PRESIDENTS ADVISORY PANEL

ON FEDERAL TAX REFORM

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MEETING

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Wednesday,

March 16, 2005

University of Chicago

Graduate School of Business

Gleacher Center

450 North Cityfront Plaza Drive

Chicago, Illinois 60611

The above-entitled matter commenced

at the hour of 10:00 a.m.

[PANEL MEMBERS:]{.underline}

CONNIE MACK III, CHAIRMAN

JOHN BREAUX, VICE CHAIRMAN

EDWARD P. LAZEAR (present telephonically)

TIMOTHY J. MURIS

JAMES MICHAEL POTERBA

I N D E X

PAGE

Remarks by the Honorable 3

Richard M. Daley

Panel I: Taxes and Individual Decisions

Testimony of James J. Heckman 13

Panel II: Taxes and Individual Investment

Alternatives

Testimony of Brian Wesbury 46

Testimony of Kathryn Kennedy 56

Testimony of Susan Dynarski 65

Testimony of Armond Dinverno 80

Panel III: Taxation of Financial

Instruments

Testimony of Robert McDonald 108

Testimony of David Weisbach 118

P-R-O-C-E-E-D-I-N-G-S

(10:05 a.m.)

CHAIRMAN MACK: I told the Mayor a few minutes ago that I would let him
go with his comments first, and I\'ll make my opening comments after
his. He\'s on a little bit tighter schedule today than we are.

So, Mr. Mayor again, we thank you so much for your participation this
morning and know that the work that you\'ve done with the earned income
tax credit and other low income taxpayers, and we look forward to your
comments.

MAYOR DALEY: Thank you very much.

VICE-CHAIRMAN BREAUX: Mr. Chairman, may I, before the Mayor starts, say
how pleased we are to be in your City once again. I think clearly
Chicago is looked upon as one of the great cities in this country that
actually works, and I know that your leadership is a major contributor
to that. And we\'re proud to be here and thank you for your hospitality.

MAYOR DALEY: Oh, thank you very much. First of all I want to thank
Chairman Connie Mack and Vice Chair John Breaux. And, members of the
President\'s Advisory Panel on Federal Tax Reform.

First of all, I want to thank you for giving your time and effort in
regards to this very serious issue, and to truly involve the public,
which you have. And, I really appreciate, on behalf of the people of the
city of Chicago, welcome all of you to our great city.

I think I can speak for most of the citizens of Chicago when I say, we
share the goal of a Federal tax system that is simpler, fairer, and more
effective. And, I would like to add two additional goals. Creating a tax
system that helps rebuild our cities. And, one that works for working
families, especially those who work hard for low wages in their quest
for the share of this great American dream.

Working families are the bedrock of Chicago, and cities across the
nation. They deserve a Federal tax system that is fair, that helps them
build a better future for themselves, and of course, their families and
especially their children.

Equally, if not more important, they need a tax system they can fully
understand. In Chicago we devote quite a considerable amount of time and
effort towards helping our families navigate their way through the maze
of federal, state, and yes, even local taxes.

Our Chicago Tax Assistance Center, which opened in 2001, has helped more
than 48,000 people receive refunds on their local property taxes as well
as assistance in state and federal income tax.

Each year, the City sponsors free income tax preparation at 31 sites
with not-for-profit and other organizations, for families earning up to
\$36,000 a year. Last year we helped 19,200 families with the
not-for-profit and other organizations receive 25.7 million in refunds.

With the assistance of private sponsors, which is the key, and
not-for-profit organizations, we have conducted an annual outreach
program campaign to make sure people take advantage of the earned income
tax credit. One of the best, and I think the finest programs ever
devised to encourage people to work for a living rather than go on
welfare, which is the opposite of the federal government.

We distribute EITC materials throughout the city in English, Spanish,
Polish and Chinese. Yet, an estimated 10 to 15 percent of eligible
families still fail to claim it, leaving some \$100 million on the table
in Chicago alone.

I\'ve argued for some time that the federal tax code, especially the
EITC needs to be made fairer, simpler, for the benefit of the millions
of working families who cannot afford tax attorneys, but, desperately
need to take advantage of every tax break available to them.

Towards this end, and with the help of a generous grant from the
MacArthur Foundation, the city of Chicago asked the Brookings
Institution to research several key questions that address the fairness,
simplicity and effectiveness of the current tax code.

I\'ve asked Brookings to examine federal tax policies from the
perspective of American cities, large or small, taking into account the
unique impact of tax policies on areas with high concentration of low
income and, of course, working families.

Let me give you some examples. We need to ensure that the tax code is
free of arbitrary distinctions that hamper a family\'s ability to
receive tax credit.

So, I\'ve asked the Brookings to research the possibility of creating
the EITC that treats all families fairly regardless of size and the
child and dependent tax credit that aids families with children of any
age.

We also need to find ways to ensure that tax relief is effective in
researching those who needs it the most. The current tax code provides
many incentives for high income individuals to save, such as capital
gains relief, and dividend tax rate reductions. It\'s equally important
to provide tax benefits for low and moderate income families.

So, I\'ve asked the Brookings Institute to look for ways to use the tax
code to help working families meet the cost of housing, heath care, and
help them save for their future, and their children\'s future.

Another problem with the tax code is that it defines a child several
different ways depending on which section of the tax code you\'re using.
If that\'s confusing to a professional tax preparer, you can imagine how
confusing it must be to a working mom with an eighth grade education.

We\'ve asked the Brooking Institute to analyze the effects of creating a
uniform definition of a child as used in the multiple sections of the
tax code. When the research is completed, I intend to share the findings
with this panel.

Just as we promote fairness, simplicity and effectiveness for working
families, we almost also explore the ways to do the same for business,
especially the small to medium-size businesses that have created the
majority of jobs in our economy.

I also hope this panel will look for ways to use the tax code creatively
to help improve the quality of life for the residents of all our cities.
A prime example is the low income housing tax credit, which has helped
fuel the construction of thousands of units of affordable housing in
cities across our nation.

I\'d also like this panel to explore the ways of using federal tax
policies to encourage the rebuilding of our urban infrastructure,
whether streets, water mains, sewers, school buildings that are
crumbling faster than we are able to repair or replace them.

This panel has a big challenge ahead of it, but I\'m confident you\'re
equal to this great task. I just want to thank you for coming to our
great city. I\'m going to thank you for basically, allowing, not only
myself, but citizens across the country to present their ideas and
recommendations and listen to us, now to improve the tax code for all.
Thank you very much for public service.

CHAIRMAN MACK: Thank you, Mayor Daley. And, I assure you that the
comment that you made with respect to the EITC and others, surprisingly
were underscored in the very first hearing that we held in Washington.
And, I think for many of us, it probably was the first time that we
heard so clearly the impact of the complexity of EITC and its impact on
individuals and families. So, thank you for those comments, again.

MAYOR DALEY: Thank you very much.

CHAIRMAN MACK: Appreciate it. And, before I call our next panelist, make
me just make a few brief comments to get us started this morning. Today,
we will explore the impact that the current tax code has on important
taxpayer decisions and how the tax system treats investment
alternatives.

At our first three meetings, we heard how the needless complexity of our
tax code creeps into our everyday lives. Much of the tax codes
complexity is the result of an excessive amount of special provisions
that treat certain tax payers or activities differently. As we will hear
today, these provisions have a huge impact on how we make decisions
about jobs, savings and investment, education and health care.

The tax code\'s education and retirement provisions are two vivid
examples of the mind-numbing complexity of our tax laws. There are at
least nine different provisions to encourage education, and more than a
dozen separate tax advantaged retirement savings plans.

Within the nine separate education provisions, there are three separate
definitions of qualifying higher education expenses, four different
measures of income, and six different income thresholds. It takes 83
pages of instructions, flow charts and worksheets for the IRS to explain
these rules.

Similarly, each of the dozen or more retirement vehicles has its own set
of complicated rules for eligibility, contribution limits, withdrawals
and rollovers. Although these incentives were created with the worthy
goal of encouraging taxpayers to pursue higher education and save for
retirement, the explosive expansion of special tax provisions and rules
has created confusion, and ultimately resulted in decreased
participation by tax payers. We will take a closer look at these and
special provisions today.

We are also pleased to hear from Professor James Heckman, one of several
scholars from the Chicago area who has been awarded the Nobel prize in
economics. Professor Heckman has conducted extensive research on the
impact of taxes on the labor supply, and, will explain how taxes
influence taxpayer\'s decisions to work.

Our next topic of discussion, we will explore individual investment
decisions. Brian Wesbury, and I might say a special welcome to Brian.
Brian served on my staff in the Senate when I was chair of the Joint
Economic Committee, my chief economist. We\'re delighted that you\'re
able to be with us this morning.

Brian is also the chief investment strategist at a local financial
services firm. He\'ll share his insights with us on the importance of
taxes on investment decisions, and on the economy.

Professor Kathryn Kennedy, who established the employee benefits program
at the John Marshall Law School will provide an overview of employer
provided health and retirement benefits and share her thoughts on the
need for reform in this area.

Professor Susan Dynarksi of Harvard\'s Kennedy School has
comprehensively studied the tax code and education incentives, and will
discuss the effectiveness of these overlapping and duplicative
provisions.

And, finally, Armand Diverno, a leader of a financial management firm
here in Chicago will explain how the tax code?s varying treatment of
investment alternatives complicates financial planning and leads to
mistakes by individual investors.

Our last two speakers, Professor David Weisbach of the University of
Chicago\'s Law School and Professor Robert McDonald of Northwestern
University\'s Kellogg School of Management will help us understand how
the tax system\'s treatment of financial instruments has failed to keep
up with the rapid pace of change in the global economy.

We will hear now how the taxation of financial transactions, like the
rest of the tax code, is in serious need of reform. We look forward to
completing our task and submitting our recommendations to the Secretary.
And, with that, I think we will turn to Professor Heckman.

VICE-CHAIRMAN BREAUX: Mr. Chairman?

CHAIRMAN MACK: Oh, excuse me.

VICE-CHAIRMAN BREAUX: Mr. Chairman, just very briefly while the first
witness \-- please come on up and take your seat. Just to say and echo
again the comments that the Chairman has made, but, to say very clearly
that in addition to the four members of the panel, we have a total of
nine panel members who, I think, bring a terrific amount of insight,
intelligence and experience dealing with the tax code.

And what the Chairman wanted to do, and the other members, is to make
sure that we didn\'t do everything in Washington D.C., that we actually
got outside of the nation\'s capital and went to places like Tampa, and
New Orleans, and Chicago, and San Francisco and the West Coast to try
and get a flavor of what people are thinking about when it comes to the
challenge of trying to simplify the tax code, while at the same time,
making it reasonably progressive and pro-growth with the challenges that
President Bush has charged this panel with following, in order to make
these recommendations.

So, it\'s very good to be in Chicago, to hear from folks from this great
area to talk about recommendations that we can hopefully incorporate and
the recommendations the panel will ultimately make, so, we\'re delighted
to be here.

CHAIRMAN MACK: If you would proceed?

PROFESSOR HECKMAN: Ah, very good. I\'m very pleased, today, to be
invited to discuss the issue of taxes and the tax system and consider
where it should be reformed. And, I\'ve asked today to address the issue
of the effect of taxation on labor supply, education, and the
acquisition of skills in the workplace. And, today, I want to make a few
basic points that my help the committee in its deliberations.

As a matter of both fact and theory, economists have shown in many
different contexts and many different transactions, many different
areas, many different parts of the world, that, in fact, incentives
matter. Taxes which reduce the incentives to work, or to acquire skills
will have dramatic effects, and I will talk about these questions.

But, at issue is how important these incentives are empirically for the
various dimensions of adjustment which we might consider. So, in
thinking about these matters, I think it\'s very important for the
committee to have a clear understanding of four points. And, let me just
go over these points, and then briefly summarize the state of our
understanding of these issues in the economic community.

First of all, I think the panel needs to develop a comprehensive view of
work and skill formation. What economists call labor supply, but which
is really a much broader concept then just working an extra hour on the
job.

I think a second aspect that the committee panel should really consider
is really understanding the full range of incentives facing persons and
firms. There\'s not just complexity in the code with respect to a
particular law, but, individuals are governed by many different aspects
of the taxation system

One needs to recognize the variety of government programs that agents,
taxpayers face. And, the variety of forms of compensation: wages,
pensions, healthcare and stock options that are effected by these
programs, tax and subsidy programs.

In order to really understand the full effect of labor supply of any of
these government programs, one needs to be able to really do a careful
accounting of the entire package, the compensation package, and the tax
package, subsidy package facing individuals. That would include the
earned income tax credit. It would include the payroll tax, it would
include a variety of other taxes I\'ll briefly talk about.

Third, I think it\'s very important in thinking about any particular
dimension of economic behavior, say, labor supply, or education, or
migration, for that matter, that one has to recognize what economists
call the interdependence of choices and incentives.

People can substitute across margins. Within activities, if we subsidize
one activity in consumption, they may have real implications for the
labor supply of the individual, and the education choices that people
take.

And so, when we really try to understand the full impact of the tax
code, we have to recognize this interdependence. And, finally, I think
it\'s very important as analytical economists and as scholars trying to
understand how the tax code really works, to understand the effects of
large scale policy on prices, wages and incentives.

This is what economists sometimes call general equilibrium effects.
It\'s understanding that if we look at studies that look at the effect
of changing the tax for one individual, we may get very different
effects if we change taxes for all individuals, when many people adjust.

And so, I want to briefly talk about each of these topics and try to
give you some notion of the range of topics and the range of evidence on
these topics. First of all, if we think about labor supply narrowly
defined, we will think about things like hours of work worked by
workers.

So, you have a person working, say, 30 hours a week, a tax effect may
effect the person working 31 or 32 hours a week. One might also imagine
another dimension of labor supply that receives less attention, but,
which turns out empirically to be very important. And that is, the
intensity of effort.

