Tax revision issues, 1976 (H.R. 10612)


Material Information

Tax revision issues, 1976 (H.R. 10612)
Physical Description:
United States -- Congress. -- Joint Committee on Internal Revenue Taxation
United States -- Congress. -- Senate. -- Committee on Finance
U.S. Govt. Print. Off. ( Washington )


serial   ( sobekcm )

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aleph - 25878813
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Table of Contents
    Front Cover
        Page i
        Page ii
    Table of Contents
        Page iii
        Page iv
    1. Investment tax credit
        Page 1
        Page 2
        Page 3
        Page 4
    2. Investment credit in the case of movie and television films
        Page 5
        Page 6
    3. Electric utilities
        Page 7
    4. Capital cost recovery
        Page 8
        Page 9
        Page 10
        Page 11
        Page 12
    5. Integration of the corporate and individual income taxes
        Page 13
        Page 14
        Page 15
    6. Corporate surtax exemption and tax rates
        Page 16
    7. Employee stock option plan
        Page 17
        Page 18
    8. Net operating loss carrybacks and carryovers
        Page 19
        Page 20
        Page 21
    9. Personal savings
        Page 22
        Page 23
        Page 24
        Page 25
        Page 26
    Back Cover
        Page 27
        Page 28
Full Text
f s F .*


(H.R. 10612)






APRIL 22, 1976









Introduction ------------------------------------------------------ 1
1. Investment Tax Credit------------------------------------------- 1
2. Investment Credit in the (C:isc of Movie and Television Films------- 5
31. le.tric Utilities ------------------------------------------------- 7
4. Capital 'Cost Recovery --------------------------------------------- 8
5. Intt-grition of the Corporate and Individual Income Taxes-------- --
0. Corporate Surtax Exemption and Tax Rates------------------------- 16
7. Employee Stock Option Plan--------------------------------------- 17
8. Net Operating Loss Carrybacks and Carryovers---------------------- 19
9. Personal S:Ivings ------------------------------------------------ 22

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This pamphlet presents background information with respect to a
variety of tax policies which would be beneficial to capital formation.
This includes provisions contained in the House-pas-('cd bill (IL.R.
10612) but is not limited to them.
The matters discussed here include the inves-titient credit both (en-
erally and as it applies to motion picture p)ro(iucctolsls, policies to
encourage capital formation in the case of electric utilities. I precia-
tion and other ways of recovering capital cost, the possible integra-
tion of the corporate and individual income taxes, thlie irooposed
increase in the corporate surtax exemption and the effect of (cor)orate
rate reductions, possible incentives to encourage employee stock own-
ership plans, possible modification of the net operating lo-s carry-
backs and carryovers, and, finally, various proposals for encouraging
personal savings.
In each of these areas the pamphlet describes present law and tlhe
issues presented. Where the House-passed bill contains provisions in
the area referred to, these also are described briefly.

1. Investment Tax Credit
P,'e.r Pt Lav
Present law provides a 10-percent investment cred(lit for thlie period
beginnings January 22, 1975. and ending D)eceliber 31. 1976. (For the
period when the basic rate is 10 percent, a corporate taxpayer may
elect an 11-percent credit if an amount equal to tlhe additional one
percent is contributed to an employee stock ownership plan.) There-
after, the rate is to revert to 7 percent (4 percent with respect to
certain public utility property). The investment credit is available
for: (1) tangible) personal property; (2) other tangible Ip)roperty (not
including a building and structural components) which is an integral
par't of manufactiu'ing production, etc.. or which constitutes a re-
.,arch or storage facility: and (3) elevators and es',alators. (Geiie1rallyi
the credit is not available with respect to property 1u-,d outside the
1 united( States.
To be eligible for the credit, the property nnust )be dep)receill prop-
erty with a useful life of at least 3 years. Property with a uiseful life
of 3 or 4 years qualifies for the cre(lit to the extent of one-thir(l of its
cost ; property with a iiseful life of 5 or G years qualifies will re- ict
to two-thirds of its cost;: and property with a u:efufl life of 7 years
or more qualifies for the credit to tihe full extent of thle property's cozt.
(Iowever, in the case of u-ed proIp)erty, not more than K )0.000 of
cost may be taken into account by a taxpayer as qualified investment
for purposes of the credit for a taxable ytar. For 1975 and 1 0)76. tlie
.50,000 limit is increased to $100.000.)

G,'(IIilt, iIv. prope-ty 1..,i,., eligible for tile cre it when it is ;lliced
in rvie. e invest 'iit tcred lit is aiso av aila,1 d before tlie propei'ty is
p1;, 1 in s4trvIi,.. as proI s.- ex d tlditu Ires air made.
Tli- a 11i:)011 t of te cn'dit that a taxpayer may tale in :ilny owll year
<';l11 ,lt X'-et'ti the first $J.4 000) of tax liability (as otherwise co,'-
pute(l) pl1 0- O p1en-vnit of the lax lia1ility iin cx'ess of 225.0(). Nl1-
vi.'.t :uent credits which lI ,,.avse of this limiitation cannot be used in 11w
ki9.t V 11r 1aV be caN ried 1Nick 3 taxablie years and then carried
forwa'rdl 7 taxalde years and used in those years to the extent pernfis-
sible within. the limitations applic able in those years. (In the case of
public utility property, tin' 50-percent limit is increased to 100 percent
for 19.)7 a(nd 1976, 90 percent for 1977,. SO percent for 1978, 70 percent
for 1979. and 60 percent for 19SO.)
Pre-ent law provides for a recapture of the investment. credit to
the extent property is disposed of before the end of the period (that
i-. --5. -7. or 7 or more years) which was used in determining the
amount of the credit originally allowed. In these cases the. tax for the
current year is increased (or unu.ed credit carryovers are reduced) by
the reductions in investment credits which would have resulted if the
credit were computed on tlhe basis of the actual useful life of tile
property rather than its estimated usef iul life.
Public utility property to which the 4-percent investment tax credit
i+ to apply after December 31, 1976, is property used predominantly in
tfle trade or business of furnishing or selling (1) electrical energy,
w;ter., or s.-wage disposal services, (2) gas through a local distribution
s..'tehm, or (3) telephone service, telegraph service through domestic
telegraph operations, or other communications services. In general.
the reduced credit applies only if the rates for these services or items
are established or approved by certain types of governmental regrifla-
tory bodies.
With respect to the treatment of the investment credit of regulated
companies for rateinaking purposes, special limitations are imposed
on the allow-ance of the credit to prevent the tax benefits of the credit
from immediately being passed on to the consumers. These limitations
are applic-able to property used predominantly in the trade or business
of furnishing or selling (1) the products or services described in the
preceding 1p,.ragraph and 2) steam through a local distribution sys-
tem (or the transportation of gas or steam by pipeline, if the rates for
those bu-inesses are subject to government regulation.
i The Qpecial limitations generally provide that the investment credit
is not to be available to a company with respect to any of it? public
utility property if any part of the credit to which it would otherwise
be entitled is flowed through to income (i.e., increases the utility's
income for rateinakiig purposes) ; however, in this case the tax bene-
fits derived from the credits may (if the regulatory commission so
requirve-) be, used to reduce the rate base, if this reduction is restored
over t-., u.-e-ful life of the property.,
1 If. within 90 irdays after enactment of the Tpvenue Act of 1971 the taxpayer has so then the investment credit Is to be avnilahle to the taxpayer with respect to
anv of its public utility Jproporty if the credit to which it wolidl otherwise he entitled
is tiwovl 1hr,'h'ii to 1Ino'le ratably over the iioo"lu life of the property ; however, In this
ease ,h'.ri, must not be n:v adjustment to reduce the rate chase An additional eleetirp
rule was prov1,il to permit certain tyvp..4 of utilities (primarily electric utilities) to
lmme.' :it,1 tIliw thiro'-icli lbonfit, to consumers. Iminpedliate flow through is permittld
In ,ltnatioI s whI rr- tlie 1i benlefits of accelerated diir.c'iation rules enacted under the

