Mr. GREENSPAN. First, Mr. Chairman, we must be careful in looking at taxes that the major force which could destroy capital investment is inflation and, if, in the process of constructing our fiscal policies, we inadvertently create large deficits, we will find whatever policies we have in the tax area will be self-defeating.

Every policy must be in the context of gradually reducing the budget deficit to remove the inflationary imbalances and the pressure that Federal borrowing has on the capital markets, which would, more than anything else, undercut any strength in the capital investment

area.

Having said that, I would say that the most important thing that should be done is to cut the corporate income tax. It is a far more important thing to do than a number of the other proposals that we tend to get involved with with respect to trying to enhance capital investment.

I do think the investment tax credit is a valuable tool and I do agree with your view that whatever we do with it, let's stabilize it and not continually change it.

One change, if we could make it, and lock it in place, which would be helpful, would be to remove the bias which now exists in the investment tax credit toward enhancing investment in short-lived as distinct from long-lived assets. Because of the flat 10 percent credit, it turns out that it unduly enhances incentives to invest in 5-year assets and for longer lived assets it is a gradually diminishing force.

Since the major element in the recent shortfall in capital investment is in long-lived assets, I would suggest that the committee take a close look at having the investment tax credit rising with the life of the asset to neutralize this bias toward short-term assets.

The last economic report of the Ford administration's Council of Economic Advisers attempted to outline this problem and showed in a table the biases which are inherent in the existing tax law. That would be the only significant change, sir, that I would recommend in the investment tax credit, and I certainly hope that thereafter there would be a tendency not to further alter this valuable vehicle.

Finally, there would be unquestionably, great advantages in accelerating depreciation which, I think, results in spurring investment about as much as an investment tax credit considering dollar-for-dollar revenue loss. With respect to the issue of eliminating the double taxation on dividends the so-called integration question, I fear the term "integration" is getting to be used in much too general a way.

How one creates integration very critically affects the impact. The major thrust of this type of legislation should be, in my view, to basically improve corporations' capacity to invest and I would tend to focus more on the issue of the deductibility of dividends in a manner similar to the reduction of interest in order to avoid a very marked imbalance between debt and equity.

There is however a major problem with that, Mr. Chairman. In a sense, if you keep the corporate tax rate where it is and you allow dividends to be deducted, you tend to impose a 48-percent tax on undistributed earnings. This might create a much larger amount of dividends than is, in fact, a sensible thing for a corporation to do.

Integration is also used to mean imputing all corporate income to shareholders. But in the context of the top-70-percent bracket, it

probably overtaxes incentive when it is passed on, especially for those who are in the upper-income brackets.

I would therefore say that one thing which should be thought of in terms of this type of integration is to reduce the 70-percent rate to the 50-percent rate and, tax earned and unearned income at the same rate, at which point it would then make sense to go to full integration in the sense of treating a corporation, and taxing it, as though it were an unincorporated business, or a Subchapter S corporation. If so, you would then not get the problem to which Senator Long alluded earlier in these hearings; namely compounded a 48-percent rate with the 70-percent rate.

Ideally I would opt for full integration, but as a part of that, I think it would be necessary to reduce the highest marginal tax rate for it to be effective as an incentive creator in the capital investment

area.

Senator BYRD. Summing up your remarks, I judge that you feel that the greatest long-range threat to our economy is inflation?

Mr. GREENSPAN. Yes, sir.

Senator BYRD. On the question of integration of personal and corporate income tax, it seems to me that this is an immensely difficult. matter to work out. I would like to see something accomplished in that field. I have never been able to get my mind clear as to just how we could realistically accomplish it.

No. 1, we would have to rule out the recommendation of the Americans for Democratic Action that you would tax the individual stockholder on the total profits of the corporation. As I understand, the way that would work-assuming 30 percent of the profit is distributed-if a person were entitled, under the present system, to a $300 dividend on which that person would then pay tax, that individual would be taxed on a $1,000 dividend and still only receive $300. That would be totally impossible, would it not?

