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SECURITIES ANDEXCHANGE COMMISSION

Washington, D. C. 20549(202) 755-4846

FOR RELEASE: 8 P.M., February 23, 1978

ECONOMIC PRIORITIES FOR BUSINESSAn Address By

Harold M. Williams, Chairman

The Economic Club of ChicagoChicago, IllinoisFebruary 23, 1978

I studied with considerable interest the findings of arecent survey entitled "Bow Americans Judge Basic Institu-tions. reported in the February 13 issue of O.S. News andWorld Report. The poll examines how a sampling ofindividuals rate some of our national institutions,including business and professional groups and theirleaders. My own interest in the survey sprang, not merelyfrom the results, but from the perverse way in which thoseresults track the direction of my own career, a career.which has progressed -- and I use that word advisedly --from lawyer to business executive to educator to regulator.Those questioned were asked to rank the various institutionson a scale of 1 to.7, and, based on the numerical average ofthe responses, the editors classified the institutions asMrelatively good,~ hmedium,u or urelatively poor" in termsof the public.s perception of their ability to get thingsdone.

The respondents rated large business as Nrelativelygood- with an average rating of 4.47 and business executives-- the field in which I spent the largest share of my workingcareer -- as -relatively good- with a rating of 4.43. Thelegal profession, another earlier phase of my career, camein at -medium- with a 3.99 average rating. Educators, the

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.group to which I belonged when I was Dean of the GraduateSchool of Management at UCLA, also earned a "medium"rating, but with a lower average of 3.84. The DemocraticParty was rated as Drelatively poor~ at 3.29, and my ~~present affiliation, ~regulatory agencies,. was similarlyperceived as -relatively poorM with an even loweraverage rating of 3.20. Finally, the Republican Partyat 3.10 and politicians at a dismal 2.69 closed out thefield. Since I have no interest in becoming a politician,it seems that the only course open to me in order tocontinue the inexorably downward trend in my career is tomove over to the Republican Party.

I interpret this data, and other similar studies,to reflect a sense that, in terms of effectiveness indischarging what is perceived as its primary mission,business is generally more effective at deliveringgoods and services than regulators generally are atregulating. I would have to agree. And while regul~torswork at doing better -- and perhaps even at doing lessand doing it better -- I am concerned that business notimpair its ability to do its job at least as well as ithas.

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For that reason, I am especially pleased to speak thisevening on economic priorities for.business -- andparticularly on inflation. The subject is an importantone; in fact~ inflation is the most serious economic

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problem facing our country. I would like to trace briefly - '",-

.the consequences which flow from the gap inflation opensbetween conventional measures of corporate financialperformance and economic reality, and to sketch the outlinesof some of the responses to that gap which I believe to beworthy of your consideration.

The Proolem: Inflation and Economic RealtyCorporate earnings are regarded as the most basic

numerical measure of corporate performance and businesssuccess, and, in the aggregate, of the success of thebusiness sector as a whole. Investment decisions, executivepromotions, public attitudes toward business, tax policy,the implementation of social programs, and a host of otherjudgments rest largely on the number which appears on Uthebottom line."

Because, I suppose, of the precision which numbersimply, it is easy to lose sight of the fact that corporateprofits, like any measurements, are no more reliable than theassumptions on which they rest. Financial reporting depends

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on a wide variety of assumptions and conventions -- theuse of historical costs, the various methods ofdepreciation, the criteria for distinguishing betweencapital expenditures and..expenses, .and many others. WhileI am not disputing the. logic of those principles, in myview, the resulting corporate earnings figures should neverhave been treated as precise; business earnings-wouldmore meaningfully be reported or interpreted as a rangerather than a single figure -- exact down to the penny whenreported in the form of earnings per share.

In any event, whatever the significance ofcorporate profit figures in an inflation-free economy,

.the impact of inflation has compelled a re-examination ofthe meaning of the portrait of corporate earnings whichtraditional financial reporting paints. Increasingly, weare becoming aware that the consequences of relianceexclusively on a measure which distorts the economiccontours of .business performance are felt throughout theeconomy -- from the overall capital formation process tothe day-to-day managerial decisionmaking in each firm.More broadly, if our ability to judge and report theeconomic performance of business is skewed, then both thepublic and its elected representatives are unable

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accurately to analyze the contribution which business ismaking to our society.