The rules with respect to the additional investment credit for 1975
and 1976 generally follow those for the 4-percent credit, as enacted in
As noted above, the investment credit lhas just been increased from
7 percent to 10 percent until the end of 1976. The objective of the
increase was to increase capital investments in plant and equipment
in a manner that would complement the stimulus provided to con-
sumer spending. Related to this is the fact that there is a large amount
of unused capacity in most industries. Business may accordingly be
hesitant in view of this unused capacity to plan significant new out-
lays for plant and equipment. However, there usually appears to be
a lag in the impact of the investment credit. In fact, there is some
evidence that the effects of the 1975 Act are beginning to be realized.
Also, while the effects of the credit may be modest so far this year, it
may be that in the absence of the credit, real investment would have
fallen even further.
.Effectieerss of the investment credit.-There is some question
about the effectiveness of the investment credit as a stimulus to invest-
mnient. In part, this stems from the difficulties of isolating the particu-
lar cause of an increase in investment at a particular phase of the busi-
ness cycle. At the trough of a recession, interest rates tend generally
to be low, and the availability of more favorable financing in part may
explain why investment usually rises during a recovery. Also, as the
economy begins to recover from a recession, corporate profits usually
rebound as a result of higher worker productivity levels. Improved
internal cash flow will also then increase investment.
Diagram 1 displays quarterly new orders for general industrial
machinery over the period 1962-1975. Quarterly new orders grew
rapidly in the fourth quarter of 1962 and then rather modestly in
1963. After liberalization in 1964, new orders grew more rapidly. The
short period of suspension of the credit evidenced a rapid decline of
new orders in the last quarter of 1966. Reinstatement of the credit
seems to have halted the decline, although it was not until late 1968
that new orders for general industrial equipment grew rapidly again.
Repeal of the credit in 1969 witnessed a drop in quarterly orders until
1971. New orders rose for the first three quarters of 1971. However,
there was a short decline in new orders after the effective date of the
1971 credit. This mnay reflect the po-sibility that business delayed new
investment until the credit was enacted even though its effective date
was made retroactive. The experience in 1975-76 may parallel the 1971
Compositional aspects of the r-idit.-Provision of the investment
credit not only may affect the aggregate level of investment, but also
in certain circumstances the composition of investment as well. As the
Tax Reform Act o:' 1969 are flow,-1 through to consumers. This election was provided
in re'iigidtion of the special competitive conditions under which a company subject to
the accelerated depreciation flow-throiilh rules was opwratin'rz. A special election is pro-
vided with respect to local steam distribution 4ys.t,.*is and or steam pipelines where
the rgiilatory *' ,ly involved dfetermined that the natural domestic supply of *z.a or steam
wvas lisutticipnt to meet the present and future requirim,-nts of the domestic economy. In
this case, if the taxpayer elected (within 90 days after enactment of the Revenue Act
of 1971) the investment credit Is not to he available unless (1) no part of the credit is
flowed throiuh to income, and also (2) no part of the credit is used to reduce the rate
m se.

cr'r, lit imnrea.-es the ret uirn ion investment, it alters choices for certain
, ro. il tllt1 enmol()yv thlat will not, illn general. 1)enllefit frmIn the credit
Jori example, the ('tedlit miay iiduce blisiness to switch froi-u investment
in --t mlet ire(s. which d() not qualifv for the credit, to investment in
ImIaclhilIVry atl1d ,eqlipenCilt which does qualify.
Ano(thrll, cOmp )siti(olial aspect of the cr('edit involves its utilization
by different ini lt ries. The overall objective of tlie credit is to stimu-
late investilment. A related objective may be to stimulate investment
in tho.-e areas of tle economy that are particularly depressed or those
areas where subsequent bottleneckls due to capacity limitations are en-
visio(led. If this second olbjective is to be pursued. (consideration could
hei given to the possiility of providing different credits across in(us-
t ie:. or credits that vary by geograpl hic arVIa.


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For example. it is scretines airgue that the current uniform credit-
(lo's not provide ti e stimulus to those areas oi greatest nnee. In thais
view, a credit bhse l in part on the level of unemployment might e be
1 iset,, to achieve natijon'al goals. Ab~o. it has beeii argue( that pa rticuhu r
inmhistl'ie~s which fa,'t, unusual capital reqiiiireiH(',its need g,'eater in-
-v',-t,,,ent ere(lits than industries in, ire,,eral. A diifculty with s,,eh dif-
f(,reiitti ate 1 iniX('tI tli.,t cred 1its is titLit suc'h diiftlenI'",es 1,~asedl on unem-
l 'loy i~ent ,a(, in 1'artieular geographic a r,,ts, or on mnemb~ership of a
fint, iH a. l)j,,ticular i]iMltitry, could be quite (hilicult to iNeastit'e. To
t lie extenlt the inlv(.-t i,,ent credit 1 )st,,l 0on unfeml)loyneJ~t, or nIefll)er-
ship in an ind,,stry iiiateri;illy differed from the general investment
credlit, hi,',- ,, iy attempt to modify the definitiot,.s to I)enefit from
suc(Ih credits.

Timing of crledt.-Periodic review of tie investment credllit can
create uncertaintyV iii the bsins i ome (0111111111lity wich in tIrn caill aI -
versely affect the impact of tle credit. If bIIsiness correctly allticipates
the direction of the chaline in the credit, substantial tax 1advaIIta(ires
may be realized. In the last 13 years, 7 decision S (appIroximately Vlne
every two years) have beeli malale wilichli l:ve altelred tlie provisions (oI
tlie credit. Such alterations liave I)eeli in *reslpo 1eL-c to cLangllnlg eco-
nomic needs to moderate or expand inivc-tn-clilt. lI oweveIr, to tlie ex-
tent such corrective action is in response to an econ'loi0lic p)roblcli, final
action when coupled witi tlie iagget(ed "multiplier" effects of tlie credit
nmay not provide the renmedial I action necessary, I)aIt rathler create exces-
sivre stiinmuluis to investment demand. ()ur currentt position in tle re-
covery may typify such a situation. There is evidence that tlhe recov-
ery in the third and fourth quarters of 1976 wivll be reasonal)v troVi2.
It would seemin likely to expect that tlhe c(rrelnt provision of tlie 1i(-
lpercent credit in 1976 coupledd with rising aggregate ehmand woild
encourage substantial new levels of investment. The steel industry hIas
already announced substantial investment plans for this year.
House Bill
Under the House bill, an increase in the investment tax credit from
7 to 10 percent (from 4 to 10 percent in the case of certain public+
utilities) was provided through I)ecember 31, 1980. In addition, the
]imitation on qualified investment in used property was increased
from $50,000 to $100.000 for taxable years beginning g after Deceni-
ber 31, 1974, and before January 1, 1980.

2. Investment Credit in the Case of Movie and Television Films
P,','^nt law
hnder present law, taxpayers are entitled to receive an investment
credit for tangible personal property which is placed in service by tlhe
taxpayer. Currently, the credit is allowed at a 10-percent rate, but
is scheduled to be reduced to 7 percent beginning in 1977. As discussed
albove, in order to receive a full credit, tlhe property must have a useft'ul
life of seven years and, in addition, there cannliot be any lre(loiinaliilit
foreign use of tle pr'oplerty during any taxable year, or lie propellVty
will cease to qualify as section 38 property.
Prior to 1971, it was not clear whether (and if so, under what ,oil-
ditions) the investment credit was available for movie or tele-visii
films. A court case held that movie films were tangible personal prop-
erty eligible for the investment credit. In tlhe Revenue Act of 1971,
it was made clear that motion pictures and television films are to be
treated as tangible personal property wlichl is eli g'ille for tlie invest-
ment credit. However, this issue is still being litigated for years prior
to 1971, and there still are a number of unsettled issues, suilc a( l how
to determine the useful life of a film, tile basis on which tle credit is
to be computed, and how to determine whether there lias been a
predominant foreign use of tlhe film.
IDue t h
Due to the uncertainties of pre-ent law with r,-'pect to tlie qe-t ions
of useful life and predominiiiant foreign !-., it is often difliciult to


deteN'mJilLe whether a film i- en titled to a full (7 or 10 percent) credit,
a partial one-tlhird or I wo-thirds credit, or, possibly to no credit. It.
wonld ah pear des-irablle to clear up thellse i.-Iues. in order to avoid
4,1st ly lit iLgat ion with repect to tile past, and to allow accurate inve't-t
menlt planini.,ge for ti le inovie industry min future years.
Tims. for tlhe past. it mighilt be desirable to resolve these two
i-u- Oil ,-om roe arC( Illdle hsis. In addition, since the major l)purpose
if tlhe inxvestlient credit is to create j,1bs in their UnIited States, sole
have sIgested that it bilt be desiralble to provide that. for thlie future
the a',,1 it of the investiicment credit in the case of movie films will
depend foreign), rather tha onl the place where revenues are received for
showinft the film.
HIo,.,., Bill
Under the House bill, different methods would be provided to deal
with the problems of the treatment of the investment credit for mo-
tion pictures and television films for the past and for the future. For
the pist. one of two alternatives would be available. A taxpayer under
the first method (in most respects the IRS litigation position) would
be eligible to receive the full credit (or any partial credit) for their
films if it is demonstrated on a film-by-film basis that the film satisfied
both the useful life requirement and the requirement that there must
be no predominant foreign use. The useful life of the film would be
treated as ending at the end of the first year in which for depreciation
purposes it was estimated that 90 percent or more of the depreciable
cost of the film would be recovered. A film would be treated as used
predominantly in foreign markets if, in any year (and not on a cumu-
lative basis), more than 50 percent of the gross revenues from the film
resulted from showing the film abroad.
A second alternative method may be elected by a taxpayer for all
years prior to 1975 (for which an investment credit was available)
or only for years prior to the reenactment of the investment credit on
August 15, 1971. Unless the 40-percent method described below is
elected for all years prior to 1975, unused investment credits may not
1e. carried over from years in which this method is used to any sub-
sequent years. Under this second alternative, a taxpayer may elect to
take an investment credit on the basis of 40 percent of the cost of all
his films without regard to the estimated useful life of the film and
also without regard to whether the film is shown predominantly out-
side of the United States. The credit would be based on the total costs
of production, including capitalized production costs, a reasonable
allocation of general overhead costs, salaries paid to the actors and
production crew, costs of "first" distribution of prints, and the cost of
thle. story being filmed. The cost for this purpose would include so-
called "residuals." but in the case of participation with respect to
actors or others, it would include only those which are guaranteed.
Films such as news features which are essentially transitory in nature,
as well as films which are produced and shown exclusively in foreign
countries, would not be eligible for the credit.
In addition, any taxpayer who has received final judgment on his
entitlement to the investment credit for any prior year may elect
to have his right to the investment credit for all years beginning prior