Mr. GREENSPAN. Mr. Chairman, if earned and unearned income are both taxed at 50 percent and some means for corporate withholding of taxes on dividends could conceivably be worked out, then the problem would be much more easily handled.

There is no question if you have a situation where you maintain a 70 percent maximum marginal rate there is an undue and excessive burden on individual taxpayers. The purpose of integration is to enhance capital investment not impede it.

Senator BYRD. In regard to the investment tax credit versus a more liberalized depreciation schedule, if you had to choose between the two, which would you prefer?

Mr. GREENSPAN. At this particular stage, if the choice were, for example, increasing the investment tax credit or accelerating depreciation, I would tend to opt for the latter, largely because the investment tax credit, by its nature, tends to be focused on shorter lived assets, while the incentives that we need now are in the long-lived assets that includes heavy construction. Accelerated depreciation, would enhance investment in the areas where I believe we need it the most. One of the problems that I do have with the investment tax credit, even though I do support it wholly, is this bias toward short-term investment and its failure to cover the full spectrum of

capital investment, both plant and equipment, whereas, accelerated depreciation, would act to cover both and to tend to move incentives into longer lived assets.

Senator BYRD. Thank you.

Senator Long?

Senator LONG. Thank you very much for your statement.

Senator BYRD. Senator Hansen?

Senator HANSEN. Mr. Greenspan, some people have recommended that there is an unfairness, inherent unfairness, in the capital gains tax for the sale of an asset held-it used to be 6 months, now it is 9 months, and then we go to 12 months next year.

There have been some who suggest that there should be a declining scale of taxes applied that will reflect the increased period of time over which an asset is being held.

What are you views on that?

Mr. GREENSPAN. Senator, let me answer the question in a broad way.

I believe we have been moving, in the last number of years, perhaps by inadvertence more than with purpose, of increasing taxes on capital investment, and on incentives. It is by no means an accident that we are now running into concerns with respect to capital investment shortfalls and its effect on growth and standards of living of the American people.

I would not focus solely on any specific tax, but clearly we are gradually removing the tax preference on capital gains. The marginal rates are now up to close to earned income rates.

If we had, for example, the type of implied indexing that you suggest on capital assets, that would clearly move us back, in many respects, to where we used to be and improve the incentives for longer term investments. That is the direction in which we should be going. If we could alternately, or in addition, treat earned and unearned income equally and reduce the maximum rate of taxation to say, 40 to 45 percent, while eliminating the capital gains tax preference completely, we would probably be moving in the right direction.

What I am concerned about is not any particular tax. Yet, it would be desirable to index capital gains, other things being equal. Indexing capital gains and simultaneously, eliminating tax preferences on capital gains would also be useful as a tradeoff.

I am inclined to support anything that reduces the tax on capital gains and anything that reverses the direction that we have been inadvertently and unfortunately following.

Senator HANSEN. Thank you very much. I have no further questions.

Senator BYRD. Thank you, Senator Hansen.

Mr. Greenspan, would you list for the record the current sources of capital available to business for investment?

Mr. GREENSPAN. First of all, most businesses start with their internal cash flow which, as you know, Mr. Chairman, has been declining. I should say its growth rate has been declining in recent years, along with what I am sure is a decline in the rate of return on facilities.

Second is, the equity market. The volume of financing tends to move up and down with the market value of securities; and here too, for rea

sons that I outlined at the beginning of my presentation, the factors creating uncertainty in capital investments have also created similar risk premiums for equities.

Price-earnings ratios have fallen, which is another way of saying that the rate of discount on expected future earnings has risen so the same force that has inhibited capital investment has inhibited the market value for stocks, and as a consequence, the cost of capital to corporations.

Finally, there are debt issues that have been, to a greater and greater extent, the source of capital for investment in this country.

We have unduly increased that debt rate. Rising debt-equity ratios have probably been a factor in causing a greater sense of instability in the business community and a factor which probably tend to accelerate inflationary pressures.

Senator BYRD. Is there a shortage of capital or only a shortage of investment, due, perhaps, to a lack of business confidence?

