Much of what I'm going to say this morning will be in way of review. Much has been covered in recent annual reports of the President's Council of Economic Advisers. I regret that little has changed over the past two years in the diagnosis of the factors behind the shortfall of private capital investment or in policy measures to alleviate it. I compliment this committee in attempting to focus attention on the issue of incentives for economic growth. It unquestionably is one of the most important policy issues this government will confront in the years immediately ahead.

We are in a period when we would expect aggregative capital investment to be rising markedly. Instead, we find that investment is lagging badly behind what one would ordinarily project at this stage of the business cycle. I should like to review the reasons for this and, by so doing, indicate the types of actions that governments can take to enhance the growth in private capital investment.

The primary reason for lagging investment is the heightening of uncertainty in the business outlook that has occurred since 1970. As we all know, other things being equal, the greater the uncertainly, the greater becomes the rate of return required on new investment to compensate for that uncertainty, and the fewer the number of projects which will qualify. As a result, anything which acts to heighten uncertainty will have a depressant effect on capital spending. It is, of course, very difficult to prove that a decline in business confidence or an increase in risk premiums is responsible for the failure of investment to rise as much as might have been expected, for example, during the current recovery. This difficulty results partly from our inability to directly measure the uncertainty or accurately assess the expectational factors and the environment within which long-term investment decisions are made. Most evidence for the view that business confidence remains poor is qualitative. One quantitative indicator of the expectations affecting business investment which was presented in the last Economic Reportof the President is the market value of a corporation's stocks and of net interest-bearing debt relative to the replacement cost of its assets. If, for example, assets are valued in the market significantly above their replacement cost, corporations will be encouraged to invest in new equipment and thereby create capital gains for the owners of their securities. On the other hand, if assets are valued below their replacement cost, corporations which sell new securities to buy new capital goods may be creating capital losses for their security holders. In the latter case we can infer that the cost of capital has arisen relative to the average profitability of past investment projects and that new investment will be discouraged. Of course, at the margin the expected rate of return on a significant number of potential new investments will remain above the cost of capital, even though existing assets on average are valued below their replacement cost. Thus, even if the market value of a firm fell below the replacement cost of its assets, this would not mean the end of investment incentives. It would be especially inappropriate to draw such conclusions from estimated aggregates composed of heterogeneous corporations. Nevertheless, it is probably safe to infer that the almost continuous decline in the ratio of the market value of nonfinancial corporations to the replacement cost of their assets during the last few years is an indication that investment incentives are much lower currently than in the second half of the 1960s. Even allowing for the possibility that the high values of the ratio in the 1960s reflected some temporary overconfidence in the evaluation of future returns, the significant downward trend is an indicator that a lack of confidence may be a factor holding back long-term investment commitments now.

Another indirect measure of the decline in business confidence is the evident growing reluctant on the part of companies to expand capacity.1

Typically, as operating rates rise the need for new capacity, is seen by companies and, with a lag, the rate of capacity expansion in the economy begins to move higher. At low rates of operation, the incremental addition to capacity is relatively small and primarily reflects rounding out and modernizing expenditures, rather than plant expansion. However, at some point, referred to by some as the "trigger" point, the rate of capacity expansion as a function of operating rates begins to accelerate. Over the period 1954-69, the trigger or inflection point for manufacturing appears to have been around 85% of capacity. Below that point, the rate of capacity expansion would increase by

1 I am indebted to my colleague M. Kathryn Eickhoff for the following analysis.

less than 0.15% for every 1% increase in operating rates; above the trigger point, capacity accelerated to nearly 4% for every 1% rise in operating rates. In 1970, the demand function for new capacity appears to have shifted downward, followed by a further downward shift in late 1973. As a result, the trigger points appears to have shifted upward to approximately 87% capacity. At low rates of operations, approximately 1% per annum less capacity appears to be coming on stream than would have been expected in the earlier period. However, at higher operating rates the shortfall may be more nearly 2% per annum. Unless the forces which caused the demand function to shift downward can be reversed, that is, unless the level of uncertainty can be significantly reduced, serious problems would appear in prospect. (One, of course, is shortages.) Although other reasons undoubtedly could be thought of, the following factors stand out as important contributors to the higher level of uncertainty over the last several years. First, and by far the most important, is the higher rate of inflation and the fear of an increasing rate of inflation in the year ahead. Second is our experience with wage and price controls and the ongoing concern of business that if, or when, inflation does accelerate in the future, it is only a question of time before controls are once more imposed. The third is the seemingly inexorable rise in the degree of regulatory intrusion into business activity and the rapid acceleration recently in the rate at which changes in the regulatory environment have been occurring.

An inflationary environment makes calculating expected rates of return on new investment far more difficult. Profit calculations are affected by the rise in price both from the cost and the price side. Even if overall profits advance in line with the rate of inflation, no single producer can be certain that his profits will rise similarly. It will depend upon how much his costs rise relative to all other prices in the economy and whether or not he can raise his price correspondingly. As a result, the dispersion of profits among producers increases as the rate of inflation climbs.