to January 1, 1975, determined under present law. as interpreted lby
the courts, rather than by any of tlhe alternatives .set forth alove.
For future yei ars, taxpayers could elect to take an investntenit credit
on a two-thirds basis for all films (i ns.lcad of determining uisefuil life
on a film-by-film bal-is). The availability of the investment ,.';dit in
this case would not depend on whether thie ilmn was predoininantly
used within the United States or in foreign countries; instead, it would
depend on where the film is produced, rathller than where receipts
are derived from the showing of the film. Films, such as news features,
which are essentially transitory in nature, would not be included in
the base on which the two-thirds credit is comlulted.
If 80 percent or more of the direct production costs of a filml are
incurred in the United States, a taxpayer would be entitled to an in-
vestment credit on the same cred(lit base as indicated above umder the
40-percent method with respect to prior years, except tlat thlie credit
base would not include direct expenses for foreign production or for
salaries paid for services performed abroad (unless the salaries were
paid to U.S. persons and were subject to U.S. tax). In determininilg
whether this 80-percent test is met, only direct costs of production
would be taken into account. (Overhead costs and the costs of screen
rights, for example, would not be taken into account.)
If less than 80 percent of the production costs are incurred for U.S.
production, a taxpayer could still receive a credit to tlhe extent of
direct U.S. production costs. The credit base in this case would not
include such items as general overhead costs or cost of acquiring screen
rights or any costs of foreign production except for salaries paid to
U.S. persons subject to U.S. tax.
This two-thirds method may also be elected by taxpayers for all of
their section 50 property (generally property placed in service after
Augu-st 15, 1971).
The investment credit for films would be available to the persons
wlbo bear the risk of loss if the film is not a successful picture. This
rule would apply under any of the alternatives set forth above.
3. Electric Utilities
The electric utilities industry faces several problems that reflect its
unique role in the economy. Among major industries, electric utilities
are the most capital intensive per dollar of revenue raised. The rapid
increase in oil and coal prices has substantially increased the operating
expenses of electric utilities. Because the industry is regulated, those
utilities that are not allowed to pass on increased fuel costs automatic-
ally have experienced substantial lags recouping those increased
costs through increased rates. In addition, high interest rates, re-
flecting in part the deteriorating financial position of the utilities
and in part increased expectations of long-term inflation, have ad-
versely affected the utilities industry by increasing their costs and
pushing some utilities to the maximum debt-equity ratio allowed by
State law. However, consumers and regulatory bodies have strongly
resisted the increased rates necessary to reflect these higher costs if
current investment plans are to be maintained. As a consequence, the
financial stability of these utilities has been adversely affected.

A- t110 Pace of inflation moderates, the regulatory process may be
:;1lc to allow appropriatee rate increases on a llore timely basis. Ov'er-
l;aul of thle re,'gulatory process is occurring in many States. as well as
innmovatio-; in su o)eratigr procedures as peak-load pricing. In the
Iiea ntilm,.e, however, there lha- been a substantial deferral of new in-
e-t-fient in nuclear and (l coal-powered generating plants, which may
re-ilt iln -apacity li miitations in thle foreseeable future.
In view of the dralmati' chianies in the relative prices of fuel which
:re i-ed by elect ric utility plants to .generate electricity, questions may
1be r:i-ed about tlhe ability of such firms to make the very substantial
capital inve-4stents. As alrea(ldvy noted, many are unable, because of
their current debt equity ratios, to utilize further debt to finance these
1,e-,arv capitall projects. On the other hand, their depressed profit
situation Ia^ limited their ability to raise new equity.
The dlitciulties in the sale of new equity in part reflects the fact that
divided( payments on outstanding stock are made from after-tax
income. WAlen dividends on outstanding stock do not grow or are. in
fact. reduced, market reaction to new equity issues is likely to be un-
favorable. The difficulty utilities have in raising dividends reflects the
difficulties they have in obtaining rate changes.
Another problem which electric utilities have is that their new
plants must be subject to substantial environmental regulation. Also.
existing facilities must comply with such regulations. Due to the capi-
tal intensive nature of the industry, these problems have accentuated
thle utilities' need for further capital.
Because electric utilities are so capital intensive, and because the
construction of new facilities is particularly lengthy and time-con-
suming, the 5-year phase-in requirement to obtain the benefit of the
investment credit for "progress payments" may be too slow to properly
encourage the construction of new facilities.

4. Capital Cost Recovery
/)'*-< f Lowi
Depreciation. Allo,,',ce.
linder present law, a taxpayer is generally permitted to claim de-
p'eieitionl allowances for property used in his trade or business or
held for the production of income under any of the following zg methods:
(1) 'Ie I-traight-line method of depreciation results in an equal
annual expense clhargre for depreciation over an asset's useful life.
(2) The 200-perient declining balance method of d(lepreciation.
more commonly referred to as double-declining balance, allows a rate
equal to twice the stnrajiglt-line rate. The declining balance rate is ap-
plied to the unrecovered cost. i.e.. cost less accumulated depreciation
for prior ta xa1ble yea ].-. Si nce the depreciation base is reduced to reflect
prior depreciation, the amount clailied as depreciation is greater in
a1.;1lier years and de'.line- in each succeediTg year of an aset's useful
(8) Thle .-\m of the yena v- digits method of depreciation is compl ted(l
u--in" a fraction tlhe numer'ator of which is the years' digits in inverse
o'vder an ,1 the dleinomina itor of which is the sum of the numbers of years.
A- in the case of the declininin balance method, the :lmual deprecia-
tion i- 2'I ge'ter in earlier ymd''- ad e(l lines in each .-tcceeding year
of an ;!-t s u-seful life.

(4) Any other consistent method of produc11in1 a1n liafulal deprecia-
tion allowance, which, when added to all allowances for the period
beginning with the taxpayer's use of the property includingg tle tax-
able year), does not exceed the total depreciation allowwa1 ces whlich
would have been taken during the first. two-thirds of the useful life
of the property had the double declining," bifilance itethod been used1.
Both the double declining balance method and the sunm-of-the-years-
digits method are accelerated depreciation in that they permit the tax-
payer to take relatively large depreciation methods deductiolis inI tlie
early years of the asset's iuse and lower depreciation in the later years.
This is generally advantageous to the taxpayer since an accelerated
method of depreciation permits him to recover his capital costs more
quickly than the straight-line method of depreciation.
The 1969 Tax Reform Act limited thlie use of rapid depreciation
methods in the (case of certain real estate because the use of these meth-
ods made it possible for taxpayers to deduct amounts in excess of those
required to service the mortgage during the early life of the property.
Under the 1969 Act, new residential housing continued to be eligible
for the double declining balance or sumn-of-the-years-digits deprecia-
tion methods. However, new construction other than residential hous-
ing was limited to 150 percent declining depreciation. Used realty
(other than used residential property) acquired after July 24, 1969f,
was generally limited by the 1969 Act to straight-line or a comparable.
ratable method of depreciation. Used residential property was a useful
life of 20 years or more, acquired after July 24. 1969, was liniited to
125 percent declining balance depreciation.
Prev:-ent. law also allows taxpayers acquiring personal property for
use in a trade or business or for the production of income, an addi-
tional first year depreciation allowance amounting to 20 percent of
the co4t of the property. This extra first-year allowance applies only
to the first $10,000 of the cost of property ($20,000 on a joint return)
placed in service in a taxable year.
The depreciation allowances that are taken in a specific case depend
in large measure on the useful life of the a'-:et. Before 1962, business
firms depreciated their property in terms of useful lives that were
established for several thousand different classifications of assets (so-
called Bulletin "F" lives). The guideline lives for depreciable assets
that were put into effect in 1962 consolidated assets into about 75
broad asset classes and also shortened prescribed lives by up to 30 or
40 percent. The 1962 guidelines also established the use of industry
classifications as distinct from classifications by type of assets.
The lives selected for use under the guidelines were determined by
reference to the useful lives claimed by the taxpayers surveyed. Gen-
erally, the lives selected were the useful lives being claimed by tax-
payers at the thirtieth percentile-that is, 29 percent of thie a-sets had
shorter lives anid 70 percent had longer lives.
The guidelines also contained a reserve ratio test which wNa designed
to assure that taxpayers would not be permitted continually to de-
preciate their asf-sets over a period of time substantially shorter than
the period of actual iicse. Basically, the reserve ratio te-t assumed that
the actual useful life of assets could be determined by comiparini
the amount of depreciation reserves to the acquisition co-tf of the
assets being depreciated. A built-in tolerance was contained in tlhe


