the House of Representatives to meet these objections, but the plan was rejected by the Senate as too complex. In 1938, the classes of capital assets were reduced to two with an exclusion of 33% percent for assets held from 18 to 24 months and 50 percent for assets held longer than 2 years, and the alternative tax concept was reinstated through the provision of a ceiling rate of 30 percent which resulted in effective ceiling rates of 20 percent and 15 percent for sales involving the respective holding periods. In 1942, the alternative tax ceiling rate of 50 percent together with a flat 50 percent exclusion for gains from the sale of assets held more than six months was introduced and retained until 1969. The gradual increase of the alternative tax ceiling provided by the 1969 Tax Reform Act represented a congressional response to public pressure to remove this provision which was of primary benefit to higher income taxpayers. Holding period requirements have fluctuated through the years. Throughout, there has been the intention to exclude speculative gains from the relief provisions. On the other hand, there have been objections to the "lock-in" effect which might result from longer holding periods. A summary of the historical evolution of the federal income tax treatment of capital gains and losses in the United States is attached as appendix B to this statement. The Importance of Incentives for Capital Investments In the normal course of practice, certified public accountants have broad experience in working with businesses and investors. Through this experience, we are in a position to judge the effectiveness and impact of taxation on the availability of capital for investment and the willingness of investors to accept the risks associated with investments. Much has been said and written about the needs of this Nation for capital investment during the next few years, but this cannot be overemphasized. Some economists have estimated our capital needs to be at least $100 billion per year for the foreseeable future. If we are to meet the challenges of greatly increased competition from abroad (both in domestic and foreign markets) and also the needs to solve problems at homesocial, environmental and economic-we must continue a tax structure that will encourage citizens to accumulate capital and take the risks inherent in investing it. As an example of the problems faced by American business in competing in worldwide markets, a Fortune survey of our 500 largest industrial companies shows that the average amount of capital investment per employee has risen from approximately $16,400 in 1957 to $31,800 in 1971. Total assets for these companies increased over this period from roughly $150 billion to over $450 billion. In spite of this increase in capital investment. U.S. industry presently has the highest percentage of obsolete industrial facilities of any leading industrial nation. Furthermore, we are replacing facilities at a slower rate than other leading countries. As an example, fixed asset investment in relation to gross national product for Japan and West Germany is currently running about 27 percent and 20 percent respectively, while our percentage is less than 13. Rapidly changing technology and modernization of facilities will continue to require large amounts of capital. If preferential treatment for capital gains is eliminated, there are serious doubts as to the availability of the capital needed and the willingness of investors to take the risks. Impact of Inflation Much has also been said about the severe impact of inflation on our economy. Changes in price levels affect all of us in many ways, but particularly acute problems arise where assets are held for relatively long periods of time. There are many indexes designed to measure inflation, but they all indicate the same picture. The United States Department of Labor Consumer and Wholesale Price Indexes, using 1967 as the base year, indicate the following changes: Expressed as a percentage increase, the Consumer Price Index has risen nearly 50 percent in the last 15 years, and about 25 percent in the last 5 years. If a taxpayer invested $100,000 in a corporate security in 1957 and sold it for $150,000 in 1972, he would have been approximately even in terms of purchasing power. However, even under our present capital gains tax structure, he probably would have incurred a tax of at least $12,500. This would have placed him in a worse position economically in 1972 than he would have been 15 years earlier. In effect, this represents a tax on capital and not a tax on income or real gain. By analogy, it represents a failure to distinguish between the tree and its fruit— a tax on the tree, rather than on the fruit. The combined effects of inflation and taxation have clearly eroded the amount of capital available for additional investment. If the present preferential treatment for capital gains were eliminated, the erosion of capital would be much greater, and in our judgment could create serious problems for our economy. Recommendations Preferential treatment for capital gains.