stated with reference to the 1940 investment in dollars of current purchasing power; in other words, the proper amount of depreciation to be taken by the utility in 1953 would be $20,000 (on the assumption that the 1940 dollar had declined to 50 cents), representing a one-twentieth part of the 1940 investment (stated in equivalent purchasing power) actually used up in 1953.

This example is typical of what is actually happening in industry today. It is estimated that, for the electric, gas, and telephone utilities, the present method of basing depreciation allowances wholly upon unadjusted original dollar cost results in underdepreciation to the extent of approximately $500 million annually; this overstates for tax purposes their actual net income by an equal amount, resulting in over half of the amount by which the depreciation allowance is understated being taken away in taxes. This is the drain which so seriously concerns the utilities at this time; for whenever tax depreciation fails to accurately state true depreciation, the amount by which true depreciation exceeds tax depreciation is taxed as income, although the entire amount of true depreciation is simply the return of real capital invested by the taxpayer.

III. WITHOUT ADEQUATE DEPRECIATION, THE CORPORATE INCOME TAX BECOMES A CAPITAL LEVY

With the decline of the dollar to one-half its value in the last 15 years, the corporate income tax has become, in part, a capital levy due to the failure of the Internal Revenue Code to provide a depreciation allowance which adequately measures the current consumption of properties used up in the production of goods and services. The understatement of depreciation produces an overstatement of taxable income, with an accompanying tax on fictitious profits. With the corporate tax as high as 52 percent, the overstatement of true income is extremely detrimental to the welfare of business in general, and particularly to public utilities. Its significance is that a tax which was originally imposed to share with the Government the profits of a business is now taking a part of the very capital which is so essential to the continued operation of that business. As such a tax continues over a period of years, the injury to business deepens, for more and more of the capital vitally needed for production is drained away. This erosive process cannot go on unchecked without real harm resulting to private enterprise.

IV. REGULATED UTILITIES ARE MOST SERIOUSLY AFFECTED BY THE PRESENT INADEQUATE DEPRECIATION ALLOWANCES

While this understatement of tax depreciation due to the decline in the purchasing power of the dollar affects most businesses, the burden falls most heavily upon those industries which have a concentration of long-lived depreciable property. The utility companies are foremost among those industries whose investments in such assets are high in relation to their total capital and to their annual revenues. Their generators, their gas production plants, their pipelines, their transmission and distribution facilities, and other installations, all have long lives, extending as much as 50, sometimes even, 100 years. With their substantial investment in such long-term assets, the utilities are seriously affected when the tax allowance for depreciation falls far below the amount necessary to permit a tax-free recovery of their investment. In our own company, the Peoples Gas Light & Coke Co., a typical gas-distribution utility, 80 percent or more of its total capital is invested in depreciable assets. the other hand, there are many industries, such as those engaged in the wholesale or retail trades, in light manufacture, in the processing of goods, and in the construction business, which have relatively little or no investment in longlived depreciable property. Their capital may be largely invested in inventories, raw materials, goods in process, or in depreciable property with relatively short useful lives. With respect to these industries, of course, there is no major problem as to the inadequacy of tax depreciation resulting from the change in the value of the dollar.

On

In addition to the fact that public utilities generally have a greater proportion of their investments in long-lived depreciable assets than most businesses, they are more seriously affected by the present inadequate depreciation allowance because they are not free to adjust voluntarily the prices of their products or services to meet their actual costs in a period of inflation. These costs include depreciation based upon the real investment of the public utilities, and not merely the tax depreciation which at present is limited to the historical cost

of the physical assets measured by the nominal dollar amount invested in the property. Industry which is not subject to regulation may adjust its prices at will to meet these actual costs; thus, to a large extent, unregulated industry may protect itself through its own pricing policies from the effects of inflation on tax depreciation. Furthermore, competing firms in unregulated industry are subject generally to the same pressures with respect to their costs in a period of inflation, and therefore they will tend to adjust their pricing upward on a more or less uniform basis in order to meet the rising costs to which all members of the industry are equally subject. Public utilities, however, being regulated as to their rates, are not free to meet these higher costs except upon the approval of the regulatory commissions; and the regulatory commissions are extremely reluctant to approve realistic depreciation rates which are not fully allowable for tax purposes.