For each hour on the job, how much does the person actually work on the
job? There\'s some very interesting studies by the panel survey on
income dynamics, the group at the University of Michigan, showing how
the substantial adjustment over time and across job locations on the
amount of effort, consumption of time on the job, another margin of
adjustment.

Another margin, yet, of adjustment, is the entry and exit of people into
the workforce, what\'s sometimes called to the labor force statistics,
labor force participation.

People are entering and exiting the workforce all the time, but, in
fact, it turns out to be one margin of adjustment which is very tax and
wage elastic. Which doesn\'t receive adequate attention in much of the
current discussions about taxation.

On top of that, there is also the issue of the entry and exit of people
in the labor force, so that\'s exit into and out of unemployment.
Looking at unemployment benefits, looking at the movement of people
between jobs and looking at the people into and out of the state of
unemployment or possibly disability as well.

Now, in addition, there are other broader dimensions of labor supply
that include topics such as education, on the job training which
includes things like learning by doing, and actual formal job training
programs, which are effected by tax and incentive programs.

Another notion, a form of skill, is searching to find a new job. It\'s a
very important activity in the American labor market. Has always been,
will always be. And, in fact, the tax code has real implications for
how, in fact, individuals search. And then, of course, the choice of
location and region.

Now, these are different dimensions of a larger notion of labor supply,
and they respond differently to incentives. Another \-- in understanding
these effects, one has to look at what I would call both short-run and
long-run effects.

And, one has to be very careful in distinguishing these policies and
assessing the evidence that\'s presented about the absence of tax
response, or the presence of a tax response.

So, immobility in the short-run may produce very little responsiveness.
So, honest empirical scholars can say taxes have little effect, when you
look at short-run effects, but, in fact, in the long run, they find very
substantial effects.

And so, in sorting through the evidence, you will see, and I\'ve tried
to append a bit of the evidence and the literature. There\'s a huge
literature, one can\'t summarize it in 15 minutes of testimony. But, I
think its very important to keep this in mind, in looking, that there
are many margins of adjustment, and recognizing that some dimensions of
labor supply are more responsive than others.

Now, it\'s a very important task. And, it\'s a task that I would
encourage the panel to encourage, even after its tasks are finished, to
try to understand and measure the full range of incentives facing
individual, and how the tax code effects those incentives. Any empirical
measurement must account for these.

Now, when we think about the effect of compensation on labor supply,
we\'re most often thinking about wages. How wages change. But, we know,
in a much richer model of how economies work, and how a modern economy
works, especially a modern economy with taxation, that there is a large
chunk of compensation that is essentially non-wage compensation.

And that, some components are payments in kind. And some of the payments
in kind actually arise in part as a way of avoiding explicit taxation,
easier to hide. So, you need to really fully assess the impact of the
tax code on behavior, a measure of the full tax price.

So, you need to know, for example, the full components of taxation on
income taxes, payroll taxes, the earned income tax credit, the tax
treatment of pensions, 401K plans, unemployment benefits and the like.
All of these have substantial implications. Often, the literature
focuses on one aspect to the exclusion of others.

Analytical convenience is useful for focus, very narrowly focused
topics. But, it may give rise to obscurity about the true total impact
of the tax system. So, we know, for example, about what the likely
effects are. We have empirical evidence of the effects of income taxes.

Income taxes have the consequence of reducing after-tax wages. They
reduce incentives to work, and they reduce participation in the market,
different adjustments. It also causes employers to shift compensation
towards untaxed payments in kind. A lot of flexibility.

One can never underestimate the power of incentives in motivating people
and the power of tax attorneys and tax lawyers and accountants in
essentially finding ways to dodge the tax system.

If we look at progressive income taxes, and we look at their consequence
on education and investment in skill, there\'s a very basic feature
about the way education is realized. People invest in education when
they\'re young, when their earnings are relatively low. They essentially
harvest the return on their education and get a very much higher tax
return.

With progressive taxation, they essentially are now facing a much lower
return than they would in the absence of that taxation. So, as a result
of the income growth due to education, what one finds is, progressive
taxation retards the incentives for individuals to undertake tasks that
involve personal investments.

Essentially, people are taxed when they harvest their income, but, the
opportunity wages in the unskilled jobs are taxed at a lower rate. And,
therefore, taxation reduced the effects, the incentive to acquire
skills.

Well, payroll taxes, one cannot ignore these. The income tax is simply
not, by itself, the only operation, only effect operating on individuals
in the market. The payroll tax reduces the benefit from working. And, of
course, depending on the labor supply elasticity, may also raise the
cost of labor to firms, and reduce employment.

The earned income tax credit has been shown to essentially raise the
incentive for individuals to work, but, may, in fact, reduce, given its
feature, its phase out features, may in fact, reduce the incentive for
extra work, by people who already choose to work. A very important
feature.

You can promote work, more people will enter the workforce, one
dimension of labor supply, but, in fact, may \-- the workers who are
currently covered by this, given the features, have an incentive at the
high end of the schedule, not to work further hours, so they lose their
benefits.

We also know that there are substantial effects of tax and subsidy
programs, welfare and disability programs. In fact, the disability
program has been shown to be a leading contributor to a growing
joblessness. Growing lack of labor force participation among prime age
males in the American economy.

So, these are obvious direct effects, although they\'re really not
obvious to put together in one program. And to my knowledge, no single
scholar has actually done this. So, you face a daunting task in this
committee.

But, in addition to these sort of more direct and obvious effects of
taxation on labor supply and employment and education, there are
indirect effects that are more subtle, and they also can be quite
important.

So, let me talk briefly about the notion of interdependence of choices
and substitution. It\'s common sense, and we see it every day that
people substitute among activities. Just like employers can substitute
among forms of compensation if it\'s, if they have to pay higher income
taxes and if they can somehow find some non-wage compensation which
won\'t be taxed, it\'s not easy to find to tax, then, in fact, there
will be that kind of substitution.

We know that if we in fact, raise an incentive, in one dimension, people
will go towards that subsidized activity. So, for example, if we raise
unemployment or disability benefits relative to wages, people will
substitute in that direction, and it\'s well documented that this
happens.

This is a problem that plagued the German economy in the last 20 years,
with its very high level of unemployment benefits and disability benefit
increases, and the high levels of disability benefits have also crippled
several Western European economies, notably Holland.

Now, we know on a very subtle level that goods are complementary. So,
when we think about labor supply, we typically think about hours worked.
But, we should also think about the taxation of those goods, those
things that people consume that either enhance or retard work activity.

An example turns out to be housing. It turns out it\'s a more subtle
point. But, in fact, as we increased deductibility of mortgage interest,
that turns out to have pro-work effects. Work, in the language of
economists, the mortgage housing and labor supply would be complements.

If we imagine as well looking at mortgage interest rate, focusing on
this, we recognize that the treatment of mortgage interest rates effects
the cost of college for children. If mortgage interest rate is
deductible, and it is for high income individuals, it reduces the cost
of borrowing and college attendance for those who itemize.

Although there recently have been some reforms, it nonetheless has a
very strong effect in encouraging attendance, especially among more
affluent individuals.

And so, when we think about tax policy for labor supply, we might also
think about its effects, tax policies that operate on those things that
effect labor supply. Like housing. Like, for examples, determinates or
skills, and, more generally. How we tax capital markets and the like.

At the low income scale, one has argued, well, why is it that labor
force participation rate has been going up \-- going down, excuse me, in
low wage labor markets, even among prime age males.

Well, part of it, in fact, some people claim that in fact, part of this
is due to recent efforts to try to enforce child support payment. Again,
what seems not to be anything related to normal discussions of taxation.

But, the point is, that if you force males to essentially support their
children, they have a strong incentive to substitute away from their
families, not to be found, not to bear the tax burden of supporting
their families. An indirect, unanticipated effect of tax reform.

Again, suggesting how subtly human being really is in finding ways to
evade taxes, and the unintended consequences of something like the child
support program, normally not considered a tax policy program.

So, tax policy in one area of economic life, really has strong effects
in other areas, and, its been documented. And, to understand the full
richness of this is a daunting, but, a very important task.

Let me also briefly talk about what economists call large scale effects.
Here, when we study tax policy, it\'s very common to sometimes do
solitary experiments, looking at an individual who faces a tax increase
in isolation from any other individual who faces an increase or a tax
decrease.

But, one has to understand that there are large scale consequences. So,
if we have system-wide effects that come from taxation, that need to be
carefully factored into the equation. So, for example, if we have a
policy that promotes work effort \-- Whoops, I guess I\'m out of time?

CHAIRMAN MACK: You can use the next minute to kind of wrap up.

PROFESSOR HECKMAN: Okay, fine. Let me skip past large scale effects,
but, simply to argue that there are very substantial effects. And, let
me just talk very briefly about the empirical evidence.

I would say that we do know that labor supply is relatively elastic,
especially at the margins of entering and exiting the workforce,
especially among low wage workers. So, the claim that wages, that labor
supply does not respond to wages is simply false.

We know especially from the work of Meyer and Rosenbaum that there are
substantial effects, for example, the earning of tax credit on labor
supply. In Iceland, there was a dramatic case where taxes were cut to
zero for one year. And, it led to an outpouring of labor supply, almost
unprecedented in the country.

So, we know that people respond. In a zero tax economy you\'ll get many
more people working. Just look at Iceland.

CHAIRMAN MACK: Zero tax collection.

PROFESSOR HECKMAN: Zero tax collection as well for that one year. I
didn\'t say taxes should be zero, even though some people outside the
building are saying so. But, I think we should really understand though,
because there is some discussion in the academic literature that
aggregate labor supply really is quite elastic.

But, it\'s driven by participation, people entering and exiting. It\'s
those margins of choice where you get the greatest elasticity. People
dropping out. People entering, the underclass if you will. People who
simply go unreported, simply because they don\'t have to face up to
their tax responsibilities.

Tax codes create, child care collection codes create those incentives,
and, they\'re documented to have a real effect. In my testimony, I
won\'t have time to go through it, there are tables prepared by Martin
Lune, who\'s sitting here, a University of Chicago graduate student,
looking at various dimensions of labor supply.

And, so I just don\'t have time to go through these. But, what you will
see, and Jim Poterba, I\'m sure, can explain this in great detail in the
deliberations of the committee, that in fact, we do know that there is a
great deal of responsiveness. And, in fact, some recent literature that
originates from the work of Martin Feldstein and others, shows that in
fact, there is a large tax responsiveness. People are really responding
rather substantially, but, it\'s through methods, mechanisms that
aren\'t frequently documented. Through the choice of deductibles.
Through work and not work. Through the choice of compensation on the
job.

So, there are a number of different clever mechanisms that aren\'t just
direct tax effects on an extra hour of work. Let me just make one last
statement. I realize I\'m way past my time, but, I can\'t resist this.

And, this actually is promoting some of my previous work on this topic,
but, I think it reflects the subtlety of what economists talk about and
the importance of understanding tax reform.

In this table, which is a very busy table I just don\'t have time to
discuss, we consider, using a model that takes into account large scale
effects, that takes into account this revised table labor supply, that
takes into account the human capital accumulation both going to school,
and, work on the job, promotion of skills on the job, what the effects
would be to revenue neutral tax reforms.

One is movement from a progressive tax, to a flat income tax. The other
is a move to a flat consumption tax, not taxing capital income. Some
very interesting consequences if you look down the margins called GE. GE
is the code word for general equilibrium, large scale effects.

And, what we find is that the tax effects are fairly moderate in terms
of what, revenue neutral taxation, flat taxation will not substantially
change the acquisition of human skills. Will not that much effect our
supply.

It has some, increasing, promoting the stock of college human capital.
Some increase in essentially reducing, raising on the job training, but,
the fraction attending college doesn\'t go up that much.

But, the subtle effect, and this is the substitution effect that I want
to emphasize is, by essentially reducing taxation on capital, you
promote capital accumulation. Capital accumulation is a major ingredient
for determination of wages. You create more jobs.

So, the net effect is more job growth and much higher wages, an indirect
substitution effect. Something which is not directly studied by the
scholars looking exclusively at taxes and labor supply, but, an
important general equilibrium effect nonetheless that\'s extremely
important to take in mind.

So, there will be effects on the labor market. Okay, yes, so, I will
simply let you summarize yourself my paper.

CHAIRMAN MACK: I apologize for having cut you off \--

PROFESSOR HECKMAN: No problem.

CHAIRMAN MACK: \-- with your knowledge and expertise in the area. But,
any event we do have to raise some questions and then move on to our
next panelist. Jim, do you want to lead on?

MR. POTERBA: Sure. Jim, thank you very much for coming and talking with
us this morning and for preparing a tour de force here of the literature
which lays out so many of the important incentive effects we need to
think about.

I\'d like to just draw on your expertise as an empirical maestro in this
area, to just get your overall take on how we should evaluate a lot of
the empirical work that we will see, and, probably will talk about as a
commission, that has studied how taxes effect various dimensions of
labor supply. And, in particular, given the changing nature of the tax
systems that we have, the difficulties with sorting out the long-run
effects as well as the transitory effects. Do you have any advice that
you can offer us on whether you think we tend to measure mostly sort of
the short-run initial impact, sort of transitory effects of policies? Do
you think we have much work that speaks to the longer-term effects, the
sort of, you know, low frequency effect of tax changes. Not just with
respect to labor supply, but with respect to other issues.

And, I think it\'s a broad issue and I\'m hoping you\'ll just share your
thought with us.

PROFESSOR HECKMAN: Well, there are some models, empirical models that
many economists have been developing which would fall under the rubric
of general equilibrium. And, the general equilibrium models, models that
recognize the large scale, excuse me, the large scale impact of tax
policy, and the fact that there are different margins of adjustment
across markets.