-We believe that full taxation of capital gains will diminish the willingness of investors to risk capital in new ventures. Furthermore, high tax rates obviously discourage investors from selling appreciated assets. This leads to undesirable results. It tends to inhibit the flow of funds into other investments, thereby prolonging the life of certain entities or ventures that may have become comparatively less productive. And, if nothing else, it produces the so-called “lock-in” effect which severely restricts the free flow of capital. We believe that these counter incentives are not in the best interests of our free enterprise system which is basically responsible for the relatively high standard of living in the United States. Preferential treatment is also needed to relieve the financial hardships created by the bunching of income in a progressive tax system when there is a realization of substantial gains which have accrued over a long period of time. Without preferential treatment, such gains would be subjected to unfair and confiscatory taxation. While the present income averaging provisions provide some relief in this connection, this relief is too limited and inadequate under the circumstances. For these reasons we believe that preferential tax treatment for capital gains should be continued. Definition of capital assets. While we favor the retention of some preferential treatment for capital gains, we recommend several modifications of the present law in this area. We believe these modifications would improve and simplify the capital gain and loss provisions of the Code and, at the same time, be responsive to public pressure for further legislative changes in this connection. At present, capital assets are defined negatively in Section 1221 of the Code. Under Section 1221, all assets are considered capital assets unless they are specifically excepted in the statute. We suggest a revision of Section 1221 to make it positive rather than negative. In addition, we would narrow the definition of a capital asset along the following lines: 1. The term "capital asset" means property which: (a) Is a corporate security or other "investment asset"; (b) Has been held by the taxpayer for more than 1 year; and (c) Is not held by the taxpayer primarily for sale to customers in the ordinary course of his trade or business. 2. The term "investment asset" for this purpose means property other than a corporate security which consists of: (a) Real estate or tangible personal property the ownership and use of which does not constitute the conduct of a trade or business; or (b) An interest in a partnership, joint venture or other similar type of entity. We believe this more limited definition of a capital asset provides greater clarity, contributes to simplification of a very complicated section of the law and continues to provide an incentive for desirable capital accumulation and the assumption of risk essential for the growth, strength and prosperity of our free enterprise system. We are aware that our tax laws now contain special provisions which extend capital gain treatment to many items which would ordinarily not be considered capital assets. In our judgment, the general approach taken in the Mills-Ullman type of legislation introduced in the 92d Congress, providing for a systematic and periodic congressional review of all special provisions in order to determine the continuing justification for such special treatment, is an appropriate way to deal with these items. These special provisions should be evaluated on their merits, and more direct ways of providing desirable incentives should be considered. Extension of the holding period.-We believe that the present 6-month holding period for long-term gain should be extended to a year. This would be responsive to the contention that quick profits contain an element of speculation which should not be rewarded by the law. A 1-year holding period also corresponds to the period generally used to distinguish a capital expenditure from a current expense. Sliding scale for inclusion of capital gains.-In conjunction with the adoption of a longer holding period, we also recommend a return to the sliding scale of exclusions similar to those in effect during the period 1934 to 1937. Although we are not recommending a reestablishment of the 1934–1937 exclusion ratios, we do support the concept of encouraging longer term investments in our Nation's productive facilities. Gains on assets held longer than 1 year could be excluded from income at the rate of 10 percent per year or at any other rate that Congress deems appropriate. Long-term losses.