any other essential operating factor. They show also that the necessary readjustment of the capitalization of the Group B roads is all that is required to make their financial showing similar to that of the Group A roads.

The figures given in the tables for Groups A and B are averages. It is a fact that figures for individual roads in each group vary from the average; such variation, however, is no greater in Group B than in Group A. This indicates that at least some of the Group A roads, if capitalized as are the Group B roads, would be considered "weak" roads, and that some of the Group B roads, if capitalized as are the Group A roads, would be considered "strong." In other words, a conclusion as to the relative strength or weakness would be the same whether comparisons are made between the two groups as such or between the individual roads in such groups.

Similar comparisons in the eastern district show similar conditions.

CAPITALIZATION MAKES THEM STRONG OR WEAK

Thus it is evident that the difference between the financial condition of the strong roads and the weak, insofar as the larger systems here under consideration are concerned, is accounted for by the form of their financial structures and has little or nothing to do with the character or quantity of, or the method of handling, their business. This is an important fact, for it indicates that by making over the financial organizations of these weak roads, and by this action alone, the financial condition of roads which carry about 25 per cent of the country's traffic can be placed on a basis of financial soundness similar to that of the so-called strong roads. While these conditions are not generally appreciated, yet the causes which have led to them are quite apparent. The principal railroad systems of the country, the so-called strong roads and the larger systems among the so-called weak roads which together carry about 85 per cent of the country's business, are the result of consolidations of separately built railroads. These consolidations took place, substantially without public regulation, previous to the year 1903, at which time the decision of the United States Supreme Court in the Northern Securities case became an important factor in checking development along these lines. By the consolidations which at that time had been made, roads of favorable situation and conditions had been united with other roads less favorably circumstanced. In this way uneven conditions had been averaged, more or less unconsciously it is true, so that in all essential operating respects the resulting systems in both the "strong" and the "weak" groups were similar. This is clearly shown by the foregoing tables.

NO UNIFORM FINANCIAL POLICY

In this development, however, no uniform financial policy was followed, and consequently no uniformity of capitalization resulted. In some cases the value of the consolidated property equalled or even exceeded the total capitalization; in other cases the capitalization exceeded the property value. Likewise, there was wide variation in the proportion of capitalization which was represented by obligations and by capital stock. The roads where capitalizations did not exceed property values and where fixed charges did not absorb so much of the income as to leave an amount insufficient to pay and to protect dividends, came to be known as the "strong" roads, the roads of sound credit which found it possible under adequate rates to finance by the issue of capital stock. On the other hand, the roads where capitalization exceeded property values and where fixed charges absorbed so large a part of their income that no balance was available for dividends came to be known as the "weak" roads, the roads of unsound credit which even under adequate rates were obliged to finance almost entirely by borrowed capital.

FINANCIAL RECONSTRUCTION NECESSARY

From the foregoing it appears that by reorganizing the financial structures of the roads which comprise the first group of weak roads which carry 25 per cent of the business of the country, both they and the strong roads, which carry 60 per cent of the business, may be expected to operate with similar success under rates which are uniform for all roads in the same rate-making territory.

THE SMALL ROADS

There remains for consideration the balance of the weak roads-the small roads widely scattered over the country-which handle in the aggregate approximately 10 per cent, and the New England roads which handle about 5 per cent of the country's business.

These small roads have been characterized frequently as "less favorably situated." Such characterization is in the main accurate. Some of them probably suffer from the form of their financial organization as do the so-called 'weak" roads which have just been described, and like them, they would be benefited by a change in their financial structures. But, the smaller roads generally are further handicapped by the character and quantity of business available for them, by higher operating costs, and by other factors which make it clear that as separately owned and operated units they can not become profitable under any rate-making system which would suffice for the larger and stronger roads competing with them in their respective territories. For the most part, they perform a necessary service; they are important lines as feeders for the larger systems with which they connect; their public very properly demands their continuance; they can not be abandoned.