re':erve ratio t.-.t to :.sslr'e it tlie te.t would be met. in the cases of
It:iJp:lcr-. dpreeiatinir their a tsets at a rate not, more than 20 percent
f-tea r I ill tithe period o()f their actiial use of such assets.
The ;ipplic;ition of tHi reserve ratio test was initially suspended
for three v e:iar.. In 1r.';., t lie reserve ratio test was substantially modi-
fied :1 nl new transitional rules were added which had the effect of
further deiaviliir the application of the test, in most cases, until about
1971. When the ITrs,.is.ry De )artment by regulation adopted its asset
depreat ion range stem ("ADW) in early 1971, it completely
eliminated the re-erve ratio test for 1971 and future years.
Tih Revenue Act of 1971 enacted into law the ADR system with
modific,.itions. Under this Act, the Internal Revenue Service may per-
mit depreciation lives within the range of 20 percent above or below
the class life where taxpayers elect to use the ADR system. The Act
:il-.() provides a unified system of class lives which may be elected by
taxpayers for assets placed in service after 1970.
Rapid 5-year amortization
In the Tax Reform Act of 1969, four provisions were enacted to
make available a special 5-year amortization as an incentive to make
certain investments. The types of investment made eligible for rapid
amortization include (1) rehabilitation of low and moderate income
housing, (2) pollution control facilities, (3) railroad rolling stock,
and (4) certain coal mine safety equipment.
In general, rapid amortization was made available as an alternative
to tlhe investment, tax credit that was repealed in the 1969 Act. Each
of the types of investment eligible for rapid amortization was con-
sidered important to the success of an existing national policy. When
the investment credit was reenacted in 1971, Congress specifically
provided that the investment credit and rapid amortization both
would not be available for the same investment. A taxpayer may elect
either the investment credit or rapid amortization.
Anwort;z'twt on and Depreciation of Railroad Bores and Tunnels
Domestic railroad common carriers may amortize railroad grading
and tunnel bores that were placed in service after 1968 over a 50-year
period on a straight-line basis. This amortization deduction is in lieu
of any depreciation or any other amortization deduction for these
grading and tunnel bores for any year for which the election applies.
If the taxpayer elects to use this provision, it applies to all railroad
gra1(inz and tunnel bores qualified for this amortization, unless the
Secretary permits the taxpayer to revoke the election. The 50-year
amorti;'ation period begins the year following the year the property
i.s- plaeeil in service.
Railroad Urading and tunnel bores, for which the 50-year-amortiza-
tion ded(huction is available, are all improvements that result from
ex(a\V1ations (including tunneling), construction of embankments,
cl( irinrs, diversions of ro:-(IS and str,,eams, sodding of slopes, and from
si il ar work. ne',-.-a ry to provide. construct, reconstruct, alter, protect,
improve, replace or restore a roa(ldbed or right-of-way for railroad
track. Expenditures incurred from such improvements to an existing
roadbed or railroad riaht-of-way are treated as costs incurred for
property played in service in the year in which the costs are incurred.
Tlhe railroad industry, uses for tax purposes what may be called
Stie "retireni ent-replacement" method of accounting. For assets ac-

counted for under the retirement-reIl)Iacenicnt method, no ratable de-
duction for depreciation is claimed and no depreciation reserve is
maintained. In the case of railroad track and ties, when new track is
laid, the costs (both materials and labor) of the Itrack and ties are
capitalized. No depreciation is claimed on tlhe original installation, but
when the ori finall track or ties are replaced in later years with track
or ties of a like kind or quality, the costs of the replacements (both
materials and labor) are deducted as current expense. This rule ap-
plies, for example, when wood crossties are replaced with new wood
ties. When the replacement is of an improved quality, it is treated as
a betterment, under which the betterment portion of thie replacement
is capitalized and the remainder is expense. For example, if 80-pound
rail is replaced with 100-pound rail, the cost of the 20-pound better-
mient portion is capitalized and the cost of the 80-potund replacement
portion, less the salvage value of the recovered rail, is charged to ex-
pense, along with all labor costs incurred in the replacement.
A replacement with a different or improved type or kind of track
or tie will, on the other hand, be treated as a retirement and sub-
stitution. Under this procedure, for example, when existing wood
railroad ties are replaced with concrete ties, the Service has held (in
(Rev. Rul. 68-118, 1968-2 Cum. Bull. 115) that this replacement con-
stitutes a retirement and substitution. As a result, the material and
labor costs for the new concrete ties are capitalized and the costs of
the old wood ties are removed from the asset account and expensed.
Diffe ie iet views regarding present depreciation allowances
Questions have been raised about the adequacy of capital recovery
allowances. Some hold the view that present capital recovery allow-
ances are not adequate and interfere with the efficient operation of the
economy. Others maintain that capital recovery allowances are too
generous in a number of respects and, as a result, permit some busi-
nesses to secure undue tax benefits and provide inducements for the
creation of tax shelter devices.
In general, those who hold that present capital recovery allowances
are inadequate maintain that this inadequacy is responsible for
declines in the ratio of corporate profits to gross national product
which have occ;irred in recent years. They particularly stre-s the
fact that the recent inflation has moved up the prices of capital goods
sharply and that present capital recovery allowances which are based
on historical costs do not fully allow for the replacement of the real
value of the assets concerned. The result, it is claimed, is that capital
formation is retarded and economic growth dampened. Another
frequently expressed view is that the United States capital recovery
allowances are substantially less favorable to business than capital
recovery allowances in foreign countries, producing competitive dis-
advantages for our businessmen vis-a-vis foreign competitors, and a
slower rate of economic growth for the United States as compared
with foreign countries.
Adjustments for binflation
Capital recovery allowances are an important source of saving for
the economy. Corporate capital recovery allowances, for example, now
account for roughly about two-thirds of total gro-s business savings


Iwvbih also inucluldes nudi-strilhted profits) and about 45 percent of
the total rIOS private S:vinglfS of businessess and individuals.
Tn dollar term-. capital recovery allowances are increasing. Capital
r.COverv allfowfe1,Ws air now rIllglnit at n annual rate. of al)iout :S"
li1 on;1i,,:1zt twi,.e tl1 le 19;7 level. However. since sluchl recovery
:illow:N es aIre 1,ased on the historical costs of tlhe assets concerned.
tihe do riot make any allowance for the effect of inflation. One recent
-'i dv finds thit capital recovery allowances would have liad to he
iiic,':,:d .1 5 billion in 1974 in order to adjust for inflation.2 More-
over, the impact of the current inflation on capital recovery allow-
ane,'.s c 1n 1e .-(-en from tlie fact that the price increases oc(ilirrinr in
1974 alone accounted for an estimated $7 billion of the total $15 1)illion
of indicated -hortfall.
The ( 11e.4tion of whether adjustments should be permitted for tax
PiPc1.'-^ in order to take account of inflation is one that applies to
areas besidtes capital recovery allowances. It has been argued that,
while the- fact that depreciation charges are not adjusted for inflation
Ilend.s to re-iilt in an overstateiment of profits, other factors should be
taken into consideration before concluding that such an adjustminent
should be I ladle.
Another alpec(t of this isCe is whether tax adjustments for inflation
sliould N, provided for business: as (compared with individual tax-
pavers. One view is that the need to increase productive capacity re-
qui(-Cs rialtinl such tax adjustments for certain business items, such
a.,, capital recovery allowance-. Others, however, maintain that it
would not be fair to provide tax adjustments for inflation to some
grou1)ps and not to others.
ELffr't on 1?v .Ftmelnt
A key que-tion is the effect capital recovery allowances have on in-
vestment in plant and equipment as well as on construction. Those who
have studied this question in detail have come up with different an-
swers. Some believe that tax policy has been highly effective in
changing the level and timing of fixed investment outlays. They also
find that tax policy has affected the composition of expenditures. More
specifically, they find that accelerated depreciation has resulted in a
shift aw:ay from equipmentt toward greater spending for structures
while the investment tax credit tends to shift investment away from
- tuctre.s toward equipment. As a result, they conclude thliat accel-
erated depreciation and the investment tax credit have stimulated tlhe
level of investment very substantially.3

The House-passed bill provides that taxpayers who have elected 50-
ye:ar amortization for railroad grading and tunnel bores placed iii
-Cervice after Decemlber ,1, 19.S, may include in that election railroad
gra.di .IIr aid tunnel bores placed in service before January 1, 1969.
The amiiot iztlble iasi- of pre-1969 grading and tunnel bores that were
aTcquired or :i-tructed after February 28, 1913, would be the adjusted
bai. of the property for determining capital gain in the hands of the
2 1. rr t eii, Txr.s for inflationi. William 'ellnnr, Kpnneth W. Clarkson and John H.
.Mroor. American Entr;ri., In-tituite for Policyv Re archli. Washingron. D.C.. pp. 27-29.
TI tv. Incenti, x ',i1l (C fiiafl Spc'ndinli, (Gary Fronimm, ed.. (Studies of Goveruim nt
Iill. in v. The Br( 1k iliis Institution. 1.;71.

taxpayer. Foir grladiiin and tunnel bores in existence on Febl'rllarlv ",
1913, tlhe ariortizable b:a sis would be that asceritailed I)y the liInterstate
Commerce Commiilssion as the lpioperty's cost of reprodliction new. i.e.,
the then current co'st o f reprlodliction. If the valilation wOl madeh I)y a
State regulatory agency -iat is the coilnterpalrt of the IJ(, the ad-
jiusted basis of the property would be thle value of the property oVri0i-
inally determined by the State agency (sec. 1701).
Under the Holluse passed bill, an exception would be mad(le to thle gen-
eral capitalization iiuies to re(qllre replaceilent, tr(';t, lment where a
domestic railroad, whiich i1.:(s tile retireient-replacement mlethod of
accounting for depreciationll of its riilro:Al trlck, acquiires and installs
replacementt ties wliich are not imadle of woo(l. As a result, current de-
ductions will be allowed not only where an existing railroatl tie is re-
placed by a tie of the same material and quality, as illunder present law.
but also where an existing tie is replaced with a tie of a differentt mate-
rial or improved quality. This will apply, for example, where exist nj
wood crossties are replaced with concrete or steel crossties.