Mr. GREENSPAN. I do not think there is a true shortage of capital. There is no physical shortage. It largely depends on the willingness to invest in the future.

In essence, there is no shortage of capital. There is a shortage of confidence.

If confidence were restored, we would have all of the capital invested that we conceivably would want and many of the problems which now assail this economy would, in my view, disappear.

Senator BYRD. The key word is confidence?

Mr. GREENSPAN. That is right.

Senator BYRD. How much emphasis would you place on the need to encourage personal savings as a part of the capital formation package?

Mr. GREENSPAN. I am inclined to agree with Assistant Secretary Brill that the aggregate amount of savings per se is very difficult to alter in a useful way. This is why I have always thought that the major action that the Federal Government could take to enhance savings for the private sector would be to reduce the Federal deficits which directly drain savings from the personal sector. Also needed is to reduce very large, off-budget financing and the large guarantee programs. We do not place these guarantee programs in the budget, but they have precisely the same effect in absorbing private savings and reducing the amount of savings available to the investment sector, as does direct Treasury borrowing.

Similarly, all the regulations that require corporations to invest in, say, pollution control equipment drain savings. The effect on savings is the same as the Government borrowing those funds and lending them to the company to make that investment.

Rather than thinking in terms of enhancing personal savings, I think the focus should be on reducing the direct drain on overall savings coming from the Federal sector and the indirect drain which it imposes through guarantees and regulations. In that respect, it can do more to create increased private savings available for capital investment for economic growth.

Senator BYRD. In that connection, a corporation in Virginia whose manager came to see me last week, earns roughly $3.6 million. It has

been ordered by the Government to convert to coal, and the estimate of the cost to do that is $30 million, about 10 years' worth of profits.

I would think that a corporation faced with that choice would have a pretty difficult time staying in business, would it not?

Mr. GREENSPAN. Yes, sir.

Senator BYRD. What we need to do is create additional job opportunities rather than eliminate job opportunities, yet we are faced with a need to convert from oil to coal.

When you add up all of those factors, where is the priority line in that area?

Mr. GREENSPAN. First of all, as I said earlier, Mr. Chairman, one thing that I think can specifically assist in the resolution of this problem is decontrol of crude oil at the well. If we decontrol, many of the applications that are moving toward the use of oil and gas will, of necessity, begin moving toward coal, not because it is mandated by the Federal Government, but because it is a far more sensible approach in meeting company requirements.

I am not saying you are going to solve all of our problems that way. I do not think, in fact, that you will. It is unquestionably a particular policy option that has very great effectiveness that we are not using, and to try to resolve our energy problems with our most important policy vehicle out of use is making it exceptionally difficult and forcing us to come up with types of solutions just alluded to.

I do not think that you can, in fact, mandate that sort of situation. Senator BYRD. If you decontrol oil and natural gas, that would not, in itself, eliminate the need of conversion to coal.

Mr. GREENSPAN. What it would do is price oil, coal, and gas in a way that users will move toward coal. I have heard a number of people in the business community say there is no way to reach our necessary coal production goals without such changes, and without some rethinking of the types of environmental regulations that we have.

We have a very serious energy problem, in my view. What we are trying to do is resolve it in ways that give us a very low probability of actually solving it. If we were to have some changes in environmental legislation and were to move toward decontrol in a phased manner on oil and natural gas, the incentives to create much higher levels of coal production will be there. Because of the differential in reserves that now exists, it is quite likely that coal would become a far cheaper fuel than oil or gas in which case you would tend to get a market increase in the consumption of coal and hence in the profitability of mining. And the solution of the particular problem that you raise, would not need mandation by the Federal Government to switch from oil to coal. It would be in the interests of the companies to do so. Senator BYRD. If you were charged with formulating capital formation proposals aimed at helping small to medium sized corporate and nonincorporated businesses, what would be your recommendation? Mr. GREENSPAN. Aside, sir, from the general recommendations with respect to tax policies I do subscribe to making permanent the lower first bracket rate on smaller corporations. Moreover, I found in talking to a number of small businessmen. the greatest problem for them is the very large amount of regulation to which they are required for adhere.

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