(The prepared statement of Mr. Guthmann is as follows:)

COMPETITION FROM TAX-EXEMPT BUSINESS*

(By Harry G. Guthmann, Northwestern University School of Commerce) This paper is chiefly concerned with tax exemption as a factor giving certain kinds of business an advantage over competing business units which pay such taxes. The field is so broad as to make anything like a full coverage impossible. Consequently, this paper is limited to the tax-exemption factor in two important types of business: the cooperative and the Government-owned utility. Chief attention is centered on the Federal corporate income tax. The two classifications were selected because of the volume of their operations and their economic and tax importance. With the huge increase in the weight of taxes in recent years, especially since 1940, differential tax treatment can be a decisive factor in giving an exempt business such an advantage over the taxed business as to raise the possibility, if not the certainty, that the former may destroy the latter regardless of its comparative efficiency. Tax immunity permits a business to lower prices to the consumer and to expand more rapidly from retained earnings.

THE COOPERATIVES

For the purposes of this discussion, three types of cooperative organizations will concern us, namely, the consumers' cooperative, farmers' buying cooperatives, and farmers' marketing cooperatives. The first two classes, which are most clearly competitive with other existing business units, have certain characteristics in common with the ordinary business corporation :'

(1) They are ordinarily incorporated and enjoy the legal and business advantages growing out of that status.

(2) They are engaged in buying and selling, and frequently engage in manufacturing and processing as well.

(3) They engage competitively in the same fields of business activity.

(4) They may pay dividends to their shareholders for the use of capital funds when, and if, they succeed in earning a net income.

They differ from ordinary business corporations in that:

(1) Their dividend rate to shareholders is generally limited, although the rate legally may run as high as 8 percent, a figure which most stockholders of business corporations would regard as generous.

(2) They pay a dividend, or "refund," to patrons in proportion to their patronage when net income permits.

(3) The cooperatives may or may not be like the business corporation with respect to the taxability of the net income available for the stockholders. The consumers' cooperatives pay a Federal income tax upon this net income for stockholders; but the farmers' purchasing cooperatives are exempt if they qualify under the law, as are their marketing cooperatives. Furthermore whatever portion of the net income of any of these types of cooperatives is returned or allocated as patronage dividends is not regarded as a part of the balance of taxable net income of the cooperative.

Because of the similarity of operation, the consumers' and the farmers' purchasing cooperative will be considered together. An analysis of the present inequality between these cooperatives and business corporations in tax treatment divides itself into two parts, the exemption of the net income whether actually distributed as dividends to stockholders or retained as unallocated reserves, and the exemption of patronage dividends for both types of cooperatives.

Tax favor to farm co-op stockholders. With regard to the first, the exemption of the net income after the deduction of patronage refunds, in farmers' buying cooperatives which qualify for exemption, we have a clearcut case of tax inequality and discrimination-class legislation. Persons who put their money into other incorporated businesses, even in consumers' cooperatives, receive no such advantage. Whether the money is invested in a share of a business corporation, or a consumers' cooperative, or a farmers' cooperative, the earn

*This paper is to be published by the Journal of Finance which holds the copyright and reserves all rights of publication. Delivered before a joint meeting of the American Finance Association and American Economic Association, Thursday, December 28, 1950, Chicago, Ill.

ings for such stock are capital return to an owner and to fail to tax them all equally is to discriminate in favor of the exempted class. It may be argued that farmers are a specially deserving class, but they included well-to-do as well as poor farmers; and if this exemption is for the benefit of poor farmers, what are we doing for the poor industrial worker who owns a few shares in a consumers' cooperative, or the elderly widow who scrimps along on a small income and owns a few shares in a large business corporation. These latter are also deserving, but their corporations have to pay a corporation income tax upon the corporate net earnings without regard to the size of the income of the individual stockholders.