During the past 10 or 15 years, the public has come todemand more and more that business discharge obligations ~,which might,- in some sense, be thought of as social ratherthan purely economic the protection of the air, water,and the other facets of the natural environment: thepromotion of occupational safety; the implementation of thenational policy of equality of emploYment opportunity;and similar objectives might fall in this category. In thelong run, of course, it may be difficult or impossible toseparate the economic components of each from the socialcomponents. In.any event, these new factors are now asreal a part of the equation of business responsibiliityas are the more traditional goals of providing employmentand a source of livelihood for our workforce and ofproducing the goods an~ services necessary to satisfy arising level of expectations with respect to the standardof living.

Thus, as a society, we are placing increased demandson our private enterprise system. The problem ofmarshalling sufficient capital in order that business.~ay disch.~rge its role in aCCOmplishing these goals is a

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serious one. Unfortunately, however, the effects ofinflation upon the present methods of reportingbusiness performance obscure the increasingly pressing ~~need to bring forth additional capital and, indeed,may lull us -- as government policymakers, as decision-makers in private business, and as individual citizens-- into a belief that corporations are generating morethan adequate funds to satisfy our long-term demands forcapital.

The public perception seems increasingly to be thatAmerican business profits -- particularly those of thelargest firms, those most able and most responsible foraiding in accomplishing our national objectives -- arehuge and growing larger. This misimpression leadsinevitably to demands that the government take stepsoften through tax policy -- to moderate those profitsand to divert them to. the commonweal, either directlythrough the funding of federally-mandated programs ofsocial value, such as OSHA, or indirectly through whatwe have come to call transfer payments wherebycorporate taxes are reallocated to social purposes.

In my judgment, American corporations, as awhole, rather than generating'shockingly high profits,

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are earning at dangerously low levels relative to their .long-term reinvestment needs if they are to discharge theresponsibilities we expect them to shoulder. Profittrends -- especially as ~hey affect cash flow availableto replenish, modernize, and expand assets and to pay ~~dividends --' are probably the most important factors inevaluating common stocks in the marketplace. Despitetheir importance, however, I believe that the functionand level of corporate earnings and corporate abilityto generate the cash needed to replace and expandproductive capacity over time are seriously misunderstoodtoday -- in large measure because of the hidden impactof inflation.-

It is commonplace to read in the press thatparticular well-known corporations-have reported "record"or ~all-time high- earnings. In terms of the absolutenumber of dollars involved, these statements are, ofcourse, true. It is, however, useful and important to putthose figures in perspective. And when the perspective iscomparative earnings over time, their "real" value, and theability of business to generate required new capital, thenwhat are reported as "record" earnings may prove to bedisappointingly low.

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How can corporate profits be low in any sense whenreported after-tax earnings of non-financial enterpriseshit a record of $77 billion in 1976 and, according toestimates, went even hig~er in 1977? One striking element

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is the consistent, substantial understatement of depreciation'in an inflationary environment. This is, however, by no

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means the only way in which accounting based on historicalcosts distorts corporate profits. Valuation methods whichdo not exclude inflation-generated inventory profits alsooverstate income. Both of these problems erode the valueof reported earnings while adding to taxable income andthus generating tax liabilities which may, in fact, have tobe paid- partly out of capital. As long as reported earningscontinue to fail to take into account an accurate assessmentof the economic costs of using and replacing the assets,both current and fixed, which produce those earnings,investors, managers, government policymakers, and the generalpublic will all necessarily remain uncertain, confused, andmisled as to the level~ expected growth, and rate of changeof profit.

Studies have shown that, if depreciation were recomputedbased on the current-cost, double-declining balance methodin order to charge against revenues a sum which more

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accurately reflected both the manner in which capitalequipment was consumed and the cost, in inflated, currentdollars of replacing it, and if inventory consumptioncharges, as reflected in the cost of goods sold, werereconverted from historical to current costs, 1976 after- \,tax profits' of non-financial corporations would shrinkto some $43 billion -- only a little more than half the$77 billion figure reported. In effect, corporationsreported as profit $34 billion required to offset or

l' • • restore capltal consumptlon. By comparison, in 1966,the year in which the market peaked, reported after-tax earnings were $40 billion -- about half of the 1976reported figure of $77 billion -- while inflation-adjustedprofits in 1976 were $39 billion -- only 10 percent belowafter-tax earnings a decade later.

If we direct our attention to the share of its profits/

which business retains after dividends as a source ofcapital for reinvestment, studies indicate that annualretained earnings, adjusted as described above and convertedto constant 1972 dollars, fell from $28 billion in 1966 to$7.9 billion in 1976 -- a drop of around 70 percent -- andproduced a $13.3 billion deficit, after dividends for 1974alone. While there were net additions to adjusted

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retained earnings in 1975 and 1976, those additions wereinsufficient to offset the 1974 deficit. Thus, over themost recent three-year period for which final figures areavailable -- 1974 to 1976 -- business has, in effect,apparently paid dividends out of capital.