So, not just to promote my own work, but, there is other work by
economists looking at exactly these large scale effects. The dramatic
effect that I was showing about how a move to a flat consumption tax
would, in fact, have real effects on wages and employment.

I think one would definitely want to look at that dimension. I think one
would also want to, in looking at the empirical studies, look at those
studies that essentially are recognizing the entry and exit. The margins
of adjustment where people drop out of the workforce or into the
workforce.

If you look at the American labor force participation pattern, you\'ll
realize that we have a situation where for many prime age groups, labor
force participation rates are dropping.

And, in fact, one has to ask, what is the role of federal tax policy?
What is the role of incentive policy, of welfare policy, of various
kinds of policies that were designed possibly with good intentions, in
promoting this reduction in participation in the economy. And, with it,
an alienation, a withdrawal of a large group of individuals from
society, social participation of large.

So I think we want to carefully recognize that margin of adjustment and
it\'s under study. Many of the studies that put forward are looking only
at hours of work by workers. I mean, academics fall into traps. You
know, you get a data set, you get used to a certain mindset. You look at
the standard methodology and you kind of avoid the hard problem.

And, the hard problem here was who works? And, it\'s a very difficult
issue, much harder, actually in terms of the methodology, but,
empirically quite important. And, that is where the margin comes. That
is where the margin comes in the aggregate labor supply when you look at
fluctuations over the business cycle and the like.

So I think there are studies you might want to look at which look at
both long run and short run effect, guided by this general equilibrium
frameworks. How many are there? Are they in great abundance? No,
they\'re not.

MR. POTERBA: We can follow up by email later on, on specifics \--

PROFESSOR HECKMAN: Yes, absolutely.

CHAIRMAN MACK: Thank you. Senator Breaux?

VICE-CHAIRMAN BREAUX: Thank you very much, Mr. Chairman. Thank you, Dr.
Heckman for your presentation. I have a relatively simple question. And,
it really I think is a follow up to your thrust of your testimony which
is that whatever we do in the tax code is going to affect just about
everything we do in society.

It\'s going to affect labor, it\'s going to affect education, it\'s
going to affect the type of skills people in the workplace have. And,
that\'s very very true. One of the problems that the Congress has, is
because of the requirement and the process of scoring tax changes, we
are forced, they are now, to follow what they call, static scoring as
opposed to dynamic scoring.

And, it\'s a real problem because if we look at a tax reduction of \$100
for instance, we have to score it as costing the Treasury \$100, even
though that tax reduction may effect behavior in a positive way,
generate more revenues, more capital, because of a lower tax rate.

We get no credit for that. I mean, lower rates, you get no credit for
that. It\'s just a cost as far as Congress is concerned. If we lowered
all the rates by 10 percent, Congress, through the scoring process is
going to say, well, you have to make up that money, even though that may
generate, under your theory, additional revenues because of people being
more productive and working hard and working longer.

So, I mean, what are your thoughts about the whole question of dynamic
versus static scoring? I mean, it makes it very difficult to do some
things if we don\'t recognize that it could have an effect on activities
and effect on the revenues that the country generates?

PROFESSOR HECKMAN: Well, I think the notion of static scoring is a very
myopic, to put it mildly. I mean, I understand, it\'s conservative,
it\'s useful, maybe in generating first round estimates. And, there is
some subtlety involved in asking when these tax effects will come on
board.

You know, for example, I mentioned short-run versus long-run. People are
fixed in the short-run into current arrangements. And so, it\'s a little
more of an art form than it is a hard science to really determine
exactly how far down the road it\'s going to take. How long one\'s going
to have to wait for the full effects, nonetheless we have \-- for the
full effects of a tax reform to work its way through labor supply,
through investment and through the whole range of activities in the
American economy.

Nonetheless, we do have a pretty good idea that on certain margins, we
have increasing knowledge about when, how long the adjustments take and
which ones are relatively quick and which ones are not.

I think it really considerably undercuts the case for tax reform not to
account on the positive side of the ledger for these large scale
incentive effects which we can get.

Now, I would suggest you make a range of estimates. You essentially go
from the static estimate, which obviously suggests there should be no
tax reduction. Still even at a given level of taxation, one can talk
about revenue neutral reforms. I tried to indicate one, two examples
where the issue of the total tax take really isn\'t an issue, it\'s a
question of how it\'s raised. That can still have effects.

VICE-CHAIRMAN BREAUX: Okay, well I got the thrust of your response. I
want to invite you to come down and talk to the Joint Committee on
Taxation and try and tell them about their myopic view on this, which, I
mean, I happen to agree with you. But, we, I mean Congress\' hands are
literally tied on getting any kind of positive effect scored as a result
of changes in the tax code that reduce taxation.

PROFESSOR HECKMAN: But I think the literature, you can look at enough of
the literature, and be very conservative within that literature to say
that, essentially, is sticking your head in the sand.

VICE-CHAIRMAN BREAUX: I don\'t think they\'ve read the literature.

PROFESSOR HECKMAN: Well, you can send

them \--

CHAIRMAN MACK: I think before I go to the next panel member, I should do
what I should have done earlier. We just got here, just in the nick of
time, and I think my mind is just starting to catch up with me. So, let
me just say a word or two about the folks here that are on the panel
with me.

You heard earlier from Jim Poterba. He is a Professor of Economics at
the Massachusetts Institute of Technology where he serves as an
associate department head. He has taught at MIT since 1982.

Tim Muris, he\'s a Foundation Professor, George Mason School of Law, and
of counsel to O?Melveny and Myers, and he served as chairman of the
Federal Trade Commission from \-- excuse me, 2001 to 2004.

And, both Senator Breaux and I served in the Senate and in the House
together for some, too many years. And, we\'re delighted to be with you
and look forward to the rest of the panel and the rest of the questions.
With that, Tim, I\'ll turn to you.

MR. MURIS: Thank you, thank you very much, Senator. Let me follow up
Professor on Senator Breaux\'s question on dynamic scoring. There are
various levels of dynamic scoring. I think one of the things that
bothers the scorekeepers the most are trying to estimate the improvement
in the economy.

They\'re somewhat more receptive in recent years to behavioral effects.
And, one of the behavioral effects that you didn\'t get a chance to talk
much about was illustrated by Marty Feldstein\'s paper about increases
in taxable income from reductions in rates.

And, I wonder if you could comment on that, and compare what you think
the, roughly the magnitude of that impact would be compared to, you
know, this more general dynamic scoring about the effect on the, the
overall effect on the economy.

PROFESSOR HECKMAN: Well, in the testimony you\'ll see in table 1-C a
summary of evidence from the United States and from other countries of
what this taxable income response estimate is. How much taxable income
would change in response to an income tax reduction of say, 10 percent.

So, you just multiply 10 percent times each of these numbers you see in
column 6 of Table 1-C. And, you can see that these numbers are not zero.
Now, there\'s some controversy. The Feldstein numbers themselves are
being questioned as being a bit on the high side.

But, even some more recent estimates, and certainly estimates from
Sweden and other countries suggest very substantial increases in the
taxable income base that come. So, you get more taxable income.

Most dramatic example I ever saw was actually was a Laffer curve, was in
Colombia, the country Colombia a few years ago, when there was such a
large scale underground economy that when the tax system was reformed
and the pension systems and the benefit systems were improved, even
though the tax rates were cut nominally, the total tax revenue rose
tremendously.

There was this enormous increase.

And so, you actually had a true Laffer curve, the level of economic
activity increased. But, that\'s the underground economy coming out. We
don\'t have an underground economy of that scale. But, I think you have
to really ignore vast literature to say there aren\'t substantial
effects.

Now, to come down and say, oh, the tax elasticity is .12 or .03, then
you start arguing a bit. But, you could take one of most conservative
estimates in this table and still find fairly substantial effects. And,
that\'s why I think you really do want to allow for the fact that
dynamic scoring, in some form, is a good idea.

CHAIRMAN MACK: In your presentation this morning you have covered a lot
of territory and some very specific issues. But, my question, and I
guess it\'s because of the limited time which we have to talk with you,
is in the broader sense, and you began to touch on it earlier.

In your comments you talked about investigating the strength of
responses to incentives. It\'s important to measure the full range,
there\'s obviously a whole range of incentives, and I would say,
disincentives in the tax code with respect to the labor force, its
movement, the hours it works and so forth.

PROFESSOR HECKMAN: Yes.

CHAIRMAN MACK: But, I\'m concluding from your earlier comment also,
though, that you would favor more of a consumption-based tax, even
though that would, in a sense, kind of wipe out all the incentives and
disincentives that are in the present tax code, maybe \"all,\" is too
much.

But, you would favor a tax on consumption because a) it would have
higher levels of growth, b) there would be capital formation, c) that
would create more jobs and more opportunity. Is that a fair conclusion
or have I \--

PROFESSOR HECKMAN: I don\'t want to be in an either/or situation here.
What I was trying to suggest from that calculation was that the
consumption tax had some very interesting and, I think, not often
explored implications for the labor market.

So, normally we don\'t say, well, you know, we\'re talking about capital
accumulation. The other side of capital accumulation, of course, is job
creation. Job creation also has real effects on wages. So, you
essentially, one way to essentially increase the wages of low wage
workers, or workers generally, is to essentially invest more in the
capital market. Invest more in the economy.

So, I was offering that as a way of sort of broadening your mindset. Not
as a specific recommendation. I don\'t come here saying, oh, we must
have a \-- I don\'t have a particular tax that I\'m in favor of at this
moment, and, therefore would advocate. I would say, however, that the,
these aspects of consumption taxation, the effects of consumption and in
fact the fact that when you look at the revenue neutral flat income tax,
versus the revenue neutral income tax, the consumption tax, we actually,
flat consumption tax, we actually saw in my mind, much more powerful
effects.

So, I do think the taxation of interest income has a substantial effect
for the economy. And, with it, because, you know, the interest income
and the cost of borrowing effects so many decisions in economic life, it
will have implications for things like job creation as well as for
education decisions.

The real margin comes in actually promoting building the capital stock
base.

CHAIRMAN MACK: Thank you very much. I\'m going to turn to Jim to ask a
question. Some of our panelists who are not here are observing this,
what \--

MR. POTERBA: Webcast.

CHAIRMAN MACK: \-- webcast, and have a question they\'d like to pose,
and so Jim is going to ask a question for Ed Lazear, who\'s the senior
fellow Stanford \-- Hoover Institution and Professor of Human Resources
Management and Economics at Stanford University Graduate School of
Business. So, Jim, if you would \--

MR. POTERBA: I\'m in the loop to make sure this economist to economist
question comes off the right way. But, it\'s actually in English, a
credit to Eddie.

Thank you, Jim. As always, you were clear and illuminating. You talked
about how regressive taxation distorts the incentive to acquire
education. But, much of the problem in the U.S. is for Americans for
lower levels of education, not for those who go to college or to
graduate school.

Do you think that altering the tax code and particularly, the regressive
nature of the current code, can effect in a significant way the
educational attainment of those below median income?

PROFESSOR HECKMAN: Well, I think that one has to understand that the
decisions to work, and the decisions to get skills for work are closely
related.

And so, if you have reforms that effect the compensation, that effect
the incentives of individuals to work at all, to come into the workforce
at all, you are also having reforms that effect their desire to acquire
skills, to maintain and then advance in those jobs.

So, for example, if we have taxation which discourages individuals from
participating in the workforce, they will have very little incentive to
acquire skills, since they\'re not going to get jobs. The two are
related.

So, in that sense, I think the taxation at the low end, which doesn\'t
receive the same kind of attention that I think it does deserve, I mean,
when we look at capital formation, we know that it\'s sort of high end
individuals. We know this small group of individuals are actually
producing quite a bit of the saving and wealth creation in society at
large.

But, we also know a substantial part of the dropout problem is from the
bottom of the distribution. So, we think about tax policy, we have to go
across the distribution. And, so I would take, one issue, I would
certainly say that the reduction in taxes or, I tell you, the reduction
of disincentives, let me state that more clearly, on low skill workers
would promote their growth of skill through on the job training, through
learning by doing, and through giving them direct payment.

But, secondly, think I would dispute a little bit your claim that in
fact, the college going situation is entirely normal and healthy. We\'ve
had a problem for the last 30 years, that, you know, for generations up
to about 20, 30 years ago, it was the case that every generation was
going to college at a greater rate than its predecessor generation.

That\'s slowed down, for men especially. It\'s stagnated. So, for women,
it\'s still increasing. And so, I would argue that, in fact, serious
reforms that promote people going to school, tax reforms, still have a
real role to play, a potential role to play.

So, I think at both ends of the skills scale, I think tax reform should
be seriously contemplated. And recognize again, these dual nature of
incentives. You go to school if you\'re going to get the skills. And,
you could use the skills, you will use the skills in a job.

And, so, I think these consequences are across the skill spectrum.

CHAIRMAN MACK: Again, thank you very much for your presentation this
morning, and for your thoughtful responses to the questions. And, as
this time we are going to have to move on the next, but, again, thank
you very much.

PROFESSOR HECKMAN: Okay. Thank you.

CHAIRMAN MACK: Again, I want to thank all of the panelists for your
participation this morning. And, look forward to your comments. And,
Brian, I think we\'ll start with you. I may have to from time to time
either ask you to shorten your statements if we\'re running short on
time, so, please be sensitive to that. MR. WESBURY: Great. Thank you
Senator Mack, it\'s great to see you again. Welcome to Chicago, Senator
Breaux, and Tim and Jim. I really appreciate the panel and the members
who aren\'t here today for what you\'re doing for this country. It\'s
great, and it\'s a pleasure for me to be here.

This was said already today by Dr. Heckman, but, it\'s not \-- while
people pay taxes, it\'s really, the tax code effects the activities that
people choose. Individuals are influenced in their decisions about where
to spend their scarce talents, their scarce resources, their scarce
time, by the tax code.