5. Integration of the Corporate and Individual Income Taxes
P'.emsnt Law
Under current law, individuals may exclude $100 of dividends from
taxable income and families filing jointly may exclude $200 from tax-
able income. Corporations may deduct 85 percent of dividends re-
ceived from other corporations (in certain cases 100 percent). Sub-
chapter S corporations are taxed as partnerships; that is, partnership
dividends are taxed at the individual level after application of the
$100 (or $200) dividend exclusion.
I.s' es
The dual system of corporate and individual income taxes, which
taxes corporate income at the corporate level and again at the individ-
ual level when it is received as dividends, has been charged by some
with being deficient on economic efficiency and equity grounds. On
efficiency grounds, it is claimed to impose a double tax on corporate
income, and as a consequence to encourage capital which would other-
wise flow to the corporate sector to flow to the noncorporate sector,
resutling in a misallocation of resources. (This corporate-noncorporate
effect has been estimated to involve from .17 to .5 percent of GNP.)
On equity grounds, the present dual system of corporate and in-
dividual taxes is claimed to adversely affect recipients of corporate
dividends as compared to recipients of other income because the divi-
dend income is doubly taxed.
Also, the current deductibility of interest but not dividend paiy-
ments is generally thought to bias corporate finance in favor of debt
as opposed to equity. Most recently, the burden of debt on corporate
balance sheets has been pronounced annd integration of the corporate
and individual income taxes is offered as a p)o:ible source of relief.
This reflects not only the relatively depressed state of equity markets
4 See A. C. Harbo.rgor. "The Incidence of the Corporation Income Tax." Tir Jtournal
of Political Economnf, LXX, No. 3 and L. (X. Rosenl,'rr-. '' Tnxi-tlon of Income irn'm
Capital by Industry Group." (in Harberger and Bailey, editors), Theic Taxation of Incomec
from Capital. (Brookings, 1969)

1'it .-11.40 t0ie ipI)act of strilgenlt monetary policies, e.g., high interest

The dual system of taxing of corporate income may be illustrated by
the following r example: From $100 of corporate gross income, $48 of
,orporate tax is paid and $., remains and is available for distribution.
If thl hyiothet i'al dividend recipient is in the 30 percent bracket, lie
will pay $15.60 tax on the dividends he receives as well as the initial
-4 L ,f corporate tax which the corporationn in effect paid for him. His
1, ,l iOx Lill theii is s6,.30. Had he been taxed directly on $100 in-
.Wine. he would have paid 3',)0 in tax. The difference between $63.60
:ind s:', ($:3.G60), is then said to represent the extra burden of the
COlI)p Orate tax.
Table 1 provides illustrative calculations of the extra burden under
dividend payout and no payout assumptions. Under the payout as-
suIiiption, the extra burden of current taxation of $100 of corporate
inc,,me is $48 for the individual with no Federal individual liability
and $.14.40 for the individual in the 70-percent. bracket. Under the no-
payiict assumption, the excess burden is again $48 for the zero-tax rate
p)er'on and falls to zero for the 48-percent individual. Thereafter, for
individuals in tax brackets above 48 percent, the excess burden of cur-
rent tax law is negative. That is, they would experience a tax increase
uider integration.


Total tax burden
Complete payout of earnings No payout of earnings I
Current Current
t.Marginal tax rate in percent law2 Integration Burden law Integration Burden

0..-------------. --------------- $48.00 0 $48.00 $48 0 $42
14--------..............-------------------- 55.28 $14 41.28 48 $14 34
15 ....--------....------.....-------------- 55.80 15 40.80 48 15 33
16 ....--------. -----..--------------- 56.32 16 40.32 48 16 38
17.....---------. ------------------- 56.84 17 39.84 48 17 31
19---......--.---------.....-------------- 57.88 19 38.88 48 19 29
22-..-.....-----------------..----------- 9.44 22 37.44 48 22 26
25----..........--.------------.. ---------- 61.00 25 36.00 48 25 23
28-----------............--.---.------------ 62.56 28 ?4.56 48 28 20
32......--------------......-.....----.---------- 64.44 32 32.64 48 32 16
36 -..-- -----......------- 66.72 )5 30.72 48 36 12
39 ...... -... ------................... 8.28 39 29.28 43 39 9
4? ....-------------------.--------- 9.84 42 27.84 48 42 6
45-----.......------------...-------------- 71.40 45 26.40 48 45 3
48...---------------------------- 72.96 48 24.96 48 48 0
50 ....---------------------------- 74.00 50 24.00 48 50 -2
b3....................----------------------------...... 75.56 53 22.56 48 53 -5
55----------------------------................................. 76.60 55 21.60 48 55 -7
58...... ---------------------------- 78.16 58 20.16 48 58 -10
60 .--. -------------------------- 79.20 60 19.20 48 60 -12
6 ............................... 80.24 62 1.8.24 48 62 -14
64 ----------------------------............................ 81.28 64 17.28 48 64 -16
66 ----------------------------............................... 82.32 66 16.32 48 66 -18
68 -------------------.--------- 83.26 68 15.36 48 68 -20
69 ----------------------------................................. 83.88 69 14.28 48 69 -21
70..----------------------------....... 84.40 70 14.40 48 70 -22

I Capit:r gains t'-t; of retained earnings not considered.
SIgnoies SI,2 dividend exclusion.

Sev!. .' .. iii:ptions underlie this analysis. First, it is assumed that
thle. corpor.,te tax is paid by the corporation and ultimately by the
stocl,',o,,ir :a:(d not by consumers through higher prices and/or by
lN1;or trough lower wage's, second, it is assumed that corporate man-


ag ers reflect shareholder interest s-that is, there is no "corporate veil."
Third, it is assumed that the dividend distribution is complete. In
fact, dividend distributions do not always exhaust after-tax ear111nings.
To the extent dividend payout, is low, the increase in the firm's equity
should be reflected in higher stock prices. This appreciation through
capital value is particularly attractive because it allows higher income
investors to shelter their corporate income at the long-terin capital
grains tax rate rather than the rate on ordinary income.
With respect to the first assumption, that the sto(ckholders beoir the
ultimate burden of the tax, there is no widespread agreement on the
extent and direction of the shifting of the corporate tax. Sonie shift-
ing, to consumers and employees no doubt, occurs, and varies among
industries. Presumably, the extent to which the tax can le shifted de-
pends on the behavior of consumers, the extent to which i1 :,y colnpany
can influence tlhe prices prevailing in its indlstrvy, andtl t ie bairgail1in
power of the company vis-a-vis its employees. There would appear to
be a bdsis for grant in. tax relief on grounds of double taxation of divi-
(lend income to the extent that thle burden of thle corporate income
tax falls on stockholders and on the grounds that the tax is a discrimi-
natory excise tax to the extent it is passed on in prices.
There is another perspective on the corporate and individual taxes
which views the corporation and shareholder as related, but separate
entities. In this view, the corporation by virtue of its separate standing
and perpetuity under law, and the limited liability of it shareholders,
derives certain benefits which are the proper base for taxation. Also,
some maintain that separate taxes on corporations and individuals
favorably diversifies our tax base.
Integration of the corporate and individual income taxes involves
eliminating this possible double taxation of corporate income and
eliminating the bias toward debt financing. Integration ultimately
affects investment because elimination of the "double tax" necessarily
reduces taxes paid by corporations or by corporate shareholders, and
accordingly raises the rate of return on corporate capital. The in-
creased return to capital in the corporate area in turn induces addi-
tional physical investment until the return on the marginal investment
equals other opportunities, e.g., the market rate of intc:'e-t. However,
as a counterpart to the increased attractiveness of investment in tlhe
corporate area. the flow of capital to the noncorporate areas (e.g. hous-
ing and agriculture) would be smaller than under pri-ent law.
Questions may be raised on the extent to which this possible double
ta-.;a-ion of coriorate income can be alleviated. lnd(,r complete ute-
g'ration, dividends are taxed at the individual level and retail <" cor-
porate, earnings are attributed to corl)orate shareholders a1nd taxed at
the individual level. Thus, under complete integpiation, there is no
sepa;';:te corporate tax. Under partial integration, a sepai-rte tax on
corporate inconie is maintained, ald dividendss are taxed on!y once at
the individual level.
There are two approaches available to alleviate the double tax on
corporate income. Under the par'tnei ship method. no tax is levied at
the corporate level; all shareholders are treated as im)plicit recipients
of undistributed profits. Thus, each shareholder would include in his
taxable income his share of distributed and undistributed profits. Such