The evidence suggests that this dispersion of profits has a far greater effect, negatively, on rate of return calculations than the overall rise in profits has, positively. In effect, a much higher rate of future discount is applied to inflationgenerated profits than to those accruing from a noninflationary business environment. The longer the effective life of a prospective investment, the more adverse the effect is apt to be because the greater uncertainty attached to projections of inflation into the future. Accordingly, inflation not only introduces greater uncertainty into rate of return calculations, but it also acts to skew the investment pattern towards shorter-lived projects on which the uncertainty is less.

Relative prices in our economy are continuously changing as market forces act to balance supply and demand over both the long- and short-run.

The imposition of wage and price controls in 1971 demonstrated that a controls system locks the economy into the pattern of relative prices that exists at a single point in time, i.e., it stops the ongoing adjustment of relative prices from continuing and perpetuates the existing disequilibria. What then follows is an attempt to alleviate the worst inequities by allowing some changes to occur. This creates further distortions. Low profit margin goods, for example, begin to disappear from markets. This creates a greater demand for substitutes which have a relative price advantage or higher profit margin, a demand which, in short-run, the economy may not be capable of meeting. Ultimately, the system breaks down and prices rise rapidly as the market attempts to restore more nearly equilibrium conditions.

While it is clear that the existence of such controls greatly increased uncertainty in the early seventies, one might think that sufficient time has elapsed since they were removed to eliminate this element of uncertainty. Unfortunately, although controls were removed, the economy has been continually threatened with their reimposition. And in this regard, it makes no difference whether the threat is of voluntary or mandatory controls. Under present circumstances, unless the problem of inflation is solved, it is only a question of time before some exogenous force once again causes prices, at least temporarily, to spiral upwards. The probability that the present Administration would allow market forces to control such a situation appears, in the view of most businessmen, small. Thus, business continues to factor in controls as an element of uncertainty in projecting future prices and profits.

In recent years, business regulation has escalated sharply in the area of environmental and health protection. Increasingly, EPA and OSHA regulatory

changes have directly affected investment. Typically, such changes increase the cost of facilities significantly. However, this, in itself, is not the worst problem. (So long as costs are calculable, higher costs reduce, but do not stop, investment.) Far worse for capital investment decisionmaking is the fact that regulations may, indeed will, change in the future, but in a presently unknowable way. As a consequence, future costs of meeting regulations cannot be calculated. To some degree, companies could conceivably be protected from this problem by "grandfathering" regulations. A plant built today could be required to meet all presently existing laws, but would be immune from future changes. No matter how seemingly prohibitive the cost associated with existing laws, it would be calculable and would therefore permit projects whose rates of return were sufficiently high to move ahead.

One major problem with instituting such an approach in the environmental area is how to handle the situation in which a previously unknown, but toxic, substance is produced by a plant. The public would have to be protected in such an event and the potential liability would be presently unknowable. However, if investment is to move forward, investors need to be protected from the possibility of presently unknown hazards suddenly wiping out their investment. Most obvious solutions imply a degree of government intrusion in the ongoing life of an investment which is also harmful to investment. Thus, this is a problem whose dimensions are only beginning to be perceived and one which is apt to be difficult to solve in a wholly satisfactory manner.

A major new source of regulatory uncertainty would occur if the broadened form of regulation embodied in President Carter's recent energy message is enacted. Such control must lead to increasing uncertainties with respect to the profitability of energy production, as well as the availability of various forms of energy in the future under potential allocation. Even if the Administration is correct that freeing so-called "new, new" oil from regulation is more than adequate to create incentives for exploratory drilling and development, uncertainty would develop from the operation of such a regulatory apparatus in that today's regulations almost certainly will not be tomorrow's. A regulatory agency's basic purpose is to make regulations, and to change them. The regulatory body which makes regulations and then self-destructs is too mind-boggling a notion to contemplate.

Hence, a prospective oil producer cannot know with any degree of surety that currently uncontrolled oil will not fall back under controls. The existence of an ongoing body whose daily purpose is to review price regulations, clearly raises the probability of such an occurrence.

One inference from the foregoing is that a direct stimulus to investment, such as a corporate tax reduction would provide, could hasten the restoration of business confidence. Another is that measures which would help reduce the risks of substantial changes in the regulatory climate over the normal life of fixed assets would also raise investment. Above all, a reduction in inflation and the risks it creates is essential. Such measures would help to offset the uncertainties which are still restraining investment and would make up for the recent slow growth of productive capital.

Senator BYRD. The next witnesses will be Bruce G. Fielding, secretary, Council of Small and Independent Business Organizations; Mr. Edward Pendergast, Small Business Association of New England; and Dean Treptow, chairman of legislative affairs, Independent Business Association of Wisconsin.

Welcome, gentlemen.