And, my belief is that people make decisions especially this is true in
the investment world and entrepreneurial world, balancing risk versus
reward. And, the reward that we\'re really talking about is after tax
reward.

So, it\'s very clear, at least from my perspective that taxes effect
decisions and they effect activities. We\'ve seen lots of research about
this, but, I think, just from a general business person\'s point of
view, it becomes a daily activity to figure out how the tax code effects
business.

This is not a new thing. I have a quote here from First Samuel, 17.25.
Saul was the King of Israel and there was this big Philistine named
Goliath.

CHAIRMAN MACK: I might say that we read that and it did kick up a
discussion among us.

MR. WESBURY: And, in order to encourage one of the Israeli citizens to
take on this Goliath, Saul offered great wealth, his daughter\'s hand in
marriage, those both are pretty big things. But then, he also promised
to exempt the citizen, the warrior\'s father\'s family, the entire
family from taxes, seems like forever, the way I read it.

So, and obviously 3,000 years ago, if we understood how taxes could
influence behavior, I think we could do that today, too.

What I wanted to do as a business person, as a macro economist was just
to kind of look at a real, in fact, in a shallow manner, kind of
investments and investment decisions, loan decisions that people can
make and how the tax code is different for almost all of them.

In the bond world, there\'s corporate bonds, treasury bonds, municipal
bonds, all of them in a sense have a little bit of different tax
treatment. Corporations deduct the interest that they pay. I, as a
bondholder or any investor as a corporate bondholder pays taxes on the
interest earned.

As a result, there\'s agreement between investors and borrowers that
raise interest rates in my view. Municipal bonds, you\'re typically not
taxed at the individual level, although municipalities issue taxable
bonds.

And, there\'s certain legal reasons for that. Banks, Senator Mack,
you\'re a former banker. Banks today have major decisions about
investing in municipal bonds because they can only invest in particular
kinds of municipal bonds, those that are issued from communities that
issue less than 10 million bonds a year, dollars worth of bonds a year.

There\'s also haircuts that come with former tax proposals and all kinds
of alternative minimum tax requirements. In fact, it becomes a very
complicated process to decide whether to increase a portfolio of
municipal bonds, or, in fact, when they\'re more profitable to invest
in.

There\'s original issue discount bonds. In fact, you can pay taxes on
interest that you have not received, because of OID discounts. There\'s
TIPS bonds, or inflation protected securities. Every year the principal
amount of those bonds is increased by the amount of inflation and you as
a bond holder owe taxes on the increase in the principal, even though
you don\'t receive it until you sell the bond.

Mortgage interest, obviously, is deductible, so are home equity lines.
Investment interest. If I have a margin account in my brokerage account,
borrowed by stock, I can deduct the interest that I pay on that margin
account, but I cannot deduct credit card interest, or a car loan
interest or any other interest that\'s not one of those other
activities.

If we go to corporate dividends, prior to 2003, they were taxed at the
individual marginal income tax level. Today that has been reduced to 15
percent but, remember that this comes after the corporation has paid
taxes.

So, if we assume the corporation is paying a 35 percent tax, they pass
on \$65 out of every 100. It\'s then taxed at the individual level at 15
percent. In fact, the tax rate is really 44 3/4 percent on every dollar
of corporate earnings that is paid out in dividends. And, remember,
also, that they have to be qualified.

There\'s capital gains on stock, today that\'s 15 percent. I\'ve spent
the last two days in a board meeting for a company that I am on the
board of, trying to decide on stock option plans for employees. The
intent is to make every employee a partner.

And, you would not believe how complicated this process is, trying to
decide how to distribute that stock. Whether to create taxable events
today, whether to try to have that stock be taxed at ordinary income tax
rates, or capital gains tax rates. It is a huge consumer of time, and in
fact, is very complicated.

Capital gains on housing, because of a tax law that was signed into, put
into place in 1997, when Mr. Clinton was president of the United States,
now exempts the first \$500,000 in gains on a house for a couple that
has lived in that home for two years. In fact, housing is one of the
least taxed investments in our economy.

But, once again, it is an asset that is taxed differently than other
assets. And, the point I\'m trying to make here is that we have a very
complicated structure when trying to make decisions about what to invest
in. These, all of these tax treatments are made even more complicated by
the existence of 401 plans, Roth IRA\'s, IRA\'s, KEOGHS, SEP IRA\'s, 529
college savings plans, on and one and on.

Now, there\'s lots of things that we have to careful of as investors or
as brokers and that is that no one should ever be allowed to buy a
municipal bond and put it into a IRA, or a Roth IRA, because municipal
bond interest is not taxable.

Therefore the interest rate on a municipal bond is lower than on other
instruments, and if you were to put it in a tax deferred of preference
vehicle, you would in fact be penalizing yourself and no broker would be
allowed to suggest that someone do that. The fact of this, of all of
these things causes behavior to change.

For example, because interest is deductible at the corporate level, and
this is especially true prior to the 2003 tax cut, corporations were
willing to borrow money, in fact, sometimes to use that to buy back
their own stock, to try and drive up the stock price rather than pay
dividends because that was a more tax-efficient way of getting
shareholder value back to the shareholders. In other words, give them
capital gains rather than pay dividends.

Now, with the lower dividend tax rate, those incentives are less and
corporations are borrowing less as a share of their balance sheet. But,
in fact, we\'ve seen a major shift because of that.

One of the interesting developments of that is the spreads between
corporate bonds and treasury bonds have come down to very low levels.
Partly that is true because the issuance of corporate bonds has been
reduced as a result of this.

Homeowners have figured ways around this, and Dr. Heckman talked about
this. If I can deduct my home equity line interest, I\'m going to use
that to pay for college. I\'m going to use that to buy cars or furniture
or make other purchases.

So, the bottom line here I guess is, the point I\'m trying to make is,
is that all of these different tax treatments cause people to do things
in ways that they might not do them, if the taxes weren\'t there to
cause that impact in the first place.

And, somewhere in there, the U.S. economy loses efficiency. And, the
interdependence of all of these taxes, as Dr. Heckman talked about,
makes it very difficult to figure out how much efficiency. But, we know
it can\'t be a positive number, it has to be a negative number.

I have thought about this a lot in recent years and my belief, too, is
one of the major issues facing U.S. economists today is the trade
deficit. And, if you think about our tax code and its impact on the
trade deficit, it\'s kind of interesting. And, that is that our tax
code, because it double taxes savings in many different ways, in fact,
increases consumption, relative to what it would be otherwise.

We consume a lot of foreign goods and therefore we import foreign goods.
At the same time, because foreigners do not pay taxes, at least, foreign
central banks for certain, and most foreigners do not pay taxes on
interest earned from buying U.S. Treasury bonds or other U.S. bonds, in
fact, they have an incentive to buy our debt, because interest rates are
higher than they would be otherwise because of the existence of the tax
code.

And, in fact, there\'s an arbitrage opportunity here, where U.S.
consumers buy goods. Foreigners invest in U.S. assets and in fact, the
tax payment structure is lower and the total tax effect is minimized. As
part of that analysis, interest rates today are higher than they would
be otherwise, and the reason is, very simply is, that there is a tax on
interest income, because the corporation can deduct it. There\'s an
agreement between the investor who says, hey, you can deduct this
interest, I have to pay taxes on it. You\'re going to have to compensate
me for that, because I want a real after-tax return. And, so, in effect,
interest rates are higher, which is one of the reasons why foreigners
who do not pay taxes on U.S. bonds in many cases, especially, say, the
Chinese Central Bank, would have an incentive to buy U.S. debt versus
others.

There are real effects, macro, from the macro economy point of view. The
2003 tax cut on capital gains, on dividends and the accelerated
depreciation completely turned investment around in our economy. After
nine consecutive quarters of decline in business fixed investment, by
the way, we have not seen nine consecutive quarters of decline in
business fixed investment since, most likely, the Great Depression,
although data is not as good as we would like.

But clearly, since the beginning of this series, we have never seen nine
consecutive quarters of decline literally on virtually the day the tax
cut was passed, business fixed investment turned around and began to
grow. Clearly they are macroeconomic effects from tax cuts.

The housing capital gains tax change that I just talked about has led to
a boom in the housing market which many people call a bubble. I ran some
quick numbers. Since 1997, and that\'s when capital gains treatment of
housing was changed to exempt \$500,000 of cap gains, construction jobs
in the residential arena have increased 36 percent. Real estate
employment, realtors employment is up 17.6 percent. Retail jobs are only
up 5.8, and manufacturing jobs in the United States are down 17 percent.

Clearly, when you make one area of the economy have higher after-tax
rewards, you\'re going to see more risk taking in that area. You\'re
going to see prices rise. You\'re going to see more employment in that
area. And, I believe that if we really are worried about different
sectors of our economy, we ought to think about how taxes treat those
areas.

Finally, I just believe that we ought to level the playing field. That
most of these problems and issues that I\'ve discussed and behavioral
changes are caused because of the tax treatment of investment, double
taxation of savings and investment.

I mean, I believe moving towards a consumption based tax, not
necessarily a national sales tax or a value added tax, but, moving
toward less taxation of investment income and savings, that in fact, we
would have a more efficient economy that would grow more rapidly, create
more jobs and increase wealth. Thank you.

CHAIRMAN MACK: Thank you very much. Professor Kennedy, we will go to you
next.

PROFESSOR KENNEDY: Thank you very much Mr. Chairman, Mr. Vice-Chairman
and other members of the panel for inviting me and to become part of the
President\'s initiative to simplify the code.

My remarks today are going to be directed at the tax code\'s incentives
for long-term savings through profit sharing and pension plans, and the
tax code?s incentive for health benefits to ensure economic security for
employees and their dependents.

The Internal Revenue Code does provide enormous tax savings for
employees and employers who sponsor benefits. Some of these benefits are
actually tax deferred pension and profit sharing, will ultimately pay
tax upon distribution. Whereas some of the welfare benefits are totally
tax free, and some welfare benefits have caps.

Why do employers offer employees benefits? There\'s a variety of
reasons, but, probably the most important is for competitive reasons, in
order to get that worker who especially wants health and retirement
benefits as a condition of employment.

But, before we before we delve into the tax code, it\'s very important
for you to know that employee benefits are also regulated by a federal
labor statute called ERISA, which is an acronym for Employee Retirement
Income Security Act of 1974.

It regulates substantively pension and profit sharing plans, and
actually amended parts of 401A of the code. Since ERISA was passed in
1974, ERISA and related code provisions relating to employee benefits
plans have been amended over 30 times, either expanding or narrowing the
scope of employee benefit plans.

As a result, we have a total patchwork of conflicting policy issues. We
have unbelievable administrative and legal costs now in providing these
benefits, undue complexity for employers in deciding which benefits to
adopt and certainly confusion among employees as to what their plan
choices should be.

In fact, it has gotten so complex that the IRS actually has a correction
program for employers to self-correct as they discover all of these
defects under the plans.

Going to, moving to the code, the code\'s original retirement plan
models were based on either a pension plan model, or a profit sharing
plan. Pension plans were designed to provide retirement benefits and
thus, there would be restrictions on when you could get that money, how
it would be distributed, and funding rules.

In contrast, the profit sharing plans were designed to be simply capital
accumulation models. And, therefore, there was less restriction on using
the money solely for retirement.

The other model that is under the code, is that of a defined benefit
plan, versus a defined contribution model. Defined benefit plans provide
benefits according to a set formula. That\'s usually related to pay, and
may be related to service.

These plans are always pension plans designed to provide benefits for
retirement purposes. In contrast, defined contribution plans which
simply allocate contributions to individual accounts can be designed
either as a pension plan, or a profit-sharing plan.

The choice of retirement plans for a given employer can be extremely
confusing. If you\'re a taxable employer you can choose under code
section 401A to either adopt a defined benefit model, or a defined
contribution model. You can also design a non-qualified vehicle for
executives to tax-defer benefits.

But other employers, especially tax exempt and state and local, have
alternative models to choose from. Public school systems and certain tax
exempt 501(c)(3) employers can also offer what\'s called a 403(b) tax
deferred annuity.

Governmental and other tax exempt employers can offer what are called
eligible 457(b) plans or, for their more compensated individuals,
ineligible 457(f) plans.

And, small employers, those with less than 100 employees, may also
choose to offer what\'s called a SIMPLE plan, under code section 408. If
that individual does \--

CHAIRMAN MACK: I don\'t know if that word should be allowed to be used
in the code.

PROFESSOR KENNEDY: For individuals, a tax deferred choice, the only one
they have is a defined contribution model, i.e., they can save under a
individual retirement account, or under a non-deductible Roth IRA, and
then, there\'s some spousal IRA\'s if one of the spouses does not have
earnings.

What I\'d like to illustrate with this is that in 1974 when ERISA was
passed, the typical model was a non-contributory defined benefit plan,
which was fairly simplistic in design. The number of defined benefit
plans peaked in 1984 with 175,000 plus plans, and it has declined to a
number of 56,000 plus in 1998. And, so, our new model, now, in 2005, is
definitely a contributory defined contribution model.

In 1998, we had over 670,000 defined contribution plans, almost half of
which had a 401(k) feature. This 401(k) feature allows employees to make
pre-tax contributions to the plan. This year, the dollar cap is
\$14,000.

With the defined contribution model, then, there are a variety of
different choices for employers. Do I set up a pension plan, i.e., a
money purchase or target benefit? Or, do I set up a profit sharing plan,
i.e., a profit sharing or a stock bonus model.

If I offer a tax deferred feature to my employees, do I offer a 401(k)
or a 403(b), or a 457(b) alternative? And, this would vary by the type
of employer. If I\'m a small employer, do I adopt a 401(k) or a SIMPLE
IRA? And, certainly individuals don\'t have that, they simply have to
decide whether to invest between an IRA or a Roth IRA.