V. WHILE UTILITY COMMISSIONS REALIZE THE INADEQUACY OF TAX DEPRECIATION, THEY CANNOT SOLVE THE PROBLEM ALONE

A number of the public commissions have realized that the tax allowances for depreciation have become wholly inadequate by reason of inflation, and a few have tried to meet the problem to some extent by granting larger allowances in the ratemaking process. For example, in the rate case of The Peoples Gas Light and Coke Company (97 P. U. R. (N. S.) 33 (1953)), the Illinois Commerce Commission granted over $500,000 additional depreciation (above tax depreciation) in view of "the changes which have occurred in economic conditions." The Commission went further and allowed some $100,000 in additional rates to cover in part the income taxes which would be levied upon that part of its allowance for current depreciation which would not be deductible (being in excess of the corresponding original-cost depreciation) in computing the company's income taxes. However, as a general proposition, extreme reluctance is uniformly shown on the part of the regulatory bodies to provide adequate allowance for actual depreciation due to the fact that the excess of such allowance over the amount of depreciation permitted under the tax laws must be split with the Federal Government for income taxes. In other words, the amount by which actual depreciation exceeds tax depreciation is not permitted to remain in the reserves of the public utility, but is taxed as income, 52 percent of it being thereby drained away into the Federal Treasury. This aspect of the problem was specifically commented upon by the Utah Public Service Commission in the application of the Mountain States Telephone and Telegraph Company (99 P. U. R. (N. S.) 1 (1953)), for additional depreciation for ratemaking purposes. In denying the applicant's request for depreciation based upon "the consump tion of real capital devoted to the business," the Commission stated: "Under existing Federal tax laws it would be necessary for the applicant to collect in excess of $2 from its customers for each $1 it could retain * * * to provide the extra depreciation allowance contended for." In view of the adverse effect which the Federal taxing provisions now have upon any effort to provide for actual depreciation sustained by the public utilities, the reluctance of the regulatory bodies to increase consumers' rates for such purpose is understandable. In a more recent rate case (Re Southwestern Bell Telephone Company (2 P. U. R. 3d, 1, 22)) before the Arkansas Public Service Commission, the following statement was made by the Commission in the course of denying the application of a utility company for an increase in rates to provide for adequate depreciation accruals:

"We are acutely aware of this problem in utility regulation, and we recognize that depreciation expense computed on original cost during this period of inflation may not maintain the capital committed to the utility service. The problem is currently under consideration by various regulatory bodies, and proposals have been made to change the Uniform System of Accounts to allow for additional depreciation expense.

"However, until some definite action has been taken to modify the Uniform System of Accounts, we do not feel that we can allow this expense for ratemaking purposes. Moreover, depreciation expense in excess of amortization of original cost is not recognized by the Federal Government for income-tax purposes at this time, although hearings have been held to consider proposals to modify the present law. Pending a revision of this law, an allowance for additional depreciation expense would require an increase in revenues of more than twice the amount of the required expense to provide for additional income taxes. We feel that it is unreasonable to expect the ratepayer to bear this excessive burden."

Unregulated industry is not so seriously involved with this problem, for it may voluntarily raise its prices to cover necessary costs (such as actual depreciation), even though the taxing provisions do not give full recognition of all such costs. Moreover, the vast wartime and postwar expansion of the property of unregulated industry has lessened the significance of their prewar properties in respect of the total of all plant and equipment now in use.

VI. CONGRESS HAS RECOGNIZED THE ADVERSE EFFECTS INFLATION HAS UPON TAXATION

With respect to taxpayers who have a substantial part of their investment in inventories, the Congress has provided for the use of the last-in-first-out (LIFO) inventory method, under section 22 (d) (2) of the Internal Revenue Code. Under this method, the income which would otherwise result from repricing at higher current costs the same physical quantities of materials initially carried in inventories at lower costs, commonly called inventory profits, may be largely eliminated by using as the cost of goods sold the most recent purchases of goods. The fictitious income thus attributable to inventories in periods of inflation is thereby excluded from taxable income. This problem which the Congress cured in 1939 for industries with large inventories, such as metal fabricators, tanneries, and also retail and wholesale establishments, by recognizing the LIFO inventory method is very much the same as that which confronts the public utilities today with respect to their depreciation charges for plants and facilities. Fictitious income similarly arises from the inadequate depreciation allowed under the present tax laws.

In 1951, the Congress recognized the tax burden resulting from inflationary gains in the sale of residential properties. Out of concern for the fact that many homeowners were paying income taxes on gains from the sale of their homes simply because the purchasing power of the dollar had dropped substantially since acquiring their homes, the Congress provided in the Revenue Act of 1951 that no such gain would be taxable if the homeowner reinvested with reasonable promptness the proceeds in a new home. In this way, they, too, were protected from having a part of their capital taken away in the form of income taxes.

