Accounting for Tax Subsidies With Special 

Reference to Cost of Service, or 

"Fair Rate of Return", Utility Regulation 

. 

Seymour Fiekowsky

U.S. Treasury Department 

OTA Paper 27 , May 1979 

OTA Papers are circulated so that the preliminary findings of 

tax research conducted by staff members and others associated 

with the Office of Tax Analysis may reach a wider audience. 

The views expressed are those of the author, and do not 

reflect Treasury policy. Comments are invited, but OTA 

Papers should not be quoted without permission from the 

authors. Managing editors are Michael Kaufman and Gary Robbins. 

Office of Tax Analysis 

U.S. Treasury Department, Room 1104 

Washington, D.C. 20220 

Issued: May 1979 
Accounting for Tax Subsidies with Special Reference to Cost 

of Service, or "Fair Rate of Return", Utility Regulation 

An Earlier Version of This Paper was Issued As 

an Annex to the Statement of 

Emil M. Sunley 

Deputy Assistant Secretary (Tax Analysis) 

Department of the Treasury 

Before the 

Oversight Committee of 

The Committee on Ways and Means 

March 28, 1979 
Table of Contents 

Page 

Introduction ........................................ 1 

I. Accounting for the "cost of service." ............. 4 

Three classes of transactions..... . .............. 4 

Assumptions underlying the base case.......,..... 6 

Description of the "base case.11.................. 7 

A note on the base case replacement of plant 

and equipment ...................................... 10 

A note on the meaning of net book-value.......... 11 

11. Accounting for a subsidy for the acquisition 

of capital ....................................... 12 

A cash subsidy for the purchase of qualified 

property........................................ 14 

The importance of correctly accounting for 

a capital subsidy ................................ 19 

The mischief caused by accounting for a capital 

subsidy as "income" in the year received ........ 20 

A capital subsidy paid as a credit against 

income tax...................................... 25 

Differences between capital subsidies paid 

in cash and as credits against income tax ....... 26 

Accounting for the "extra" subsidy inherent 

,in the investment tax credit.................... 30 

111. Accounting for a subsidy for the financing 

of capital ....................................... 32 

A "zero interest" Federal loan for financing 

the purchase of qualified property.... . ......... 34 

Accounting for the specified "zero interest" 

loan subsidy .................................... 35 
ii 

Clearing the interest-free loan program 

through the income tax.......................... 38 

Mischief caused by regarding the proceeds of 

interest free loans as additions to equity 

"income" for the year........................... 42 

The combined effect of the two tax subsidies..... 45 

IV. Consistency of Tax Subsidy Normalization Rules 

with Dynamic Change .............................. 46 

Relaxing the no-growth assumption: the 

investment tax credit........ . .................. 46 

Deferred taxes................................... 48 

Effects of unforeseen changes .................... 50 

V. Extension of the regulated company analysis 

to unregulated companies ......................... 51 

Deferred taxes in the unregulated sector......... 53 

Tables: 

Table 1 Base Case Financial Statements............ 60 

Table 2 Illustrating Maintenance of a Constant 

Capital Stock, When The Regulatory Depreciation 

Imputation Rule is Straight-Line.. ............... 61 

Table 3 Financial Statements, with 10 Percent 

Capital Subsidy .................................. 62 

Table 4 Net Rate Base, Income from Sales, and 

Cost of Service Elements, with 10 Percent Capital 

Subsidy, when Tax and Regulatory Measurement 

Rules are Identical.............................. 63 

Table 5 Financial Statements, When a Capital 

Subsidy is "Flowed-Through" to Equity.. .......... 64 

Table 6 Schedule of Interest-Free Loans Extended 

and Repaid: 1979 Vintage of Plant and Equipment.. 65 
iii 

Table 7 Privately Financed Rate Base, Income 

from Sales, and Cost of Service Elements, With 

Federal Interest-Free Loan Program............... 66 

Table 8 Financial Statements, First Year of a 

Federal Interest-free Loan Program Financed 

Through the Tax System ........................... 67 

Table 9 Comparison of Income from Sales, When 

Proceeds of Interest-Free Loans Are so Accounted 

For and When They Are "Flowed-Through" to Equity 

Income in the Year Received...................... 68 

Table 10 Combined Effect of Investment Tax 

Credit and Interest-Free Loan Program on Cost 

of Service (millions) ............................ 69 

c 
Iri t r od uc t ion 

The prices of goods and services exchanged voluntarily 

in markets, when there are no barriers to entry, tend to 

approximate "cost of production." Conventionally, cost of 

production comprises two elements, payments for labor 

services and materials embodied in the goods and services 

produced for sale and payments for the services of capital-­

plant, equipment, inventories, etc.--similarly embodied in 

the output. In the unregulated sector, where freedom of 

entry and exit by individual enterprises is presumed to 

exist, prices "automatically" equilibrate with costs: if a 

seller receives prices in excess of labor, material and 

normal capital costs, his abnormal return, conventionally 

expressed as a return to his equity capital, attracts 

competition; if the prices he receives fall short of his 

total costs, he exits. In the regulated sector, where it is 

presumed that technological conditions preclude freedom of 

entry and exit, regulatory commissions function to 

equilibrate prices and costs.l/­ -__-------

-1/ Another function performed in unregulated markets is the 

assurance that the costs of production to which prices are 

equilibrated are minima. Since markets for labor and 

capital both function to allocate these resources to 

employments in which the value product is a maximum, it 

follows that least-cost technologies will tend to be 

employed. Neither workers nor capital owners will accept 

returns for productive services that are lower than might 

be earned elsewhere either because the products they 

produce fail to fetch sufficiently high prices -

or because

the technology being employed is obsolete. In the case of 

regulated industries, it is presumed the regulators will 

exercise vigilance to ensure that prices received are no 

higher than costs, -and that the costs are as low as 

technology permits. 
-2-

Because regulatory agencies must replace impersonal 

market forces in establishing both quality of service and 

schedules of allowable maximum rates to be charged for 

services, their responsibilities are varied and complex. 

Given a specification of "quality of service", the "cost of 

service" must be measured so that revenues generated by the 

schedule of allowable rates will not be "excessive." To 

carry out this responsibility, regulatory commissions 

establish procedures by which the varied transactions of 

regulated companies are recorded so that the outcome of the 

operations of the companies may be reviewed and made subject 

to control by the commissions. 

An understanding of these standard procedures, commonly 

known as standard accoLlnts, is critical to an understanding 

of the logically consistent way in which tax subsidies should 

be accounted for, in both the regulated and unregulated 

sector of the economy. Therefore, the first section of this 

paper sets out the elements of an accounting system, and 

defines the terms relevant to an accounting for "cost of 

service" and for the subsidies which affect this cost. The 

next section introduces a capital grant subsidy, the class to 

which the investment tax credit belongs, and demonstrates how 

this public support of capital formation operates to reduce 

the "cost of service." The following section introduces a 

capital subsidy in the form of an "interest-free loan," the 

class to which "artificially accelerated tax depreciation" 

allowances belong, and contrasts this with a capital grant 

form of subsidy. The subsidy accounting procedure commonly 

called "normalization" is shown to be the only technique that 

correctly portrays the intended effect of both capital subsidies on the cost of service. The fourth section demonstrates 

that "normalization" accounting also effectively portrays the 

results of capital subsidies under dynamic conditions; the 

last section comments on the extension of these subsidy 

accounting techniques to the unregulated sector. 
Although the perspective of this paper emphasizes 

private firms' accounting for certain capital subsidies, the 

rules it derives are also fully applicable to both social 

accounting and Federal budget accounting. The private sector 

transactions that constitute the raw mater ials assembled by 

accounting rules at the firm level are also the raw materials 

assembled by the Commerce Department in its preparation of 

the National Income and Products Accounts (NIPA) and the base 

for Federal and other governments' tax systems. Similarly, 

the private claims against stocks of capital and the related 

claims to product flows recorded in private accounting 

systems are also legal property rights which should be duly 

observed in the construction of the NIPA and in the presentation of governments' financial claims against, and 

obligations to, the private sector shown in budgets. As a 

matter of fact, the treatment of the subsidies discussed 

below in the NIPA and their presentation in government 

budgets does not follow the rules derived from an analysis of 

the economic effects of these subsidies. Instead, the NIPA 

and government budget apply rules which are shown below to 

misrepresent the effects of subsidies cleared through the tax 

system; that is, the NIPA and budgets treat such subsidies as 

"reductions in tax", not as payments for the performance of 

acts Congress and other legislatures have deemed worthy of 

compensation. The consequences of this asymmetrical treatment of subsidies paid, or cleared, through the tax system in 

both the NIPA and government budgets, however, is a subject 

beyond the scope of this paper. Identification and measurement of these consequences is an object of continuing 

research within the Office of Tax Analysis to be reported in 

future GTA Papers. 

Finally, there is another purpose served by the analysis 

of tax subsidies presented below that should be noted. The 

subsidies examined, the investment tax credit and artificially accelerated tax depreciation allowances, both relate 
-4-

to the acquisition and use of capital goods. Since the early 

work of Robert Hall and Dale Jorgenson,2/ - econometric models 

of investment behavior commonly have incorporated a variable 

called "rental cost of capital" as one of the determinants of 

investment outlays; and the terms on which capital income is 

taxed is, in turn, among the significant determinants of 

"rental cost of capital." For many, an understanding of the 

content of "rental cost of capital" has been impeded by its 

mathematical presentation and liberal use of discounting. In 

this paper, the "rental cost of capital" is simply called 

"cost of capital services" the content of which may be 

grasped with the aid only of simple arithmetic; and, without 

resort to discounting, the reader may see how subsidies 

affect rental cost and the "incentive to invest." Other 

readers, familiar with 'the econometric uses of rental cost of 

capital may detect in the analysis of subsidies that follows 

an implicit criticism of the way the two kinds of subsidies 

are specified in econometric models. But this is also a 

matter beyond the scope c?f this paper. 

I. Accounting for the "cost of service." 

Three classes of transactions 

Any enterpr ise, whether regulated or unregulated, 

engages in a myriad of transactions involving the employment 

of labor, procurement of materials, the acquisition and 

maintenance of plant and equipment, and the payment of taxes 

in the course of producing and selling goods. Organizing 

these transactions in a structure that is both comprehensive 

-2/ Hall, R.E. and Jorgenson, D.N., "Tax Policy and Investment 

Behavior", American Economic Review, LVII (June 1, 1967), 

pp. 391-414. 
-5-

and analytically useful is the subject matter of accounting, 

both for financial reporting and income tax compliance. 

Three sets of transactions must be dealt with: First those 

involving the purchases of goods and services which are 

directly embodied in the goods and services sold within an 

accounting period, usually a year. In principle, purchase 

transactions are cumulated, or "inventoried" over the course 

of the year and subtracted from the sales transactions as 

"cost of goods sold"; the excess of sales proceeds over cost 

of goods sold is "operating income" of the enterprise. 

The second set of transactions to be dealt with are 

those pertaining to the acquisition and use of plant and 

equipment items, the services of which are embodied in the 

enterprise output over a long span of accounting periods. 

For this class of transactions, in addition to accounting for 

acquisition of the assets encompassed in market exchanges, it 

is also neceL.iary to account for the using-up of these 

assets; and since this cost of output is normally not 

observable in a set of market transactions, a procedure for 

imputing the value of the capital consumed during a period is 

required. 

Finally, there is the class of transactions concerned 

with financing operations, particularly the acquisition of 

plant and equipment items. These include the extension of 

trade credit to finance sales, the receipt of trade credit to 

finance purchases, and the issuance of long-term debt instruments or issuance of stock to obtain additional equity. 

Unlike the other two sets of transactions which are concerned 

with measuring the cost of producing goods and services for 

sale, and the net outcome of an enterprise's economic activity, these transactions involve only the recording and 

assignment of claims against the assets of the enterprise. 
-6-

Assumptions underlying the base case. 

We will not concern outselves here with the problems of 

maintaining surveillance over the classifications of transactions in order to derive reliable measures of income, 

whether for financial .or tax purposes. This is a tremendous 

burden of auditing borne by regulatory, financial, and income 

tax personnel which we will assume is satisfactorily accomplished in the real world. Instead, we will concentrate our 

attention on the statements which summarize the outcome of 

accounting for the economic performance of an enterprise. 

To do this most expeditiously, and to facilitate the 

later discussion of accounting for the introduction of tax 

subsidies, we will . make the following simplifying 

assumptions: 

(1) The enterprise, a regulated utility, has financed 

its operations in such a way that its "current 

assets" equal its "current liabilities." That is, 

the amount of its cash on hand, accounts receivable, 

and inventories of materials and supplies is exactly 

equal to its accounts payable (including accrued 

taxes). This means that the net value of its plant 

and equipment is eactly equal to outstanding 

interest-bearing debt and the claims of its equity, 

or share, owners. Plant -and equipment is therefore

-the "rate base." More generally "rate base" 

includes such assets as inventories, land and other 

"nondepreciable" assets that are employed in an 

enterprise and which are also financed by debt and 

equity. 

(2) All plant and equipment is depreciable. 
-7-

(3) The acquisition cost of plant and equipment is the 

same for both regulatory (financial) and tax 

accounting purposes. 

(4) The regulatory life of plant and equipment is 30 

years; and the total plant and equipment account is 

comprised of 30 equal units, one of which must be 

replaced each year. 

(5) There is no growth and no inflation; the state of 

technology does not change. 

(6) Sixty percent of the rate base is financed by debt, 

40 percent by equity; the interest payable to bondholders is 1.0 percent, the after-corporate-tax 

return to equity is 15 percent. 

(7) All interest is paid at the end of the year; corporate income after taxes is also distributed at that 

time. 

(8) Plant and equipment acquisitions are made at the 

beginning of each year. 

These assumptions generally define the case of a "going 

concern" in what is technically described as "stationary 

equilibrium." However, as will be noted below, this model of 

an enterprise may also be used to describe dynamic adjustment 

to changes in the size of the enterprise or in the terms on 

which its assets are acquired or financed. 