Varying importance of corporate income tar in competition. Furthermore, this tax differential makes a considerable difference to business corporations which have to compete with the exempt farm cooperatives, but its importance varies greatly with the kind of business. To illustrate let us take examples of business corporations in four different fields: Retail food merchandising, farm implement manufacturing, gas and oil production and distribution, and electric utility service. The figures in table 1 are drawn from the 1949 annual reports of Kroger Co., Deere & Co., Continental Oil Co., and Puget Sound Power & Light Co., and show the percentage relation of the Federal corporate income tax and the net profit for stockholders to the sales and the investment of the stock. holders of the respective companies. (The rate earned on total investment would be lower than the percent shown in the table for all except Kroger Co. because of borrowed invested capital upon which a low return is paid.) An examination of the percentages in the last two columns shows how large the income tax was in relation to the sales dollar and the stockholders' investment. They should be compared with the first two columns. With the increases in corporation tax rates for 1950 and 1951 these percentages would be correspondingly higher.

TABLE 1.-The relation of Federal income taxes and net profits to sales and stockholders' investments, 1949

What the income-tax figures in the next to the last column mean is that an exempt cooperative in the retail grocery business could charge its customers 1.2 percent less than a competing business corporation and make as much for its stockholders because it has no Federal corporation income tax; in the farmimplement business it could charge 8.6 percent less; in the oil business it could charge 3.3 percent less; in the electric utility business, 6.3 percent less. When a cooperative is exempt from the Federal income tax and operates under similar business conditions to that of an ordinary business, it can pay a patronage dividend equal to the percentage of tax to sales shown in table 1 and still have as much earnings left over as the ordinary competing business corporation has as its total net profit. Such a competitive advantage is obviously substantial if not overwhelming.

Such figures will vary between companies and in different years. Earnings and tax rates fluctuate. The figures do illustrate vividly the varying importance

79120-51-pt. 2—63

of the tax factor in merchandising, manufacturing and processing, and in the utility field.1

The figures in the last column show how rapidly the capital of a successful exempt cooperative could be built up in good years by retaining earnings derived from income-tax saving. If the cooperative could avoid paying stockholder dividends, it could use the sum of the net profits and the tax "savings" for growth. No dividends will be expected in later years on any capital resulting from retained earnings. Most successful farm cooperatives probably rely primarily on this source of ownership capital. One, the Eastern States Farmers' Exchange, Inc., showed no capital stock in its balance sheet for December 31, 1949:

Patrons' equity:

Commodity contingency reserve__.

Portion of 1949 savings retained as a reserve for expansion of facilities and equipment---.

$1,584,250

2, 543, 348

Accumulated savings retained for necessary operating and capital purposes..

11, 816, 419

Total

15, 944, 017

To illustrate how the application of the Federal income tax would affect the reported net earnings available for distribution among cooperative members as patronage or stock dividends, some examples may be cited. They represent merchandising, processing, and oil production and refining in varied proportions. TABLE 2.-Illustration of how an income tax of 38 percent would affect coopera tives in relation to sales and owners' investments, 1949

1 Year ended Apr. 30, 1948. History and Bylaws of the Union Equity Cooperative Exchange, 1926-48, pp. 11-13.

2 Year ended June 30, 1950. Twenty-seventh annual report from Southern States Farmer, November 1950, pp. 16-18.

3 Eastern States Cooperator, April 1950, pp. 16-19.

* Farmers' Union Central Exchange Messenger, April-May 1950, pp. 15-17.

Applicable tax would probably be less because of petroleum operations, as for Continental Oil Co. in preceding table.

1 The reader interested in average percentages for the various industries will find them in the April 1949 monthly letter on Economic Conditions published by the National City Bank of New York. Figures for the four industries used here were:

Footnotes to the original table point out (1) that net income includes some investment and other income not related to sales; (2) that return on investment is high because supporting assets are valued below present-day values, and (3) that because a larger part of electric utility investment is funded debt, the return on total investment would be lower than that shown on net assets (or net worth).