THE NEW ENGLAND ROADS

With the New England roads the situation is in some respects similar. Like the small roads they must operate under rates made for roads more favorably situated, since their rates are and must be the same in large part as those made for all roads in the eastern territory, even though statistics show that they are more costly to operate. It must not be concluded, however, that these roads constitute a problem by themselves without interest to people outside of New England and unrelated to the railroad problem of the whole country. New England with her enormous factory development is an important market for the raw materials produced by other sections of the country-coal, steel, cotton, wool, copper, and leather-as well as the source from which the country receives many kinds and large amounts of manufactured products which are its necessities and comforts. Thd food producing sections of the country also find a large market for their products in the dense population of the New England district. The extent of the commercial value of New England to other sections of the country and of their dependence upon her is shown by the fact that nearly 65 per cent of the freight tonnage of the New England roads is interchanged with railroads outside of New England. This high percentage of interchanged business taken with the fact that the haul on the New England roads is short shows very clearly that the latter are to a large extent terminals for their connecting roads and are important parts of these systems.

That the credit of the New England roads be restored and maintained so that they can perform adequately the service required is thus a matter of concern not only to the public of New England, but to the country at large. It is obvious, however, that due to high operating costs their credit can not be maintained under rates which are sufficient for the more favorable situated roads with which they connect.

NECESSITY OF CREDIT RESTORATION

A satisfactory solution of the problem of credit involves: rates adequate to insure a credit position for all roads; such readjustment of capitalization as may be necessary to give each road a sound financial structure; and some provision to overcome the handicaps of location.

Large amounts of new capital will be required by all roads, not only for the adequate maintenance and expansion of their facilities, but also for the liquidation of vast amounts due to the Government as a result of Federal control.

These enormous debts due the Government at the present time are a menace to private operation; their continuance will eventually lead to Government ownership. The conclusion is inevitable, if private management is to be perpetuated, that the railroads of the country individually and as a whole must secure for themselves a credit position which will enable them to meet their capital requirements from the investment markets and without dependence upon the Public Treasury.

THE BASIS OF RATES

From the above it is evident that the factor common to all the railroads is the matter of rates-their adequacy, and the theory upon which they are to be established so as to afford each railroad system a sufficient income, The importance of this factor is clearly recognized by the transportation act.

The provisions of the transportation act relating to rates recognize that the cost of capital is part of the cost of service, and as such must be protected by the rates charged. The act provides accordingly that rates shall be so established as to provide a return on the aggregate value of all railway property held for and used in the service of transportation. It stipulates that for two years, beginning March 1, 1920, such fair return shall be 52 per cent and, in the discretion of the Interstate Commerce Commission, may be increased to 6 per cent; and that after the expiration of two years the rate of return shall be left to the judgment of the commission, who shall give "due consideration, among other things, to the transportation needs of the country and the necessity of enlarging such facilities in order to provide the people of the United States with adequate transportation."

* * *

This recognition by the transportation act of the cost of capital as a factor in the cost of service is not the recognition of a new principle in its application to publicly regulated corporations. The decisions of our highest courts time and again have held that property used in the public service is entitled to a fair and just return-which, obviously, must be provided by the rates charged-and less than such return results in confiscation of property that is abhorrent to the safeguards of the Federal Constitution.

THE SERVICE-AT-COST PRINCIPLE

In

Various plans which have come to be known as "service-at-cost" plans, in which cost of capital has been given equal consideration with other factors, have been adopted successfully for determining the rates to be charged by public utility companies, especially those furnishing local transportation service. such cases an agreement has been reached both as to the value of the property to be used for rate-making purposes as well as to the rate constituting a fair return. Heretofore, however, it has been impossible to make railroad rates on this basis, for opinions have differed in regard to the rate constituting a fair return and to the factors which should determine value for rate-making purposes. Progress in this direction has been made, however, in recent years.