. The effect of this effort to adjust corporateearnings for inflation is even more startling from theperspective of federal tax policy. During the past 11years, the effective tax rate on reported corporate taxbasis earnings has generally hovered around 42 percent.However, if actual tax liability is compared to pre-taxprofits adjusted for inflation-based underdepreciationand inventory gains, a much different picture emerges:In 1966, the effective rate on adjusted earnings wasquite close to the 4.2 percent rate on reported income.In 1976, the effective tax was 56 percent, while in 1974it was an amazing 80 percent. Not only are we reportingthe consumption of capital as income, but we are payingtaxes on it. Inflation, and the failure of the taxsystem to recognize its distortions, have increased thereal rate of corporate taxation substantially withoutcongressional action and without the debate that wouldoccur if such a tax increase were formally proposed.

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.If we are to meet our need for adequate new investment,

the disclosure and taxation systems must be converted intotools which will aid the effort rather than obstacles whichfrustrate it.

The Impact an Capital FormationIn 1976, the Department of Commerce prepared one of

the most detailed and comprehensive discussions of invest-ment requirements ever undertaken. Its findings aregenerally consistent with other studies. In its "Study ofFixed Capital Requirements of the o.s. Business Economy,1971 to 1980," the Department's Bureau of EconomicAnalysis looked at capital needs on an industry-by-industrybasis. The purpose of this study was to estimate the amountof investment necessary, through 1980, in order to have aneconomy capable of meeting three objectives -- reasonablyfull employment, a national program of environmentalDrotection, and decreased dependence on potentially unstableforeign energy resources. The Bureau found that real capitalinvestment -- that is, nonresidential, fixed investment --must average about 11.4 percent of gross national product.Capital spending has, however, not led the economic recovery,averaging less than 10 percent for the recovery period. Infact, the Department predicted recently that the rate of

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real capital spending during 1977 would be only 8 percentand would be lower still in 1978, running at half thefigure which the Administration had targeted as necessary

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to reduce unempl~yment.i

The Department's 1976 study also contains interesting "finding~ with respect to the uses to which new investmentwould be put. It found that the majority of the projectednational investment needs during the period analyzed wouldbe employed simply to keep us from slipping below presentproductive capacity. This finding is a reflection of ourchronically low rate of capital formation in the last decade.

And to the extnet that investment is insufficient,society will pay the price in terms of fewer jobs, agenerally lower standard of living, and -- perhaps mostimportantly -- a perception that our economic system is notcapable of satisfying our needs. Reginald H. Jones, theChairman and Chief Executive Officer of General Electric,has translated this concept into an analogy which, I think,aptly illustrates the problem. He notes that one of thewatershed developments in human history was the concept ofplant husbandry -- that, by saving some of the seeds producedby this year's crop for next year's planting, the continuation

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and indeed the increasing prosperity of society could beachieved. He then observes:

HThe same thing applies to industrial societiesand business firms. Every year, some part ofthe total output -- some seed corn -- has to besaved and reinvested in the replacement,modernization and expansion of the industrial ~~machine. This is the process of capital forma-tion. And nations that neglect their capitalformation find themselves susceptible to scarcity,

, inflation, unemployment, and decliningstandards of living.In recent years, the United States has beeneating into its industrial seed corn."

The Impact On Corporate DecisionmakingFinancial reporting which ignores the impact of

inflation also has important implications in businessdecisionmaking. The most obvious area in which thisoccurs is in the process of estimating capital needs,the internally-generated capital available, and theprojected returns from proposed investments.

Further, disregard for the impact of inflationon the adequacy of earnings distorts pricing decisions.If corporate profits are insufficient to generate thecapital necessary to maintain existing capacity, apart of the reason may be that the goods a~d serviceswhich the firm sells are priced unrealistically

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relative to their true costs of production. It maybe difficult for one business to correct underpricingif its competitors choose to ignore the problem, and,in some industries, foreign competition would makecorrection impossible. Eventually, of course, boththose who recognize that they are eroding theircapital and those who do not will have to come togrips with the truth. Thus, financial reportingwhich obscures or ignores the impact of inflation,impedes efforts to identify and deal with emergingproblems until they become crises.

Finally, there undoubtedly are managers who are beingcompensated and promoted in return for showing increasesin the reported earnings of their operations when, "inreality, they-are dis~ipating its capital.

