APPENDIX A

COMMUNICATIONS RECEIVED BY THE COMMITTEE EXPRESSING AN INTEREST IN THESE HEARINGS

STATEMENT OF GENERAL TELEPHONE & ELECTRONICS CORP.

The intense need of the utilities to continually raise large amounts of equity capital gives urgency to the need for reform of the tax laws to encourage capital formation and to remove disincentives to personal investment. Congress should promptly adopt the following three tax proposals:

Defer taxation of automatically reinvested dividends of utilities, treating them as stock dividends (IRC § 305);

Permanently increase the investment tax credit (ITC) to 12 percent for all businesses, equalizing the utility and nonutility ITC rates, and remove the 50 percent limitation on the credit; and

Allow a corporate tax deduction by utilities for dividends paid on designated new issues of preferred stock (IRC § 247).

I. THE UTILITIES MUST CONTINUALLY RAISE LARGE AMOUNTS OF CAPITAL The continued growth of the economy of the United States is largely dependent on the ability of the utilities to increase their facilities in line with the economic growth. The utilities, in turn, must obtain the capital to invest in new plant and facilities to meet the expanding needs of the growing economy. The utilities are the infrastructure upon which continued growth of the economy is fundamentally dependent.

Thus, the overiding challenge to the utilities-and to our domestic economy-is the necessity of raising, on an economical basis, the large amounts of new capital required to finance continued expansion and improvement of service in the years ahead. This point can be illustrated by a look at the telecommunications industry. Historical and future capital requirements of the telecommunications industry Demands for service translate into capital requirements and can be illustrated by both the historic and the forecasted construction expenditures of the telecommunications industry. As shown on chart 1, expenditures for new plant and equipment in the telecommunications industry totaled approximately $107 billion in the 1967-76 period, and are estimated to reach $248 billion in the 1977-86 period, a significant increase of 132 percent. U.S. Department of Commerce figures show that total expenditures for new plant and equipment have risen far more rapidly for all utilities, including the telecommunications industry, than for the economy as a whole. For example, during the period 1967 through 1976 expenditures for new plant and equipment for utilities increased by 137 percent, whereas for manufacturing the increase was only 83 percent (chart 2). Annual capital expenditures of all utilities were approximately $26 billion in 1971, increased 35 percent to $35 billion in 1976, and are estimated to increase 94 percent to $68 billion by 1981 (chart 3). The utility industry is concerned about the availability and price of funds to support these necessary expenditures. This concern will intensify as the economy continues to recover and the competition for and cost of funds increase.

Utilities are by nature capital intensive

Because of the nature of the industry and the large investment required to meet service demands, the utility industry is highly capital intensive. A comparison of the assets required to generate $1 of revenue in the utility industry with those required for all manufacturing companies illustrates this characteristic feature of the utility industry. Chart 4 shows that the utilities generally

require approximately 3.5 times as many dollars in assets to generate each dollar of sales as do manufacturing companies. As a consequence, the utility industry, compared with manufacturing companies, has relied and must continue to rely much more heavily on the external capital markets. In fact, utilities, including the telecommunications industry, account for a major segment of the private external capital financing in the United States.

Other factors affecting capital needs

In addition to the growth in demand for service and the capital intensive nature of the telecommunications industry, capital requirements are also affected by other important factors such as the declining useful economic life cycle of plant and equipment, the inadequate depreciation allowed for rate-making purposes and the need for investment to improve services and to increase productivity to keep pace with wage increases.

In past decades, customer demands for totally new telecommunications services were met principally by orderly advances in technology; depreciation rates were based largely on the historically long physical service life of plant and equipment. But today, changes are occurring at a far faster rate, a trend which seems certain to continue. Exploding technology, the ever increasing customer demand for sophisticated new services, and the need to improve productivity have greatly increased overall capital requirements. Telephone companies will be unable, economically, to retain equipment developed with past technology, not only from an operational point of view, but also on the basis of demand and competition. For example, it is more costly to operate and expand some existing telephone switching systems than to install entirely new systems. These conditions are causing economically justinable desires on the part of telephone companies to accelerate the replacement of existing equipment with electronic telecommunications systems.