STATEMENT OF DEAN TREPTOW, CHAIRMAN OF LEGISLATIVE AFFAIRS, INDEPENDENT BUSINESS ASSOCIATION OF WISCONSIN

Mr. TREPTOW. Thank you, sir. My associates have designated me as lead-off speaker here today.

My name is Dean Treptow, I am a banker as a profession, president of an independent bank whose primary business is serving the needs of small business. In fact, I consider myself a small businessman.

A major function of government is the redistribution of capital. All too frequently this redistribution is accomplished with a very shortterm perspective which results in a simplistic taking from areas of abundance, at a particular point in time, and giving to areas of deficiency.

I am most bothered by the seeming inability of our tax planning to recognize the long term impacts on the economy. We seem to have a propensity to cure immediately today's symptoms while completely ignoring the imputed future costs of these actions.

As regards small business, I am far less concerned with how the tax codes treat us relative to large business, than I am with the tax codes tendency to strangle off small business, endangering survival, stifling innovation, and in the end, precluding economic contribution over the long term.

I will not take your time by extolling the numerous virtues of small business in our free enterprise economy. I am certain that you have heard them all before. In any event I have never heard serious objection to the arguments that small business benefits the consumer by product innovation and reduced pricing through competitive activity. I believe we all agree that the small business sector of this country has given this economy its best bargain for a long time. It being my impression that we have reached agreement on this point, then I think we are overdue for reexamining our tax impact on small business, that restrict its ability to better serve our economy.

Frequently, our tax codes are not unlike the dairy farmer who for fear of current revenue loss, milks his cow dry to the detriment of the newborn calf standing at her side. Eventually the bawling calf is starved out of existence, there is no perpetuation of the herd and no future generations to perpetuate the stream of income.

Capital is the milk that nurtures business activity. People who do not possess it call it wealth and ask that it be redistributed. The employer of capital, a business entity, regards it in its true nature, as an indispensable resource which supports growth in sales, research and development, competitive practices, and payrolls. In almost every type of business, it is possible to develop firm ratios between capital employed and jobs available.

The next point that I would like to make is that sources of capital for all businesses are retained earnings from operations, and outside investment. If either of these are in sufficient quantity, then they can be supplemented with borrowed money.

Small business differs from large business in our economy, in that it must rely primarily upon retained earnings to support its growth. Outside equity capital is relatively less available to small business than it is for large business and the extent of this condition is becoming greater each year.

The reasons for this are numerous. Among them are the facts that small businesses are inherently more risky from an investor's viewpoint than large businesses, simply because they tend to have shorter track records, have less ability to control their markets and thereby their pricing and profit margins and in any equity offering, must bear the same expensive and exhaustive securities regulations that apply to large businesses.

The conclusion is that it should be a matter of public policy that small businesses be enhanced by an increased ability to retain the earnings that they have created out of their own productivity. This differs sharply from an appeal for external governmental support. Our appeal is to government.

To view the taxing of small businesses with a longer range perspective that would diminish the tax impacts in the short term in return for the creation of larger and stronger small businesses in the future, would result in a greater tax base later in the life cycle of a business, both directly from corporate income and directly from increased payroll taxes on people employed.

The most significant tax factor affecting retained earnings, in my opinion, is the corporate income tax. During the vital years of startup, early growth and research, outside equity investment is probably totally excluded and capital must come exclusively from internal cash flow and borrowing.

Congress recognized this in principle 39 years ago, when it exempted a company's first $25,000 in earnings from the full 48-percent tax rate. Two years ago, after 429 percent of inflation had made that $25,000 all but irrelevant, Congress raised this exception to $50,000. This exemption still is not adequate for modern needs.

We need to reduce the tax rate on the lower levels of corporate earnings so as to allow that corporation greater strength to sustain it in its early years. Specifically we recommend that the corporate surtax exemption be increased to $150,000. The payoff for government will be a higher survival rate of small businesses who will pay corporate income taxes over a longer time period and most likely in greater amounts due to their increased ability to develop markets, competitive positions, and conduct research.

Small businesses are labor intensive and as they are able to enhance cash flow by reduced tax burdens in their early years, they will employ more people and the Government will get the added payoff of increased payroll taxes and greater economic stability from higher levels of employment.

The SBA task force on venture and equity capital in its report issued a few months ago, supported this contention when it said that allowing small business to use a larger portion of their earnings would be "the most direct and effective step that can help small business."

Recovery of cash invested in capital assets is the next most important step to enhancing small business growth. Writing off depreciable assets as a tax deductible expense is an important method that small business does use to increase internal financing.

Every dollar deducted as an expense increases cash available by the amount of the tax savings. These writeoffs have long been permitted, but they are presently permitted, over too long a period to give the required benefit.

The staff of the Joint Committee on Taxation in their "Tax Policy and Capital Formation" report, prepared for the House Ways and Means task force on capital formation, supported the well-known economic fact that growth in the labor force is directly tied to capital investment. This same report goes on to point out that businesses will only purchase capital goods if they lead to a combination of increased