I don\'t mean to go through this example. The point of this chart is to
show, if I\'m a small business trying to decide between a 401(k) or a
SIMPLE IRA plan, there are a variety of different issues I have to go
through in order to discover which one is the best for myself and my
employees. So, while the SIMPLE IRA is a simple plan, the choice of
whether to adopt one is not at all simple.

The cost of employee benefits for employers and employees, retirement
benefits continue to be the dominant cost. Of all the benefit dollars
that are spent, 47 percent of those are used to provide retirement
benefits. And, that\'s been virtually unchanged since 1970.

The major growth, though, has been in the health benefits, which in 1970
was only 21 percent of the total benefit dollars, now has moved up to 30
percent plus. And, employers have continued to spend a greater portion
of wages on employee benefits because of the growth on the health
benefit side.

Workers, too, are spending proportionately more on both retirement and
health benefits. You see an increase in the retirement, where
individuals are now spending up to 46 percent more on retirement
benefits. And, in the health arena, spending up to 27 percent of
personal spending in the health area.

What I\'d recommend in the area of pensions is to simplify the defined
contribution model. The distinction before the money purchase or the
defined contribution model between pension and profit sharing plan was
that the profit-sharing plan had a lower deductible ceiling. EGTRRA has
eliminated that. Now, the ceiling between defined contribution pension
and profit sharing plans are on the same parity. They both have a 25
percent payroll.

As a result, any new employers would simply choose the flexibility of a
profit-sharing model, and not take up all the restrictions of a pension
plan defined contribution model. So, I would suggest a single type of
defined contribution model, that of a savings plan with the same
flexibility provided for employers that profit sharing plans produce,
and eliminate the pension plan model.

I\'d also recommend a single 401(k) feature, regardless of the type of
employers, not offer all these alternatives of a 403(b) or 457. And,
I\'d certainly make the choice between adopting a qualified 401(k), or a
simpler IRA, much easier for small businesses to ascertain.

Moving now to health benefits, employment based health benefits cover
nearly two thirds of all of the working individuals under age 65. And,
ranked by employees benefits, health benefits are ranked number one.
What the code does with respect to this, is if the employer provides you
health insurance premiums, those are totally deductible by the employer,
and completely tax free to the employee.

Cafeteria plans under code section 125 permits employers to allow
employees to set up what are called flexible spending accounts. Under
those accounts I can pay for healthcare expenses tax free. And,
self-employed can deduct up to 100 percent of the amounts paid for
health insurance, whereas individuals without employment based health
coverage only get a deduction their benefits exceed seven and half
percent of adjusted gross income.

As I mentioned, there are skyrocketing health care costs. Over the past
five years, we\'ve had a 59 percent increase, which is a dilemma for all
employers, not just small employers. The basic cost drivers are
demographically, we\'re becoming more of an aging population. Cost of
prescription drugs, research and technology and medical malpractice
claims.

As a result, employers are shifting more cost to employees. And,
Congress has responded with a variety of initiatives. As I mentioned, we
do have a cafeteria arrangement where you can allow flexible spending
accounts. A huge problem with that model is this use it or lose it
feature. If I accurately can predict what those health care costs, then
I have a pre-tax savings. But, if I don\'t accurately recommend it, I
lose the portion that I don\'t take advantage of.

Health reimbursement accounts are employer funded flexible spending
accounts that can be or don\'t necessarily have to be coordinated with a
high deductible plan. The Archer Medical Savings Account was a temporary
initiatives to see whether small businesses would set up flexible
savings accounts in conjunction with high deductible health plans.

And then, most recently, Congress has passed the Health Savings Account,
under code section 223, allowing employee and employer deferrals under a
spending account. However, it has to be coordinated with a high
deductible health plan.

My concluding thoughts is definitely the code should be made more simple
with respect to the defined contribution model. Unfortunately, the
code\'s defined benefit model is out of date. And, since defined
contribution plans shift mortality and investment risk to employees,
greater education obviously is going to be necessary for employees who
are undertaking more risk.

On the health side, you can take the position to either reform existing
code provisions, for example, eliminate the use it or lose it concept
under cafeteria plans. Or, come up with a dramatically different model
to help employers curb costs. Here, too, the importance of consumer
education so that employees can make the right health care choices is
absolutely paramount.

And, lastly, you may consider offering additional tax incentives for
employers to adopt preventative programs, such as disease management or
wellness or non-smoking plans. Thank you.

CHAIRMAN MACK: Thank you very much. Susan, you\'re next.

PROFESSOR DYNARSKI: Mr. Chairman, Mr. Vice-Chairman, members of the
panel, thank you for inviting me to testify this morning. Today, I\'m
going to talk to you about provisions in the tax code that relate to
education. Let me dive right in.

What I\'m going to do first, is give you some background on college
costs that have been the impetus for many of the policies I\'m going to
show you. Then, I\'m going to talk in broad terms about what the tax
expenditures for education are in dollar amounts. Then, I\'m going to go
in detail into the education savings accounts, talk a bit about their
complexity and who benefits from them. Same story with the tuition tax
credits, the deductions and the exemptions. And then, give you some
concluding thought.

So I wanted to fix ideas first with this graph. So for many of the tax
incentives, the value of the incentive actually depends on what your
schooling costs are. So, I wanted to lay down what schooling costs are.

So, the lifetime learning credit, for example, is worth 20 percent of
tuition and fees, up to a maximum credit of \$2,000. So, you need a
tuition and fees of at least \$10,000 to get full advantage.

CHAIRMAN MACK: Do me a favor and start that over again. You lost me in
it, so \--

PROFESSOR DYNARSKI: Okay. I didn\'t get to it yet, so, you\'re not lost.
So, the top line there \--

CHAIRMAN MACK: You\'re only lost if you are lost.

PROFESSOR DYNARSKI: Exactly. You are found. The top line there is
private four year schools. And, these are real dollars, constant
dollars, so we\'ve got 1976, up to the last academic year. And, for the
private schools, that\'s what gets all the press. That tuitions are
almost \$20,000. This is tuitions and required fees, and it\'s a
doubling approximately from it\'s level in 1976.

What gets less press is the bottom two lines. The public four year
colleges, and the public two year colleges. These schools are where the
vast majority of students are. More than 80 percent of students go to
the schools on those bottom two lines which you might note are much
lower than the top line.

So, average tuition at a public four year right now and required fees,
is about \$4,700. At a two year, it\'s about \$1,900. Virtually no two
year college has tuition over \$2,000 a year.

So, the typical student is attending a school that does not have costs
high enough to obtain the highest tax benefits I\'m going to show you.
So, the tax incentive to the degree that they\'re dependent on tuition
are going to flow disproportionately to the small percentage of students
who are at the most expensive schools. Okay? So, that\'s the take home
point from this particular graph.

Okay, so let me give you an overview of what the tax expenditures for
education are. I\'m giving you the biggies, there\'s more than this,
but, I wanted to just hit the high points.

So, first there\'s a set of incentives that are focused on future
education costs. So, helping parents save for the future education costs
of their children. And, that\'s the Coverdell savings account and the
529 savings account, all these I\'m going to describe in couple of
slides here.

I\'m just giving you the amounts that are spent on them, the tax
expenditures. Together they represent about \$.5 billion right now,
going up to about 1.1 billion in 2009.

The next set of incentives are those that are intended to help with
current education costs, for families that currently have their kids
enrolled in college. That\'s the hope and lifetime learning credits,
they\'re about \$5.7 billion right now.

There\'s the personal exemption for student dependents who are age 18 to
23 that usually wouldn\'t be considered dependents, but, if they\'re in
college, they are. So, that\'s about \$2.6 billion right there. There\'s
an above the line deduction for tuition costs, about \$1.7 billion right
now, sunsetting very shortly.

And then, there\'s the exemption from taxation of employer benefits for
education. So, while you\'re working, if your employer pays for your
education, sometimes that\'s exempt from taxation.

And, the last small category is one that helps to pay for completed
education. If you took out a loan in order to get through college, you
can, if your income\'s in the right range, deduct student loan interest
from your taxable income at the federal level.

So, let\'s start with Coverdell and the 529. The Coverdell is a federal
program, Coverdell Education Savings Account, started out as the
education IRA. The 529 are state programs. You can think of both of
these programs as Roth IRA\'s for education.

So, after-tax dollars get put away and the earnings build up tax-free,
and when they\'re withdrawn, they\'re not taxed either, as long as you
spend them on education. So, that sounds just like a Roth IRA, after-tax
dollars go in, build up, draw it down, no tax if you use it for
retirement.

Earnings and withdrawals are untaxed in the case of the 529 if you use
them for college. In the case of the Coverdell, if you use them for
anywhere from kindergarten up through college. And, that Coverdell
provision is the only tax incentive that is for primary, secondary
school in the code. Everything else you\'re going to see today is for
higher education, for college.

So, until 2001, \-- 2001, the states did not tax withdrawals from the
529\'s, but the feds did. And, in 2001, the federal taxation of
withdrawals from 529\'s was eliminated. That\'s when the growth in the
529\'s took off. That\'s when you started seeing in every Sunday paper
every page of the business section was an advertisement for a 529, and
the number of accounts in the 529 programs grew quite a bit after that.

As a result, these programs are quite young. All right, the accounts are
quite young. They were established pretty much since 2001. The kids
whose college education they\'re intended for are quite young. And the
tax consequences of these programs won\'t be realized until quite a bit
in the future when they\'re drawn down.

Right now, they\'re set to sunset in 2010. If they don\'t sunset,
sometime after 2010 when those tuition bills start coming due for the
current generation of kids, you know, under five, that\'s when the tax
consequences of this program really start to kick in.

So, if you are a family trying to decide how to save for college, you
have quite an array of tax- advantaged options. So, we have the two
types of accounts I just described to you, which are formal education
savings accounts, the 529 and the Coverdell.

Or, you could save in a retirement vehicle.

You could put money away in a Roth IRA or a traditional IRA, both of
which waive penalties on early withdrawal, if you use the money for
higher education. You could take a loan from your 401(k). You could put
the money into a UTMA account, which puts the money in the kid\'s name,
and so the tax is at the kid\'s presumably lower rate.

You could put the money into EE savings bonds, or, as was discussed
earlier, you could save in your home, which is tax advantaged and draw
down the money for college through a home equity loan.

Now, there\'s quite a bit of complexity even beyond that, because the
529 is not a single choice, but, it\'s well over 100 choices. So, every
state has it\'s own 529 plan. Many of them have more than one. Arizona
and Nevada have the records, they have six each. And, a person from any
state can invest in any state\'s program. So, you\'ve got well over 100
options to choose from.

Each plan has its own application, its got its own contribution limits,
its own investment options, its own costs, which, by the way, are not
governed by SEC disclosure rules and so there\'s no set way to describe
the costs. You can\'t open up a prospectus and just quickly find what
the cost of a plan is, and so, it\'s hard to shop.

And, finally, there are different penalties from state to state for
non-educational use. So, this is an extremely complicated market.
Perhaps indicative of that is that about two-thirds of people who open
new accounts at this point are doing so through brokers, not by buying
it themselves, they\'re paying front-end loads, because they\'re paying
people to try to untangle this very complicated market for them.

So, there\'s quite a bit of variation in after-tax returns, net returns
across these different instruments. So, it matters which instrument you
actually choose to put you money away for, in which to choose, to put
the money away for your kid\'s college.

It\'s going to vary across these instruments which I\'m going to
describe to you a little bit, whether you put the money in a standard
mutual fund with no tax incentives, traditional IRA, UGMA, a 529 or a
Coverdell.

And, I\'m not going to tell you the assumptions, but, what I\'m going to
do is calculate for you what a family earns if they take a \$1,000 when
the kid\'s born, \$1,000 of pre-tax income, dump it into a savings
account, leave it there until the kid\'s 18, and start drawing it down.
They just keep reinvesting all the earnings, they pay any taxes if they
have to, kids turns 18, they start drawing it down. What do they earn on
their \$1,000 investment, what do they have to pay for college?

So, if you put the money in a standard mutual fund in the parent\'s
name, that\'s the first column on the left. You end up with about
\$2,500 minus your \$1,000 investment, your return was \$1,500. You
earned a return of \$1,500.

If you live in one of the states that lets you deduct contributions to a
529 from your state taxable income, you earn closer to \$2,000, okay?
So, that\'s, you know, 30 \-- one third increase in your return, if you
shift into that instrument.

If you\'re in one of the states, about half the states that don\'t have
such an upfront deduction, you still do pretty well, about \$1,800. And,
as you can see, I describe the ESA and the 529 and being quite similar.
They have exactly the same net return.

One thing I\'m extracting from in this set of results, here, is I\'m not
considering fees, so, as has been brought up quite a bit, the 529\'s
tend to have quite high fees. Here I\'m holding fees constant across the
different instruments.

CHAIRMAN MACK: This is an investment of a \$1,000, and what it has
earned over 18 years?

PROFESSOR DYNARSKI: Yes, net of taxes paid. So it\'s your net return on
that initial \$1,000. So, what you earned on that initial \$1,000, for a
typical family in the middle of the income distribution, this is for a
family with \$50,000 in income.

Now, this is the same story, but, now I\'m just doing it for each
bracket to show you that the value of this thing depends on your tax
bracket. So, the second set of columns is what I just showed you, but,
what I\'ve done here is normed to zero, the return on a plain vanilla
account with no tax advantages. It\'s set to one, so you can read the
differences as percent differences, percent benefits relative to
non-advantaged account. So, on the left, you have the bottom bracket.
People in that bracket, if they are in a state that has this extra
deduction, earn about 25 percent more than they would if they put the
money in a non-advantaged account. \'

Go all the way up to the top bracket, those folks earn about twice as
much as they would if they put the money in a non-advantaged account.
The benefits of this thing are much much higher at the upper end of the
income distribution then the lower end of the income distribution.