Despite the telecommunications industry's relatively high level of productivity and capital intensive nature, it remains one of the largest employers in the United States, employing in 1976 nearly 940,000 people, or over one-half of all those employed in the utility industry as a whole. The fact that improvements in productivity in the telecommunications industry are well above the national average has been brought about, for the most part, by significant and growing investment relative to the number of employees. Chart 5 shows that gross plant investment per employee was $127,000 in 1976 compared with only $42,000 in 1960. This increase of over 200 percent is based solely on historical costs. On a replacement cost basis, the 1976 investment per employee would be far greater— $180,000 compared with the 1976 historical figure of $127,000. Because of forecasted demands for service, technological improvements, and inflation, it is expected that the investment per employee in the telecommunications industry will continue to increase.

Inflation not only increases the cost of capital, it also substantially raises the price of needed plant and equipment. Chart 6 shows that actual construction expenditures grew at an annual rate of 10.1 percent between 1968 and 1976, while in terms of 1968 constant dollars the percentage growth was only 4.0 percent per year. The additional capital requirements resulting from inflation place an added burden on the industry and tend to further intensify the already highly competitive capital markets.

II. FURTHER CAPITAL REQUIREMENTS OF UTILITIES CANNOT BE MET BY INCREASING DEBT LEVELS.

The utility industry is concerned about the availability and the price of funds required to support essential capital expenditures. This concern will intensify as the competition for funds and the cost of capital increase in the future.

Largely because of the bias in the tax laws favoring the issuance of debt rather than equity, the utility industry utilized a disproportionate amount of debt to fund its rapidly growing construction expenditures from 1960 through 1976. Key indicators of financial strength now show that telephone and electric utilities are virtually precluded from financing their future construction requirements by further increasing the proportion of debt in their capital structures. The level of debt of Independent telephone utilities at year-end 1976 was 55 percent of total capitalization, slightly greater than that of electric utilities (chart 7). The important fact is that both telephone and electric utilities have about reached the practical limit of their ability to increase leverage because of the need to protect bond ratings, or the reasonableness of risk that security holders can be expected to assume.

The adverse consequences of the extensive use of debt have been magnified by the rapid increase in interest rates during the period 1960 through 1976. Interest rates on "A" rated utility bonds increased from 4.8 percent in 1960 to 9.3 percent in 1976. Although there has been a modest cyclical decline in interest rates recently, the secular trend of long-term interest rates remains upward (chart 8). Because of anticipated future inflation, long-term interest rates are expected to remain far above historical norms. As a result, the utilities will have to refinance the debt sold prior to the mid-sixties at two to three times the original interest rates while simultaneously financing new construction at the higher rates. The combined effect will be to significantly increase the amount of debt to be raised and inevitably continue to increase the embedded cost of debt capital to utilities (chart 9).

Extensive use of debt and the escalation of interest rates has caused a dramatic erosion in the interest coverage of utilities. Average pre-tax interest coverage for both Independent telephone and electric utilities fell to approximately three times in the 1970-76 period, as compared to nearly four to five times in the late 1960's (chart 10). The decline in the utilities' interest coverage has reduced the credit worthiness of most utilities and increased the risk to investors. During the period 1971 through 1976, Standard & Poor's downgraded the bond ratings of 90 public utilities while upgrading only 27. As a direct result, utilities have found it more difficult and more expensive to raise needed capital.

III. CONGRESS SHOULD AMEND THE TAX CODE TO ENCOURAGE CAPITAL FORMATION AND TO REMOVE DISINCENTIVES TO CAPITAL FORMATION

To alleviate the financial problems facing the capital intensive utilities, to remove basic inequities in existing tax laws, and to stimulate the economy and employment, Congress should promptly adopt the following three proposals:

Defer taxation of automatically reinvested dividends of utilities, treating them as stock dividends (IRC § 305);

Permanently increase the investment tax credit (ITC) to 12 percent for businesses, equalizing the utility and nonutility ITC rates, and remove the 50 percent limitation on the credit; and

Allow a corporate tax deduction by utilities for dividends paid on designated new issues of preferred stock (IRC § 247).

