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 carryback 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 the prospects for adequate reward, and discourage them from taking on new venture risks needed to create jobs." Seemingly oblivious to these warnings, “tax reform” proponents continue to urge elimination of what little remains of the capital gains concept. They disregard the fact that, if tax penalties are imposed upon equity capital formation, investors will turn to the more certain returns of other investments not as conducive to long-term job formation. Frederic Hickman, formerly Assistant Secretary of the Treasury for Tax Policy, in a March 1977 article, excerpts of which are quoted below, explains that, because of the intricacies of the Act. its economic consequences may have eluded some Congressman: "*** the Act was a back-door increase in the effective rate of tax on capital gains. This increase came disguised as changes in the so-called minimum and the maximum tax ***. "Were the members of the tax-writing committees fully aware that what they were enacting was a very substantial boost in the tax on capital gains? The record and the dialog at committee session suggest that most were not. Most Congressmen doubtless thought that they were addressing the situation of the high income taxpayer who pays little or no Federal income tax. The interaction of the minimum, maximum and regular taxes had become sufficiently intricate that even those who voted to enact them can be excused for misunderstanding them ***. In fact, some of the members who voted for these provisions were the same members who had been calling for reductions in the tax on capital gains! "Unfortunately, the increase to 49-plus percent in the top tax rate is only part of the story. A 49 percent rate for capital gains is, in reality, more like a 70 percent effective rate on economic income because such a large part of the nominal capital gains taxed is created by inflation." Elimination of the capital gains tax system is not a matter of closing a supposed "loophole" which benefits only those with sufficient substance to afford the risks of investing in equity ventures. It directly affects a major portion of this nation's population: approximately 30 million shareholders in publicly-held corporations which look to individual investors as a source of new equity investment; and additional millions who invest their savings in small businesses. It indirectly affects millions who depend upon both for jobs. UNEMPLOYMENT AND EQUITY INVESTMENT BY INDIVIDUALS Current estimates of total capital investment necessary over the next decade to build new plant and facilities and to maintain full employment vary, but they are all staggering. A recent Department of Commerce study indicated that total investment necessary over the next five years to meet our full employment goals by 1980 and also to bring about effective control over pollution and expand our energy production will have to be some $300 billion above the 19711975 level. Similarly, the New York Stock Exchange estimated that capital investment by 1985 will have to be increased almost $650 billion over current levels to accomplish the same objectives. In 1976, however, capital investment as a percentage of our gross national product showed little increase over that of 1975. The Small Business Administration in January 1977 released the results of a Task Force Study on Venture and Equity Capital in Small Business to determine the current availability of long-term capital to small businesses. The study revealed that small businesses comprise 97 percent of all unincorporated and incorporated businesses in the United States. More than one-half of all business receipts are generated by their operations, and they employ more than half the United States business work force. Small businesses cannot grow or compete effectively if they have to finance solely out of retained earnings. External sources must provide the funds needed for significant growth. Current inflationary factors, however, increase the willingness of companies to borrow rather than to issue equity. In a competitive economy it makes considerable sense to borrow dollars of known purchasing power today for repayment with dollars of reduced purchasing power tomorrow. This incentive toward debt financing is increased by the fact that interest costs are a tax deductible expense. However, high interest rates coupled with high levels of debt repayment lead to a burden of fixed charges that reduces a small company's ability to withstand adversity and obtain credit from lenders. Thus, the growth which produces economic stability and significant numbers of new permanent jobs depends upon the availability of new equity investment. The S.B.A. Task Force noted that small firms lack established earnings records and large amounts of outstanding common stock that are prerequisites for investment by large institutions Thus, in the sale of their equities, small businesses are almost entirely dependent upon the individual investor. Though individual investors must often accept large risks in purchasing the securities of such ventures, increases in capital gains taxes effected by the Tax Reform Act of 1976 have so reduced the after-tax return on equity that many such equity investments are no longer acceptable. Even before these changes, high capital gains levies contributed to the decline in venture capital investment. The study indicated that in 1972 there had been 418 underwritings for companies with a net worth of less than $5 million. In 1975 there were four such underwritings. The 1972 offerings had raised $918 million while the 1975 offerings brought in $16 million. Over the same period of time, smaller offerings under the Securities & Exchange Commission's Regulation A fell from $256 million to $49 million and many of these were unsuccessful. THE FLIGHT OF THE INDIVIDUAL INVESTOR Small business is obriensly not the only sector of the economy hurt by declining individual investment. In terms of volume of trading in our equity securities exchanges, the individual has largely been replaced by the institutional investor. Although performing essential services in regard to professional money management and family security, such institutions do not necessarily serve the same market-making and liquidity functions as do masses of individual investors. Individuals contribute the great variety of opinions and judgements that make a free market place, and it is the individual who has traditionally been the principal source of equity capital for smaller companies. James M. Roche, former Chairman of the Board of General Motors, summarized the value of the individual investors to our securities markets and small businesses to our economy when he stated: “*** Every large corporation depends upon hundreds or thousands of small enterprises, as suppliers of components, as generators of ideas and products, as producers of income for their owners and shareho'ders who buy our products. "These small companies must depend upon the smaller, non-institutional investors for equity investment, and all companies, small and large, as well as the institutions themselves, depend upon the individual investor to supply liquidity, depth and continuity to the market." REDUCTIONS IN CAPITAL GAINS TAXES AND INCREASED TAX REVENUES One of the most detrimental consequences of increases in the capital gains tax is its effect on individuals' willingness to "roll over" their investments-sell existing holdings, pay capital gains taxes and reinvest the remainder. It is this "roll over" or "unlocking" process which simultaneously produces both jobcreating new investment and additional revenue to the Treasury. The results of a poll undertaken in 1973 by Oliver Quayle and Company, a national opinion research company, present some findings which demonstrate the benefits to the Treasury of reducing capital gains taxes. The Survey showed that reducing the capital gains rate would produce significant increases in both sales of appreciated securities and tax revenue to the Treasury. If the 25 percent maximum rate had been cut to 12.5 percent maximum, and the 35 percent rate to a 25 percent maximum, an additional $1.7 billion would have been received by the Treasury in tax revenues, or an increase in such revenues of 43 percent over 1972. Cutting the then-lower capital gains tax rate in half for all investors would have produced even more tax revenue to the Treasury-$3.2 billion more than received in 1972, or an 82 percent increase in taxes from long-term gains. The Quayle Survey also demonstrated that if the capital gains tax had been 20 percent higher for all investors, sales from which capital gains were realized would have been significantly less, and the Treasury would have received an estimated $358 million less in tax revenue than it actually received from long-term gains. If the holding period had been one year, capital gains tax revenue would have been $467 milion less to the Treasury. These findings highlight: To obtain greater tax revenue from capital gains, the rate should be reduced. ALTERNATIVE INCENTIVES FOR CAPITAL INVESTMENT A number of proposals to stimulate business investment have been offered which include some long overdue changes in corporate taxation. One suggestion |