The Impact on Public Confidence in Business•If the validity of the general type of analysis I

have outlined is accepted -- or, at minimum, if it isaccepted that the net effect of financial reportingpremised on a stable level of prices is to buoy profits

. unrealistically upward when the environment becomesinflationary -- it seems clear that we are caught in

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a dilemma. Much of the pUblic perception -- encouragedby traditional methods of financial reporting -- is thatbusiness profits are already too large -- even obscene --and still gr~wing. At ~he same time, the economic realityis that American business overall is not generating andretaining funds adequate even to replace existingcapacity and continue operations at present levels.Indeed, some businesses may actually be distributingtheir capital and be in the process of liquidation.

It is difficult to overstate the importance of abetter public grasp of the size, in real terms, ofcorporate income. Constant reports of IIrecord"

.corporate earnings, while at the same time businessis pleading the case for tax and other incentives tostimulate capital spending, aggrevate the credibility gapwhich already exists. The net result is both a declinein the credibility of business, based on those inordinatebusiness profits as reported, and government action -- orinaction -- which is not consistent with enhancing theeffectiveness of our economic system. Aggravation of thepublic's confusion concerning profits -- and the manifesta-tions of that confusion in governmental responses -- isperhaps the most serious consequence of financial reporting

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Steos To solution•.I would like now to outline some steps which, in my

judgment, would contribute to solving the problems. I havedescribed. Although I recognize the costs and difficultiesin changing corporate reporting procedures and inpersuading Congress to alter the tax laws, I believe thatmore realistic accounting and tax practices could be animportant step toward educating the public, their electedofficials, and other policymakers to the impact ofinflation, to the dimensions of the problem of capitalformation, and to the direction in which policy must movein order to deal successfully with the problem.

First, I believe that inflation accounting -- as asupplement to, not a substitute for, historical costaccounting -- must become a permanent feature of financialreporting. In my judgment, the need for disclosure of theimpact of inflation on corporate performance is simply nolonger open to serious debate. The question is not whetherit should be disclosed, but how.

As I imagine many in this room are well-aware, in1976 the Commission adopted Accounting Series Release No.

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190 requiring major companies to disclose the impact ofinflation on inventories, productive capacity, and cost ofsales. I recognize that many corpo!ate managers havegreeted the opportunity ~hich ASR 190 affords them toprovide a perspective on reported earnings with somethingless than enthusiasm. As I have tried, however, to pointout this evening, financial reporting must aid investors,business managers, politicians, and the general public inrealistically evaluating the performance and capabilitiesof private ~enterprise. This is not a theoretical orabstract problem. It impacts directly on the capitalformation process and on society's attitudes toward theeffectiveness of the private enterprise system.

My purpose tonight is not to defend the methodologyof the Commission's current replacement cost rules. Infact, the Commission recently issued a release requestingcomments on any problems which companies have encounteredin providing replacement cost data pursuant to ASR 190.However, although I am mindful of the expense whichdeveloping replacement cost data has entailed, this areais, I believe, one in which the cost of compliance withgovernment regulation will prove to be far outweighed bythe benefits. Accordingly, I hope that ASR 190 will not

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be written off as another example of bureaucracy in action,but rather that the industry will work with the Commissionby submitting its best thinking and insights on how theusers 6f financial information can be given a meaningful

-,picture of the impact of inflation on reported corporate "earnings. 'The resulting benefits in more rational taxpolicy, improved investor confidence in business, and betterpublic and governmental understanding will, in my view,repay the costs of developing such a disclosure system manytimes ove r.,

In addition, some modifications in our tax structureare clearly necessary to stimulate capital formation.Without attempting to be comprehensive or prescriptive, Iwould offer five suggestions for a plan of positive actionto promote capital formation:

1. Further acceleration of depreciation schedulesfor tax purposes.

2. Expansion of the investment tax credit. Thismay entail an increase in the tax creditpercentage rate, a removal of the 50 percentcap on the credit, and provision for theelilgibility of plant expenditures. Theextension of the investment tax credit toplant might be especially appropriate giventhe latent need for wholesale replacement ofaging production capacity.

3. Reduction of the corporate tax rate. Anyreduction would provide some relief from

. double taxation and woulQ.I at least t,o?--'"..':. :,...:.degree',' h~1.p, tb "undo".tne" effects' of, the' "

inflation-generated increases in the

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4. Integration of the corporate and personaltax systems. In general, the effects ofdouble taxation are a serious impedimentto capital formation, and I would supportsteps to ameliorate the problem. I expectthat, to the extent that corporations judgeinvestments and competitive pricing policieson an after-tax basis, a substantial part ofthis savings might, over time, be passed tocustomers.