Description of the "base case." 

In the base case, we assume that income tax accounting 

perfectly matches regulatory accounting, and there are no 
-8-

subsidies. Then, for the year 1979, Table 1 shows the income 

statement summarizing the first two classes of transactions 

noted above. Sales of utility services aggregated $274.6 

million, of which $165 million (60 percent of sales) 

consisted in cost of goods sold, leaving an operating income 

of $109.6 million. This operating income is allocable into 

$30 million for depreciation, $27.9 million paid in interest, 

$23.8 million in corporation income tax, and an aftercorporate-tax return to shareholders of $27.9 million. 

Operating income is therefore no more, or less, than the 

capital cost portion (40 percent in this example) of total 

cost and sales: it includes provision for recovery of 

capital consumed during the year, a return to bondholders, 

corporation income tax--a tax on the income attributable to 

equity capital, the incomes attributable to labor, suppliers, 

and creditors having been allocated to them--and a return to 

shareholders. The 40 percent of total cost (sales) allocable 

to capital is approximately typical of electric utilities. 

Since we are assuming that interest and shareholder 

earnings are paid out at year end, the beginning and ending 

balance sheet, summarizing the third class of transactions 

dealing with claims against the assets, also in Table I, 

shows that, net, no change in total assets or claims against 

them have occur red. 

On the asset side, cash and other current accounts are 

up by $30 million, representing the cash-flow resulting from 

the allowance for 1979 depreciation included in cost of 

service (sales): but net plant and equipment has been reduced 

by that same $30 million. As claims against the total of 

$565 million of assets, current liabilities remain at $100, 

and the $465 million of plant and equipment continues to be 

financed by $279 million in long-term debt, the basis for an 

interest charge of $27.9 million, at 10 percent, and by $186 

million of shareholder equity, the basis for an aftercorporate-tax return of $27.9 million. 
-9-

If we assume there are 10 million shares outstanding, 

they will sell at $18.60 a share, for they will receive $2.79 

a year in dividends, a 15 percent return, which is sufficient 

to warrant their being held, under the assumption we are 

operating with. So long as the prices of utility services 

yield $274.6 million in total revenue, and costs, including 

market rates of return to capital, remain unchanged, the 

combined return to capital of $55.8 million, representing a 

12 percent return to the $465 million of privately furnished 

funds to operate the utility, is a "fair return" and the 12 

percent a "fair rate of return." 

In fair rate of return regulation, then, a regulatory 

commission forecasts the net plant and equipment (rate base) 

that will be required. to furnish a postulated quantity of 

service, multiplies this by the "fair rate of return", adds 

to this an income tax quantity which is functionally determined by the equity return, and finally adds to this estimate 

of the cost of capital services a forecast of labor, fuel, 

and materials costs of production. This forecast total cost 

of service becomes the required sales revenue, and given a 

forecast of the service produced and distributed, rates per 

unit of services fall-out. This is "cost of service" utility 

regulation, including a "fair rate of return", on rate base. 

Thus viewed, cost of service rate regulation is consistent with any structure of rates that will yield the necessary c* sales revenues, -i.e., with "marginal cost," time-of-day or 

year, fixed charge plus price per unit consumed, etc., 

pricing policies. Obviously, different pricing strategies 

will result in different quantities demanded and different 

rate bases. Thus, in what follows, the capacity taken as 

given presumes some structure of rates by which customers are 

charged for their consumption of service. This rate structure may, or may not, be optimal or be fair in any particular 

sense; it is only required to produce a flow of revenues 

sufficient to yield a "fair rate of return." 
-10-

equipment. 

By our assumptions of no growth, inflation, or change in 

state of technology, it follows that each year our illustrative company will have to acquire $30 million of plant and 

equipment items in order to maintain its service capacity at 

unchanged prices (and cost of service). Thus at the beginning of 1980 (end of 1979), the illustrative utility will 

have to buy $30 million of replacement capital goods. Therefore, at the beginning of 1980, the $30 million increment of 

cash and other current assets accumulated during 1979 is 

exchanged for the plant and equipment, and the balance sheet 

reverts to its beginning-of-1979 appearance. Under plant and 

equipment, $30 million. of assets that had been acquired in 

1950 are removed from the account and are replaced by $30 

million of new items. Similarly, the $30 million of accrued 

depreciation with respect to the 1950-vintage assets is 

removed from the accrued' depreciation account; this restores 

the net plant and equipment account to $465 million, the rate 

base required to produce the utility company services for 

1980. 

Table 2 may be helpful in comprehending the process of 

maintaining a capital stock. There a partial array of each 

vintage of assets in service at the beginning of 1979 is 

shown. Under the regulatory rules for measuring cost of 

service, each vintage is 8gdepreciated" 1/30th each year; an 

imputation method called "straight-line." Thus, at the 

beginning of 1979, the 1950 vintage, the oldest in use during 

1979, has a net book-value of $1 million, $29 million having 

been recovered in costs of service over the prior 29 years of 

its use, whereas the 1979 vintage, being just acquired has a 

net book-value of $30 million. Altogether, of the original 

acquisition cost of $900 million, $435 million has been 

recovered by the private suppliers of financial capital, 

leaving a net rate base of $465 million. 
-11-

At the beginning of 1980, the 1950 vintage drops out, 

its position at a $1 million net book-value being assumed by 

the 1951 vintage; likewise, the 1979 vintage eases down a 

notch to a net book-value of $29 million, being replaced by 

the new 1980 vintage with a net book-value of $30 million. 

Thus, at the beginning of 1980, the original cost of all 30 

vintages in use is still $900 million, of which $435 million 

has been recovered in depreciation charges embedded in the 

cost of service for years prior to 1980. 

A note on the meanina of net book-value. 

Clearly, the allowance for depreciation is an imputation 

of the decline in value of depreciable assets. In the regulated company case, since regulatory commissions establish 

rates based on their rule for imputing depreciation, so long 

as the fair rate of return applied to the rate base (original 

cost less previously imputed depreciation) matches the opportunity cost of financial'capital for the utility, the market 

value of stock will equal the book-value of that stock. That 

is, the regulatory commission's valuation of plant and equipment, $465 million, less the claims of bondholders, $279 

million, equals the book-value of equity. Then book-value -is 

the market value of plant and equipment as well; by its ratemaking power the commission establishes a market value of 

regulated company plant. In the unregulated sector, however, 

where firms lack the power to exclude competitors and hence, 

are powerless to maintain prices to assure capital suppliers 

their opportunity cost rates of return, book-values of assets 

and shares do not normally equal market values. This is a 

point to which we will return in Section IV. 

For what follows, the normal equality between book and 

market values of regulated companies, is 6 critical point. 

Regardless of the "quality" of regulatory ratemaking rules, 
---------- 

-12-

coniin iss ion rules for imputing deyrec iat ion as a cost of 

service must be taken as the "norm" against which tdx depreciation rules bill be compared. For example, it might be 

dcmnnstrated that, if utility commissions tried harder to 

account for obsolescence due to technical change in production and distribution facilities used by the utility and/or 

to changes in the relative costs of fuels or other inputs 

used, they would find a set of depreciation imputation rules 

other than straight-line more realistic. Applying these more 

realistic rules would permit more timely introduction of 

improved plant and equipment, and these "better" depreciation 

imputation rules would ultimately result in a lower total 

cost of service as more efficient combinations of labor and 

materials were thereby put into use.3/- But, since the logic 

of fair rate of return price setting validates whatever 

depreciation imputation rule that is used by a regulatory 

commission, whethcr the rule is optimal or not; it is the 

norm to measure incone of the regulated company, both for 

f inzncial and tax accounting purposes. 

11. Accounting for a subsidy for the acquisition of capital 

So long iis a replacement module costs $30 million anu 

the entire $30 million must be financed with funds obtained 

in 2rivatc capital markets, the capital portion of cost of 

service will be $109.6 million in the example Ne have 

postulatec as the base case. Guring 197Y, 1900, and every 

succeeding year, this cost of service will recur and have to 

be recovered in the chctrges ptrmitted the reguldtea company. 

-3/ The FCC staff hds recently suggested that depreciation 

imputation rules used by that agency nay have retarded 

technichl progress and cost reduction in the teleconmunications industry. Virtually every investigation of 

depreciat ion patterns for machinery and equipment has 

concluded that. "stI aight-line" patterns are poor approximat ions for asset value decl ine, the phenomenon deprec iation is suuoosed to describe. 
---------- 

-13-

Let us now examine the consequence of a 10 percent subsidy 

for the purchase of depreciable property, when tax accountinq 

rules--match regulatory accounting rules.l/ ­ Since the 

-4/ Those familiar with the analysis of excise taxes and subsidies will be aware that whether the subsidy is conferred 

on the purchaser, or the seller of a commodity, the net 

effect will be the same. If the subsidy is given to the 

seller, and if entry into the production of the subsidized 

article is free, selling prices will be competed -down by 

the amount of the subsidy. If the subsidy is given to the 

buyer, offer prices will be bid 2 by the amount of the 

subsidy. But, if the article in question can be produced 

at constant prices, then the selling price (net to the 

producer) cannot be more than the cost of production, and 

the whole amount of the subsidy will be "passed through" 

to buyers in the form of lower net purchase prices. The 

government will be paying that fraction of the cost represented by the subsidy; buyers will be paying for the 

remainder with their own disposable resources. 

In the present case, a subsidy for the purchase or sale of 

capital goods, a subsidy paid to the buyer rather than the 

seller is preferable on administrative grounds. Whether a 

"qualified" article is a capital good OK not depends on 

the use to which a buyer will put it. A vehicle used by 

the purchaser in a productive enterprise ("trade or 

business") is obviously a capital good; the same vehicle 

used for recreation or personal transportation is not. 

Since qualification of an article for a capital subsidy 

can be more easily determined after its purchase by 

whether the purchaser must "capitalize" the acquisition 

cost and recover his capital through depreciation imputations as he uses it to produce salable output, it is more 

convenient to pay a capital subsidy to the purchaser. 
-14-

"proper" regulatory accounting rules for a form of this subsidy conveyed as a credit against income tax otherwise due is 

the subject of controversy, we shall here simply develop the 

"regulatory ruleb1 that reflects the logic of cost of service, 

or fair rate of return, utility rate regulation. As will 

become apparent, this .rule for accounting for a subsidy is 

generally that called "normalization." 

A cash subsidy for the purchase -.. of qualified property.

Suppose that, effective January I, 1979, Congress 

authorizes the Secretary of Commerce to pay each purchaser of 

depreciable property with an expected life of 7 or more 

years, on the submission of evidence that such property has 

been acquired, an amount equal to 10 percent of the purchase 

price of the property. Since the regulated company buys and 

uses depreciable property with an expected life of more than 

7 years, its 1979 purchase of $30 million will be eligible 

for the subsidy when company officials duly present invoices 

or contracts and similar documentation of the purchase. As 

was shown in Table 1, in any year, the result of the regulated company's operations was to increase its cash and other 

current assets by $30 million which was then available to 

acquire that amount of replacement items for its plant and 

equipment account. Thus, at the end of 1978, the company had 

$30 million, amassed as a recovery of capital consumed during ' 

1978 from its sales revenue, with which to buy property that 

would now only cost it $27 million, net of the cash contribut ion of the Commerce Department. 

The remaining $3 million of cash and other current 

assets at the beginning of 1979 is now redundant for maintaining the constant stock of company plant and equipment. 

The $3 million excess therefore should be used to reduce debt 

and outstanding equity so that utility customers will not be 
-15-

burdened with providing a return to the now displaced private 

financing; customers should pay only for returns to privately 

financed capital used to produce the output they buy. Since 

there is no reason to alter the debt-equity ratio of the 

company, $1.8 million of outstanding bc+nds will be retired 

along with $1.2 million of shareholder equity. The bonds may 

be retired either by not "rolling over" that amount of debt 

maturing on January 1, 1979, or by buying back that amount of 

outstanding bonds. Similarly, the $1.2 million of redundant 

equity might be paid back as a "return of capital" to all 

existing share-holders, or $1.2 million of outstanding stock 

might be purchased in the market and cancelled. 

The effect on -net rate base of the utility therefore has

been a reduction of $3. million at the beginning of 1979 as 

compared with the pre-subsidy case discussed above: total 

net acquisition cost of the property is now $897 million 

because the 1979 vintage cost only $27 million rather than 

$30 million, while accumulated depreciation is still $435 

million, leaving a net rate base of $462 million rather than 

$465 million; and this reduced rate base is financed with 

$277.2 million of debt, and $184.8 million of shareholder 

equity. 

The subsidy also has two effects on the cost of service 

for 1979. First, only $0.9 million of depreciation, recovery 

of private capital, need be provided for the 1979 vintage 

addition to the capital stock. Thus, since the other 29 

vintages in use during the year each require $1 million, the 

? 

total depreciation charge entered into cost of service for 

1979 need only be $29.9 million instead of $30 million. 

Second, interest paid bond holders is reduced to $27.72 

million and the after-corporate-tax return to equity is also 

reduced to $27.72 million. The reduction in required return 

to equity has a related effect on the Federal income tax. 
-16-

Altogether, the cost of service will have been reduced by 

virtue of the subsidy in 1979, assuming the regulatory 

authority acts promptly to reflect the subsidy in the rate 

charges it approves. 

But before tracing the net effect of the subsidy in 1979 

and future years as each additional replacement vintage benefits from the 10 percent subsidy, an accounting convention 

needs to be introduced and explained. Because the market 

price of the equipment items acquired in 1979 is still $30 

million, accountants feel constrained to show $30 million as 

the acquisition cost in balance sheets. But, since $3 

million was contributed by government subsidy, they initially 

offset the $30 million by a $3 million account labelled 

"unamortized subsidy". . Thus, at the beginning of 1979, the 

balance sheet entry for the 1979 vintage, in isolation, would 

be : 

Plant and equipment (beginning of 1979) : 

Acquisition cost........... ...........$30 

less: Unamortized subsidy ....$3 

Accrued depreciation ...-0 -3 

Net rate base.. .................$27 

For the 1979 vintage, still in isolation, the end of 1979. 

balance sheet entry would be: . 