tax tre'atitielient cu rlenlitly exit.s for Subchapter S corporatiolls witlh 10
M f k'\V t kl p a rtnl eI l r s'.< .
Unlrder tilted partial integration aplproacllh. a separate tax onil cOrlporate
illcolle' i- m iainrtailned. anld dividlenlds- are taxed only once at the i idivid-
11:11 level. ID)ouble taxation of dividends is elimi late by either allowing
corporations to dedu' t dividenld paylients (as intere.,t paynllellts ale',
currently tretatld) or liy allowing taxpayers a cre(lit for tlie taxes paid
onT dividtwnd -i received. lnder the credit approachh, a taxpayer 'would
"Cruss-uI" I his dividend income to reflect, taxes, already paid at tie
corporate level, and take a credit for an equivalent anmoulit.
6. Corporate Surtax Exemption and Tax Rates
I Yc..' ut La I'
(orilorate income s ,1enerally subject to a normal tax of 22 percent
adIII a s:Iurtax of 2-'; percent, with tlhe initial $25.000 of taxable incomiie
exempt from the surtax. In the Tax Reduction Act of 1975 the surtax
exemption was increas-ed to $50,000 and the iiormial tax was reduced
to 20 percent on the initial $25,000 of taxable income. Both changes
applied only to the year 1975.
I.,'., 7 / ( ,
The increase in the surtax exemption in the Tax Reduction Act of
1975. was included in both the House and Senate bills. The Senate bill
included a provis-ion that reduced the normal tax rate from 22 per-
cent to 18 percent and increased the surtax rate from 26 percent to
',) percent. Thie 2-point reduction in the normal tax rate on the initial
$25,0)0U or taxable income was adopted in conference.
These tax reductions are generally viewed as attempts to provide
tax relief to small businesses. The increase in the surtax exemption
from $25,000 to $50.000 provides a tax reduction of $6.500 to all
corporations with taxable income above $50,000, smaller reduction to
corporations with taxable income between $25,000 and $50,000, and no
tax reduction for corporations with taxable income below $25,000.
Thus 24 percent of this reduction is received by corporations with
taxable income below $50,000. In the case of the 2-point reduction in
thei normal tax on. tlhe first $25,000 of taxable income, fifty-seven
percent goes to corporations with incomes less than $50,000.
Temporary reductions in corporate tax rates for small corporations
generally are not viewed as being as effective in stimulating business
investment as increases in the investment tax credit. When a corpora-
tion is considering whether to make an investment, it is concerned with
what the tax burden will be on the income produced by ithe investment,
income that is usually received over a long period of time. A one-year
reduction in corporate tax rates, therefore, has only a small effect on
expected after-tax rates of return, so it provides little stimulus to new
investment. A permanent reduction in corporate tax rates, however,
would increase after-tax returns over the life of a new investment and,
therefore, may be as effective at stimulating investment as an increase
in the investment credit.
A reduction in corporate tax rates increases the incentive to invest
only insofar as it reduces tlihe marginal tax rate; that is, the rate ap-
plied to additional income. For example, a corporation with taxable
income of -100,000 receives a s.Q.500 tax reduction as a result of the

increase in thle surtax exemption from S25.000 to 50.000. Each addi-
tional dollar of taxable income that the corporation would re. cive
froin a new investment, however, would still be taxed at :a 48-percent
rate, and it is this tax rate that the corporation will ise in calcillat-
ing" the expected profitability of a new winvestilent.
Increasinir the surtax exemption from $25,000 to $50,000 i'eiluces
the marginal tax rate for a corporation Vwhose income is between "
00) and $50,000. A corporation with income below S-25,0()00 receives
no tax reduction at all, while a corporation with income above $50,0)(00
receives a $6,500 tax reduction but experiences no change in thel tax
rate application to additional income. Since 3.7 percent of corporate
income is received by corporations with taxable income between 25
000 and $5,000 the increase in the surtax exemption is not likely to
induce substantial additional investment.
The 2-point reduction in the normal tax rate on thle first i-25.000 of
income reduces the marginal tax rate for corporations with taxable
income below $25,000, which receive 5.4 percent of corporate income.
but not for firms with higher income. This proposal is an efficient in-
vestment stimulus since most firms experience a reduction in their
marginal tax rate.
House Bill
The House bill increased the corporate surtax exemption from $25.-
000 to $50,000, and reduced the corporate normal tax from 22 to 20
percent on the initial $25,000 of taxable income (the 22-percent rate
applies to the second $25,000 of taxable income) for additional years.
through December 31, 1977.

7. Employee Stock Ownership Plans (ESOPs)
Present Law
Under present law, employee compensation paid in the form of em-
ployer contributions under an employee stock ownership plan (ESOP)
is treated as deferred compensation for tax purposes, that is, tlhe em-
ployee generally is not taxed on these employer contributions until
they are distributed under the plan.
ESOPs are generally designed to be tax-qualified plans. In order
to qualify, a plan must, for example, satisfy rules prohibiting discrim-
ination in favor of highly paid employees, and it must meet stand(ar(ds
relating to employee participation, vesting, benefit and contributtion
levels, the form of the benefits, and the. security of the benefit.-. Under
the tax law, if a plan meets these requirements, in addition to deferral
of employee tax on employer contributions the employer is allowed
a deduction (within limitations) for his contributions, the inconlme
earned on assets held under the plan is not taxed until it is distrilbuted,
special 10-year income averaging rules apply to distributions made i1,
a lump sum, and estate and gift tax exclusions are provided.
An ESOP uses a tax-qualified stock bonus plan or a compaiiy stock
money purchase pension trust.6 It is a technique of corporate finance
B A qualified stock bonus plan is required to distribute benefits in the form of employer
6 A pension plan which invests in employer securities, and uiini.r which employer con-
tributions are credited to the separate accounts of employees. An oimployee's benefits
uindter such a plan are las<,"l upon the balance of his account.

designed to 1)uild beneficial equity ownership of shares in the employer
corporate ion into its employees substant ially in proportion to their rela-
tive ill('iicoit'-, witllollt reqlipirilgl on their part any cash ,uitlay, any re-
dt1('tion in pay or other empl)loyee benefits, or the surrender of any
rights on the p);alrt of the Cen)loyees.
Under anll ESOP, an employee stock ownership trust generally
acquires stock of the employer with thle proceeds of a loan made to it
by a financial institution. Typically, tlhe loan is guaranteed by the
employer. The employer's contributions to the employee trust. are ap-
plied to retire thle loan so that, as the loan is retired, and as the value
of the employer stock increases, the beneficial interest of the employees
increases. Of course, if the employer fails to make the required con-
tributions, or if tlhe value of the employer's stock declines, the benie-
ficial interest of the employees declines.
Under present tax law, an employer is entitled to an additional per-
centage point of tlhe investment tax credit 7 (11 percent rather than
10 percent) if he contributes the additional credit to an employee
trist which satisfies thle requirements of the Tax Reduction Act. of
1975. Tlhe ESOP, which may be a qualified or nonqualified plan. must
satisfy special rules as to vesting,8 employee participation,9 allocation
of employer contributions,1 benefit and contribution limits,11 and
voting of stock held by a trust under the plan.12 The ve-ting, alloca-
tion. and rvoting rules are -enerally considered more favorable to rank
and file employees than tliose which ;re required for tax qualification.
7,y.s eGS
Several problems have arisen under the investment tax credit rules
designed to encourage the adoption of ESOPs. For example, because
the additional investment tax credit is only available for a short pe-
riod, many employers have not become aware of it in time to establish
an ESOP. This lag in recognition of the new provisions and uncer-
tainty as to hliow they would be applied probably accounts for tlhe
modest number of ESOPs established under the investment credit
rules.13 Also, because of the short period during which investments
may qualify for the additional credit, some employers have found
that the cost of establishlinz an ESOP under the investment tax credit
rules is unreasonably high in relation to the benefits of the plan. Addi-
tionally, because the economy has been depressed, some employers
have been unable to utilize investment tax credits available under the
usual rules, and the additional investment tax credit has not provided
an adequate incentive to encourage them to adopt ESOPs.
The investment tax credit recapture and redetermination rules are
another factor which lhas discouraged the adoption of ESOPs. Under
7'The additional credit is allowed with respect to qualifying investments made after
January 21, 1975. and before January 1. 1977.
s Each participant's right to stock allocated to his account under these rules must be
nonfor feltable.
9The ESOP must satisfy the same participation rules applicable to qualified plnne.
10 An employee who participates In the plan at any time during the year for which an
employer contribution is made Is entitled to a share of the employer contribution, bane1
upon the amount of compensation paid to him by the employer. Only the first $100,000
of employee compensation is considered for purposes of the plan.
11 The ESOP Is subject to the same benefit and contribution limitations applicable to
quaillfiPd plans.
12Employees must be entitled to direct the voting of employer stock held by the em-
plnvrp trilst.
.s of February 2S. 197r,. 30 applications were pending in the IRS for determination
letters with respect to ESOPs under the Investmnent credit rule.,. As of that date. one fav-
orable determination letter was issued under those rules and two cases were closed without
the i,,iuane of a letter.


tho-e rules, if a portion of the additional investment tax credit i- re-
captured or the credit redetermined by the Internal Revenue SefrviCe
to be a smaller amount than claimed, the employer inii-t b,0:1r thle cost
of repaying the excess credit; he caliliot recover it from the e:.iployee
trust under an ESOP.
Special problems have dis.,ouraged the adoption of ESOP.- by elec-
tric utilities. Publicly regulated utilities have been reluctant to e(-i ab-
lish ESOP's under the investment tax credit rules because they are
concerned that regulatory commissions will require that the additional
investment tax credit be "flowed-through" to customers. If the reLrila-
tory commissions take that position, the utilities will be. require(, in
effect, to pay out the additional investment tax credit twice-once to
the ESOP and then again to the customers.