(A) Stockholder Reinvestment of Utility Dividends Should Be Taxed in the Same Way as Stock Dividends

Stock issued under automatic dividend reinvestment plains of utilities should be treated for tax purposes under Section 305 of the Internal Revenue Code just as though it had been received as a stock dividend which is taxed upon disposition at capital gain rates. Under this proposal, utility stockholders would be permitted to reinvest their dividends in newly issued stock of the dividend-paying corporation without being penalized by having to pay a tax on dividends they never actually receive.

Investors in utility stocks traditionally seek a high dividend yield. As a result, the dividend payout of Standard & Poor's 40 utilities averaged 65 percent of net income for the 1967-76 period while the rate for Standard & Poor's 400 industrial was 48 percent (chart 11). Furthermore, because of the nature of their investors, utilities do not have the same degree of flexibility in dividend payouts as do most industrial firms. The importance of dividends to utility investors can be illustrated best by the traumatic experiences of Consolidated Edison when it omitted a dividend payment in 1974 and General Public Utilities when it unsuccessfully attempted to switch from cash to stock dividends.1

Since cash dividends are taxed to the individual recipient at ordinary income tax rates, the tax laws in effect discriminate against high dividend-paying companies (e.g. utilities) while favoring companies which retain more of their earnings (chart 12). This discrimination against investors in high dividend-paying utility stocks results in a higher cost of capital to the utility-a cost that is reflected in higher rates to consumers.

If investors in public utilities had the option of reinvesting dividends under automatic dividend reinvestment plans without a tax penalty, the adverse effects of existing discrimination would be significantly reduced because investors in utilities would be treated more equitably with investors in industrial companies.

1 "A Case for Dropping Dividends," Fortune, June 15, 1968, page 181.

Furthermore, the ability of utilities to obtain much needed equity capital from a far broader investor constituency would be enhanced.

Another particular advantage of this proposal is that it is simple to implement in that it builds on existing dividend reinvestment plans which have proven to be popular, particularly among utility investors. Many utility companies have already established these plans and participation rates are increasing. As an illustration of the success of these programs, participation in GTE's dividend reinvestment plan has increased from 11 percent of registered holders in 1972 to 20 percent in 1977. The amount of money invested annually by participants has increased over three times, from $5 million in 1972 to an estimated annual rate of $18 million in 1977 (chart 13). The increased participation provides an important source of new equity capital to the company.

These plans are particularly well suited to the needs of the small investor, because they provide an automatic, convenient, systematic and inexpensive means of investing. For example, in the GTE plan, participants pay no brokerage commissions or service charges. The popularity among small investors is illustrated in the case of GTE's plan wherein 80 percent of the participants own 100 shares or less. Conversely, participation among investors with large shareholdings is very modest (chart 14).

The adoption of this tax proposal would significantly increase participation in existing dividend reinvestment programs and induce other utilities to establish similar programs for their shareholders. It would enhance the attractiveness of high dividend-paying utility stocks for prospective investors interested in capital appreciation, while retaining traditional investment appeal for shareholders seeking cash dividends. The increased equity investment would help strengthen the capital structure of the utility industry, reduce reliance on outside capital markets and help provide funds required to increase capital expenditures and employment.

The initial revenue loss of this proposal to the Treasury would not only be small but would be quickly overcome by the resulting expanded economic base, including jobs created both directly and indirectly.

(B) The Investment Tax Credit (ITC) Should Be Made Permanent at 12 Percent for All Businesses

There is little question that the ITC has proven to be an effective tool for stimulating investment and fighting recession, unemployment, and inflation. A permanent 12 percent ITC for all business, including telephone and electric utilities, would immediately provide and maintain needed cash flow to strengthen capital structures and to improve interest coverage, thus permitting increased construction programs. Private and governmental studies indicate that the long-term effect of the ITC on tax revenues is favorable, because an increased permanent ITC would both directly and indirectly stimulate tax revenues by providing jobs and improved earnings.