VII. EMERGENCY AMORTIZATION DOES NOT PROVIDE A SOLUTION TO THE PROBLEM OF INADEQUATE DEPRECIATION

The amortization deduction for emergency facilities which was enacted in 1950 to encourage the development of essential plants in connection with the Korean crisis is not a solution to the tax problem of the public utilities. While the emergency amortization provision gives much earlier (and larger) deductions for certified facilities, it is applicable only to plant expenditure made since the major share of the present inflation took place. Even so, the provision continues to use as the basis for the deduction the original cost measured in dollars which are not adjusted for any change in their purchasing power since the acquisition of the property. Accordingly, if the dollar should drop substantially further in the value between the time when the property was purchased and the year in which the depreciation or amortization deduction is taken, the deduction figure will still be an inadequate representation of the cost of the investment to be recovered.

Similarly, the liberalization of the depreciation allowance under section 167 of the current revenue revision bill (H. R. 8300), wherein there is provided the declining-balance method for measuring depreciation, does not solve the problem confronting utilities. This provision would permit a taxpayer to write off twothirds of the original cost of the property during the first half of its life. This version of accelerated depreciation will be of very little use to the utilities in meeting their present problem for two reasons. First, it applies only to new properties acquired after 1953. Second, it is still tied to original cost dollars unadjusted for any change in the purchasing power of the dollar. Thereunder, if the dollar fluctuates in value between the time the property was acquired and the period for which depreciation is computed, the allowance under that method in the bill will be either under or over stated, just as it would be under the present method of computing depreciation.

VIII. RECOMMENDED SOLUTION IS THAT PUBLIC UTILITIES BE GIVEN AS TAX DEPRECIATION THE AMOUNT ALLOWED BY THE REGLATORY COMMISSIONS

In order to prevent the income tax from taking part of the capital of public utilities through wholly inadequate depreciation allowances, it is urged, as a

minimum solution at this time, that public utilities be permitted to take as a deducton the amount of depreciation determined to be currently necessary and essential by the regulatory bodies in their ratemaking procedure. Tax depreciation and depreciation for ratemaking purposes are intended to accomplish the same thing; both are designed to provide for the recovery of the investment in depreciable property consumed in the business operations in a given period prior to the determination of net profits. It is believed that the appropriate agency to make a fair determination of necessary and proper depreciation would be the regulatory body having jurisdiction over the public utility. The regulatory agency has the obligation to see not only that the public utility is allowed sufficient reserves to maintain its capital at an efficient operating level for the future but also that the rates for its services to the public are as low as possible consistent with reasonable earnings for the investor. These pressures are counterbalancing and would tend to produce a fair and equitable depreciation allowance; the amount allowed would not be too large because that would increase unduly consumer rates, nor too small because in that event the utility could not adequately maintain its productive capacity. Although traditionally the Internal Revenue Service has had the initial authority over tax deductions, in appropriate cases the Congress has made use of determinations made by other governmental agencies for tax purposes. For example, in the Excess Profits Tax Act of 1950, public utilities were permitted, under section 448, to compute their excess profits tax, credits by reference to the corporate books of account kept by the utilities under the direction of the appropriate regulatory agencies. The amendment which is attached to this memorandum specifically provides that the amount to be taken for current depreciation is not to be limited by the original dollar cost of the depreciable property as specified under section 113 (b), because it is intended by the amendment to permit the regulatory bodies, if they find it necessary and appropriate, to determine the depreciation allowance by reference to the original dollar investment adjusted to reflect the changed purchasing power of the dollar. Thus, in such instances the total number of dollars charged as depreciation may exceed the number of dollars of greater purchasing power originally invested by the particular utility; but in no case will the value of the depreciation charges ever exceed the value of the investment made. The objective of the amendment is to permit the regulatory bodies to provide an adequate allowance for the full tax-free recovery of the real value of the wealth invested in the physical plant and equipment, and no more. The present law merely permits the taxpayer to recover over the life of the property the same number of dollars which he originally invested in the property; due to the very substantial drop in the value of the dollar during the last 10 years, the taxpayer is not permitted a full tax-free recovery of his investment.

The amendment is made wholly elective, so that no public utility will be forced to use this method for measuring depreciation; those companies which desire to pursue the present depreciation practice may continue to do so undisturbed by the amendment. In addition, the amendment would not allow any public utility to use both this adjusted cost method and the declining balance method prescribed in section 167 of H. R. 8300. While it is felt that utilities generally will find little or no help in the declining-balance method, they should not in any event be permitted to take both accelerated depreciation (which is what the declining-balance method really is) and adjusted-cost depreciation.