Plant and equipment (end of 1979): 

Acquisition cost....... ...............$30 

less: Unamortized subsidy.. ..$2.9 

Accrued depr ec ist ion. ..-1.0 -

3.9 

Net rate base ..................$26.1 
-17-

In effect, this esoteric accounting treatment, in which the 

subsidy is amortized over the life of the property, shows the 

net book-value of the subsidized asset at private cost. Also 

under this accounting treatment, while the $30 million is 

apparently "depreciated" over 30 years, this is offset by 

annual amortization of. the subsidy so that the net reduction 

in book-value, at private cost is, in fact, $0.9 million, 

1/30th of the $27 million. "Net depreciation" of subsidized 

assets entering cost of service is of private cost only. 

With this in mind, we may now assemble the 1979 

financial statements incorporating the cost of service impact 

of the $3 million capital subsidy received with respect to 

the 1979 vintage of capital; these are shown in Table 3. 

Instead of the base case required total revenue of $274.57 

million, after one vintage of capital has been subsidized, 

the required revenue shrinks to $273.95 million. This saving 

to utility customers of $0.62 million in 1979 results from 

the following reductions: 

Private capital recovery ......$0.10 million 

Interest payment..............$O.l8 

Federal tax.......... .........$0.16 

Return to equity.. ............$0.18 

Total ....................$0.62 

million 

million 

million 

million 

We have already noted the reduction in rate base, from 

$465 to $462 million, at the beginning of 1979, also shown in 

the beginning and end of year balance sheets in Table 3. It 

will be observed that, at the end of 1979, the book-value of 

plant and equipment has diminished by only $29.9 million, for 

the "depreciation" of the $30 million market price of the 

1979 vintage is offset by a $0.1 million reduction in 

unamortized subsidy. By the same token, cash and other current assets have increased by only $29.9 million, instead of 
-18-

$30 million as in the base case because only this amount of 

cash-flow has been provided in the reduced cost of service 

charges. 

Thus, at the beginning of 1980, after one year of 

operation under the subsidy, the regulated company has $29.9 

million to finance the acquisition of a new vintage of equipment items. Again, with a 10 percent cash subsidy, the 

market price of $30 million will require only a $27 million 

drain on the company's cash resources. Thus, at the 

beginning of 1980, $2.9 million of excess private debt and 

equity develops, resulting in a retirement of $1.74 million 

of debt and $1.16 million of shareholder equity. For the 

year 1980, cost of service will be further reduced, and the 

process of reducing annual net (of subsidy amortization) 

charges for depreciation and returns to creditors and equity 

holders will continue until all 30 vintages have been 

replaced by property subsidized by the Commerce Department. 

The annual net rate base, total revenue required, and cost of 

service elements compris'ing the revenue requirement 1979 to 

2009, are arrayed in Table 4. Each year, a little more of 

the privately financed net rate base is displaced by public 

subsidy so that, by 2008, the net rate base has shrunk by 

$46.5 million from its unsubsidized level of $465 million; 

since the capital subsidy is 10 percent, so long as the 

subsidy remains in effect for at least thirty years, 10 percent of privately financed capital in a regulated company 

will be replaced by publicly financed capital. 

Taxpayers generally will assume the cost of maintaining 

10 percent of the qualified capital stock, and since they do 

not require a return for supplying this capital used in the 

private sector, for both these reasons the capital cost 

portion of total cost of service shrinks by 10 percent. In 

the year 2008, gross revenues need cover only $27 million of 
----- - -------- 

-19-

the cost of $30 million of equipment items required to maintain the company's capital stock; the other $3 million is 

' supplied by Federal taxpayers through the Department of 

Commerce. Interest coverage in sales revenue becomes $25.11 

million, as does the after-corporate-tax return to shareholders, 10 percent less than the unsubsidized levels of 

$27.9 million. Finally, the Federal income tax coverage in 

revenues becomes $21.39 million, also 10 percent less than 

the base case level of $23.77 million. Because capital costs 

comprise 40 percent of the base case total cost of service, 

the subsidy induced 10 percent reduction of capital cost of 

service becomes a 4 percent reduction in total cost of 

service; in 2008, customers would need to pay only $263.61 

million for the capital-subsidy-assisted output of a plant 

costing $3U million in resources annually to maintain instead 

of $274.57 million. 

The importance of correctly accounting for a capital -_.--.1_ I_--- --.­

-subsidy. 

The foregoing step-by-step analysis of a procedure for 

accounting for a capital subsidy has an inherent economic 

logic worth exploring. As noted earlier, the function of an 

accounting system is to portray the outcome of transactions, 

economic decisions, involved in the production and sale of 

goods and services. The names one attaches to the procedures, or to the transactions, are unimportant; rather, the 

test of validity of the accounting procedures is whether they 

produce accurate measures of underlying phenomena. 

To demonstrate that the foregoing procedure, popularly 

called "normalization," is the only acceptable way to account 

for a capital subsidy, because it alone provides an accurate 

measure of the underlying phenomena, let us substitute a -

re61

10 percent reduction in the cost of acquiring the regulated 
-20-

company's plant and equipment items. That is, suppose that, 

at the beginning of 1979, some unspecified change in the cost 

of producing this plant and equipment occurs so that what had 

formerly cost $30 million now costs $27 million to purchase. 

Referring to Table 3, we would observe that the only changes 

in the income statement and the beginning and ending 1979 

balance sheets would be elimination of references to 

"unamortized subsidy" and "subsidy amortization.'' The rate 

base would have shrunk by $3 million, assuming the regulatnry 

authority is vigilant; the excess $3 million would have been 

rcturnctl to creditors and sh~reholders to Cispose of however 

they chose; and the cost of service would have been shrunk 

accoruinqly. Similarly, at the end of 1979, $29.9 million of 

cash-flow would have been generated, $2.9 million in excess 

of the $27 million capital expenditure requirement at the 

beginning of 1980, Then Table 4 might simply be recaptioned 

to refer to the effect on rate base, income from sales, and 

cost of service in the event capital goods prices are reduced 

by 10 percent. Since the economics of a 10 percent capital 

subsidy are exactly the same as the economics of a 10 percent 

goods price reduction froin the point of view of the private 

firm, the proper way to account for the latter is also the 

proper way to account for the former. 

-The mischief caused by accounting for a capital subsidy 

as "income" in the year received. 

Note has been taken earlier of the self-fulfilling 

character of rate regulation. Because entry into regulated 

markets is restricted, and regulatory commissions prescribe 

accounting procedures on which they base maximum rates, the 

depreciatinn and other income accounting rules they prescribe 

produce the rates which, in the end, will validate the rules. 

If, in a particular year the rules produce too low revenues, 

market prices of regulated company shares will tend to fall, 
-21-

destroying the relationship to book-value. Such an occurrence indicates the commitment to creditors and shareholders 

is being abrogated. Should revenue from sales fail to 

sufficiently cover out-of-pocket expenditures and contractual 

interest payments, to provide funds for dividends, and to 

finance the outlays for maintenance of plant and equipment, 

these consequences would follow: As analysts observe that 

the "interest coverage" provided by operating income has 

declined, they will downgrade the company's bond ratings. 

This will cause the company's borrowing rates to rise, and 

this will increase cost of service automatically as debt is 

refinanced or additional debt is incurred. If, as a result 

of inadequate cash flow from sales, dividend payouts are 

reduced, market prices of the company's shares would decline. 

Recognition of this possibility might exert pressure on 

regulated company managements to divert funds which would 

otherwise be used to maintain plant capacity to "dividend" 

payments. If this is done, the payments are, in fact, not 

distributions of current earnings but a "return of capital", 

either paid-in capital 'or reinvested prior year retained 

earnings. The consequence of this strategy is also to 

increase cost of service both because continuation in service 

of obsolete plant requires more dawn-time for repairs and 

repair expense or because the obsolete plant consumes more 

fuel. 

Although regulatory commissions may respond with a time 

lag in making rules adjustments to cope with changing conditions, they are ineluctably driven to recognize real costs 

of producing a given quantity and quality of service. 

Lacking any taxing powers, they are unable to commandeer 

resources with which to produce utility services; they can 

only supervise rate setting and the quality of service to 

ensure customers each year cover cost of service. Of course, 

regulatory commissions may bring about a maldistr ibution of 
-22-

cost of service over time by failure to respond to changed 

cost conditions with speed and accuracy. Thus, one further 

test of the rationality of tk,e 8tnormalization" rule is to 

examine what happens when a capital subsidy, or real reduction in the price of plant and equipment is srbitrarily 

accounted for by a regulatory commission as an increase, or 

source of, after-corporate-tax income of regulated company 

shareholdcrs. This is popularly called "flow-through" 

accounting for a subsidy. 

In terms of our illustrative exhmple, Table 5 presents 

the 1979 "flow-through" outcome as it would appear in the 

f inclnciiil statements of the regulated coinpcny. "Flowingthrough" the $3 million capital subsidy permits a $5.56 

millinn reduction in required 1954 revcnues, as crimpiired with 

the base case. This "amplification" of the $3 million flowthrough to after-tax equity income results from the fact thclt 

a given amount of tax-exempt compensation is equivalent to a 

much larger pre-tax payment. In this case, "flowing-tlirough" 

the $3 million capital subsidy to equity holders displaces 

$5.50 million in service charges customers woulU otherwise 

bave to pdy in order to yield the shareholdcrs $3 million in 

after-corpordte-tax income. Generally, the larger the t&x 

rate applicable to market-der ived income payments, the 

greater is the pre-tcix income displaceu by e&ch tax-exempt 

dollar.5/ - As compared with the 1374 results unuer proper 

accounting for the subsidy, or normalization, shown in 

-5/ Ths reader should note that, for expositional simplicity, 

we have extended equality of tax and regulatory accounting 

to treatment of the subsidy, presumed to be in cash, &s a 

tax-exempt income payment to shareholders. In fact, the 

tax accounting for a cash capital subsidy would be to 

exclude the subsidy from the depreciable basis of tht 

property and this would increase the tax due as well as 

increase the required revenues. 
-23-

Tables 3 and 4, 1979 rates are lowered by $4.94 million 

through this incorrect accounting for the capital subsidy. 

But, since "flow-through" procedures maintain the $465 

million rate base, and hence the equivalent amount of private 

financing, as the balance sheets in Table 5 show, the lowered 

"flow-through" rates, which are permanently sustained so long 

as the subsidy remains in effect, merely borrow from the 

future. As may be seen in Table 4, in 1989 and every year 

thereafter, a proper accounting for the capital cost of 

service will yield a lower required revenue than "flowthrough" procedures. In 1989, the properly measured cost of 

service is $268.76 million and declining while the "flowthrough" cost of service is still $269.01 million, its 

permanent level. 

"Flow-through" procedures never approach the cost of 

service reduction measured by the appropriate accounting for 

a capital subsidy because they, in effect, finance a larger 

first-year reduction in required revenues (and reductions for 

9 more years, in our example) with the proceeds of additional 

borrowing and equity financing, for which rates of return 

will have to be paid. Since the rate base to finance this 

erroneous treatment of a capital subsidy is permanent, its 

recovery through depreciation and its interest and after-tax 

return to equity (plus income tax) will be permanently paid 

by the regulated utility's customers. There is no way to . 

interpret cost of service rate regulation theory in a way

.' which authorizes a regulatory authority to permanently impose 

a burden in excess of their real cost of service on future 

users of utility services in order to provide current users 

rates below their real cost of service. 

This characteristic of "flow-through" accounting of a 

capital subsidy appears clearly when that procedure is 

applied to a real reduction in the price of plant and equipment items. Suppose again that on January 1, 1979, the $30 
---------- 

-24-

million vintage of equipment drops in price to $27 million. 

As we have noted before, this event should result in a $0.62 

million reduction in the real cost of service, with the $3 

million saving in equipment cost utilized to reduce the rate 

base. However, if a regulatory commission designates the $3 

million saving in equipment cost an addition to "net income" 

attributable to shareholders' equity, while treating the $27 

million of equipment purchased as if it cost $30 million, the 

current year cost of service could be reduced by $5.56 

million; the $3 million saving is "flowed-through".6/- Thus, 

the rate base remains at $465 million, supported by that 

amount of debt and equity, rather than falling to $462 

million, reducing the required amount of debt and equity. 

Clearly, to manipulate a lower current charge for service, $3 

million of additional. private funds are utilized in the 

regulated company, the unnecessary cost of which will 

ultimately have to be paid by utility customers. 

Happily, this "flow-through" of savings in the cost of 

acquiring capital would never be tolerated by regulatory 

commissions: They would note that, for the same reason they 

did not "flow-through" to current cost of service the $30 

million of equipment cost, nor the reduced $27 million cost 

(since neither expenditure was embodied fully in the service 

sold in the year of acquisition), it would be improper to 

consider the $3 million difference an addition to net income ' 

of the regulated company. Transactions involving the 

purchase of assets to be used for a period of years affect 

-6/ Again, for simplicity, we assume that $30 million will be 

l'ermitted as the tax basis for depreciation purposes. If 

inly $27 million is paid, under the tax laws and all the 

normal rules of financial accounting, only $27 million of 

the taxpayer's (enterprise's) capital is recoverable 

through imputed depreciation allowances. 
-25-

current year cost of service only to the extent the assets 

are used-up that year, as estimated by the depreciation 

imputation rule I ani as the net investment of creditors and 

shareholders is changed by virtue of those transactions. 

In view of the co.nclusion reached by this discussion of 

procedures for accounting for capital subsidies, the 17 years 

of controversy over the accounting treatment of the investment tax credit, the most general capital subsidy paid by the 

Federal government, is indeed perplexing. That there is any 

1ingering question about the mer its of "normalization" versus 

"flow-through" of the investment credit is probably attr ibutable to the (originally) unconventional way in which the 

subsidy is conveyed. We now turn to the issues peculiar to 

the tax credit. 

A capital subsidy paid as a credit against income tax. 