8. Net Operating Loss Carrybacks and Carryovers

Pr; ,s.cnt law
Present law, in general, provides that a taxpayer is allowed to carry
a net operating loss back as a deduction against income for the .3 years
preceding the year in which the loss occurred and to carry any rn-ii:i: i-
ing unused losses over to the 5 years following the loss year. This
general rule enables taxpayers to balance out income and loss years
over a moving 9-year cycle, to the extent of taxable income in the 3
years preceding, and the 5 years following, any loss year. A net operat-
ing loss carryback results in a refund of income taxes to the extent that
the carryback offsets taxable income previously reported for the carry-
back years.

CHART 2.-Net operating lo-s carryback and carryover periods for different
categories of taxpayers.
~.yb C ~fg~gLoss
Ctrybark Ci6rsYovif Yzrs
'10 9 6 7 6 5 -4 -3 2 1 1 2 3 4 5 6 7 8 9 to011 12 13 14 IS
...---- \* \ \ r 'T~ T t_ { r i i t
GCenem : Ru!t "' -'. . "

len: 'rel b trf.?.ort alls "" " -
rct^tj'ted Tr.,nsporl Ian~o
r c 1"'3. ,iTrL aSto i ." 975. [ 1 -..... ....... ......... -.
rore ,, j,-'a . .* "'. ".
rel't .r,' oi (Cuba) ----- --." i- -"-""
gotA-it"cin M'2tcrs Provls'on"*- - -

after 1975)
\ r* ..* ---.-*' .-':. .>. .': .. ... . ,, -- -

Present law also provides several exceptions to the generall 3 year
carryback-5 year carryover rule in the case of certain indistmi-. or
categories of taxpayers, as indicatedl in chart 2. One exception allows
certain regulated transportation corporations to carry back and deduct
net operating losses for the usual 3 years and to carry over such lI.sse,
for 7 years. Another exception prohibits the carryback of a net oper-


atti l..t -os to tlie extent tlle et o ierati losqs wu as attrilb)table to a
foreign exp io pri ationf loss. 1 oeer Ia 10-eer ,arryover period is
allowed for the foreignl ex)Iropriation loss (15 years in the case of
a Cnlh:iHi exI)pop)riation lo)ss).
A thirdi exception. app)!licable, to financial institutions foir taxable
yte1's 1, '.inllilgL after 1)eceibe,'r "1, 1975.) le ,gi(t liens tlie carryback
lieriod for 1e0t o)peal i1- losses to 10 1ears and allow tlie usual 5-year
C;li' over period(. Siimilarly. a ban:k for cooperatives is presently al-
lowed to carry net operating losses .ack for 10 years and forward for 5
.a rs. A fourthil exception is provided for taxpayers which have in-
cr' ''dl nt operating losses reslltililg from increased imports of con-
pe ti j p)rodIts uler t',lae coicessions inade pursuiant to the Trade
Expansion Act of 196:2. Where a taxpayer hIas elected to ol)btain certi-
fication as provided by this Act, it is allowed a 5-year 1 (:rrivback period
a"nd the usual 5-year carryover period.
Priesnt law also contains a provision desilnedl for American Motors
Corporation permitting a 5-year carrvl)ack period and a carryover
period of 3 years for losses, incurred for taxable years ending after
Decetei wr 31, 1966. and prior to January 1, 1969.

Net operating loss carrylbacks and carryovers provide business tax-
p:,yers with a form of averaging which, in effect, permits them to
share their losses within the government by offsetting these losses against
their taxable income in other years (within the prescribed time limita-
tions.) This is generally regarded as equitable since taxpayers are re-
quired( to share their income with the government by paying income
tax when they have profitable years.
However, there have been proposals to revise the present carryback-
carryover rules by permitting longer carrybacks or carryover periods
and by allowing taxpayers an option to substitute carrybacks for car-
ryovers. Others would provide a longer carry forward period. These
p1roposalss stemin, in large part, from the fact that in the current economic
situation-and in particular in certain depressed indtustries-taxpay-
ers have incurred substantial losses which they cannot offset fully
against the income of other years. Such taxpayers, for example, may
not be able to offset fully their losses in the present cariryback period
because these losses are large and the prior years were either loss
years or low income years. Moreover, a number of these companies
doubt that they will be able to fully offset such losses through carry-
overs because they anticipate only modest, profits in the future years
covered by the present carryover.
Liberalization of the net operating loss provisions is also supported
as an effective way to assist temporarily nonprofitable businesses which
derive no immediate benefit from tlie usual capital formation and
recovery provisions such as increased investment tax credits, acceler-
ated dep,,eciation deductions, rate reductions or dividend deductions.
1;'h ~to .ibst.hlfe'ni'backs for carryforw'ards.-So far as the
taxpayer is concerned,. whether a longer carrybaek or a longer carry-
forwvard is desired depends on the business's pattern of income and
losses over the years. Taxparivers which ha-ve had a very long string of
annual l(.-se- which extend beyond any feasible carryback period will
ordinarily prefer ca rryforwards because the business will not be in a

position to benefit from lon 10nger carryvbaclk. Similarly, new bulsine-,s
which, of cou1r-'c. have l)o lfloiiwe iln past years against which to apply
carrybacks will generally prefer longer loss carryforwar(Ids. however,
taxpayers with sufficient income in past years to benefit firoI ca rry-
b)acks are apt to prefer cai'ryba(ks to carrvforwards, particularly since
carrybacks prov'i(de tax refllnds, wlile obtailling tlhe benefit of carry-
ove'rs is dependent Ulpon the ability of the business to earnll profits in
future years. A rule requiring business losses to be carried forward also
provides an incentive to tlie business to operate (efficiently so as to geil-
erate future incolmie which can absorb the earlier loss.
In order to give taxpayers greater flexibility to adal)t net operation
loss deductions to their particular circilloiistaiices., taxIpavers co(ld be
given the option of substituting additional carryback years (on top of
the existing carryback years) for their presently allowable caTrrIover(I
years. This would give the coilpany the opti(11 of taking lo.,- offsets
wit hin a prescribed number of years as carrybacks or as carryfor-
wards. Under this approach, for (exainlple, instead of the general 3)-year
carrlak- -year caarryforwar(d, a taxpayer might elect to car'v
back hiQ :;:.-es for 8 years with no carry fo ward, or to carry his los,.s
forward for 8 years with no carryback. If this approach were adopted.
longer carrybacks would be frequently elected )by taxl)ayers desiring to
secure relatively speedy refunds to bolster their business positions.
Time period covered by carrybar.Z-' avnd carriyover's.- In theory,
there seems little objection to a longer carryover period except for the
fact that the longer tlhe period over which the losses can be offset, tlhe
greater the loss in revenue to the government. As a practical matter.
however, the longer the carryover period, the greater the likelihood of
trafficking in loss corporations.
It is sometimes maintained that longer carrybacks do not result in
substantial revenue losses because a taxpayer who utilizes them will
have smaller (or no) carryovers in future years. However, a rule
which allows taxpayers to carry back losses beyond the present carry-
back period (3 years) is likely to involve significant loss of revenue
because there is no assurance that particular taxpayers will. in fact,
have sufficient profits in future years against which to offset such losse-.
Similarly, longer carryover can also involve revenue los-e.-.
In general, the longer the period over which a loss carryback can be
used, the greater are the administrative problems. A long carryb)ack
period, for example, requires the recomputation of tax for past years.
and the further such past years go back, the greater the problem of
recomputing the tax from a taxpayers old books an(l recor(dls. The
p)resit 3-year (carryback period appears to have been designed, in part.
to correlpond with the 3-year period for tlhe statute of limitations for
applying tax assessments.
NaSes of 1oss (wrryo'vers.-At pIesnt. there is suibstalntial 'a t raflick-
Pl I It -, ofi
ing" in the sale of loss carryovers, primarily for tax purposes. Profit-
able business enterprises, for example, ma.y n ow acquire )usin,,<:es
with loss carryovers mainly to make use of these lo-s carryovers
aga iist the profits of their businesses.
Under the p'eseniit law, where the lo:(.-s corporation is tlhe acquired
corporation in a taxfree reorganization or illn a sale of stock to nlew
owners, there are limitations on the availability of the acquired cor-


