of fiscal policy that the corporate income tax is "absorbed," hence that it represents substantially a dollar-for-dollar reduction of profits. More recently there has developed a substantial body of opinion that the tax is partially, if not largely, "passed on" to the market. Certainly "shifting" theory appears to be gaining on "absorption" theory.2

2 This can be illustrated by a few quotations from recent literature:

"One of the most troublesome and important economic problems of the corporate income tax is who actually pays it. In recent discussions it has been repeatedly asserted that the tax is shifted forward to consumers in higher prices or backward to workers in lower wages. This view is in direct conflict with the conclusion about the incidence of a net income tax that has usually been reached by economists." (Richard Goode, "The Corporation Income Tax." John Wiley & Sons, Inc., 1951, p. 44.)

"A brief summary *** cannot do justice to the richness, refinement, and complexity of recent discussions [of corporate tax incidence], [but] it is apparent *** that it is impossible to arrive at a general consensus." (Daniel M. Holland, "The Income-Tax Burden on Stockholders," Princeton University Press, 1958, p. 90.)

"The economic literature on the subject is extensive, with a preponderance of opinion that the tax is not shifted. I wish simply to record myself among the skeptics on the subject of the incidence of the corporate income tax." (Dan Throop Smith, "Effects of Taxation Corporate Financial Policy," Harvard University, Graduate School of Business Administration, 1952, p. 93.)

"Perhaps the best way of describing the present situation is to say that, insofar as the corporate income tax is concerned, incidence theory is in a state of flux. It seems clear, however, that the newer theory is in the ascendancy. This theory, it should again be emphasized, does not hold that the corporate income tax is always reflected in price. Rather, it holds that this tax tends to be reflected in price and may be completely shifted in many circumstances. (Lewis H. Kimmel, "Taxes and Economic Incentives," The Brookings Institution, 1950, p. 27.)