-Although we do not recommend unlimited deductibility of capital losses at this time, we do believe the present structure for the deduction of capital losses and carryovers should be improved. We suggest that a 3-year carry back of capital losses on a basis similar to that already prescribed in the case of corporate taxpayers should be allowed. In our view, such carrybacks in the case of noncorporate taxpayers should be limited to previously realized capital gains. We feel that this 3-year carryback is more appropriate and equitable, since gains are taxed as they occur and fairness would seem to indicte that losses which occur shortly afterward should be available to offset such gains. The deductibility of net capital losses from ordinary income has been arbitrarily limited to various amounts since 1934. In view of the fact that the present rules for allowance of a $1,000 per year write-off of excess capital losses against ordinary income dates back to 1942, we feel that an increase in this allowance may be warranted at this time. EXCERPT FROM TESTIMONY PRESENTED TO THE SENATE FINANCE COMMITTEE ON MARCH 18, 1976 PART 1. CAPITAL GAINS AND LOSSES After careful consideration of the impact of inflation, the need for capital formation, and the retention of incentives for investment, it is the Institute's view that continuation of the present rules for taxing capital gains is desirable, subject to certain suggestions for modification which follow: Extend the Holding Period Requirement The present six-month holding period requirement for long-term capital gains treatment creates opportunities for speculators to realize quick profits at lower tax rates. One of the principal reasons for continuing present rules is the need for capital formation and the assumption of long-term risk. Lower taxation of profits realized in as little as six months does not seem compatible with that objective. Accordingly, the Institute favors extension of the holding period for long-term capital gain treatment to one year. Provide a Sliding Scale of Exclusions The Institute recommends the adoption of a sliding scale of exclusions, increasing with the holding period for capital assets, for two reasons. First, this would recognize to some extent the impact of inflation. If a smaller percentage of gain is taxed, based on a longer holding period, this would tend to offset the loss in purchasing power of the dollar. Second, by adopting a sliding scale of exclusions, if the scale is gradual enough, the lock-in effect would be reduced. The investor could give greater weight to the value of the use of money in deciding when to sell an asset. For individual taxpayers, an exclusion scale starting at 50 percent after one year and increasing by 5 percent each year thereafter, to a maximum of 80 percent after seven years, might be appropriate. Since the present method of taxing capital gains realized by corporations is in essence a flat 30 percent rate, a graduated rate scale for corporate gains consistent with that for individuals would be equitable, Extend the Capital Loss Carryback Provisions to Individuals The present rule prohibiting capital loss carrybacks to individuals is inequitable. If the exclusion rules discussed above are adopted, an overall net loss from sales of capital assets in a particular year would be applied first against other income of the year. If this creates a net operating loss, it should be subject to the regular operating loss carryback rules. Alternatively, if Congress believes this too great a liberalization of the capital loss provisions, the net capital loss in a particular year should be allowable as an offset aginst ordinary income to the extent of $5,000, as recommended below, and any excess should be allowed as a capital loss carryback for individual taxpayers, as is now the case for corporations. Increase the $1,090 Limitation on Deductibility of Net Capital Losses In lieu of the ordinary loss treatment of net capital losses described in the preceding proposal, the Institute believes that the $1,000 limitation on the deductibility of net capital losses from ordinary income of individual taxpayers should be increased to $5,000. The $1,000 amount was established in 1942, and in view of the inflation that has been experienced since that time it seems appropriate to grant an increase in relief to those taxpayers who enjoy no capital gains against which to apply their losses. Furthermore, it is recommended that this treatment be extended to corporate taxpayers. Conclusion The subject of capital gains taxation has been and will continue to be controversial. There are opposing forces and philosophies that are difficult, if not impossible, to reconcile. The present capital gain tax structure may be too lenient, and some changes therefore seem appropriate. On the other hand, current economic conditions and problems justify retention of preferential treatment for true capital gains despite the fact that considerable simplification could be achieved if the special rules applicable to capital gains were abolished. EXCERPT FROM TESTIMONY PRESENTED TO THE WAYS AND MEANS COMMITTEE ON MARCH 15, 1976 You are aware of the alternatives that have been suggested to either (1) impose an additional tax at the time of death, perhaps equivalent to a capital gains tax had the appreciated property been sold, or (2) continue the decedent's basis in the property in the hands of the beneficiary. We have reviewed very carefully these alternatives, and recommend that neither of them be adopted. In our view, it is incorrect to say that unrealized appreciation is not subject to tax, since it is subject to up to a 77 percent level of estate taxes. It is also important to keep in mind the basic premise that estate and gift taxes as a whole are in effect a levy on capital. With our likely shortage