Many of them do not have the means, or the particular accounting firms or large tax lawyers that the large corporations have to deal with this. They are overburdened with regulation which essentially inhibits their willingness and their incentives to expand. I have run into situations in which some of the regulations that have come from Washington for several small businesses were too obscure for the individual to understand. He may be a good businessman, in the type of product he is in, but he is not a lawyer. They do not know what to do. They obviously want to adhere to the law in every way that they can. They do not know how to do it, and this, in my view, if it continues, will undercut this very vital segment of our economy. So simply, I would say a simplification and reduction of regulation, especially for small business, will do more to enhance expansion and investment in small establishments than anything I could think of. Senator BYRD. I was talking the other day with a very able individual who has had a bit of experience in the tax field. He feels that in regard to depreciation that a business should have the right to set its own depreciation schedule and to write off the equipment-speaking of the equipment right now-in 1 year, if that business desires, or to write it off over a longer period of time. Would that, from the point of view of the Government as well as the point of view of the business, would that be a practical or reasonable thing to do? Mr. GREENSPAN. The only sensible thing a businessman should do, if confronted with those options, is to write it off immediately. The only reason he might not is that he might not want to make his reported earnings to shareholders reflect it. But I find that, a rather irrational point of view. While I would certainly be in favor of as short a schedule of depreciation as possible, I do not think, as a practical matter, that you can leave it to the businessman's full discretion, because any sensible businessman would then choose-provided he has a tax liability-to write it off immediately. If he does not, it is for nonsensible reasons, Senator BYRD. Of course, if he writes it off in a very short period, in 1 year, 2, 3, or 4, then of course, then his tax liability after that will substantially increase. Mr. GREENSPAN. However, what it amounts to is that he has, in a sense, an interest-free loan from the Federal Government owing to a delay in his tax liability. You will find, if you go through the arithmetic, that it will always pay to continuously defer taxes, even though the absolute dollar amount that is paid will, if legislation does not change, be the same. You are saving the interest on the loans to pay the taxes earlier. Senator BYRD. Do you feel that the depreciation rates are currently set at the right rate, or should they be liberalized? Mr. GREENSPAN. I think they should be more liberalized. It is evident when you run into an inflationary period such as now, there is a tendency for depreciation to lag. I think some acceleration would be clearly desirable. Senator BYRD. But not to the extent of a 1-year depreciation? Mr. GREENSPAN. I will say this-if you had that, it would be a major boon to capital investment, but you would have a huge revenue loss in the process. That is a tradeoff that we must make. Senator BYRD. Do you happen to have any information as to how the new schedule in Canada is operating? I understand it can be written off in 2 years. Mr. GREENSPAN. They have an acceleration that I am not familiar with. I do think the tendency that the tax system is moving toward, indexing individual income tax rates and accelerating depreciation, is clearly something which we should be moving toward. The indexing question has been discussed more and implemented less than I think most any proposal I have seen in years. Senator BYRD. To get back to the question of integration, if an integration proposal is to be adopted, do you feel we should compensate for the revenue losses? Do you feel that some of the present provisions in the tax law, such as the tax credit, investment tax credit, should be eliminated? Mr. GREENSPAN. At this stage, Mr. Chairman, I would be reluctant to move in that direction. In the name of sustaining capital investment, it depends obviously on the type of integration we are talking about. If it turns out that we are looking at full integration and reduction in the upper brackets, then I think on net balance it may well be advantageous. But you would have to have some very significant, offsetting advantages to capital investment for that to be a tradeoff which would enhance investment in the country. Senator BYRD. If you had a choice between integration, which would involve eliminating many of the tax benefits that businesses now have, or modifying the existing tax system, namely a reduction in the corporate income tax itself to provide for greater investment without integration, which do you think would be the sounder approach? Mr. GREENSPAN. I would opt, at this stage, if capital investment was my sole purpose to emphasize a cut in the corporate tax. I would, for example, be very much inclined to move toward some acceleration in depreciation and would prefer that the investment tax credit be embodied into an overall corporate tax reduction. There are a number of statistical studies that suggest that that would actually be negative to capital investment. It might be at the margin but the overall distortion that is reduced by having high corporate tax rates come down would work in the other direction. I would be more inclined to the removal of various preferences and reducing the rate as a vehicle that would tend not so much to increase aggregate investment, but direct it in the areas where it does the most good. Senator BYRD. Would you have a figure where you would care to indicate under those provisos what would be an appropriate figure to reduce the tax rate? Mr. GREENSPAN. You are talking about the corporate tax rate? Mr. GREENSPAN. If you realize, Mr. Chairman, that the direct, immediate Federal revenue loss will be a little more than over $1 billion per percentage point, we could drop the corporate rate very substantially, say, by 10 percentage points. The actual final revenue loss would be significantly less than the immediate, and it certainly would act to restore a good deal of the business confidence which has been eroded in recent years. It could be one of those rare corporate tax cuts that actually would not lose revenue. That was an essential argument of the Kennedy administration when they introduced their tax legislation. I think they were proved right at the time. Subsequent analysis indicates that their tax program which reduced the tax on capital and on investment was not a revenue loser, and if we could take the principle of the legislation which the Kennedy administration introduced and applied it to the current period, we might well find that we could reverse this erosion in capital incentives. Senator BYRD. One final question. In regard to depreciation, would a more liberalized depreciation policy work somewhat like the investment tax credit; namely, if an asset is fully depreciated at the end of a short period of time, would that have the effect of encouraging business to replace that equipment more quickly and thus create additional business activity at the other end? Mr. GREENSPAN. It might, in some cases, Mr. Chairman. In general, it probably would not. The reason that it would not is that most sophisticated analysis within companies does not look at a particular piece of equipment from the point of view of the books, so to speak, whether or not depreciation has or has not pertained, but what does it cost to produce item x with the existing facility and what does it cost if you replace the facility wholly independent to what the books show with respect to depreciation or net book value. As a consequence, the main thrust of accelerating depreciation is largely to move the cash flow on new investment up front, where it is more likely to be an incentive to new investment. It may be, however, as you say, that there are some companies which would consider the fact that investment is already written off as a reason to move ahead on new investments. I suspect that they would largely be in the minority. Senator BYRD. As a general proposition, that would not be a very viable way of stimulating economic activity? Mr. GREENSPAN. Not for that purpose. Accelerated depreciation is, but not because in itself writing off something quickly would create new investment incentives. Senator BYRD. Thank you very much, Mr. Greenspan. I appreciate your being here today. Mr. GREENSPAN. Thank you very much, Mr. Chairman. It is always a pleasure to testify before you, sir. [The prepared statement of Mr. Greenspan follows:] STATEMENT BY ALAN GREEN SPAN, PRESIDENT, TOWNSEND-GREEN SPAN & CO., INC. It is a pleasure to appear before this subcommittee today to discuss the incentives needed for economic growth in the years immediately ahead. In recent years, I have often stressed, before this committee and other committees of the Congress, the critical importance of enhancing incentives for capital investment in this country. If we fail to do so, our chances of achieving a noninflationary full employment economy by the early 1980's are, in my view, remote. 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 |