Attention should probably be called to the effect and prospective treatment of an offsetting factor in connection with inflation, and that is long-term indebtedness which may be a part of the capital structure of the utility company. To the extent of the borrowed capital, there is a builtin protection against the effects of a rise or fall in the purchasing power of the dollar insofar as the measurement of depreciation is concerned. Thus, to the extent, both as to amount and period of time, that the dollar is stabilized through the hedging effect of long-term indebtedness, the original cost depreciation works satisfactorily. This partial hedge against the decline in the value of the dollar is one of the factors which the regulatory commissions would certainly be expected to take into account in determining the appropriate depreciation allowance for ratemaking purposes. Indeed, in the recent rate case of the Peoples Gas Light & Coke Co., previously referred to, the company itself took the position that it was entitled to depreciation based upon original cost adjusted to the current purchasing power of the dollar only with respect to the equity interest in its depreciable property.

IX. NO SUBSTANTIAL REVENUE LOSS FROM PROPOSED AMENDMENT

While the cost to the revenues of enacting the proposed amendment would be difficult to estimate with accuracy, it is believed that in any event it would not be substantial, for the following reason: The regulatory commissions have at the present time almost uniformly refused to grant more depreciation for ratemaking purposes than that allowed for tax purposes. Therefore, immediately upon enactment of the proposed amendment, there would be no immediate revenue effect. However, with the enactment of the amendment, public utilities could be expected to, and most certainly would, apply to the regulatory commissions for service rates which would reflect adequate depreciation allowances. At that time, the commissions would be no longer deterred from giving full depreciation allowances because of the tax laws; they would be able to grant adequate depreciation allowances in the fixing of service rates with the knowledge that no part of such allowances will be taken from the utilities in the guise of taxes on income. The increases in the depreciation allowances so granted by the regulatory bodies would thus be reflected simultaneously in rate increases fully offsetting the drop in the taxable income of the public utilities which would otherwise result from the increase in depreciation allowances alone. For example, if the regulatory commission in its ratemaking process gave an increase in the depreciation allowance of $500,000, the commission could only do so effectively by increasing the revenues of the utility to make up for the added expense. Accordingly, there would be no actual decline in the taxable income or the income tax of the public utility. However, the depreciation accumulations by the utility would thereby be restored to an adequate level for continued maintenance of its service capacity and capital investment.

For this reason it is doubtful that the revenue cost of the enactment of the proposed amendment could be substantial.

APPENDIX A. AMENDMENT TO PROVIDE ADEQUATE DEPRECIATION FOR PUBLIC UTILITIES Add the following new subsection at the end of section 167 of the Internal Revenue Code of 1954, as contained in H. R. 8300:

"(i) DEPRECIATION FOR PUBLIC UTILITIES.-For taxable years ending after December 31, 1953, at the election of a public utility (as defined in sec. 247 (b)) the term 'reasonable allowance' as used in subsection (a) shall be an allowance computed according to the method and in the manner prescribed for ratemaking purposes by the appropriate regulatory agency or appellate body with respect to the utility property held by such taxpayer. The election of such method shall be made in accordance with such regulations as the Secretary or his delegate may prescribe, and shall be irrevocable for the taxable year in which it was made and for all subsequent taxable years, unless a change to a different method is approved by the Secretary or his delegate. The allowance under this subsection shall not be limited to the adjusted basis of the property under section 1011. In computing the adjusted basis of property with respect to which an election has been made under this subsection, the adjustment for exhaustion, wear and tear, obsolescence and amortization required under section 1016 (a) (2) for taxable years to which such election is applicable shall be determined under subsection (b) (1). For taxable years to which an election under this subsection is applicable, the taxpayer shall not be entitled to use the method prescribed by subsection (b) (2) or (3). In no case shall this subsection apply to that part of any property with respect to which the taxpayer is entitled to take an amortization deduction for an emergency facility under section 168."

Senator CARLSON. The next witness will be Mr. Sherlock Davis, United States Cuban Sugar Council.

Mr. Davis, we appreciate your appearance before the committee, and you may proceed in any way you care to.

STATEMENT OF SHERLOCK DAVIS, GENERAL COUNSEL, UNITED STATES CUBAN SUGAR COUNCIL

Mr. DAVIS. My name is Sherlock Davis. I am general counsel of the United States Cuban Sugar Council.