To this point we have dealt with a 10 percent subsidy 

payable by the Commerce Department on the submission of 

evidence that a depreciable asset with an expected life of 

more than 7 years has been acquired for productive use. In 

the examples we have detailed above, the regulated company 

annually acquires $30 million of assets eligible for the 

subsidy, hence receives a cash payment on this account of $3 

million so that the net cost to it is $27 million. Also, 

each year, the company pays income taxes, in amounts depending on the rate base and, consequently, on the amount of 

private equity invested, given the after-corporate-tax return 

required to maintain the value of the company's shares and 

the corporation income tax rate. The $27 million expenditure 

enters cost of service as depreciation allowances, returns to 

financiers of the (reduced) rate base and as taxes attributable to the equity share of those returns. The $3 million 

subsidized reduction in acquisition cost is reflected in 

reductions in each of these elements of cost of service. 
-26-

Suppose that Congress, in order to reduce the volume of 

checks being written by the government decides to make 

capital subsidy payments in the following way: Companies 

qualifying for the subsidy will be permitted to simply subtract from the taxes otherwise payable by them the amount of 

the subsidy owed them; eligibility for the subsidy would 

still be documented by invoices, contracts and other evidences of purchase, as in the case of the subsidy payable by 

the Commerce Department. This mode of payment will save 

check-writing expense for the government; it will also save 

administrative expenses because the capital goods qualifying 

for the credit are already accounted for in the tax books-ofaccount reviewed by the IRS. 

Under this mode of payment, -i.e., as a credit against 

tax otherwise due, the illustrative regulated company, at the 

beginning of 1979 still has $30 million in additional cash 

and other current assets with which to purchase a replacement 

vintage of plant and equipment items. But now, when it buys 

the items, it will automatically reduce the cash requirement 

for paying taxes (included among the current liabilities in 

its end of 1379 balance sheet) by $3 million. Thus, the 

financial statements shown in Table 3 still correctly portray 

the results of its subsidized acquisition of plant: The $3 

million of redundant cash would be used to reduce outstanding 

debt and equity to correspond with the $3 million reduction 

in rate base; the 1979 income statement would show exactly 

the same entries, including $23.61 million as provision for 

Federal income taxes, an amount that must be included in cost 

of service. 

This latter figure, the $23.61 million provision for 

Federal income tax when $3 million less will actually be 

paid, is the source of continuing confusion as to the proper 

way to account for the capital subsidy. Many argue that the 
-27-

$3 million is not "paid" and, hence ought not to be included 

in the 1979 cost of service, -i.e., that the "reduction in 

tax" be "flowed-through" and accounted for as in Table 5. 

These persons regard the $3 million of investment credit not 

subtracted from the $23.61 million of 1979 tax expense and 

therefore included in cost of service as a "phantom tax" that 

inflates the cost of service and thereby enriches regulated 

company stockholders. 

The confusion results from a common tendency of laymen 

to regard the clearance of payments through a single account 

as destroying the basic transactions which gave rise to the 

net payment. That is, while these same persons would agree 

that a Federal subsidy of $3 million paid in cash to a 

regulated company on the purchase of plant and equipment is 

perfectly consistent with a tax expense of $23.61 million 

that year; nonpayment of $3 million in tax liability in order 

to get the same subsidy as additional cash is inconsistent 

with the same tax expense of $23.61. 

Since these persons are not persuaded of the analytical 

error they are committing by a demonstration that the dollar 

magnitudes resulting from a transaction in which $30 million 

of assets are purchased at a net private cost of $27 million 

are the same whether the subsidy is paid in cash, accompanied 

by a full payment of tax liability, or not paid in cash but 

cleared as a credit against tax liability, the following 

example may be helpful. Suppose that, included in the cost 

of goods sold for 1979, is $5 million of fuel purchased from 

company A and that included in the regulated company's 1979 

sales is $1 million of services sold to A. Suppose further, 

that A and the regulated company have agreed that, in view of 

their reciprocal seller-customer relations, the regulated 

company will remit to A only the net amount owed it. The 

regulated company will therefore use its account payable to A 
---------- 

-28-

to clear amounts owed it by A. Thus, in the year in question, the $5 million of fuel purchases are recorded as an 

expense (debit) and as an equivalent account payable 

(credit); and the $1 million sales to A as gross income 

(credit) and an equivalent account receivable (debit). At 

the end of the year, the regulated company clears its account 

receivable from A of $1 million against the $5 million 

account payable, and closes its account payable by remitting 

a check for $4 million.7/- Clearly, the fact that the regulated company paid only $4 million in cash in settlement of 

the reciprocal obligations of it to A and from A to it does 

not mean that the $1 million in sales to A have been obliterated or that its cost of goods sold has been reduced from 

$5 million to $4 million, because this is the net cash 

remittance to the fuel supplier. 

Similarly, when a capital subsidy, such as the investment credit, is cleared against the tax account of the 

regulated company, the clearing operation does not obliterate 

the tax liability generated by the company's operation, nor 

does it obscure the conveyance of a subsidy to the company in 

respect of its acquisition of property qualified for the 

subsidy. Thus, the accounting procedure that properly analyzes a cash subsidy for the acquisition of capital is also 

appropriate for a capital subsidy paid by permitting a credit 

-7/ The accounting entries to reflect this clearing transaction are: 

Debit: Accounts payable ........$1 million 

Credit: Accounts receivable............$l million 

Debit: Accounts receivable.. ...$4 million 

Credit: Cash......... ..................$4 million 

Note that none of these entries affect entries for sales 

of $1 million to A or of cost of goods sold of $5 million 

(purchases of fuel from A). 
---------- 

-29-

against income tax. The "phantom tax" issue raised in 

connection with capital subsidies cleared through the tax 

system is a false issue: It arises from incomplete analysis 

of the transactions involved. Moreover, any careless consideration of "tax paid" net of subsidies, or other payments, 

cleared through the tax accounts of a given year as a measure 

of tax liability generated by a taxpayer's economic performance during a year will lead to a grossly misleading 

indication of the taxability of that taxpayer's income, or 

what is popularly called his "effective tax rate."8/-

A1 though the accounting for capital subsid ies, when 

paid, is independent of the form in which they are paid-­

whether as cash or as credits against income tax otherwise 

due--there are three notable differences between cash capital 

subsidies and the present investment credit. First, because 

capital subsidies cleared through tax accounts are regarded 

as "reductions in tax," the amount of the subsidy payable 

during a year is limited to the first $25,000 of tax 

liability plus (ultimately) 90 percent of the tax liability 

in excess of $25,000.9/- Although attachment of conditions 

8/ See U.S. Treasury Cekartment, Effective Tax Rates Paid by - - Corporations, 1972, May, 1978. 

Prior to 1979, the annual limitation on the amount of 

investment credit that might be taken by a single taxpayer 

was the first $25,000 of tax liability that year plus 50 

percent of the tax liability in excess of $25,000. In 

1979, the annual maximum is the first $25,000 plus 60 percent of any additional tax liability, the percentage 

increasing by 10 points in 1980 and each succeeding year 

until it becomes 90 percent in 1982. Amounts of credit 

earned in any year but not taken by reason of this 

limitation may be carried back 3 years and forward 7. 
-30-

to the granting of cash capital subsidies is not unusual, 

imposition of a requirement that the private investor have 

current tax liability is not a normal condition. The effect 

of this limitation on effective receipt of the capital 

subsidy is frequently a delay in its conveyance to the 

investor, and in some cases, partial denial of the subsidy. 

The second difference between a normal cash subsidy for 

the purchase of qualified capital goods and the present 

investment credit is that the credit is payable in advance of 

the legal acquisition of the asset, under certain circumstances. If the asset in question takes more than two years 

to construct, then if the purchase contract calls for advance 

payments, popularly called "progress payments", then the 

investment credit may be taken as these payments are made.lO/ - This is a curious, and asymmetrical, intrusion of "cash 

accounting" procedures in a tax accounting system that, 

except for its general reliance on the occurrence of an 

exchange event to trigger "recognition" (measurement) of 

gross and net taxable inc'ome, applies accrual procedures. 

The event that signifies entitlement to a purchase 

subsidy is the legal acquisition of the qualified property; 

the basis for the subsidy is the value of the property at the 

time acquisition occurs. If the terms are C.G.D., the 

exchange price covers all costs--including capital costs-­

incurred prior to the exchange; if the terms call for pre-

.­

delivery, "progress," payments, then part of the capital 

costs--interest on working capital--are assumed by the buyer; 

if the terms call for deferred payment, then two transactions 

are involved, an exchange of property, and a loan. In 

710/ Internal Revenue Code, section 46(d). 
-31-

principle, the subsidizable basis of the property should be 

the same in all these cases, because the value of the 

property is the same when the property exchanges. -If, in the 

progress payment case, an explicit imputation of the contribution by the purchaser to the value of the property in the 

form of interest on loans he has made were recognized, and 

that interest income attributed (and taxed) to him as lender, 

it would be clear that the "progress" payment should not 

trigger a "purchase" subsidy. The implicit amount of 

interest paid, like that paid to any creditor, would be 

incorporated in the selling price of the property, and that 

selling price, when paid on delivery, would constitute the 

basis for the purchase subsidy. 

Under present tax law conventions, no interest is 

imputed with respect to progress payments: it neither appears 

in the taxable income of the implicit lender, nor is it 

accumulated as part of the cost of the property. It therefore follows that, when delivery has occurred and the 

property financed by progress payments has been placed in 

service, the amount of subsidy payable is less than it would 

be under a C.O.D. contract. But, this is as it should be, 

for part of the acquisition price has been paid with untaxed 

funds--the implicit interest on the advance of funds. To 

allow an acceleration of subsidy payments therefore provides 

an unwarranted enhancement of the subsidy that encourages 

this form of project financing.ll/ -

-11/To appreciate the illogic of allowing purchase subsidies 

. when prepayments of the purchase price are made, consider 

whether purchase subsidies should be delayed as repayments 

of principal are made over the life of a deferred payment 

plan to finance the same purchase. This would clearly 

devalue the purchase subsidy. There is no reason to 

structure a purchase (or sale) subsidy in a manner to 

favor particular payment schedules. 
---------- 

-32-

As it happens, "progress" payments are common among 

regulated companies so that this unusual characteristic of 

the investment tax credit is particularly valuable to this 

sector of the economy. We shall not attempt to demonstrate 

here how this further reduces the cost of service for, to do 

so, we would have to introduce an additional set of accounts 

relating to "construction work in progress", an activity of 

regulated companies that is separate from its normal activities of producing and distributing services, which is of 

major concern here. Rather we will simply observe that, in 

terms of real resource costs, the $3c1 million expenditure for 

rate base assets we have been recording are already subsidized by some amount, the amount depending on the length of 

time the utility has taken to construct the $30 million unit 

it places in service each year. 

The third difference between a cash capital subsidy and 

the investment tax credit derives from the tax treatment of 

the subsidy itself. Whereas a government grant (or other 

nonshareholder "contribution to capital") for the purpose of 

acquiring an asset is treated under the tax laws as not 

recoverable by the beneficiary of the grant, the subsidy 

conveyed as an investment tax credit is. That is, if the 

Commerce Department had paid $3 million toward the purchase 

of $30 million of equipment, the purchaser of the equipment 

would be treated under the tax laws, as under the normal 

rules of financial accounting followed in the balance sheet 

presentation above, as having only $27 million in private 

resources recoverable as depreciation. -12/ However when that 

same subsidy is conveyed as a credit against income tax, the 

investor is permitted to take tax depreciation deductions 

with respect to the $3 million of subsidy as well as the $27 

million paid with his own (or borrowed) funds. Clearly, a 10 

percent investment tax credit so structured is worth more, 

-i.e., displaces more privately financed rate base, than a 10 

percent cash subsidy. 

I12/Section 362(c). 
--- - - 

- - ------ ---- -- 

---------- 

-33-

Accounting for the "extra" subsidy inherent in - ____I_________ the .-

investment tax-credit.l3/ -

Just as it was convenient to develop rules for accounting for a subsidy by first examining it when paid in cash, so 

it will be illuminating to translate the additional subsidy 

element conveyed by tax depreciation of a capital subsidy 

into cash grant equivalents. To do this, we modify the 

original 10 percent subsidy paid by the Commerce Department 

in the following way: To enhance the capital subsidy while 

not initially paying the full amount, the Secretary of 

Commerce offers to add to the 10 percent subsidy, which is 

payable on submission of evidence that qualified property has 

been acquired, an additional subsidy in subsequent years, 

provided the purchaser .retains and uses the property. Thus, 

the additional subsidy is formulated as an amount, payable at 

the end of each period of use, equal to the reduction in 

income tax payable had the government's grant been included 

in the investor's tax depreciation basis. The rationale for 

such a subsidy might be 'that the government believes that, 

first, by delaying the payment of the additional subsidy to 

the purchaser he will be disciplined into making fewer 

frivolous investments since he initially will have to pay the 

90 percent unsubsidized portion of the asset's cost and wait 

for the remainder for the full life of the asset. Secondly, 

it might be thought that stringing out part of the subsidy 

c 

13/ Ke do not here account for the enhancement of the investment credit resulting from its availability as "progress 

payments" are made. To do so would require complicating 

the presentation to separately account for the regulated 

company's construct ion activity . Since this is not 

related to current cost of service, it is better ignored 

in the exposition. 
-34-

over the life of the investment will serve to induce the 

investor to squeeze out the full productivity of the asset. 

Gearing the amount of additional subsidy to the tax rate of 

the subsidized investor is questionable. There would appear 

to be no economic policy objective served by making the 

additional subsidy worth more to high-income investors. The 

basic 10 percent subsidy, of course, is equal-valued to all 

investors. 

Under this revised formulation of the 10 percent capital 

subsidy, still assuming that tax depreciation imputation 

rules match those used by the regulatory authority, at the 

end of 1979, the first year of the subsidy program, the 

Commerce Department will pay an additional subsidy of $46,000 

to the utility company.. This is equal to 46 percent (the 

income tax rate) of $100,000, the annual depreciation of the 

subsidy ($3 million/30 years) for the 1979 vintage. At the 

end of 1980, both the 1979 and 1980 $3 million subsidies will 

qualify for an additional $46,000 payment from Commerce. 