There\'s a further disincentive at the bottom of the income distribution
for investing in these things, which is that because they\'re education
savings accounts, you don\'t yield the full tax benefits if you don\'t
use them for education. That\'s obviously not true of the Roth. If you
don\'t use your Roth for the kid\'s education, you use it for retirement
later on.

You\'re pay a penalty which consists of ordinary income tax on the
earnings, plus ten percent of the earnings as a penalty if you withdraw
it for non-educational purposes. Since the tax benefits were so small at
the bottom tax bracket anyway, that erases any benefit and you\'re worse
off than if you\'d invested in a regular account.

At the top, however, the benefits are so large, that the benefits are
not erased. You\'re still getting about 20 percent more than you would
have in a regular account. In fact, the high income family who uses a
Coverdell for non-educational purposes gets a bigger bang for their buck
than a low income family who uses it for educational purposes.

Okay? So, this is not intentional, I don\'t think. But, this is an
example of a kind of perverse incentive you can end up with when you
have such a complicated code, that the code writers don\'t quite know
what incentives they\'re creating.

These are some statistics on who is investing in these accounts. In the
first column there, I have all households with kids less than 17 years
of age. Then, the next, you can see this is in 2001, about three percent
of them were invested in these accounts. The next column focuses in on
these folks. As you can see, they had considerably higher income than
typical families with children, \$91,000. Their net worth is about four
times that of other families with income. So, it\'s a pretty, it\'s a
top flight for the income distribution that\'s getting this.

So, let me turn to the other types benefits for current education costs.
The tuition tax credits, and the tuition tax deduction. And, I\'ve got
two slides of rules, and I left some rules out to simplify. We have
three different benefits that are all intended to help pay for current
college costs. They each have their own income phase out range, the
credits have one range, the deduction has another.

The credits don\'t survive the AMT, the deduction does. The marginal tax
rate of an individual tax payer does not effect the value of the credit,
because they\'re lumps, but it does increase the value of the deduction.
It increases with your marginal tax rate. The HOPE only covers the first
years of college, the lifetime learning credit (LLC) covers all levels.
You have to be at least half-time in school for HOPE, but, not for the
LLC, so forth and so on.

The bottom is the bottom line of what these things cover. The HOPE
covers 100 percent of the first \$1,000 of tuition and fees, 50 percent
to the second for maximum value of \$1,500. The LLC covers 20 percent of
the first \$10,000. So, only somebody who has tuition and fees of
\$10,000 or above get the maximum benefit. The deduction is for up to
\$4,000 from income.

The, who\'s taking these up? It\'s in the middle essentially, is who\'s
taking up these particular benefits. So, this is the tax credits alone.
And, as you can see, the high, the biggest chunk of tax expenditures at
the \$50 to \$100,000 group, \$2.55 billion, this group is 36 percent of
all credit claimants, but, just 21 percent of all households. So,
they\'re disproportionately taking it up.

They\'re also getting the largest credits because their kids are at
these most expensive schools. So, they\'re able to take it up because
they\'re within the correct income range, and also their kids have
higher costs that they can get the maximum credit.

No one\'s getting at the top because of the income cutoff, no one\'s
getting at the bottom relatively because these are non-refundable. So,
if you don\'t have tax liability, you don\'t get one.

So, who benefits from these, to summarize? The value\'s highest for the
highest income families for the savings plans, risky for the lower
income families due to penalties, and early take up\'s been concentrated
among the higher income households.

For the tax credits, the greatest benefits is to those at the most
expensive private schools, and the take up is highest in the middle and
the upper brackets. Now, we don\'t have much information at all at this
point about what impact these particular programs have on behavior.

They\'re relatively young. There\'s been one study of the impact of
credits on college-going behavior and basically found a zero impact,
with the explanation that the program is too complicated for anyone to
understand, you can\'t respond to price discount if you don\'t know
about it.

So it doesn\'t matter if college is cheap if you don\'t know it\'s
cheap. And, the program rules are complicated enough that people don\'t
actually know how cheap it can be. Further, the program\'s not currently
available to the lower brackets because of the non-refundability issue,
and that\'s where there\'s more room for response. Because, if you look
across the nation at who\'s going to college and who isn\'t, folks in
the top brackets, 90 percent of their kids are going to college. It\'s
in the bottom where we have some room for growth in our college going
rates.

For the savings plans, again, there\'s just one study at this point that
looked at the impact on savings, found very weak evidence about it, that
doesn\'t really make a strong case one way or the other. It\'s too early
to tell at this point to tell if they actually have an impact on college
going.

So, concluding thoughts on what the costs of tax complexity are in this
particular context. So, there are some taxpayers who spend a lot of time
researching the very complicated tax rules. Or, they pay somebody else
to advise them about the very complicated tax rules, and then they alter
their behavior to maximize their credits and deductions and to maximize
their asset returns.

All this time spent is a waste of social resource. People could be doing
something else rather than trying to figure out what the best 529 is for
their kid. They could be reading to their child, for example, in order
to make a, give a better chance of getting into a good school.

Other taxpayers don\'t understand the complicated rules and I would
argue that among those taxpayers might be families in which the parents
have not gone to college. Parents don\'t speak English as a first
language, they\'re not going to be able to game the system and they\'re
paying higher taxes than those who do, who have equivalent income. So,
this leads to horizontal inequities.

So, potentially, simplifying the code can have a positive impact on both
efficiency and equity. And, in particular, moving towards a more simple
code that is less open to gaming by the most informed people who
potentially have the highest incomes, you could actually the increase
the progressivity of the system in actuality, even without changing the
progressivity of it on paper.

CHAIRMAN MACK: Thank you. That was an excellent presentation. Armond?
We\'ll listen to you next.

MR. DINVERNO: Thank you. Good morning. I want to thank the panel for
inviting me to speak. It\'s an honor and a privilege to be here. I\'m
going to talk about how the tax code effects planning for individual
taxpayers.

And, I\'m one of the people that people some of the other panelists have
talked about. As an attorney and a CPA and a certified financial planner
individual taxpayers come to me to help them understand many of the
concepts we\'ve been talking about. And what we do is we help our
clients very simply look at how they can best advantage themselves from
a tax perspective in handling their finances. Just to give you a little
bit of background about our firm, we started in business in 1986. We\'re
a financial management firm mainly working with individuals, business
owners, and pension plans. We have 20 employees, and speaking to the
complexity, we have eight certified public accountants, two attorneys,
two MBA\'s and eight certified financial planners.

And, obviously the strength of our organization is understanding the
complexity that we\'re here to talk about. We have approximately \$830
million in assets that we manage for our clients.

CHAIRMAN MACK: Let me make, let me just make a comment for fun, here.

MR. DINVERNO: Sure.

CHAIRMAN MACK: There are a lot of people who would say you\'d be the
last person who would want simplify the tax code. Is that a fair \--

MR. DINVERNO: Honestly, as a taxpayer, though, and a business owner, I
think it\'s the best thing, because I think what we\'re driving for is
benefitting not only the individual taxpayer, but, our economy as a
whole. And, the simpler you make it, the more involved you\'re going to
get taxpayers and business owners into maximizing the benefits. Creating
more economic growth.

Kind of like the concept of reducing taxes and then, we actually raise
more revenue. The same thing.

CHAIRMAN MACK: Good response.

MR. DINVERNO: Sure, in our business we see that every day. Absolutely
every day. So, the first question is, I guess, how do we keep up with
the tax law changes? Well, obviously a constant amount reading and
research. There\'s specialists in our firms that are charged with
following different areas of the tax law.

You can\'t be a generalist when you\'re looking at tax law and tax
policy. We purchase specialized tax research and software. And, as you
can see, two out of every three professionals in our firm are CPA\'s
because we need experts in each of the areas we\'re looking at.

The tax code makes achieving a single objective difficult. Our charge
for our clients as Brian mentioned as well, maximizing after-tax return.
Because when you\'re handling your finances, if you\'ve got a cost of
those finances, and we look at taxes as a cost, our job is to maximize
after-tax returns. We want to minimize the cost of taxes.

Unfortunately all the rules that are in place today make that very
difficult. And, as you look at it, let\'s just take a new client that
comes to us. There\'s a number of issues that we have to address first
before we even get started. Because we need the background and
understanding of that taxpayer.

We need to know their family tax filing status, the number of exemptions
they may have. Their amount and sources of income, because as was
mentioned, income from different places has different tax aspects to it.
So, is it Social Security income, is it retirement income, is it
interest or dividend income, is it wage income?

The nature and amount of their current financial assets. Do they have
investments in taxable accounts? Or, are they in tax deferred accounts,
IRA accounts, pension plans, 401(k)s? Because, and I\'ll talk a little
bit about this later, the aspect of where the finances are held has a
definite impact on the tax of that account.

Do they have, what kind of real estate do they own? Do they have
mortgage debt? Do they have equity lines of credit? Do they have rental
properties. And, it\'s the interplay among all of these things that is
the bottom line. And so, when we look at an individual we say, how do we
maximize with all these moving parts, the after-tax impact to our
client.

Additional planning considerations, these are just very practical
examples of someone who\'s worked close to 25 years with individual
taxpayers. Let\'s talk about asset placement. It\'s a simple concept of
looking at do we have the right investments in the right kinds of
accounts?

And so we look at are we maximizing tax deferred growth. Is it the best
place for a taxpayer to maximize growth in a 401-K plan, and IRA, a Roth
IRA, profit sharing plan, an age-weighted plan, or a defined benefit
plan?

You know, which, because some of the rules have changes and if you\'re a
certain taxpayer in a certain space, one of those is going to benefit
you more than the other. And so, that\'s what we look at in terms of
advising our clients.

Asset placement also involves where you put your assets. If you\'ve got
a taxable account versus a tax deferred account, it may make sense to
own certain kinds of investments in a taxable account, as opposed to a
tax deferred account. Because if you want capital gain assets, the lower
capital gains rate, you\'re going to want to own those generally
speaking in a taxable account.

If you\'ve got higher yielding or high income assets you\'re going to
own those in tax deferred accounts, because you don\'t want to pay
income tax annually at ordinary rates. So, asset placement is very basic
planning consideration when we\'re looking at how to maximize after-tax
returns.

Another very straight forward concept is tax loss harvesting. Are we
using losses on investments that aren\'t doing well and using those
losses up against investments that have done well?

So, in other words, if a taxpayer is going to sell a capital asset and
realize a capital gain, what they ought to do is look through all their
other holdings, investments and assets to see if there are other assets
that they could sell at capital loss to match losses with gains.

And when you\'ve got, most taxpayers have multiple accounts in multiple
places, different kinds of assets, it becomes very tricky to figure out
where are my losses and where are my gains, and I need to match them in
the same calendar year. But, that\'s an excellent opportunity to, that
we use to maximize after-tax return.

This chart is just an example of different tax treatment for investment
alternatives. On the left you have, and I\'m not going to go through all
of them, but, different types of investments in different tax advantaged
accounts.

Bonds, stocks, municipal bonds, taxable bonds, and you\'ve got Roth
IRA\'s, IRA\'s, 401(k)s. And, each of those has a different tax
treatment for the way money\'s contributed to it, how it\'s taxed
annually, and how it\'s taxed at sales and withdrawals.

And so, the taxpayer needs to understand, okay, it may make sense to
contribute money to one of those alternatives, but, on the withdrawal
end, it may make sense to be doing something else. And, it becomes very
complicated for taxpayers to try and understand that.

So, how do they navigate this complexity. You know, how do we help them
with the different tax rates, tax treatment and favored tax status? How
do they choose which is the best after-tax return.

Another complexity is the various sunset provisions. Taxpayers are truly
challenged to plan for the future. When you know certain laws that we
have in effect will expire, or, they may get extended, and it\'s an
ongoing challenge to know will this law be in existence five years from
now? Well, maybe I ought to pay taxes today because it may change in the
future, or, maybe rates will go up. So, they are constantly reacting to
the unknown. Very much making not necessarily wise economic choices,
because of the unknown.

For example, let\'s say a taxpayer has an additional \$250 that they
want to save. And so, here are just some of their choices. Should they
apply it to their mortgage, where the interest is deductible? Should
they apply it to credit card debt, where the interest is not deductible.
Should they save it in their 401(k) plan?

What I hear often with 401(k) plans is, well, only contribute up to the
match. That doesn\'t really make sense from an economic standpoint. You
should want to contribute and build for retirement beyond the match.

Should I contribute it to an IRA or a Roth IRA? Would you want to save
in a college 529 plan? And, as Susan said, there\'s over 100 of those,
with each state having different tax benefits to that, another extremely
complex area. Should you invest it in a taxable account? Not even put it
in a deferred account?

And oftentimes the easiest solution, generally not the best, is just to
spend it. Taxpayers throw their hands up, they say, well, whatever, and
it\'s gone. And, I don\'t think that accomplishes anything that any of
us want in terms of building for the future.

Common mistakes taxpayers make. Due to the complexity and taxpayers
trying to navigate through that complexity, some of the things that we
see every day, they don\'t save enough for retirement, because they
don\'t know where to save. Very simple concept. If it\'s not simple and
straightforward, they\'re not going to know how to do it.

Using municipal bonds in a taxable account. Individual taxpayers don\'t
even do some of those very simple things. The number of college savings
plans. What we see often is taxpayers letting the tax tail wag the dog.
In other words, they\'re trying to make an economic decision, and trying
to make a good economic decision, but, they don\'t because the tax tail
is wagging the dog.

Oftentimes they won\'t sell assets for fear of paying taxes when sound
economics would dictate a sale. A great example of this is low cost
basis stock, where clients hold onto a security that they\'ve maybe
owned for 20 years, sound investment and diversification principles
would encourage a sale, but, they won\'t sell because of the tax
implications.