of capital both present and for the foreseeable future, we are concerned with a change that would impose an additional levy on the capital represented by the unrealized appreciation of assets transferred through an estate. Both of the basic proposals for change in this area would introduce significant complexities and we do not think the alleged benefits derived would be sufficient to offset them. We have worked with the present system for many years and there is merit in continuing a system that is understood and that reaches a reasonable result. AMERICAN BAR ASSOCIATION, Hon. HARRY F. BYRD, Jr., Chairman, Subcommittee on Taxation and Debt Management, DEAR SENATOR BYRD: The Section of Taxation of the American Bar Association appreciates the opportunity afforded by your letter of June 16, 1977, to express views on the several tax matters mentioned therein. The Section has actively underway several studies on matters concerning tax incentives for capital formation. These include integration of the corporate and individual income taxes, conforming changes in Subchapter C, consideration of the continuing role of the foreign tax credit, and studies of taxation and price indexing. Other studies concerning tax simplification will also be relevant to capital formation. At the same time, I regret to respond to your invitation by stating that none of these studies will be completed in time for inclusion in the record of your current hearings. It is probable that these studies will be completed by the end of August. As each study is completed, the Section would appreciate the opportunity of submitting it to members of your Committee staff and thereafter meeting with members of your staff to discuss the studies. I have orally reported the foregoing to Mr. Bruce of your Committee staff, and have thought it advisable to write this confirmatory letter. Sincerely yours, Hon. HARRY F. BYRD, Jr., DON V. HARRIS, Jr. PRULEASE, INC., Boston, Mass., June 6, 1977. Chairman, Subcommittee on Taxation and Debt Management, DEAR SENATOR BYRD: President Carter will soon be sending a major tax reform program to the Congress. As you consider this legislation, I hope you will keep in mind two important points relating to employment: 1. Capital investment and increased employment go hand in hand. Realistic investment incentives are essential to the acquisition of a modern and productive stock of plant and equipment, the development of new technologies and the growth of this nation's small businesses-the basis of a healthy economy and an expanding work force. 2. Adequate levels of job-creating investment cannot be obtained through a program concentrating solely on reinvestment of internally-generated capital. Individual investors are a major source of external risk capital, and investment incentives must be an integral part of any policy to encourage employment. One essential route to spur job formation and capital investment is through the tax code. I have recently written the attached article, scheduled to be published at an early date, outlining the connection between unemployment and the present system of taxing capital gains. I respectfully urge you to read this article and consider its proposals for encouraging new capital formation and job creation. Sincerely yours, CAPITAL GAINS TAXES AND UNEMPLOYMENT (By Alvin Zises) ALVIN ZISES. "The tax on capital gains directly affects investment decisions, the mobility and flow of risk capital from static to more dynamic situations, the ease or difficulty experienced by new ventures in obtaining capital, and thereby the strength and potential for growth of the economy." -Tax Message of President John F. Kennedy to the 88th Congress, First Session, January 24, 1963. When the late President sent his tax message to the Congress fourteen years ago, he sought to reduce the maximum tax rate on capital gains from 25 percent to 19.5 percent. The Tax Reform Act of 1976, which raised the "minimum" and "maximum" taxes on so-called "preference income", increased the effective capital gains tax to as much as 49.125 percent. The long-term effect of this change will be felt by those who may never pay significant amounts of capital gains taxes-by American workers in search of jobs. There is a causal relationship between higher capital gains taxation and higher unemployment. Equity capital is the foundation for other kinds of monetary capital including debt. Without total monetary capital formation, expansion of physical capital in the form of plant and equipment will be retarded. Without physical capital, job formation is impeded. Thus, to enhance job formation equity capital formation must come first. Although there was much that was sound socially and economically in the Tax Reform Act of 1976, the impact of the uneconomic and inequitable sections of the Act is dawning upon investors as evidenced by such recent statements as that of Walter B. Hoadley, Chief Economist for the Bank of America : "The Tax Reform Act of 1976 is widely seen as a further step to redistribute income and wealth***. The danger is that further steps in this direction will only compound the fears of potential investors, already very skeptical about |