Ultimately, after all 30' vintages have been brought within 

the scope of this modified subsidy, each year the regulated 

company will realize a cash subsidy of $4.38 million for each 

$30 million of plant and equipment it purchases: $3 million 

representing 10 percent of the purchase price of the qualified property, $1.38 million as supplementary subsidy for 30 

vintages in use, at $46,000 per vintage. The annual subsidy 

per $30 million investment in qualified property is, therefore, effectively 14.6 percent ($4.38 million divided by $30 

mill ion) . 

Altogether, the revised "10 percent" cash subsidy will 

ultimately reduce the unsubsidized rate base of our regulated 

company from $465 million tn $397.11 million, the remaining 

$67.89 million of capital having been furnished by the 

Federal government. Thus, the enhanced "10 percent" subsidy 

brings about the following cost of service: 
---- 

-35-

Cost of goods sold. .........$165.00 million 

Net depreciation ............ 25.62 

Interest paid ............... 23.83 

Income taxes................ 20.30 

After-corporate-tax return 

to equity .................. 23.83 

Total cost of service.. ..$258.58 million 

By reducing the capital cost elements by 14.6 percent, the 

"10 percent" subsidy supplemented by future su-bsidies equal 

to the value of private tax depreciation of the initial 

subsidy succeeds in reducing total cost of service by 5.8 

percent. 

The present investment tax credit possesses exactly the 

character istics just described for an enhanced "10 percent" 

capital subsidy. It therefore follows that the proper procedure for accounting for the investment credit is that also 

just described: While the tax expense entering cost of 

service is $20.30 million each year after full adjustment to 

the enhanced subsidy, a total capital subsidy of $4.38 

million is cleared against this accrued liability, resulting 

in a payment of $15.92 million in cash to the Treasury and 

leaving $4.38 million as an addition to "unamortized subsidy" 

which will exactly offset the amortization of the balance in 

that account and sustain a net rate base of $397.11 million 

financed by $238.27 million of bonds and $158.84 million of 

equity. 

111. Accountinq for a subsidy for the financing -of I__-­

capital. 

Subsidies to private capital formation may either be in 

the form of grants, or the investment tax credit, discussed 
-36-

above, or in the form of financing. In the case of grants, 

the government assumes some part of the cost of acquiring the 

eligible property, thereby relieving the customers who purchase the product of this capital of a part of the costs of 

replacing the capital as well as the return thereon (and the 

income tax attributable to that income). In the case of 

financing subsidies, loans to displace private financing are 

either made directly by the government, or the terms of 

private loans are subsidized, -i.e., by government guarantees

to lenders which reduce loan rates of interest, or by governmental assumption of all or part of the interest payments to 

lenders. Thus, in the case of subsidies pertaining to the 

financing of private capital, customers are relieved only of 

the subsidized capital return costs; they must still pay 

prices which will permit recovery of the capital used-up in 

product ion. 

Normally, the accounting for interest subsidies raises 

no issues. However, the formulation of Federal financing 

subsidies commonly described as "tax deferral" contains 

elements that confuse analysts and laymen alike, making the 

accounting for these subsidies a continuing source of controversy, again centered on debate over the merits of 

"normalization" or "flow-through". To clarify analysis of a 

proper accounting for such subsidies, we shall again first 

specify the present "tax deferral" subsidy as a program 

administered by the Commerce Department to derive from its 

structure and functions a set of accounting procedures 

capable of measuring the impact of the subsidies. These will 

again be found transferable exactly to an accounting for the 

same subsidies cleared through the tax system. And once 

more, these procedures will be found to be those called 

norm a 1i z a t ion .I' 
-37-

purchase of qual if ied property . 

Suppose that, beginning on January 1, 1979, Congress 

authorizes the Secretary of Commerce to make loans, at zero 

rates of interest, to .any purchasers of depreciable property 

in order to assist them with the financing of this form of 

capital formation. The Secretary, after seeking a formula 

which would be easy to administer, avoid 100 percent 

financing, and could be flexibly adapted to the varying life 

character istics of depreciable property, devises this formulation: At the end of each year after the purchase of 

depreciable property, the Commerce Department will lend a sum 

to the owner, at zero interest, equal to the product of his 

tax rate times the dif.ference between a proclaimed depreciation imputation schedule for that property and one which 

describes the real economic decay of that property. The 

proclaimed schedule will simply be that produced by the sumof-years' digits formula computed for a life equal to 80 

percent of the real life. The "real" life and depreciation 

imputation schedule will be that used for financial 

rep'or t ing . 

This is an extremely clever formulation of the terms of 

a loan to achieve the objectives of Congress in authorizing 

the program to encourage private capital formation: 

1. The timing of loans and their repayment are automatically determined. Since the total basis of the asset 

to be recovered under either the proclaimed schedule 

or the real underlying schedule is the same, loans 

tomatically will be extended in the early years of 

the ownership of the property, repaid in the later 

year's. 
---------- 

-38-

2. The amount of the loans will be greater the more 

durable the asset, i.e., the longer lived and/or 

decelerated the pattern of real underlying depreciation. This is desirable because the private 

financing needed to "carry" assets is roughly 

correlated with durabil ity .14/ -

On the other hand, because the amount of the financing subsidy thus provided is directly proportional to the investor's 

tax rate, the program formula lends more to high income 

investors than others. Again, this seems to serve no useful 

economic policy objectives. 

Accounting for th.e ---------..---.----------_------------------.-----specified "zero interest" loan 

subsidy. 

In tracing out the effects of this Federal lending program, it is helpful to ignore any subsidies for purchasing 

the assets. Considering 'only the loan, since the regulated 

company's 1979 investment qualifies for the zero interest, or 

interest-free, Federal lending program, we may easily determine the schedule of such loans and repayments this vintage 

of investment will generate. This is shown in Table 6. The 

proclaimed schedule of "depreciation" amounts in this case 

14,' In the limit of non-durability, an asset which is used-up 

and requires replacement each year will require a cost of 

service charge for depreciation equal to replacement cost 

and no private financing of its acquisition is required; 

the beginning balance sheet will show $X for such an 

asset, the ending balance sheet zero, with cash and other 

current assets increased by $X, available for purchasing 

a replacement. Virtually no capital is required to carry 

such an asset. At the opposite extreme, an infinitely 

durable asset costing X will require permanent financing 

of x. 
-39-

will distribute the $30 million cost of the qualified property over 24 years (80 percent of 30) by the sum-of-years' 

digits formula. Thus, in the first year, the proclaimed 

schedular amount for the regulated company is $2.4 million. 

Since its norm for depreciation that year is $1 million, it 

can borrow from the Commerce Department $644,000 at the end 

of 1979 ($2.4 million, less $1 million, times the 46 percent 

tax rate equal $644,000). At the end of 1980, the 1979 

vintage will qualify the regulated company for an additional 

$598,000 of interest-free borrowing, and so on, through 1992 

for, in 1993, the proclaimed schedular amount is equal to the 

depreciation norm of $1 million. Through 1992, $4.8 million 

of interest-free borrowings will have been generated by tile 

1979 vintage. Then, beginning in 1994, unuer tliis leniiny 

program, repayments begin sn that, when the 1959 vintage is 

retired at the end of 2008, all $4.8 million of outstdnding 

loans generated by the 1979 vintage will have been repaid. 

However, at the beginning of 1980, the regulated company 

will acquire another $30' million of qualified property, and 

this, too, will generate qualification for interest-free 

loans. Indeed, at the end of 1980, the $598,000 of loan 

eligibility of the 1979 vintage just noted will be added to 

by the $644,000 first-year contribution of the 1980 vintage, 

providing a total of $1.242 million in new interest-free 

loans. 

Continuing with the assumption of no growth or inflation, Table 7 arrays the annual results of this lending 

program over the next 3i) years. In columns (2) and (3) are 

shown the annual loan proceeds to which qualified property in 

service entitles the regulated company. For 1979, the 

$644,000 generated by that vintage is shown in column (2), as 

is the combined $1.242 million the 1979 and 1980 vintages 
-40-

generated at the end of 1980. Returning our attention to the 

end of 1979, it is obvious that the $644,000 of interest-free 

loans may be used to eliminate that amount of private financing of the $465 million of rate base; thus, at the beginning 

of 1980, $644,000 of debt and equity has been retired, 

leaving only $464.356 million of private financing for the 

$465 million of rate base. Then the additional loan eligibility of $1.242 million generated during 1980 enables the 

retirement of that additional amount of private financing so 

that, at the beginning of 1981, private debt and equity to 

support the $465 million rate base has been reduced to 

$463.114 million. 

Until 1992, the addition of each vintage of assets 

increases the regulated, company's loan eligibility each year 

by an amount greater than the preceding year. The reason why 

increases in the annual increment to loan eligibility peaks 

in 1992 is that, after that year, as we saw in Table 6, loans 

with respect to the 1979 vintage have to be repaid. Thus, in 

1993, the combined increment to loan eligibility provided 

that year by the 1993 vintage and others is offset in part by 

repayment of $46,000 with respect to the 1979 vintage assets. 

Beginning in 1994, the annual increment to loan eligibility 

declines, reaching zero in 2008, after all vintages in use 

have become eligible for interest-free loans to the regulated 

company. 

By the beginning of 2008, outstanding interest-free 

loans to the regulated company have increased to $94.3 

million, a total which will remain constant so long as the 

regulated company maintains its stock of subsidy-f inanced 

plant and equipment (rate base). Should it fail to spend $30 

million some year, it will have to reduce its interest-free 

loans outstanding, pay-off $644,000 that year, the amount of 

expiring loans with respect to all its vintages not offset by 
-41-

"new" lending �or the vintage not acquired. But, since we 

have no reason to suppose that the regulated company will not 

continue to maintain its rate base, the $94.3 million of 

interest-free loans will be sustained by the equivalent of 

"rolling-over" outstanding private bonds: Loan repayments 

will be covered by new.borrowing. 

The ultimate effect of the Commerce Department lending 

program has been to reduce the unsubsidized financing of $465 

million required to sustain a $465 million rate base to only 

$370.7 million, with consequent reductions in the cost of 

service. The effects on cost of service resulting from the 

subsidized financing program are tabulated in columns (5)- (9) 

of Table 7. Since the subsidy does not reduce the private 

cost of purchasing pleant and equipment, the $30 million 

annual depreciation cost of service remains unaffected. 

However, the interest paid, income tax, and after-corporatetax return to equity steadily declines as Federal interestfree financing grows. Ultimately, since the private 

financing required is reduced by 29.3 percent, the portions 

of cost of service relating to returns to private capital 

similarly decline, and this brings about a 5.9 percent 

reduction in total cost of service, from $274.57 million to 

$258.43 million. 

Clearing the interest-free loan program through the 

income tax. 

The lending program just described required the Commerce 

. Department to write checks in exchange for private firms' 

notes agreeing to the terms of the loan, including repayments. Once again, the necessity for writing checks to 

implement the financing subsidy program can be avoided by 

clearing the government lending through the income tax 

accounts of investors. Indeed, this has been done. In 1954, 
-42-

all taxpayers were allowed to use formulas for determining 

annual depreciation allowances that include the sum-of-years' 

digits method and others consistent with it, whether or not 

this matched the real depreciation pattern of assets. 

Beginning in 1971, taxpayers have been allowed to use 80 

percent of the guideline life for such assets published by 

the Treasury Department, regardless of the economic lives of 

their assets. In certain other cases, Congress has 

explicitly introduced 5-year write-offs and immediate 

expensing privileges that are the functional equivalents of 

interest-free lending programs described above. 

It will be recalled that the magnitude of the interestfree loans is dependent on the difference between the 

"procldimed" schedule of depreciation allowances and that 

which would be used for actual income measurement. This 

character istic of the lending program raises certain issues 

concerning the "norm" of depreciation imputation that should 

be used for "actual" income measurement, a matter to which we 

will turn below. However', in the regulated company case, as 

has been noted above, the depreciation imputation norm is 

specified and validated by regulatory commission rate making 

rules. 

Thus, to the extent that taxable income of utilities is 

measured with the use of depreciation imputation rules that ' 

depart from those used by regulatory commissions, the Federal 

government is implementing an interest-free lending program 

of the type just described. Prior to the modifications of 

the tax laws beginning in 1954, there was reasonably close 

correspondence between the regulatory and tax rules governing 

depreciation imputation. In regulated industries, therefore, 

the post-1954 deviations of tax rules for income measurement 

from regulatory norms marked the introduction of a subsidy 

program that may only be correctly accounted for as a source 

of interest-free loans. 
-43-

We may translate the discussion above of an accounting 

for the effect of interest free Federal financing into the 

terminology of regulatory accounting for tax expense as 

follows: Attendant on investment in depreciable assets is 

the need to measure pre-tax income flowing from their use, 

after making allowance for the ultimate worthlessness of 

those assets due to wear-and-tear and to 

ever formula is used for imputing the 

decline in value over the life of the 

measure taxable income, the same total 

made for regulatory purposes. If the 

larger depreciation imputations early in 

obsolescence. Whatoccurrence of this 

assets in order to 

imputation will be 

tax rules result in 

the lives of assets 

than is imputed under regulatory rules, then tax depreciation 

imputations for the same assets will be smaller later in the 

assets' lives. In effect, the entries in Table 6 measure the 

time-displacement of tax payments--"tax deferral"--not a 

"forgiveness" of tax. Since income tax is a statutory percentage of income, and income is a function of the privately 

financed capital used to produce service by the regulated 

company, then if, and only if, the regulatory commission 

computes tax expense--an element of cost of service--by using 

its own depreciation imputation rules will it measure and 

fairly distribute the cost of capital services over time. 

"Tax deferral" represents interest-free borrowing, the benefits of which will be distributable to customers as the 

loans, generally called "deferred taxes", displace private 

financing. 