Other common mistakes and I won\'t go through all of these. I\'ll just
mention a couple of them and ones that we see often, where there\'s
extreme complexities. Additional taxes paid by taxpayers where they
aren\'t able to increase their cost basis with mutual fund dividend
reinvestments. If you\'ve owned a mutual fund for 10 or 15 years, every
year there\'s reinvestments, those should be added to your cost basis.

Failing to name or naming the wrong beneficiary to an IRA. IRA
beneficiary is a very complex area. I mean, there\'s very important tax
aspects to it. One of the \-- we talked a little bit about short term
debt and home equity lines of credit. We see converting short term debt
into long term debt. Where taxpayers are buying furniture as mentioned,
and things like that, and putting on a long-term debt program, when
really that should be a short term. And, the interest cost to that,
although they\'re deductible, really raises the cost of that overall
acquisition to them.

Concluding, the time and money spent on figuring out the tax code could
more productively be used by taxpayers, making their life simpler.
Simpler taxes and an easier application of the tax law will help
taxpayers make better economic decisions, that\'s what we\'re all after.
And, better economic decisions will continue to maintain the economic
growth engine of the United States. Thank you very much.

CHAIRMAN MACK: Armond, thank you very much for your comments this
morning.

MR. DINVERNO: Sure.

CHAIRMAN MACK: Senator Breaux?

VICE-CHAIRMAN BREAUX: Thank you very much, Mr. Chairman, and thank all
the panel members for a real good discussion on the complexity of the
code. Mr. Diverno, we\'re trying to put you out of business. When we
have a real simple tax code, they won\'t need you.

MR. DINVERNO: I don\'t really think so, actually. Because I think that
\--

VICE-CHAIRMAN BREAUX: Never get it that simple, huh?

MR. DINVERNO: Well, I guess that would be the challenge to the panel,
could you get it that simple? But, from an investment perspective and
helping our clients with their finances, send their children to college,
save for retirement, there\'s whole aspect of investment that we
haven\'t talked about that are equally as complex as the tax law.

VICE-CHAIRMAN BREAUX: I was just telling Jim, I was just showing him my
wife and I met with tax consultants just last week. I mean, here I am on
the tax simplification panel, I spent 18 years on the Senate Finance
Committee and I had to go get this entire book from, I won\'t mention
their names, but, the consulting group to tell me what to do.

I mean, it\'s, you know, if I\'m doing that, I can imagine how difficult
it is for someone who\'s middle income trying to struggle to pay the
mortgage, trying to figure out what to do. And, I mean, you all made the
point, when it comes to savings, our savings rate is deplorable. And, I
think one of the reasons it has to be is, they don\'t know where to go.

I mean, if you\'re looking at all the alternatives, IRA\'s, Roth IRA\'s,
KEOGH\'s, 401(k)s, 529\'s, life insurance plans, pension plans, I would
imagine that person who could not afford someone like you or a real tax
expert, they\'d say look, it\'s just too complicated, I\'m going give up
and I\'ll just go out and spend it.

I guess a general question, whoever wants to take it is, should the tax
code determine investment and savings decisions? Or, should we just have
a code that doesn\'t give preferences to anything? Should we have a code
that just says you\'re going to make the best economic decision that\'s
best for you, and not what is best for the tax code?

I mean, if we just had a code that didn\'t encourage anything, savings,
charitable giving, education, health care. Just have a tax code, you
make this, you\'re going to send this to the federal government and
other decisions will not be influenced by the tax code.

Investment decisions will be made, not because of the tax code, but,
they\'ll be based on the character of the investment. Is that a general
goal, or, do we have to have some complications because of what we want
to encourage in society? Anybody.

PROFESSOR KENNEDY: I\'ll take that on. Yes, I do. I think you have to
encourage long-term savings for retirement, especially in light of
Social Security which was intended to be a defined benefit safety net.
If that\'s the case, then, we\'re relying on employers and individual
employees to save long-term for their retirement. Without incentives, I
think it\'s very difficult to save strictly for retirement and not take
advantage of those funds and pull them out when you need them, and then,
not have them available for retirement.

MR. WESBURY: Just to follow up on Kathryn\'s comment, our code right now
is biased against savings. Savings are double taxed, you could make the
case they are even triple taxed on occasion. And, just leveling the
playing field between consumption \--

VICE-CHAIRMAN BREAUX: The health savings account is not that we just
passed last year, though.

MR. WESBURY: Right, but in terms of a dividend, once the corporation
will pay taxes, you pay income taxes once you save, you\'re paying taxes
again on interest. You know, so, there are layers of taxation on savings
which encourage, it makes current consumption cheaper than future
consumption, is the bottom line. You\'ve heard that in front of this
panel before, I believe in your second meeting in Washington D.C.

I go so far as to say that\'s one of the things that encourages our
trade deficit to be as large as it is. In other words, we are not saving
as much, we\'re consuming more. And, part of that consumption is
imports. And so, clearly one of the problems that we hear people talk
about all the time, has at least some impact from the tax code and it\'s
because of this different treatment of savings and consumption.

CHAIRMAN MACK: Thank you. Anybody else.

MR. MURIS: Let me turn to education for a question. Given the various
goals that we have, do you have ideas for simplification or at least
principles to guide us?

PROFESSOR DYNARSKI: I would suggest taking the three subsidies to
current college costs, the two different credits and the deduction and
collapsing them into some sort of super-credit. So, there\'s just one
credit, it\'s got a single definition for what higher education expenses
are. The simpler, the better, essentially.

So, there\'s extensive evidence at this point that very simple programs
to subsidize college costs can change behavior. And, there\'s basically
no evidence that complicated subsidies will change behavior.

For example, the need-based aid program, which I didn\'t even talk about
today, but which intersects with the tax program as well. So, the 529\'s
and the Coverdell\'s, for example, enter into how the Department of
Education determines how much financial aid you get. So, that\'s two
very complicated programs intersecting with each other in sometimes very
perverse ways.

The collapsing into a single credit and making it refundable, I would
say would be the best thing to do. So, you want something that you can
describe in a line to an 18 year old and his family and they can
understand it. So, if you go to college, you will get \$2,000 which is
the cost of going to a community college, for example. And, you just
know you have that. And, that\'s that.

That might be done by combining the spending side. You know, so, we\'ve
got the Pell Grants, which are several billion dollars on their own, and
then we\'ve got these tax credits. And, putting it all together into a
very simple system that just says, when you get to 18, you\'ve got this
guaranteed amount of money that would cover community college, I think
that would go pretty far.

The empirical evidence indicates that something simple that people can
understand in a line, can actually have a real impact on their behavior.

MR. WESBURY: Can I follow up? Dr. Heckman said today that our
progressive tax code actually discourages investment in education as
well. So, if you\'re going to talk about investment you have to think
about the incentive effects of the income tax system.

MR. POTERBA: There\'s a tension that I hope some of you can help us sort
through. Brian, you said that we do double tax savings at the moment,
yet, there are many programs as each of you have mentioned where we in
fact do not do that at the moment. Where we provide opportunities to
save so that the investors, the savers can earn the pre-tax rate of
return.

Some might argue that if there is enormous pent up demand for additional
saving, that we would expect to see lots of people taking advantage of
these programs, up to the maximum, stuck at the constraints, and
therefore, you know, that sort of moving towards even more opportunities
for this kind of saving would bring forth additional savings dollars.

What I\'m hearing from various comments all of you have made is that
there\'s a lot of complexity, confusion, and that maybe even if we
don\'t see people taking advantage of these programs today, that if
there were something simpler where they understood that the tax system
rewarded them for saving and not for consuming today, that they would,
in fact, be inclined to take advantage of these programs to a greater
extent.

This is an argument, by the way, which is not in the standard economists
toolkit on this, because we\'re accustomed to thinking people just look
at these after-tax rates of return, and do all the things that they can
that earn high rates of return first, and then, move down to the lower
opportunities next.

Would any of you want to sort of push in this direction that said,
leaving aside just the question of who\'s at the max already, we might
get more saving if we did something simpler, or should I think of it in
a different way?

PROFESSOR KENNEDY: Well, I\'d like to respond to that just in the
context of if an employee is offered a 401(k) through their employer,
the Employee Benefit Research Institute just got done doing a study, and
they found for the employee between \$30,000 and \$50,000. So we\'re not
talking about a high pay. Okay -? they\'re 11 times more likely to save
under that plan, than if you don\'t offer a plan, and all they have is a
traditional IRA. So, they are working. They just have to make simpler.

MR. POTERBA: Those are often matched 401(k)s?

PROFESSOR KENNEDY: Correct.

MR. POTERBA: Return on the 401(k)s are a lot higher than the return on
an IRA in some cases, right?

PROFESSOR KENNEDY: Yes. Well, the individual IRA you have to invest
yourself.

MR. POTERBA: Right.

PROFESSOR KENNEDY: You pay the fees yourself. Under the 401(k), usually
there\'s an institutional investor, and usually the employer picks up
the fees.

PROFESSOR DYNARKSI: We also have evidence that, for instance, making it
simple to save, by, for instance, for employees making it the default
that they invest in their 401(k) has a huge impact on behavior. So, how
the rules are applied makes a huge difference. And, as I said before, if
somebody doesn\'t know the price, if somebody doesn\'t know the
benefits, they can\'t respond to it. So, simplification in this area I
think potentially could increase savings and potentially increase the
impact of the programs that we have in place that are trying to
encourage going to college, having a home. Simplifying all of those
things even in a distributionally neutral way could actually have a
bigger impact on behavior.

PROFESSOR KENNEDY: And, I\'d just like to supplement that. With 401(k),
only about eight percent of the plans have what\'s called automatic
enrollment, where we enroll you in the plan with a automatic three
percent deferral and we\'ll match it.

Why is there such a low percentage even though it shows that
behaviorally people do save more? There\'s a lot of unanswered questions
under ERISA which makes it very difficult for an employer to decide
whether I\'m going to do that or not. Those are simple changes that
could easily be made to ERISA. And, as Susan said, have a dramatic
impact on behavior.

MR. DINVERNO: I don\'t think there\'s any doubt that the simpler, the
more people will be involved. I think the success of 401(k) plans is an
example, because the employer provides that plan, builds it and then
serves it up to the employee and says, here it is, here are your choices
and you get that participation the more straightforward it is.

For example, if you have, let\'s say, 10 choices in a 401(k) plan, as
opposed to 40 or 50, makes it very challenging when you have that
complexity for taxpayers to decide. I mean, we see our clients and
taxpayers reacting every day to the complexity. And, whenever it\'s
simpler, even if we\'re trying to devise a strategy for them, if we
can\'t get across the simplicity of the strategy, they just don\'t get
it. And, therefore, not likely to go with it, and embrace it. And, the
easier that they can embrace it, I think the more successful any change
in policy will be.

CHAIRMAN MACK: I think you\'re exactly right on that. And, let me maybe
pick up on that point to make maybe an embarrassing admission, that my
wife and I, who we have five grandchildren, the two youngest are four
and two. And, we have been talking for the last four years about how
we\'re going to set up some special education account for our
grandchildren.

And, it\'s four years later and there is no account, because every time
we get into the discussion, all of these, this host of choices rose out
in front of us. And, I then take the information back to Priscilla and
say well, this is what I think, this is what, we put it off.

And, I think it is just very natural behavior that takes over. Kathryn,
you mentioned something about ERISA. And I want to try to figure out how
much of making things simpler would be done in the tax code versus
amendments to ERISA?

PROFESSOR KENNEDY: Well, in the pension area, you\'d have to make
amendments in both. In healthcare, you\'d probably only have to make
changes in ERISA.

CHAIRMAN MACK: Okay. And, a general question, I, you know, we\'ve heard,
we\'ve had more focus today on the education, medical and savings
account incentives and the numbers of different plans and the
qualifications and the definitions and all of that.

But, I don\'t know that I can speak for all nine of us, but, there is a
sense that, we ought to just go back to a notion that says, if you save,
you don\'t pay tax on it. And, not try to determine what you save it
for, how you can spend it, when you spend it and so forth.

Now, that\'s a lead in to kind of ask you all, in a sense, you kind of
represent a perspective, or a point of view. You know, healthcare and
retirement saving, educational and the other. How do you react to that
kind of notion that we ought to in essence, establish one kind of
savings accounts that is tax free and let it go at that?

PROFESSOR KENNEDY: I guess I would echo my thoughts that I voiced
earlier that unless there are some restrictions put on the access of
those accounts, they won\'t be available for retirement. They will have
been consumed prior to retirement, which means the individual is going
to have to keep on working, or, have greater reliance on Social
Security, which I don\'t think was its intent.

CHAIRMAN MACK: So, basically, your response would be, I think it\'s a
great idea to maybe eliminate taxes on interest, but, you\'ve got to put
some restriction on there with respect to use if you want to have people
save for retirement, you have to state that.

PROFESSOR KENNEDY: Yes.

CHAIRMAN MACK: And, I would suspect, I don\'t want to put words into
your mouth, Susan, that you would probably say well, I think that
there\'s a component that needs to be there for education. But, anyway,
give me your \--

PROFESSOR DYNARKSI: I mean, the sort of classical economics would say,
you know, let people have full freedom to do what they want with the
money, right? But, a growing field of economics would say that sort of
mental accounts, having an account that commits you to saving for
college, or saving for retirement can have a substantial impact on
behavior. You know, that you won\'t touch it because it\'s there for
retirement. So, I guess I would agree that if we want to get people to
actually put the money away and keep it for retirement or for college,
some sort of commitment device is helpful, whether that be a penalty, or
whatever. But, the penalty can be relatively simple.

CHAIRMAN MACK: Right.

MR. WESBURY: And, Senator Mack, I was going to come back to you and to
Jim\'s questions and that is that these programs do exist. Now, one of
the problems we have with savings is, we look at this BEA estimate of
savings which is not really a good estimate of savings in the United
States.