2 Eastern States Cooperator, April 1950, p. 18. For the period 1945-48, 62 percent of "savings" or net income was retained, the balance "refunded," that is, paid out as patronage refunds. Capital stock may also represent retained earnings rather than cash investment. Thus, at the founding of the Unity Equity Cooperative Exchange (Oklahoma) the original member associations agreed to accept capital stock for their part of the earnings until such time as its total amounted to $20 per active local member. History and By-laws of the Union Equity Cooperative Exchange: 1926-48, p. 10.

The comparative figures for the business corporations help to explain why the farmers' buying cooperatives are and would be expected to continue expansion from buying, or merchandising, operations into manufacturing, processing, oil production, and refining. They also explain why the consumers' cooperatives in urban food retailing have caused less concern to their ordinary business competitors in this country. The income-tax advantage is of less relative importance in its effect on selling price in urban food retailing than in farm cooperatives. Consequently, businessmen have been less interested in the tax position of the urban consumers' cooperatives than in the farm cooperatives. It is also true that consumers' cooperatives in this country have had to meet the competition of efficient chain stores and mail-order houses. In England and Sweden, on the other hand, the consumers' cooperatives were started years earlier and their rapid growth in those countries was the natural outgrowth of their being the first to introduce the economies of mass retailing that were the result of the chain store and mail-order movement in this country. In their growth in England and Sweden these cooperatives have, however, now expanded into manufacturing in a large way.

Clearly the earnings of a cooperative for its stockholders are capital return just as they are for the stockholders of any corporation engaged in business. To exempt farmers' cooperatives and tax consumers' cooperatives and business corporations gives the former a large and unfair advantage in their competition with the latter, especially in these recent years of high corporate tax rates. So long as Congress permits such a major advantage to farmer cooperatives, it creates a strong inducement for business corporations that serve the farmer to adopt the cooperative form of organization or to sell out to farm cooperatives. By conversion to an exempt cooperative, a tax saving can be gained for paying either patronage or stockholders' dividends. So-called reserves may also be set up by farmer cooperatives that would be taxable income for a business corporation, and the cooperative can use such reserves for expansion or to maintain dividends in depression times.

Patronage dividends or refunds.-When we turn to patronage dividends, we find that both consumers' cooperatives and farmers' purchasing cooperatives are permitted to treat such dividends as refunds on their sales to customers or members. Consequently, some cooperative spokesmen argue, such amounts are not a part of the net income or net profit of the cooperative. The debate as to whether this payment is refund or dividend brings us to the question of whether the cooperatives are not really making profits and distributing them as patronage rather than as stock dividends.

What are the profits of the ordinary business corporation? What is their nature? They are the amounts left over as earnings after the payment of all expenses and the cost of goods sold. The Secretary of the Treasury publishes statistics which show that many business corporations make no profit whatsoever.

The corporations that do earn money derive their profits from two chief sources. The first is ordinary return for the use of money invested in the business; the second is, in some cases, in the nature of an extra return which results from extra managerial skill in the operation of that unit. How does this situation differ from that which creates net income from which cooperatives pay patronage dividends?

Their management states that these cooperatives charge their customers competitive prices much as do ordinary business units. Therefore, if they are able to earn net income so as to pay refunds or patronage dividends, what is the source? It is true that some cooperatives are unable to earn income or to pay any patronage dividends but those which do, derive their net income from the same two sources.

Some cooperatives pay very low dividends on their stocks and this, of course, may be called a savings, which may be used to swell the patronage dividends. Where, as in the case of the consumers' cooperative, the earnings for the stockholders are subject to the corporation income tax, and any dividends paid to the stockholders are taxed as personal income while patronage dividends are taxed neither to the corporation nor the receiver, there is a strong incentive to pay as little as possible as dividends on the cooperative stock and as much as possible in the form of patronage dividends.