This accounting procedure is called "normalization" of 

. the difference between income tax liability, the current year 

tax expense, using the company's depreciation imputation 

rules (the regulatory commission's rules in the case of a 

regulated company) and that using the tax depreciation 

imputation rules. The tax liability computed using the 

regulated company's own rules, since it is purely a function 
-44-

of the tax rate applied to an income measure based on the 

value of assets employed, and which are p,*ivately financed, 

is the correct neasure of income tax expense for the period; 

the difference, "deferred taxes" is a source of financial 

funds available (and used) to displace private financing. 

The financial statements for 1979 that reflect this 

procedure are shown in Table 8. The only difference between 

these statements and those of the base case for the same year 

(Table 1) is the $0.64 million ($644,000, rounded) of 

deferred tax: In the income statement reflecting the firstyear lending program, tax expense of $23.77 million is 

presented in two parts, the net $23.13 million payable after 

netting the $0.64 million of interest free loan plus the loan 

proceeds for the year itself, labelled "deferred tax"; in the 

end of 1979 balance sheet, deferred tax appears on the 

liability side, offset on the asset side by an equivalent 

$0.64 million of cash and other current assets. This raises 

total assets and liabilities to $565.64 million at the end of 

1979. When the $0.64 million is used to reduce debt and 

equity, at the beginning of 1980, the asset and liability 

totals will revert to $565 million. This process of displacing private financing of the rate base, shown in Table 7 

to reflect the accumulation of interest-free loans, can 

occur, of course, only if the regulatory commission properly 

regards the total tax expense, computed on the basis of its 

own depreciation imputation rules and also shown in Table 7, 

as a cost of service. Assuming prompt regulatory response, 

this normalization procedure to account for the effects of an 

interest-free lending program charges each year's customers 

their true (private) cost of service, as this has been 

reduced by the volume of interest-free lending by Federal 

taxpayers. 
tax 

-45-

Mischief caused by regarding the proceeds of interestfree loans as additions to equity "income" for the year. 

The fundamental accuracy with which "normalization" of 

subsidies cleared through the tax system accounts for the 

underlying phenomena qan be demonstrated again by considering 

the outcome of "flow-through'' procedures applied to proceeds 

of interest-free loans cleared through income tax accounts. 

In Table 7, column (2) arrays the annual amount of interestfree loans, or "deferred taxes", generated by the volume of 

subsidy-qualif ied property then in service. If these loan 

proceeds, payable to the regulated company in exchange for 

notes labelled "deferred taxes", are simply regarded as 

"reductions in tax" for the years in question, then they make 

possible a reduction in required revenues that is a multiple 

of the deferred taxes. As noted in connection with "flowthrough" of the investment credit, since these payments are 

tax-exempt, at a tax rate of 46 percent each dollar of loan 

proceeds can displace $1.851 of pre-tax--customer-paid-­

income from sales. For example, in 1980, as shown in column 

(2) of Table 7, the 1979 and 1980 vintages generate $1.242 

million of interest-free loan proceeds that year. This makes 

possible a reduction in required revenues of $2.3 million 

($1.242 times $1.851) as compared with the base case level of 

$274.57 million, or a required 1980 revenue of $272.27 

million. If that is the 1980 revenue, after deducting $165 

million (cost of goods sold), $27.9 million (interest paid), 

and a - depreciation deduction of $32.7 million (28 vintages @ $1 million each plus $2.3 million for the 1979 

vintage and $2.4 million for the 1980 vintage), taxable 

income is $46.67 million, and the tax liability payable is 

$21.47 million. This amount is treated as tax expense for 

the year, "deferred tax" not being recorded; the interestfree loan is therefore not accounted for by the regulatory 

authority. The required 1980 revenue of $272.27 is 

decomposed in that year's income statement as follows: 
-46-

Cost of goods sold.. ..$165.00 million 

Depreciation .......... 30.00 

Interest paid ......... 27.90 

Federal income tax 

paid ................. 21.47 

Net return to equity.. 27.90 

Total. .........$272.27 million 

Table 9 shows this annual required revenue from sales, 

along with those for 1979 and other years through 2009, under 

a regulatory procedure which "flows-through" to net income of 

equity the proceeds of interest-free loans made available for 

depreciable assets acquired after January 1, 1979. To compare this result with a proper accounting of the effects of 

interest free loans, the required revenues from sales under 

"normalization" accounting for each year, transcribed from 

Table 7, are also shown. Under the "flow-through" procedure 

costs of service assessed steadily drop until 1992, and after 

1993 steadily rise. This pattern mirrors the pattern of 

interest-free loans generated, shown in column (2) of Table 

7. Thus, by 2008, when no additional interest-free loans are 

generated to clear through the tax accounts, the "flowthrough" required revenue from sales that year has returned 

to the base case level, where it will remain so long as there 

is no change in the rate base. 

Given the nature of the underlying phenomena, a shifting 

in time of tax liabilities, and hence the generation of 

interest-free loans, the "flow-through" pattern is indeed 

curious: u n t i 1 19 9 2, 'I f 1ow- th r o ug h" pr oced ur e s a f for d 

custnmers lower rates than if the loan proceeds were properly 

accounted for as interest-free loans; thereafter, they are 

assessed higher charges, and by 2008, they are paying rates 

as if the Federal loan program had never existed or continued 
-47-

in effect1 Any technique for accounting for the effects of 

tax deferral which produces such results must be defective: 

so long as tax deferral is in effect, and the calculations 

here assume the subsidy program is permanent, it should be 

reflected in lower costs of service. Though the conditions 

in 2009 include the in.terest-free loan program while the base 

case does not, revenues required in the two instances are the 

same. If this is the result of "flow-through" accounting for 

the loan program, it must be an improper regulatory accounting technique. 

The inherent error of "flow-through" techniques is their 

failure to account for the cumulative effect (a growing 

stock) of interest-free loans provided by artificially 

accelerated tax depreciation imputation methods. It therefore misallocates the proceeds of interest-free loans to 

current year consumers as a cost of service reduction; this 

deprives future years' consumers of the benefit of 

interest-free financing of plant and equipment. As noted in 

the previous section dealing with the accounting for a 

capital purchase subsidy, forcing future generations to pay 

the price of unnecessary private financing of rate base is a 

policy inconsistent with the objective of cost of service 

rate regulation. Under that regulatory procedure, each 

year's customers ought to pay the cost of their service; they 

should neither be forced to bear a burden to benefit future 

generations of customers, nor be given price breaks that will 

be a burden to other generations. 

Moreover, in the (improbable) event that replacement 

does not continue so that loans will have to be repaid, the 

generation of customers in that year will experience an 

increase in cost of service. For example, if in 2009 the $30 

million is not spent on replacement, $644,000 of the deferred 

tax will have to be repaid. But, in order to 'Irepay" this, 
-- 

-- 

-48-

income from sales will have to be increased by $1.193 million 

above the base case, which has no subsidy! Had the subsidy 

been accounted for properly in the first instance, the 

increase in tax payable due to a net repayment of deferred 

taxes would not have been accounted for later as an increase 

in cost of service. Rather the $644,000 would be correctly 

accounted for as a reduction in deferred taxes, a repayment 

of outstanding loans, and this would not require an increase 

in current cost of service. 

-.-

The combined effect .---of the two - tax subsidies. 

The previous section showed how the investment tax 

credit, if properly accounted for in the cost of service, 

would ultimately reduce the rate base of $465 million 

required, absent a subsidy, to $397.11 million requiring 

private financing. In this section we have shown how a 

properly accounted for interest-free lending program financed 

through the income tax accounts would reduce the required 

private financing of rate base assets by 20.3 percent. Table 

10 summarizes the combined effect of these two subsidies on 

the cost of service, when the assumed static stock of assets 

required to produce the established level and quality of 

service have all come under the cover of the subsidies. 

As noted, the investment credit, by providing complete 

Federal financing and replacement of 14.6 percent of the $465 

million worth of plant and equipment, reduces the financing 

requirement to $397.11 million. Then, the interest-free lojn 

progr;lm provides $80.53 million of financing, leaving only 

$;lU.5L million to be financed with long-term debt and shLreholder equity. The net effect of these two subsidies is, 

then, a reduction in all the capital cost elements: the net 

depreciation charge is reduced by the investment tax credit, 

and the interest, income tax and return to equity are reduced 
-49-

by both the investment credit and the loan program. 

Altogether, the capital cost elements have been reduced by 

30.6 percent, from $109.57 to $76.06 million, and this 

translates into a total reduction in cost of service of 12.2 

percent, from $274.57 to $241.06 million. Depending on the 

responsiveness of service demand to this reduction in cost of 

service, expansion of service capacity, and hence plant, will 

ensue. 

It is worth noting in conclusion that the indicated 

reduction in tax liability shown in Table 10 does not imply 

some net reduction in Treasury revenues. We are here examining only the outcome of Federal subsidies for a unit of 

capital employed by a regulated company to provide utility 

services. The reduction in income tax revenues generated by 

these subsidies to private capital formation, which are 

translated into reductions in prices paid by customers, are 

regenerated when the purchasing power released in lowered 

prices is spent for other goods and services. Whether these 

tax subsidies to private capital formation result in net 

changes in Treasury revenue flows depends largely on whether 

the response to the subsidy programs in the aggregate stimulates a net change in the tax base, i.e., GNP originating in 

the private sector. This is an empirical question for which 

there is as yet no definitive answer. 

IV. Consistency of Tax Subsidy Normalization Rules with 

Dynamic Change 

Relaxing the no-growth assumption: the investment tax 

credit 

The foregoing accounting of the way in which subsidies 

to private capital operate to reduce the private cost of, 

charges for, service in the context of fair rate of return 
-50-

utility regulation was intentionally presented with the aid 

of a model of a regulated company in "stationary equilibrium." Assuming the regulated company merely operates a fixed 

stock of plant and equipment items incorporating an unchanging state of technology and using labor and materials with 

similarly unchanging costs makes it possible to clearly trace 

out the effects of a subsidy. The accounting of these 

effects, however, is not dependent on the model's assumpt ions. 

For example, suppose that, as a result of the subsidyinduced decline in service charges, or for any other reason, 

the amount of service demanded in the regulated company's 

market increases. Then, in addition to the $30 million 

annual investment in pl.ant, some additional investment will 

be made to expand capacity. Suppose that a one percent 

increase in capacity is called for in 1979, and approved by 

the regulatory commission. If the book-value of the existing plant is $465 million, a one percent expansion would 

require an additional expenditure of $4.65 million, if the 

entire expansion is made at the beginning of 1979. Absent a 

purchase subsidy, $4.65 million of additional financing, 

$2.79 million of new issues of bonds, $1.86 million of stock 

(or retention of that amount from 1978 after-corporate-tax 

income of the company), would be required. In 1979, this 

addition would add $0.155 million of depreciation to cost of 

service, $0.279 million for interest, a like amount for 

return to equity, and $0,238 million to income tax expense. 

If, in 1979, a 10 percent investment credit is introduced, the combined purchase of $34.65 million that year 

would generate a subsidy of $3.465 million (plus $1.594 

million later). Then, just as we saw above, the subsidy 

would ultimately decrease capital costs of service of both 

the initial rate base -and the 1979 increment by the relative 
-51-

size of the subsidy, 14.6 percent in the case of the present 

investment credit. Moreover, the availability of $3.465 

million in cash due to the subsidy means that only $1.185 

million of new financing will be required at the beginning of 

1979 to finance the additional $4.65 million acquisition. 

Thus, introducing growth changes nothing in the accounting for the investment subsidy. However, it is worth noting 

that because the dollar magnitude of the investment subsidy 

each year is determined by the sum of "replacement" plus "new 

investment", the net new financing required for the addition 

to capacity (rate base) is greatly reduced: the redundant 

private financing with respect to "replacement" rate base is 

available to help finance the increment to rate base. In 

inflationary times, when mere "replacement" prices rise, the 

additional current dollar investment called for which would 

also have to be financed with additions to debt and equity, 

equally benefits from the subsidy as if it represented real 

growth. Thus it can be' seen that in any period in which 

regulated companies are both growing in a real sense and 

plant and equipment costs are inflating, the existence of a 

subsidy program greatly reduces the search for additional 

private financing. This is probably why regulated company 

managements have come to regard the investment credit as 

essential "means" of financing their annual outlays for plant 

and equipment. Again, the use of cash or other accounts 

through which to clear a multitude of transactions may cause . careless observers to accept this fallacious interpretation 

of the function of a capital subsidy. 

Deferred taxes 

In a similar fashion, interest-free loans generated by 

additions to capacity provide the same pattern of future 

reductions in cost of service associated with additions as 
-52-

was observed above in connection with the gradual qualification of all the vintages of plant for deferred taxes. 

Continued growth, or inflation, by generating larger -cambined loan eligibility for each vintage of "replacement" and 

the ''new" investment, provides a larger fraction of each 

year's new financing, requirements and again creates the 

illusion that the current year's subsidy is mainly an expansion financing device. Of course, in terms of the underlying 

economics of the transactions, while the aggregate displacement of private financing of the rate base may be large 

relative to any current year's purchases of plant and equipment, the distinction between the two elements of the 

displacement--that pertaining to additional loans for which 

previously acquired property become eligible and the other 

pertaining to the first-year eligiblity of the increment-­

should not be obscured simply because both elements are 

cleared through the current year's tax account. 

It is worth noting in passing that, if the rate of 

growth of annual outlays for rate base assets rises at a high 

enough rate, the point at which annual required revenues 

determined by "flow-through" of interest-free loan proceeds 

exceeds the revenue required under a proper accounting of 

these loans is delayed, as compared with the no growth case 

we have examined in detail above. So long as growth and/or 

inflation cause the rate base to increase, the cumulation of 

deferred taxes also increases. Thus as compared with the 

U-shaped cost of service decline from 1979 to 1992 and rise 

from 1993 to 2008 shown in column (2) of Table 9, which may 

be regarded as a cost per unit of output because it is 

assumed capacity remains constant, had annual outlays grown 

at some constant rate, the cost curve would have been 

stretched over time, the minimum cost of service would have 

occurred after 1992, and so long as the annual rate of growth 

had persisted, the annual cost per unit of service would 
-53-

I' 

never quite return to the unsubsidized level. However, even 

under these circumstances, the cost of service established 

under "flow-through" accounting procedures would never reach 

the levels of correct cost of service calculation. If 

properly accounted for, the continued increase in interestfree financing of the growing rate base would bring about 

steadily declining costs of service. 