The transportation act has fixed the rate of return, or provided the basis for determining the rate of return, which the railroads will be allowed to earn on their property value in the future. Furthermore, in response to act of Congress passed in 1913, the Interstate Commerce Commission has been engaged in preparing a valuation for each railroad of the country, and these valuations are nearly completed. Now for the first time, with more accurate and definite knowledge of these two essential factors, it is possible to apply to the railroads of the country the service-at-cost principle of rate-making and to include in the cost the factor of fair return upon the value of railroad property. In the application of this method of rate making the public in the territory served is charged rates to provide income sufficient to cover the cost of all services performed, including an amount equal to the agreed return upon the aggregate value of the property used in the service.

Provided there is a common interest in the results of operation through a common interest in the ownership of all parts of the property used in the service, it is not essential that the income from each service performed should be proportionate to its cost, nor that each individual part of the property should be selfsustaining so long as the total income received from all services is adequate for a fair return on the aggregate value of the property.

APPLICATION OF "SERVICE-AT-COST" PRINCIPLE-DIFFICULTIES IN ITS APPLICA

TION TO COMPETING COMPANIES

In the case of public utility companies this method of rate making has been applied to companies having a monopoly and, hence, a common interest in the results obtained. In its application to the railroads, however, the companies, because of diversity of ownership of the constituent parts of the property, have

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no common interest in the results of operation, and furthermore competing for the same business are obliged to operate under uniform rates. As in the case of a monopoly, however, the rates can not be made to produce income in excess of the combined requirements of the roads as a whole in any given territory which may be determined to be a unit for rate-making purposes. While rates must be established which will afford the required fair return upon the aggregate value of all the railroad property in a given rate-making territory-and neither more nor less than such fair return-it does not follow that under competitive conditions such fair return will be received by each road in the territory.

If the rates were established at a figure just sufficient to give a fair return to the railroad most favorably situated, such rate would be insufficient to give a fair return to another competing railroad in the same territory less favorably situated. Thus, the second railroad under such a rate would be selling its service at less than cost and, under such conditions, could never arrive at a position of sound credit. On the other hand, if the rates were made at a figure to cover the cost of service of the inferior railroad, the railroad of superior position would receive more than the fair return contemplated by the statute.

Since property values and operating costs of each road are factors which determine the rates to be used for all roads, they should also determine the amount of income to be received by each road. While a separate rate for each road can not be established, this impossibility should not operate to give to any road a return larger than would be received if the rates were established for it as a separate unit; nor should it operate to deprive any road of the full amount of income to which it is entitled on the basis of its individual requirements.

The transportation act recognized these difficulties but found no adequate way to meet them. By providing for the "recapture of excess earnings" it attempts to limit the income of the more favorably situated roads to the fair return on the value of their property; by requiring the Interstate Commerce Commission, in determining the equitable division of joint rates, to give weight to the circumstances of each road and especially to take into account "the amount of revenue necessary to pay operating expenses, taxes, and to give a fair return on the value of the property" it attempts to some extent to divert earnings from the more favorably situated to the less favorably situated roads.

REQUISITES FOR ITS SUCCESSFUL APPLICATION TO COMPETING COMPANIES Unless some practical way is found to give to each system income adequate for its needs, some roads which are important parts of the Nation's transportation system can not be made financially sound, and the provision for rate making under the transportation act will not fully accomplish its purpose. To apply the serviceat-cost method with complete success it will be necessary either (a) to consolidate all the railroads in each rate-making territory into one system, thus creating a monopoly and completely eliminating competition; or (b) to provide a method which is practicable and economically sound for equalizing the income of the various roads by a redistribution of the earnings so that each road will receive from the whole such amount as is necessary for its cost of operation and a fair return upon the value of its property; or (c) to combine the more favorably and less favorably situated roads in each rate-making district so that the systems resulting from the combinations will be able to obtain uniform results under uniform rates.