From the point of view of economics or business analysts, the source of patronage dividends is the same as that of the dividend which is paid to the stockholder of the cooperative, and both are distributions of the net profits of the business corporation. They stem from the fact that capital tends to earn a return when

used in a business, and that there are differences in managerial ability. In adtion, there is the differentiating factor that net income available for patronage dividends for the cooperative may stem in considerable part from tax exemption. We have seen above that under recent conditions in the field of retailing, such exemption from the Federal income tax would have permitted an exempt corperation to save as much as 1.2 percent on sales. In the farm implement manufacturing field this saving from exemption would have been over $ percent of sales. In the field of oil refining and distribution the savings would have ben over 3 percent, and in the electric utility field, about 6 percent of the sales figure. If then we are to have tax equality, both the patronage dividends of consumers' cooperatives and farmers' purchasing cooperatives, which are like other dividends, in their economic origin and also the income available for such dividends should both be subject to the same taxes as those levied upon the net income, or net profit, of the business corporation with which they compete.

We have a precedent for this scruitiny of the economic nature of so-called savings, or patronage dividends, in the practice of the Internal Revenue Bureau which scrutinizes the salaries paid by business corporations to their officers when these officers are also important stockholders. If the Bureau finds the salaries excessive for the services performed, it treats such excess salaries as corporation profits and they are taxed as such. Since patronage dividends for consumer- and farm-buying cooperatives grow out of the same source as the profits of business corporations, namely, superior managerial skill and capital return, they should be subject to the same corporation income taxes. If the cooperatives should choose to pay these amounts to their members as patronage dividends or refunds instead of as dividends on stock, that is a matter for their own management to decide. But taxation should be based upon the economic character of the item in question rather than upon a formalistic or legal classification.3

An even clearer illustration of this principle is found in the case of Eastern Carbon Black Company v. Brast. In that case the corporation had sold its products to its stockholders for less than cost and less than market. In upholding the Commissioner's action in increasing the taxpayer's sale price and taxing the corporations net income on the basis of the increased price, the court said:

"In the case of ordinary sales, there is no point in distinguishing between market value and sale price; but, where there is a sale to stockholders below market value, this is in effect a distribution among stockholders and the price obtained is not determinative in computing income, a part of which is thus distributed. The carbon black delivered to the stockholders here was worth more than 6 cents a pound in the hands of the corporation. When it charged the stockholders less than that amount for it, it was not in reality reducing its income but giving o part of that income to the stockholders. The real income of the corporation can no more be affected by such a transaction, we think, than by the payment of ezorbitant salaries; and the existence of a formal contract constitutes no more justification for ignoring the real income in the one case than in the other. [Italics supplied.]

Tax equality should not handicap co-ops.—Such equality of taxation between these cooperatives and business corporations with which they compete would merely restore equality of position and certainly should not destroy the cooperatives affected. That this should be the case is attested by some of the cooperative leaders who admit that they have equally good management and the ability to carry on successfully in competition with business corporations. Furthermore, some of these leaders have stated that if their patronage dividends were subject to taxes they would lower their prices to their customers by the amount of the patronage dividends and so avoid the question of the taxability of such amounts.

The adoption of such a practice of price reduction wherever the return is higher than needed for stockholders' return would be in line with the practice of the business corporation which reduces its price under the same conditions. The direct lowering of the cooperative selling price rather than the payment of patronage dividends would, as a matter of fact, make for fairer and more straightforward competition and a clearaer demonstration of the relative effi

For the opposite, or "legalistic" view, see Bradley, W. L., "Taxation of Cooperatives." Harvard Business Review, xxx: 576 (Autumn 1947):** The right to exelnde patronage refunds from gross income in the determination of the taxable net income of the taxable entity is not a matter of statutory right but rather solely one of contractual right, recognized by the courts whether an organization be set up to function as an agricultural cooperaive or to serve the needs of strictly proprietory commercial organizations."

4104 Fed. (2d) 460 (Circ. Ct. App. 2, 1939).