In sum, the appropriate accounting for subsidies cleared 

through tax accounts in no-growth situations is also appropriate for a growth situation. In either case the technique 

called "normalization" distributes the benefit of the subsidies to customers over time in accordance with the terms of 

the subsidies: the investment credit as an initial reduction 

in the acquisition cost of the qualified property, plus subsequent supplements earned as the asset is held in c.;e; the 

interest-free loan program, with the proceeds in the form of 

deferred taxes determined by the loan and repayment schedule 

implied by the divergence between tax and regulatory rules 

for imputing the occurrence of depreciation, as a displacement of private financing. 

Effects of unforeseen chanaes. 

Suppose that an investment error has been made: The 

"wrong" facilities were acquired at the "wrong" time. That 

is, facilities were built to embody a technology that later 

proves to be inefficient, or the plant is located on a site 

that later appears to have been badly selected, or anticipated demand for utility services has failed to materialize. 

These investments that subsequent events prove to have been 

made in error are incorporated in the rate base. Under the 

logic of fair rate of return regulation, since the regulatory 

commission has tacitly approved inclusion of the "excess" 

investment in the rate base, the costs of these "mistakes" 
---------- 

-54-

are distributed to customers over time in the form of charges 

for depreciation, rate of return, and income taxes.l5/ -

The accounting for subsidies 

system is, of course, not affected 

generated by the mistaken investment 

the same way as the mistaken costs 

probably the case that, if there are 

effect of reducing private costs 

cleared through the tax 

by this; the subsidies 

should be distributed in 

themselves. It is also 

subsidies which have the 

of acquiring and using 

capital, more llmistakesll will be made pari passu with the 

increase in investment that may be induced by the lower cost 

of service made possible by the subsidies. However, given a 

quality of regulatory vigilance over the investment planning 

of regulated companies, there is no reason to suspect they 

will relax their vigilance because subsidies are available. 

The relative cost of "mistakes" is not altered by the subsid ies, which apply equally to llgoodll and "bad" decisions. 

V. Extension of the regulated company analysis to 

unregulated companies. 

The phenomena associated with the provision of subsidiees for the acquisition, or financing, of private 

are the same in both the regulated and unregulated 

It therefore follows that the proper accounting of 

sidies described above for regulated companies 

equally to unregulated companies. In the unregulated 

-15/ Footnote 1 indicated that surveillance over the 

of regulated company decision making is one 

responsibilities of regulation. In unregulated 

capital 

sectors. 

tax subapplies 

sector, 

quality c

of the 

markets, 

commission of investment errors results in losses to 

equity owners. As a consequence, rates of return to 

equity in the unregulated sector tend to be higher than 

rates of return in the regulated sector. 
-55-

however, the economic import of the company's own accounting 

system is much less. Because entry into markets in the 

unregulated sector is more or less free, and because there is 

also inter-product competition in the unregulated sector, 

selling prices, and hence revenue from sales, does not 

annually track changes in cost of goods sold and the several 

elements of capital cost as these are recorded in the financia1 records. "Required revenues" to cover all costs, 

including a "fair rate of return", cannot simply be obtained 

in unregulated markets by the mere posting of such prices. 

In the regulated case described above, capital cost 

changes were "rolled-in" over 30 years, the average life of 

the plant. This is one example of average cost pricing: The 

annual charge for depreciation, interest, and return to 

equity is derived from the costs of the 30 prior years. 

Thus, when a subsidy, or any other cause for a reduction in 

private cost of acquiring capital, reduced the purchase price 

of capital by 10 percent, 30 years had to elapse before the 

full change in cost, the lower marginal cost, was finally 

realized by customers. And with perfect cost of service 

regulation over this period, the regulated company's bookvalue of rate base was kept equilibrated to the market value 

of the company's bonds and shares. 

In the unregulated company case, however, where market 

prices are freer to vary as cost conditions change, revenues 

more quickly adjust to cost changes. For example, after a 10 

percent capital purchase subsidy has been introduced, in an 

industry which replaces its capital in, say, 15 years, it 

will not take 15 years for the effect of the subsidy to work 

its way through to prices and revenue. New firms, for 

example, or divisions of firms in other industries, that 

equip themselves after the introduction of the subsidy will 

be able to install a plant at 90 percent of the cost of 
-56-

plants built before the subsidy. These firms will be able to 

price their output lower to capture larger shares of the 

market, and this will force older firms to more rapidly 

adjust prices downward to reflect the lower costs or be 

forced out of business. For an unregulated company, therefore, the historic book-value of assets acquired before the 

subsidy, and the corresponding book-value of equity, may be 

overstated as compared with the valuation placed on these 

assets in the market, after a subsidy has been introduced. 

For example, if market prices of products adjusted instantaneously to the change in marginal capital costs, then the 

earnings of pre-subsidy assets, and the Corresponding equity, 

would immediately shrink. These lower "earnings per share" 

of "old" firms would cause market prices of these shares to 

decline, which is to say the -market value of pre-subsidy 

assets carried in balance sheets would be lower than bookvalue. 

In the unregulated sector, then, the response to a 

capital subsidy is much more rapid than in the regulated 

sector. A 10 percent purchase subsidy will more quickly lead 

to a higher rate of investment to expand capacity. Of 

course, after adjustment to the reduction in capital costs 

has been made, the only effect of the subsidy will be to sus-' 

tain the higher replacement investment required to sustain 

the larger capital stock it has induced. 

Deferred taxes in the unreaulhted sector. 

The foregoing remarks on the looser ties between bookvalue and market value of unregulated company assets and 

equity than is found in the regulated sector apply also to 

the substantive content of unregulated companies' imputations 

of depreciation for financial reporting purposes. For an 

unregulated company, its depreciation imputation rules do not 
-57-

determine a "cost of service (production)" element it can 

"claim" in prices it charges. Rather, it is an accounting 

convention employed to derive a financial measure of pre-tax 

income, and to correspondingly revalue depreciable assets in 

its balance sheet. If the company's depreciation imputation 

rule produces too low an annual depreciation "expense", as 

compared with real depreciation, this simply means that pretax income for the period is overstated, and "net income" 

(after-tax) likewise. But, since dividend payouts need not 

correspond to this measure of book-income, there is no 

financial or other penalty to overstatement of book-income. 

On the other hand, if the depreciation imputation rule used 

by an unregulated company aims to rapidly write-off assets, 

regardless of the real rate of depreciation, its book-pre-tax 

income will be understated, and its "net income" correspondingly. Again there is no penalty for not measuring income in 

a manner such that the amount so measured could actually be 

paid out and permit the company to carry on its operations, 

as in the regulated company case. 

Of course, "quality" of reported earnings is an important dimension of a company's performance that is carefully 

assessed by investment analysts. Shares of companies that 

employ depreciation imputation methods calculated to overstate "net income" will naturally sell for prices that are 

smaller "multiples" of reported earnings per share in recognition of this source of "low quality" earnings; companies 

that use more accelerated depreciation imputation methods 

will sell for a higher multiple, all other things being 

equal. Since too slow a method of imputing depreciation also 

results in a higher book-value of depreciable assets, bookvalue per share of companies employing such depreciation 

methods will tend to exceed market value on this account, as 
-58-

well. Conversely, the consistent use of too rapid depreciation imputation rules for financial reporting will be 

associated with a market value in excess of book-value.l6/ -. 

Since the depreciation imputation method employed by an 

unregulated company hgs no normative value, the divergence 

between it and tax depreciation imputation methods also has 

no normative implications. However, the logic of accounting 

in the unregulated company case nevertheless requires recognition of "deferred taxes" for, whether the book imputation 

really measures dcpreciGtion, t iiilirly differences between it 

cinL tCh ~iit~reci~tion must be accountsu for if only to provide 

a record of the degree to which assets employed in the business hsve less "tax basis" to be recovered than the assets' 

reported book-value and., therefore, how much extra income tax 

liability might be owed in the event assets are not replaced. 

Thus in the case of unregulated companies, due to the uncertain content of the company's reported (book) depreciation, 

reported accrual of "deferred taxes" during a year is not 

normally a satisfactory measure of interest-free loans 

extended. 

To obtain a measure of interest-free loans extended to 

unregulated companies requires that an independent, reliable 

measure of depreciation for the year be computed and this be 

compared to the tax depreciation imputation allowed for the 

same year. The corrected figure, less the tax depreciation 

amount, times the corporate tax rate yields the measure of 

interest-free loans qualified for during the year, the proper 

-16/ Cf., Solomon, Ezra, "Alternative Rate of Return Concepts 

and Their Implications for Utility Regulation," -Bell 

Journal of Economics and Management Science, Vol. 1, No. 

1, (Spring, 1970), pp. 65-81. 
17/ 

---------- 

-59-

"deferred tax amount" to add to the net income tax payment to 

derive tax expense for the year. As has been noted elsewhere, the "effective tax rate" of an unregulated company is 

then a ratio, the numerator of which includes the corrected 

deferred tax plus net tax paid (gross of credits) and the 

denominator of which .is the pre-tax income corresponding to 

the corrected book depreciation.l7/ -

--_ Fiekowsky, S., "Pitfalls in the Computation of "Effective 

Tax Rates" Paid by Corporations,'' OTA Paper No. 23, U.S. 

Treasury Department, 1977. This paper briefly catalogues 

the numerous payments that are cleared through current 

year tax accounts and which, therefore, make "taxes paid" 

during a year a poor measure of tax liability generated 

by a corporation's operations that year. 
- 60 -

Table 1 

Base Case Financial Statementr 

Income Statement 

for year, 1979 

(mi11ions) 

Income from sales ....................................$274.57 

less: Cost of goods sold .......................... 165.0 

equals: Operating income ........................ 'm 

less: Depreciation .............$30.00 

Interest paid ............ 27.90 57.90 

equals: Pre-tax income ....................... m 

less: Provision for Federal income tax Q46 percent. 23.77 

equals : After-tax ("net") corporate income .......'$mo 

less: Distribution to stockholders................. 27.90 

equals: Addition to retained earnings ........... 

Balance Sheets 

1979 

(millions) . 

Assets Liab il it ies 

Beginning; End Beg inning :En2 

Cash and other Accounts payable 

current assets $100 $130 (including tucr) $100 $100 

Plant and equipment Long-term debt 279 2 79 

orininal cost $900 $900 

less: accrued Net worth: 

depreciation 435 $465 465 $435 Capital 8tock -

186 186 

iota1 assets $565 $565 Total liabilities $565 $565 . 
- 61 -

Table 2 

Illustrating Maintenance of A Constant Capital Stock, When 

The Regulatory Depreciation Imputation Rule i8 Straight-Line 

Assets in use, at beg

1979 

Year asset t: t 

vintage was acquireciiwiginal M a t 4 I &-: original I .Nsk 

(Jan. 1) : mst : ckpreciatian: vah : cost :depreciation: value 

1950 $ 30 $ 29 $ 1 - -

1951 30 28 2 $ 

1952 30 27 3 30 28 .. 

1959 i0 ' io io 30 21 9 

1960 30 19 11 30 20 10 

1978 30 1 i9 30 2 

1979 30 0 30 30 1 29 

1980 0 - 0 30 0 

.' Total $900 $435 $465 $900 $435 $465 

UEice S o taryo 9 Office of Tax &lysis 

1 

2 

39 
- 62 -

Table 3 

Financial Statements, With 10 Percent Capital Subsidy 

Income Statanent 

for year, 1979 

(millions) 

Income from sales ........... ;....................$273.95

less: Cost of goods sold ....................... 165.00 

equals: Operating income.. ..................nn 

less: Depreciation ................$30 

Subsidy amortization.. ...... (0.1) Interest paid ............... 27.72 57.62 

Pre-tax corporate income ..........................$51.33 

less: Provision for Federal income tax.......... 23.61 

equals: after-tax ("net") corporate income.. .$27.I"c 

less: Distributions to stockholders ............. 27.72 

equals: To retained earnings ................. 

Balance Sheets 

1979 

(millions) 

Assets Liabilities 

Beginning : End Beginning: End 

Cash and other Accounts payable $100 $100 

current assets $100 $129.9 

Long-term debt 277.2 277.2 

Plant and equipment original cost $900 $900 Net worth: 

less: unamortized Capital stock 184.8 1848 

subsidy 3 2.9 

accrued 

depreciation 435 $462 465 $432.1 

Total assets $562 $562.0 Total liabilitiesS562.0 $562 -0* 

1 
3 . ,, 

Table 4

Net Rate Base, Income from Sales, and Coat of Service Elementr,

vith 10,Percent Capital Subsidy; when Tax and Regulatory IncMeasurement Ru1ul.s are Identical 

: Net 

: rate base : Coat of service 

:(beginning : Income : Cost of : Net : Interest : Federal kturn : of year) : from sale8 : goods eold : depreciation : paid : income tax : to e : (1) (2) (3) (4 ) (5) (6) Year 

Base case $465.00 

with subsidy:

1979 $462.00 

19d0 459.10 

1981 456.30 

1982 453.60 

1983 451.00 

1984 448.50 

1985 446.10 

1986 443.80 

1987 441.60 

1988 439.50 

1989 437.50 

1990 435.60 

1991 433.80 

1992 432.10 

1993 430.50 

1994 429.00 

1995 427.60 

1996 426.30 

1997 425.10 

1998 424.00 

1999 423.00 

2000 422.10 

2001 421.30 

2002 420.60 

2003 420.00 

2004 419.50 

2005 419.10 

2006 418.80 

2007 418.60 

2008 418.50 

2009 418.50 

2010 

(prllli on81 

$274.57 $165 t 00 $30,00 $27.90 $23.77 $27 PO. 