poraltionrs 1o,-, carr forwards to the acquiring corporation. The prin-
cil)pal limiitattlols are:
(1) If more than 50 percent of the stock is purchased within 2
yeir.t and by thle end of that period the business of the acquired
(',roi'at iln lias chan-led, tlen tihe loss carryforwards are elimi-
nat.d ( ((a. _()
(2) I f 'ill thI assets of the corporation are acquired in a tax-free
i-i'rger, then if the shareholders of the acquired corporation ob-
t;.iii L.-- than a 20-percent interest in the acquiring corporation.
tli( lo-- carryforwards are reduced by 5 percentage points for
(:i4,1 1iercentaire point less than 20 that the acquired company's
shi: rLolL'.is own in the acquiring company. (For example, if the
:ncquie (- c, ,mpanv's shareholders obtain a 12-percent interest, only
GO ip'rc,'i t of the loss carryovers are allowed. (sec. 382(b).)
(3) If a corporation is acquired with a principal purpose to
evade or avoid income tax. then the loss carryovers may be dis-
;dlowv(d in whole or in part (sec. 269).
(4) If one corporation acquires more than SO percent of the
stock of another (either in a taxable or a tax-free acquisition) and
then files a consolidated return, the preacquisition losses of the
corporation acquired can be used only against the income of that
However, while these limitations restrict, they by no means elim-
inate the advantages of "trafficking" in loss carryforwards from an
acquired corporation.
Av-ailale data suggest that such trafficking in loss carryovers is ex-
tensive. In 1974 there were 224 advertisements in the Wall Street Jour-
nal relating to the sale or purchase or loss carryover corporations. A
total of ",50 million of loss carryovers were involved in those adver-
tisements irn this group that cited dollar figures, and inclusion of the
cases in which dollar figures were not cited undoubtedly would have
boosted this figure to a much higher level. Moreover, the $250 million
figure does not reflect the substantial volume of transactions in loss
carryovers which are consummated without being advertised.14

9. Personal Savings
Pre.sent law
Under present law, personal savings are made out of taxed income-
that is. the income that individuals save is subject to individual income
tax an is any investment income on such savings. In this respect, the
income tax applies equally to income regardless of whether it is spent
on contsumption items or saved.
However, different tax treatment is accorded to certain income saved
for retirement purposes under pension, profit-sharing, and other plans
that qualify under the tax law and therefore do not discriminate in
favor of highly paid employees and excentives as compared with rank
and file employees. Employees covered by such plans do not include
in their current taxable income contributions made for them by their
employers to these plans. Instead, they postpone payment of tax until
they receive the benefits, generally on retirement. In addition, invest-
14 Spe ttcfimnny of Miehnol Waris. Ja., in Pubhlie TTnrinz. bWfore the Committee on
W;iys and M'ann,. -THouse of R,0prsentatIves. 94th Congress, 1st Session, on the Subject of
T:ix IRf.rm,. Part 5 (July 29-21, 1975), page 3589.


ment earnings on the aniounts contributed to qualified pension, etc(..
plans are exvinpt from tax when earned by the plan and are not taxed
until they are paid out to the covered individuals, at which time they
are taxed at the individual rates. This provides co"nsiderably l ore
advantageous tax treatment to savings in qualified. pension plan; than
to savings out of taxed income since it permits the employee covered
by the p,-ns.ion plan to defer payment of tax for substantial periods of
time. This deferral provides significant intere-t savings. Additionally.
by deferring tax until the time that he receive: the pension benefit-.
the covered individual generally reduces liiM tax since hiM income, and
hence applicable tax rates, are generally lower at the time of retire-
ment than during his working career. Also, if the covered individual
dies before he receives the amounts he is entitled to, the remainder is
not included in his estate even though it is payable to his heirs.
Since 1... self-employed individuals may choose to be covered by
so-called H.R. 10 plans if they provide comparable covera,!.re and
benefits for their employees. This permits self-employed people (in-
cluding those? who have no employees) to deduct limited contributions
to a pension plan on their own behalf and to defer payment of tax on
such retirement savings until they receive the benefits. Since 1974 the
deductible pension contributions of the self-employed on their own
behalf are limited to the lesser of 15 percent of earned income or $7.500
a ypar.
In addition, since 1974 individuals not covered by pension plans
may set up individual plans for themselves (individual retirement ac-
counts. or IRA's ). Individuals are permitted to deduct their con-
tributions to these IRA accounts up to the lesser of 15 percent of their
earned income or .1.500 a year. The amounts placed in IRA accounts
to-ether with the investment earnings on these amounts remain free
of tax until they are withdrawn, generally upon retirement, when they
are included in the individual's tax income. This permits individuals
e-tablishing IRA accounts to receive much the same favored benefits
accorded to individuals who are covered by employer-established pen-
sion plans.
Present concern about the possibility of capital to meet
the Nation's future needs has -tiiulated the study of tax proposals
designed both to increase personal savings and to provide greater
equality in the tax treatment of saving. Such proposals could extend
the favorable tax treatment now provided for retirement savings for
other purposes.
Deterred tax treatment for personal savings for purpose- other than
retirement is supported on the ground that savings for sich purp,-.s
as the education of children, the purchase of a home. and financial
contingencies merit tax assistance just as imuch s retirement -avings.
There are practical gir',unad, however, for tlie favorable tax t t-
ment of pension savings finanedI by employer contributions that do
not apply to other kinds of savings. To a very considerable extent, the
p1ese-nt deferred tax treatment of employer contributions to qmialiiel
pension plans evolved in recognition of the practical difficulties of
taxing covered employees currently on such contributions. particu-
larly since employees may not actually receive .inefits from pinsion
plans until long after the confti i butions are made. A similar considera-

tion for d(e'ferred ticatmient does not apply to the individual's own
s-tvings in such as-evts as ajlnk county. sto.ks. Aand i house, since, as
tOe owner, he liai' al 'ready directly received these, assets.
Proposals to extend dleferredl tax treatment for income saved for
purpl(ses other tli:an retirenlent would invol-(ve a substantial revenue
lo,:s. T"i exact revenue h)!s would depend on tlhe specifics of the pro-
.1Tanm adopted.
ljxtendjnj.Lt d(Jferred(l tax treatment, beyond tlhe pension area to in-
ilividiial Q;vinis gLreneally could fund mentally change the nature
of tlie individual income tax. A.ny extension of deferred tax treatment
to specific typv-, of savings would create an additional precedent for
extendlinit siImilar treatment to other kinds of personal savings. Ulti-
mately, such extensioI's cold lead to a generalized deduction for
-;imngs which would tend to chlanse the individual income tax from
a tax on income to one on spending. This, it is argued, would be con-
trary to the principle of taxation based on the ability to pay since
high incout- individuals save more than low income individuals and
hence would receive larger tax deductions for personal savings. Such
a tendency for savin's deductions to favor hig-h income individuals
might be offset to some degree by plaicn, relatively low maximums on
the amount of '-avings eligible for tax deductions.
There is al-o an important question as to how effective the proposed(
deferred treatment would be as a means of increasing the total volume
of savings. For many years, economists have questioned whether
changes in interest rates significantly affect the volume of personal
If a deferred tax treatment were granted to personal savings with-
out regard to whether such savings represented an increase over tihe
amounts that would be saved in any event, much of the resulting
revenue loss would be wasted since it would not have stimulated addi-
tional savings. This could be dealt with by restricting the savings
which are ded(lucted to those savings which are considered additional
savings. However, such a procedure would be administratively difficult
to put into practice. It would appear, for example, that the presence
of such additional personal savings could be demonstrated only
through a comparison of the individual's assets for successive years;
it cannot be demonstrated merely by examining the size of savings in
the particular savings items eligible for the deferred tax treatment
because it would be possible for the taxpayer to shift his existing sav-
ings from those forms not eligible for the favored tax treatment to
those forms which are eligible.
Additionally, whether an increase in personal savings is desirable
depends to a considerable extent on the economic setting in the future.
Perhaps the most important factor in encouraging total savings and
the growth of capital is a generally prosperous and relatively high
employment economy. Experience hac shown that total savings are
generally hig-hi when GNP is growing but that savings tend to drop
in periods of recession. Therefore, the effectiveness of provisions to
encourage personal savings through favored tax treatment may de-
pend on the contribution that this tax treatment would make toward
a prosperous and fully employed economy. If the economy is growing
it may be appropriate to encourage greater savings to combat infla-
tion; on the other hand, if the economy is faltering, attempts to en-

courage greater savings could merely depiv-.-, the economy still fulrtlher
and reduce total saving.
House Bill
The House bill contains two provisions wbih affect personal hav-
ings. The first, Sec. 1501. which provides for tax-free rollovers for
employees who received payments resulting from ternin action of their
retirement plan, became law on April 15. 1976.
The second, Sec. 1502. provides that an individual wlio i anIl active
participant in a qualified defined benefit (pension) plan, a (qualified
defined contribution (profit-sharing, stock bonus, etc.) plain, or an
annuity contract described in Code section 403 (b) would le, permitted
to deduct (1) his contribution to an individual retirement account
(IRA) and (2) his employee contribution to his employers qualified
plan, but only if that qualified plan was in existence on Septeimber 2.
1974. The aggregate contribution to IRA's and qualified plans could
not exceed the present IRA contribution limit (the lesser of 15 percent
of earned income or $1,500), reduced by the amount of his employer
contributions allocable to that individual. This provision would not
apply to an individual for any year when he was an active participant
in a Government plan.
These provisions would apply for taxable years beginning after
December 31, 1975.

3 1262 07125 7371