Increasing the ITC clearly provides a strong stimulus to investment. Historically, there is a strong correlation between changes in new fixed investment and changes in total employment (chart 15).

The increase in the ITC for all industries to 10 percent from the prior 7 percent for industrial companies and from a discriminatory 4 percent for all public utilities was a step in the right direction. The increased ITC must not be allowed to expire as scheduled at year-end 1980 and all utilities returned to the discriminatory 4 percent level.3

Importantly, it should be noted that the long-term benefit of the ITC is greatly reduced by an on-again, off-again policy, particularly in the case of many businesses such as utilities, which require long lead times in construction planning. Similarly, the relaxation of the 50 percent limitation on the credit in Section 46 of the Internal Revenue Code should be continued. Otherwise, the benefits of the increased rate will be denied to those less profitable businesses with the highest capital needs.

The legislation should continue to require normalization for utility rate-making purposes.

2 There would, of course, be no revenue loss with respect to dividends paid to those shareowners who do not participate in dividend reinvestment plans.

3 See IRC § 46 (c) (3) (A).

(C) Utilities Should Have the Option of Offering Designated New Issues of Preferred Stock With Dividends Tax Deductible to the Issuer.

The ability of the utilities to at least maintain their debt/equity ratios by selling equity is severely hampered by discrimination in the tax laws which allows the deduction of interest on debt but does not allow the deduction of dividends on equity. The difference in tax treatment is particularly indefensible with respect to preferred stock which has most of the characteristics of debt and which is a commonly used vehicle for utility financing. The discrimination should be removed by making dividends on designated new issues of preferred stock deductible by the utilities.

Enactment of this proposal would make an important and substantial contribution to the ability of utilities to raise needed equity capital and to improve, or at least maintain, their debt/equity ratios. The market for preferred stock would be substantially broadened to attract new investors because the issuer could economically pay a higher dividend rate than is currently available on most nxed income securities of similar quality. Enactment of this proposal could enable utilities to almost double the amount of preferred stock sold at approximately the same cost, thus economically increasing their equity bases. Utilities not electing this new alternative could continue to sell, more advantageously, the traditional preferred stock to institutional investors who would continue to utilize the 85 percent dividend-received deduction (IRC § 243). Indeed, some utilities might offer both types of preferred stock.

This proposal would cause a minimal loss of tax revenue, since the new preferred would not have the 85 percent dividend preference of the old preferred and could be used extensively as a substitute for debt, interest on which is already deductible. Therefore, the resulting tax revenue loss would be less than the difference between the interest rate and the preferred dividend rate since both interest and dividends would be fully taxable income to the recipients. Utilities with adequate debt issuing capacity would not find this proposal economically advantageous to use, thus further minimizing the potential tax loss to the Treasury.

CONCLUSION

The long-term demand for utility services requires large and continuous capital expenditures. In the past, utilities have depended heavily upon the issuance of debt securities to finance capital requirements. They cannot depend as heavily upon this source of capital in the future, because they have virtually reached the practical limit of their debt capacity. The overall deterioration of the financial strength of utilities is reflected in the erosion of interest coverage and the numerous downgradings of utility securities. These adverse factors must necessarily be reflected in higher costs to the consumer.

Because of the importance of telephone and electric utilities to the health and growth of the economy, their financial deterioration calls for prompt action by Congress. Three changes in the tax laws are recommended which would help remedy the financing problems of utilities and remove basic inequities in the tax laws:

Defer taxation of automatically reinvested dividends of utilities, treating them as stock dividends;

Permanently increase the investment tax credit to 12 percent for all businesses; and

Allow a corporate tax deduction by utilities for dividends paid on designated new issues of preferred stock.

Enactment of these provisions would help telephone and electric utilities to attract needed capital at a lower net cost thereby allowing them to provide required plant and equipment, stimulate employment, and operate more efficiently for the benefit of the public.

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