$273.95 $165 .'OO $29.90 $27.72 $23.61 $27.72 

273.36 165.00 29.80 27.55 23.47 27.55 

272.78 165.00 29.70 27.38 23.32 27.38 

272.22 165.00 29.60 27.22 23.18 27.22 

271.67 165.00 29.50 27.06 23.05 27.06 

271.14 165.00 29.40 26.91 22.92 26.91 

270.63 165.00 29.30 26.77 22-80 26.77 

270.14 165.00 29.20 26.63 22.68 26.63 

269.66 165.00 29.10 26.50 22.57 26.50 

269.20 165.00 29.10 26.37 22.46 26.37 

268.76 

268.34 

267.93 

267.54 

267.16 

165.00 

165.00 

165.00 

165.00 

165,OO 

28.90 

28.80 

28.70 

28.60 

28.50 

26.25 

26.14 

26.03 

25.93 

25.83 

22.36 

22.26 

22 * 17 

22.09 

22.00 

26.25 

26.14 

26.03 

25.93 

25.83 

1 

m 

W 

1 

266.81 

266.47 

266.14 

265.84 

265.55 

165.00 

165.00 

165.00 

165.00 

165.00 

28.40 

28.30 

28.20 

28.10 

28.00 

25.74 

25.66 

25.58 

25.91 

25.44 

21.93 

21.86 

21.79 

21.73 

21.67 

25.74 

25.66 

25.58 

25.51 

25.44 

265.28 

265.03 

264.79 

264.57 

264.37 

165.00 

165.00 

165.00 

165.00 

165.00 

27.90 

27.80 

27.70 

27.60 

27.50 

25.38 

25.33 

25.28 

25.24 

25.20 

21.62 

21.57 

21.53 

21.50 

21.47 

25.38 

25.33 

25.28 

25.24 

25.20 

264.18 

264.01 

263.86 

263.73 

263.61 

165.00 

165.00 

165.00 

165.00 

165.00 

27.40 

27.30 

27.20 

27.10 

27.00 

25.17 

25.15 

25.13 

25.12 

25.11 

21.44 

21.42 

21.41 

21.40 

21.39 

25.17 

25.15 

25.13 

25.12 

25.11 

263.61 165.00 27.00 25.11 21.39 25.11 
- 64 -

Table 5 

Financial Statements , When a Capital Subsidy

Is "Flowed-Through'' to Equity 

Income Statement . for year, 1979 

(millions) 

Income from sales ................................... $269.01 

less: Cost of goods sold ........................... 165.00 

equals: Operating income ......................... 

less: Depreciation ..............$30.0 

Interest paid ............. 27.9 57.90 

equals: Pre-tax income .......................... m 

less: Provision for Federal income tax............. 21.21* 

equals : After-tax corporate income. ............ .$O 

plus: Capital subsidy.............................. 3.00

"Net" income. ................................... .$-

less: Distribution to stockholders ................. 27.90 

equals: Addition to retained earnings ...........Il.(JO

*Assumes tax accounting will ignore nonshareholder contribution to capital. 

,Balance Sheets 

1979 

(millions) 

Assets Liabilities 

cash and other Beginning : End Current liab ilit iesBeginning :End 

current as sets $100 $130 (including taxes 

payable) $100 $100 

Plant and equipment original cost $900 $900 Long-term debt 279 279 

less: accrued 

depreciation 435 $465 465 $435 Net worth: D 

Capital stock 186 186 

Total assets $565 $565 Total liabilities $565 $565 
$0.046 

Table 6 

Schedule of Interest-free Loans Extended and Repaid

1979 Vintage of Plant and Equipment 

Loan 

: Deprecietion Schedule i extended : End of : : Loan repaid

End of :ProclaimedI/ - Norm 1/ i/(l)- (2)/~.46: year :Proclaimedjl : Nom2/ : /(6)-(5)/~.46

year : (1) (2) (3) (4)

(mil 1ions) (5) (67 (7) 

1979 $ 2.4 $ 1.0 $0.644 1994 $0.9 $ 1.0 0.092 

1980 2.3 1.0 0.598 1995 0.8 1.0

1981 2.2 1.0 0.552 1996 0.7 1.0 8.138

1982 2.1 1.0 0.506 1997 0.6 1.0 0.184

1983 2.0 1.0 0.460 1998 0.5 1.0 0.230 

1984 

1985 

1986 

1987 

1.9 

1.8 

1.7 

1.6 

1.0 

1.0 

1.0 

1.0 

0.414 

0.368 

0.322 

0.276 

1999 

2000 

2001 

2002 

0.4 

0.3 

0.2 

0.1 

1.0 

1.0 

1.0 

1.0 

0.276 

0.322 

0.368 

0.414 

1988 1.5 1.0 0.230 2003 0.0 1.0 0.460 

1989 

1990 

1.4 

1.3 

1.0 

1.0 

0.184 

0.138 

2004 

2005 

0.0 

0.0 

1.0 

1.0 

0.460 

0.460 

, 

~ 

1991 1.2 1.0 0.092 2006 0.0 1.0 0.460 cn 

1992 1.1 1.0 0.046 2007 0.0 1.0 0.460 ,

1993 1.0 1.0 0.0 2008 0.0 1.0 0.460 

Total8 $25.5 $15 $4.830 $4.5 $15 $4.830 

thrlce at the Secretary ot the Treasury March 5, 1~79 

Office of Tax Analyris 

-1/ The proclaimed schedule is based on sum-of-years' digits, for 24 years. Thus, the denominator 

for each year'r fractional depreciation is 300. Then for 1979, the fraction for determining

the rchedular amount ir 24/300, and this multiplied by $30 million yields $2.4 million. The 

aaount for 1980 is 23/300 timer $30 million, and so on through 24 years, 

-2/ The depreciation norm is based on 1/30 cnf $30 million each year. 
Privately Finericed Hate ?a$,b!?racome 7 from Sales, 

and Cost of Service Elements, 

' I With Federal Intereat-Free Loan Program 

Financing of rate base 

: Zero interest loans i Coat of service : Beginning : at end of year: : coat : 

: of year : For : i Income : of : : After-tax 

private given : : from : good8 :Depre- : : Income : return to : funds : year :Cumulative : aalea : aold :cfatlon: Interest: taxer : equity 

Year (1) (2) : (3) (4) : (5) : (6) : (7) : (8) : (9) 

Base cane $465.000 - - $274.57 $165.00 $3Q00 $27.90 $23.77 $27.90 

With 

subsidy:

1979 $465.000 $0.644 $0.644 $274.57 $165.00 $3000 $27.90 $23.77 $27.90 

1980 464,356 1.242 

1981 463.114 1.794 

1.886 

3.680 

274.46 

274.24 

27.86 

27.79 

23.73 27.86 

23.67 27.79 

1982 461.320 2.300 5.980 273.94 27.68 23.58 27.68 

1983 459* 020 2.760 8.740 273.54 27.54 23.46 27.54 

1984 456.260 3.174 11.914. 273.07 27.38 23.32 27.38 

1985 453,086 3.542 

1986 449.544 3.864 

15.456 

19.320 

272.53 

271.92 

27.19 

26.97 

23.16 27.19 

22-98 26.97 

1987 445.680 4.140 

1988 441.540 4.370 

23,460

27.830 

271.26 

270.55 

26.74 

26.49 

22.78 26.74 

22.57 26.49 

1989 437.170 4.554 

1990 432.616 4,692

1991 427.924 4.784 

1992 423.140 4.830 

1993 418.310 4.830 

32,384

37.076 

41.860 

46.690 

51.520 

269.80 

269.03 

268.22 

267.40 

266.58 

26.23 

25.96 

25.68 

25.39 

25.10 

22.34 26.23 

22.11 25.96 

21.87 25.68 

21.63 2s.39 

21.38 25.10 

1994 413.480 4.784 

1995 408.696 4.692 

1996 404.004 4.554 

1997 399.450 4.370 

1998 395.080 4.140 

56.304 

60.996 

65.550 

69.920 

74.060 

265.75 

264.93 

264.13 

263.35 

262.60 

24.81 

24.52 

24.24 

23.97 

23.70 

21.13 24.81 

20.89 24.52 

20.65 24.24 

20.42 23.97 

20.19 23.70 

1999 390.940 3.864 

2000 387.076 3.542 

2001 383.534 3.174 

2002 380.360 2.760 

2003 377.600 2.300 

77.924 

81.466 

84.640 

87.400 

89.700 

261.89 

261.23 

260.63 

260.08 

259.61 

23.46 

23.22 

23.01 

22.82 

22.66 

19.98 23.46 

19.78 23.22 

19.60 23.01 

19.44 22.82 

19.30 22.66 

2004 375.300 1.840 

2005 373.460 1.380 

2006 372.080 0.920 

2007 371.160 0.460 

2008 370.700 0.000 

91,540

92.920 

93.840 

94,300

94.300 

259.22 

258.90 

258.67 

258.51 

258.43 

22.52 

22.41 

22.32 

22.27 

22.24 

19.18 22.52 

19.09 22.41 

19.02 22.32 

18.97 22.27 

18.95 22.24 

2009 370.700 0.000 94.300 258.43 $1 io0 $ LOO 22.24 18.95 22.24 

mce of the Secretary of the Treasury Office of Tax Axulyaia lurch 6, 1979 

lending 
.. 

- 67 -

Table 8 

Financial Statements, First Year of a 

Federal Interest-free Loan Program Financed 

Through the Tax System 

Income Statement 

for year 1979 

(millions) 

Income from sales.. .............................. .$274.57 

less: Cost of goods sold ........................ 165.00 

equals: Operating income.. ...................srzrsrrsS 

less: Depreciation. ...........$30 

Interest paid ........... 27.96 57.90 

equals: Pre-tax income. ..................... .$= 

less: Provision for Federal income tax: 

Accrued taxes payable.. $23.13 

Deferred tax. .......... 0.64 23.77 

equals: After-tax ("net") corporate income.. .$= 

less: Distribution to stockholders .............. 27.90 

equals: Addition to retained earnings ........-

Balance Sheets 

1979 

(millions) 

Assets Liabilities 

Beginning : End Beginning :End 

Cash and other Current LiabLLi.ties $100 $100.00 

current asset s $100 $130.64 

Long- term debt 279 279.00 

Plant and equipment 

acquisition cost $900 $900 Deferred taxes 0 0.64 less: accrued 

J. depreciation 435 $465 465 $435 Net worth:

Capital stock 186 186.00 

Total assets $565 $565.64 i

* $565 $565.64 
Table 9 

Comparison of Income from Sales. When Proceeds of Intereat-Free Loans Are So Accounted For 

and When They Aro "Flowed-Through" to Equity Income In tho Year Roceivod .. Income ~ 

I. 

: from ealrs: : 

: loan benefitn : 

Interest-free loans "f lowed-through" to income 

bate of service 1 

i 

: distributed Y Income Income : as earned: I from : Cost of : taxor : Uot return : ''normalize'' : ralee : good8 so1d:Depreciation: Interert : "paid" : to 0

(4)uity 

Year (1) (2) (3) (4) (5) (6) ;

Bane can. $274.57 

With loan 

subsidies: 

1979 $274.57 

1980 274.46 

1981 274.24 

1982 273.94 

1983 273.54 

1984 273.07 

1985 272.53 

1986 271.92 

1987 271.26 

1988 270.55 

1969 269.80 

1990 269.03 

1991 268.22 

1992 267.40 

1993 266.58 

1994 265.75 

1995 264.93 

1996 264.13 

1997 263. 35 

1998 262.60 

1999 261.89 

2000 261.23 

2001 260.63 

2002 260.08 

2003 259.61 

2004 259.22 

2005 258.90 

2006 258.67 

2007 258.51 

2008 258.43 

2009 256.43 

(milllone) 

$274.57 $165.00 $30.00 $27.90 $23.77 $27.90 

$273.37 LOO 

272.27 21.47 

271.24 20.44 

270.31 ' 19.51 

269.46 18.66 

268.69 17.89 

268.01 17.21 

267.41 16.61 

266.90 16.10 

266.47 15.67 

266.13 15.33 

265.88 15.08 

265.71 14.91 

265.62 14.82 

265.62 14.82 

265.71 14.91 

265.88 15.08 

266.13 15.33 

266.47 15.67 ! 

266.90 16.10 

267.41 16.61 ! 

268.01 17.21 

268.69 17.89 

269.46 18.66 

270.31 19.51 

271.16 

272.01 

272.86 

273.71 

274.57 

20.36 

21.21 

22.06 

22.91 

23.77 

I' 

274.57 $1 j. 00 s 1. 00 $2; 90 23.77 $21 0 

1 !, 

Office of the Secretary of the Treasury Office of Tax Analyeie 

w-ch bI 19m0 1 

i 

I 
Table 10 

Combined Effect of Investment Tax Credit 

and Interest-Free Loan Program on Cost of Service 

(millions) 

Plant and equipment required to produce specified quantity

and quality of service; "rate base;' at market prices ..............$465.00 

Rate base assets to be financed: 

Base case (without subsidies 1. .......................... 465.00 

After 10 percent investment credit fully effective ......t 397.11 

Financing of rate base assets: 

Base case: Interest-bearing debt ..... ;.......$279.00

Capital stock..................... 186.00 $465.00 

After investment credit and interestfree loan program effective: 

Interest-bearing debt .......$189.95 

Capital stock...............$126.63 316.58 I 

Interest-free loans, 

"deferred taxes". ................. 80.53 397.11 I 

Cost of Service 

Subsidies 

Base case fully effective 

Total cost of service ...........................$274.57 $241.06 

Cost of goods sold. ......................... 165.00 165.00 

Capital costs: Depreciation ................. 30.00 25.62 

Interest paid ................ 27.90 18.99 

Provision for Federal 

income tax........... ..... 23.77 12.45* 

After-corporate tax return 

to equity ................. 27.90 18.99 

*Includes covera e of $4.38 million in initial and supplementary

investment credBt, but no addition to "deferred taxes."