MONOPOLY NOT TO BE CONSIDERED

The solution of the problem by creating a monopoly should be considered only after failure to meet the situation by one of the other methods. A railroad monopoly in any district would eliminate competition, would offend public sentiment, and would be directly contrary to the clear intent of the transportation act.

SOLUTION BY EQUALIZING INCOME IMPRACTICABLE

The second suggestion, that of equalizing the income by a redistribution of earnings, even though sound in principle, presents difficulties which appear to be conclusive against it. It would require both the recapture of the excess earnings of the more favorably situated roads and the allocation of such earnings in varying amounts to the less favorably situated in accordance with the requirements of each. To take from some railroads a part of the income which they have received under a given schedule of rates, because they have received more

than that to which they are entitled under the service-at-cost principle, and to hand it over to other roads which have meanwhile received less than that to which they are entitled entails exact standardization of operating costs and maintenance charges, and standardization also of efficiency in management, for a road is entitled to its fixed return only provided it is efficiently operated. Such standardization is practically impossible. A given railroad management knowing that any excess earnings received by it are to be taken away will be constantly under temptation to conceal its excess earnings through an increase in operating expenses; it will not be under any incentive to keep costs down to the lowest amount consistent with safe and sound operation. Likewise, a management which knows that a shortage in its income is to be made up will have little incentive to keep the shortage small by economies in operation. Extravagances of corporate management to avoid payment of taxes is a phenomenon of recent development which illustrates the point.

RECAPTURE OF EXCESS EARNINGS ECONOMICALLY UNSOUND

In order to exercise all of its ingenuity in a competitive field each management must be assured that what it receives under established competitive conditions shall remain its own and shall not be handed over to a management which may be less resourcefull and less careful. To take away rewards to efficiency and to make awards to inefficiency (and this in the absence of exact standards of accounting and management) would destroy the incentive for railroad managements to take advantage of their opportunities in the knowledge that they may not keep everything that they receive. Under the one plan railroad management would inevitably become shiftless and extravagant; under the other, each management would constantly strive to conserve its resources and to become efficient.

DIFFICULTIES OF APPLICATION ILLUSTRATED

The difficulties of this method of solution are well illustrated by the controversy between the New England roads and the trunk lines over the division of joint rates. Negotiations which started to determine the equitable division of such rates between these roads, because of some implied authority in the act for giving weight to the circumstances of the roads concerned, developed intoa contention for a redistribution of earnings on the basis of the needs of the roads. In the hearings before the Interstate Commerce Commission testimony was presented purporting to show that rates had been established for the whole of the eastern territory higher than they would have been if New England had not been included, and that because of these higher rates the roads in the eastern territory outside of New England would receive approximately $25,000,000 more than if rates were made with a view to their requirements alone, without taking into account the cost of operation and property values of the New England roads. The New England roads contended that these excess earnings measured and established the amount which they were entitled to receive from the outside roads because of their inclusion in the rate group. This excess would be received in varying amounts by all railroads in the eastern territory, including roads which have no physical and no direct traffic connection with the New England roads. In this case, if it should be determined how much each road should pay into a fund equitably belonging to the New England roads, and if such payment should actually be made, there would remain the equally perplexing question of the equitable division of the fund among the several New England roads. The practical difficulties of solving the problem in this way have proved so great that no agreement has been reached, although negotiations have extended over many months under repeated requests of the Interstate Commerce Commission.

This single incident well illustrates some of the practical difficulties which would occur hundreds of times if the expedient of equalizing income by a redistribution of earnings were adopted in order to apply the service-at-cost principle.

CONSOLIDATIONS THE ONLY SOLUTION

From the foregoing it is clear that the service-at-cost method can not be applied successfully to competing companies unless they are uniform in essential respects. Unless such uniformity can be brought about, the operation of the rate-making provision of the transportation act will prove disappointing in the results attained. The question thus becomes this: Can the railroads of the