5. Retention of the capital gain treatment.Indeed, I would advocate returning the scopeof those provisions to where they were earlierthis decade. Much of the capital gains we taxnow reflect the impact of infla~ion and nota true capital gain at all •

.The New Economic Environment

Having talked about what government should do forbusiness -- and may .not -- let's look at what businessshould do for itself. I am very concerned that business,troubled by the many uncertainties it faces, is shiftinginto neutral waiting for the storm to pass.

Inflation is the most severe retardent to businessvitality on the economic landscape. Perhaps, however,the persistence of inflation is only symptomatic of alarger change in the business climate. Nineteen seventy-seven was, after all, a good year in terms of business

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-20-activity, profits, and dividends. Most sets of economicstatistics were at all time highs. Not many years ago,record highs in employment, income, production, spending,savings, and financial transactions would have been reasonfor genuine bullishness. Today they go unnoticed~

For a'long list of reasons we can all recite, we areboth feeding and reflecting a lack of confidence -- indeeda crisis in confidence -- a lack of confidence in oureconomy, in our government, in ourselves, and in ourability to~control and solve our problems. The uncertaintyis particularly acute, for it was only a decade ago in the60.5 that many were convinced that, at the national level,we had indeed mastered the economic cycle. Now we findthat, not only have we not mastered it, but we are notcertain we even understand it. Traditional cyclicaltheory neither explains what is happening nor forecastswhat lies ahead.

And at the corporate or investor level, most thingswe did in the 60's turned out right, and we becameimpressed with our judgment and wisdom. Now those sameactions turn out all wrong. And we are beginning tosense that these conditions, both macro and micro, willprobably continue at least through the remainder of thebu~in~ss ,c~reers. of,.tpe present-crop-of CEOs.

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We have a decision to make. Do we let lack ofconfidence dominate our thinking? Do we dwait and see"?Do we build corporate histories of inaction and indecision?And do we indulge in self-fulfilling prophecy, collectivelyfeed the mood of lack of confidence, and drive the economyand the society deeper into the hole while we wait for "theother guyN to show the way or for your friendly Washingtonpublic servant to give you an incentive? Or do we ventureforth and find new ways to make progress in this new realitywe have to.live with?

We can expect much less certainty and more crisesin the years ahead. Yet there will also be opportunitiesfor progress for those who have the foresight and wisdomto look for and pursue them.

None of our problems are susceptible of easy solutions.They are part of a new, unsteady .steady state." And, thosewho are awaiting the return of the boom economy .of the priordecade before committing themselves to positive action aremaking a serious mistake. In simple terms, I believe thatwhat we should do is to recognize that we are going througha difficult and important period of economic, social, andpolitical transition in this country -- and that the periodwill be prolonged and lacking in the predictability that we

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experienced in the post-war era. What is needed is forbusiness to apply its very best thinking to how to prosperand have an impact in such an environment -- to have theconfidence and the courage to move forward and take risksand not wait for the game to become more inviting.

In terms that a Chicago audience will understand, manycorporations and chief executives may be acting likeSewell Avery. Waiting for the picture to clarify is futileand just another way of playing it safe. Walter Hoadley ofthe Bank of America stated the alternatives this way:

"Each organization and individual now has afundamental choice to make, consciously:1. To adjust to this new era of major structural

change by adopting or reaffirming a positive,aggressive posture rooted in the conviction-that new opportunities can be found inchanging periods and that we must learn tolive with these new conditions, while notforegoing our right to try to modify andimprove them; or

2. To retrench by pursuing a prolonged wait-and-see, defensive, cautious posture and verylikely to partially liquidate (as at least afew companies are already doing). Theconsequences of this choice, if made widespread,obviously will be depressing for the generaleconomy.-

Waiting for certainty or comfort ensures the deferralof corporate growth. Piling up cash is not an end in

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itself and is no tribut~ to corporate management. Nor isa tender for your company's stock. Nor is an invitation toa take-over. If you do not put your resources to work --in increased.efficiency -- in plant and equipment -- in newproducts -- in marketing -- in research and development '~.in acquisition -- or in expansion -- you are part of theproblem. If you do not put your resources to work to expressyour views timely on social issues, government priorities,and regulation, and in being sure your own house is inorder, the~consequences are pred~ctable.

We need to consider whether the waiting game isbeing overdone. We understand the lack of certainty.We understand the kind of risks that are involved. Butthis is the new reality, and we need to adapt to it; weneed to recognize that there are opportunities withinit. Our the responsibility to the company and to thecompany's contribution to the society call for courageand investment and not for waiting for Congress or thePresident to make life easier or more certain. Theproblem is of national and international consequence. Butit originates in the individual mind, and the solution lieswith you and me. Let's get on with it.