And, the Roth IRA\'s and the IRA\'s have been a huge success. Billions
and billions of dollars have poured into them. We don\'t really measure
very well from a macro point of view. But, the other thing that\'s an
issue with these are the limits on them. So, there are a number of
people that don\'t take advantage of this and are forced to save other
ways, and this is part of the complication when you\'re cut off and so,
I would say that, in fact, savings has gone up because of these vehicles
and changing the tax treatment of savings would be a perfect example.

Susan\'s chart showing who took advantage of 529\'s was dramatic. And,
what it said to me was, everyone figures out these incentives, whether
it\'s with Armond\'s help or not.

CHAIRMAN MACK: Well, I haven\'t, yet.

MR. WESBURY: Yeah.

MR. DINVERNO: I can help.

MR. WESBURY: And, they figured it out, and they know where the best
benefits are, the largest after-tax rewards are and those are the people
that are piling into those things. And so, I think these changes would
have an immediate and dramatic impact, just like the changes in 2003 had
on investment. Just like the changes in 1997 had on investment in
housing as well.

CHAIRMAN MACK: Brian, I have one more question to raise, and you and I
have probably talked about this over the years. But, I couldn\'t help
but, your comment with respect to the tax code today encourages
consumption versus savings, which could or could not be effecting the
trade balance \--

MR. WESBURY: Right.

CHAIRMAN MACK: But, it\'s a reasonable argument to make, I guess, if
consumption is

increasing \--

MR. WESBURY: Right.

CHAIRMAN MACK: \-- we\'re going to be buying more from abroad. But,
here\'s the thrust of my question, though. Because we on this panel are
at some point going to have to address this issue of, should there be an
income tax base, or should there be a consumption base for taxation, or
some, you know, combination thereof.

MR. WESBURY: Right.

CHAIRMAN MACK: Which raises the question that I have, is that, could we
end up shifting more of the tax on consumption that you do, in fact,
reduce demand. And, what happens, then.

MR. WESBURY: Right. There\'s lot\'s of moving pieces to this, but, let
me start out by saying that I believe that really taxing income and
consumption, if you\'re talking about a flat tax, there\'s really no
difference in the end. And, let me get there by

saying \--

CHAIRMAN MACK: Well, you\'re making an assumption, you don\'t pay tax on
any saving or investment.

MR. WESBURY: Right, that\'s the point, so, in other words the reason I
work is to consume, whether now or in my retirement. So, whether you tax
my consumption over my lifetime, or, you take my income, it\'s all the
same to me in a sense. If it\'s both 20 percent, 30 percent, whatever
the tax rate is, I still consume 80 cents out of every dollar, or 70
cents, as long as a flat tax.

What I would propose is that we really work within our existing
structure, but, exempt more and more of our investment and savings from
taxation. And, one of the key reasons that I believe that is that,
imagine if you had worked all your life up to this point.

The day that we\'re going to shift to a retail sales tax on a nationwide
basis, and you\'ve paid taxes your entire life, and now, you\'re
retiring. You\'re going to now spend what you\'ve saved and you\'re
going to have to pay taxes again.

And so, in other words, there\'s a generational pain that is in fact
taxing, in many cases dollars twice during someone\'s lifetime, because
we changed the focus of the tax code.

Now, there\'s lots of money put away in retirement accounts which
haven\'t been taxed, which in fact, if you shifted to a consumption tax
would avoid this problem of double taxation during a lifetime. But,
there\'s lots of monies that haven\'t. And, as a result, I think that
the cost of shifting to a national sales tax is too high, because of the
generational issues.

CHAIRMAN MACK: But, setting the generational issue aside again, this
issue of, can we, could we come up with a tax change that would tax
consumption too much that would have a dramatic effect on demand.

MR. WESBURY: I don\'t think so. Well, the issue right now is that it\'s
not that consumption is undertaxed. It\'s that savings is overtaxed.
And, all you would be doing is reducing, by moving toward a more
consumption based tax system, reducing the tax on savings and no longer
penalizing it. You would not increase the tax on consumption by doing
that.

CHAIRMAN MACK: Okay. All right. I think we\'ve run a little bit over on
our time. I think we\'ll take a break and can we get back in here by \--
we\'re having a little caucus here, among the \--

I think at this point, let us say, thank you all very much while we
caucus and figure out whether we go right to the next panel or whether
we go take a lunch break or not. Thank you all again, very much. And, I
might take you up on that 529.

Well, the decision, the first and hopefully not the last unanimous
decision by the panel is that we\'ll just go ahead and move forward and
take our next two witnesses and we\'ll finish early as a result of that.
We\'ll take a biological break for a moment.

(Off the record.)

CHAIRMAN MACK: Robert, why don\'t we go ahead and start with you.

PROFESSOR MC DONALD: Okay. Thank you very much. Well, it\'s an honor to
have the opportunity to address this distinguished panel on the subject
of the taxation of financial instruments. And, I think it goes without
saying that this is a very complicated subject.

And, in part, this complexity stems from the fact that the tax code
draws distinctions that are not economically meaningful. And, that\'s
the, what I\'ll be discussing in my testimony.

So, the things I\'m going to talk about, I\'ll first discuss the
distinctions in the tax code that deal with different kinds of financial
income, and different kinds of financial instruments.

And, I will also then talk about the role of dealers in blurring these
distinctions. And, talk about the prevalence and growth of derivatives
which are an instrument that have also contributed to blurring these
distinctions.

And, I will show how the derivatives market has grown and provide some
examples of transactions that exploit this blurred line between debt and
equity. And, finally, I\'ll touch on the complexity of the rules and my
fellow panelist David Weisbach will elaborate on some of these themes.

So, with respect to distinctions in the tax code, the code draws a
distinction between debt and equity as financial instruments, as the
code also distinguishes among interest, dividends and capital gains as
forms of income.

The distinction between debt and equity may seem clear at first blush,
but, there are well known and long-standing instances where it\'s hard
to draw a distinction. So, junk bonds and convertible bonds are two
examples of instruments that can be thought of as either debt or equity.

And, as for distinctions among kinds of income, interest, dividends and
capital gains are all forms of income that you receive for an
investment. And, apart from their tax treatment, sophisticated investors
will regard them as interchangeable, and won\'t make the same
distinctions the tax code makes.

So, derivatives further blur the distinction. So, the term financial
derivatives describes a general category of financial instruments that
can resemble debt, could resemble equity, could resemble neither.
Derivatives are financial claims that have a payoff determined by the
price of some other asset.

Although many consider derivatives to be arcane, they\'re, in fact,
quite common. Automobile insurance is an example of a derivative. It\'s
an instrument that has a payoff, it depends upon the value of your car.
If you put it into a tree, then your auto insurance pays off.
Derivatives can seem complicated, but, there\'s a well understood
technology for pricing and creating them, and they\'re very common.

So, what is it that dealers do? Well, securities dealers make markets
and financial instruments including derivatives. They stand ready to buy
when customers want to sell, and sell when customers want to buy. Among
the derivative instruments in which they trade are forward contracts,
options and swaps.

A forward contract is simply an agreement made today to buy or sell in
the future at a price that\'s fixed today. Swaps are multi-period
forward contracts. Call options and put options accounts are somewhat
like forward contracts in that they\'re agreements today about the fixed
price for a transaction in the future, but, they differ in that they
allow the buyer of the option to walk away if they decide not to
undertake the transaction.

Dealer activity in the markets for forwards options and swaps leaves
dealers exposed to price risk, and dealers generally hedge this exposure
by taking an offsetting position. So, that is, they take a position
where they make money if their position with the customers loses money.

So, just to see an example of how dealer operate, and I should say the
point of this example is to illustrate, again, the blurring of the
distinction between different forms of financial assets. Suppose that
you have a customer who owns shares that are worth \$100 and wants to
sell them five years hence at a guaranteed price of \$125.

So, what the dealer will do, is serve as a counter party, and, they\'ll
agree to buy shares in five years for \$125. So that exposes the dealer
to the risk that the shares will be worth less than \$125 in five years.
So, to hedge the risk, the dealer borrows shares from some other
investor, and puts the, sells them and puts the money in bonds.

The dealer is obliged to return the shares in the future. If the share
price goes down, the dealer can buy the shares back cheaply and then
makes money on the short sale, and that offsets the loss on the
agreement with the customer.

So this example both illustrates how dealers operate, and, it also
illustrates an important point about the malleability of assets. The
dealer has taken positions in assets that appear very different from a
tax perspective, namely forward contracts, bonds and stocks, and
combined them to create a risk-free position.

So, the net result is, with the help of the dealer, the customers
converted their share position into the economic equivalent of a bond, a
certain return in five years. The dealer has no price risk. And this
particular transaction would be deemed a sale, under a 1997 change to
the tax law, but it turns out they\'re close variants, and I\'ll discuss
later where the customer retains some small amount of risk and can defer
the capital gains tax.

So, the problem we heard about in the last panel, where customers do not
sell because they don\'t want to pay the tax on an asset is not a
problem if you\'re wealthy enough to afford the services of an
investment bank.

So, the transaction I just discussed was a very simple example of dealer
activity. It turns out dealer can create instruments far more
sophisticated then the forward contract I discussed by using a financial
technology that was developed in the early 1970\'s by Fisher Black,
Myron Scholes and Robert Merton. As a matter of course, dealers trade
stocks and bonds to hedge positions in forwards options, swaps, and they
can also create synthetic stocks and bonds. And, an important tax code
feature that supports dealer activity is the dealer\'s market to market,
and all financial income is ordinary income.

So, distinctions in tax code between kinds of income are mute for
dealers except to the extent that customers care about these
distinctions. Virtually all derivatives are hedged by dealers being long
in some asset and short in some other asset.

So, you have a system where dealers don\'t care about kinds of income,
customers do care. And a system where you have that distinction is
begging for transactions that exploit those kinds of differences.

So, the effects of the technology are that the traditional distinctions
between debt and equity and types of financial income are hard to
identify and support. And, it\'s important to note that the market for
derivatives had grown tremendously in the last 30 years. And, this chart
will illustrate some of the recent growth. So, I have information from
the Swap Dealers Association and from the Chicago Board of Options
Exchange illustrating that, especially, since the early 1990\'s there
has just been a tremendous growth in the quantity of derivatives.

Now, to get back to the distinction between debt and equity, the two
graphs here show how people typically think of debt and equity. So, the
graph on the left shows the payoff for a claim that varies with the
stock price. So, the higher the stock price, the more the claim is
worth.

The payoff on, the graph on the right shows a payoff that\'s fixed as
the stock price varies. So, most people would think of the payoff on the
left as equity, the payoff on the right as debt. But, the problem is
that it\'s easy for dealers to construct hybrid instruments.

So, if you look at picture like these, what are they? How do you decide
what they are? If you thought you could identify debt and equity in the
previous slide, you can only guess what these pictures show.

So, both payoffs are, in fact, common in practice. I\'ll refer to the
payoff on the left as a DECS style payoff and that on the right at a
collar style payoff. And, DECS stands for Debt Exchangeable for Common
Stock. Dealers love acronyms.

The important point here is that depending upon circumstances, either
payoff could be taxed as either debt or equity. So, it simply depends
upon how you arrive at the particular position. And, it could be a
single financial instrument, or, it could be a combination of financial
instruments.

As an example, I mentioned individual capital gains deferrals. Suppose
you have a wealthy investor with a billion dollars in appreciated stock.
So, this investor wants to sell, doesn\'t want to pay the capital gains
tax.

So, what the investor can do is take on a position called a collar. So,
the investor enters into an agreement with the dealer, where in five
years, the investor has the right to sell the stock for a billion
dollars to the dealer, if the stock is worth less than a billion
dollars.

If the stock is worth more than \$1 3/4 billion, the dealer, the
investor has the obligation to sell the stock to the dealer for that
price. And, in the middle between a billion dollars and billion and
three quarters, the investor retains the risk.

So, you have a situation in where the investor is protected against
losses, gives up gains above a certain level. But, capital gains on the
position are deferred for at least three to five years, and, can often
be deferred past that point.

So, this entering into the collar is not a taxable transaction. And, the
position itself, that the investor is left with, could actually be a
position that\'s equivalent to bonds and stocks, so, if you were to
deconstruct it, you might say that the investor had a position that was
like, three quarters debt and a quarter equity, and yet the investor
pays no taxes on the position until they eventually unwind the entire
thing.

Corporations can do the same thing. There\'s one well-known transaction
in which Times-Mirror Corporation basically created a collar by selling
a DECS-like note that had a principal payment linked to the price of
Netscape stock. That had an appreciated position in Netscape stock. They
were able to defer tax on about \$75 million of capital gains.

It\'s common for firms to issue DECS-like securities and deduct the
interest. So, if you thought the position that I called a DECS-style
payoff resembled equity, you can create variants of this in which
you\'re able to deduct interest payments on the debt underlying that
position. So, it really isn\'t clear whether you have debt or equity.

So, in the end, there are numerous rules for, that have been designed
and added to the tax code in an attempt to stop egregious abuses of the
tax code. And, some of the examples include having, if you have a
position that looks like a bond, it should be taxed as interest.

If you have a bond that doesn\'t pay explicit interest, it should be
taxed as if it does pay explicit interest. A completely hedged position
is deemed to have been sold. Hedging stops the capital gains holding
period. Futures contracts get their own special tax rules.

David Weisbach will talk about some of these, some more of these rules.
But, the point is, the reason you have all of these rules, is that the
tax law is trying to draw distinctions that make no economic sense. So,
as taxpayers find ways to exploit the rules, you need special changes to
the rule in order to offset those transactions that taxpayers have done.

So, there are proposals such as a consumption tax that eliminate the
issues that I\'ve raised. But, what seems clear is that piecemeal
reforms don\'t seem likely to stop the kinds of unfairness and, in the
tax system and compromising the ability to raise revenue. So, I
appreciate your willingness to sort through all of these difficult
issues. And, thank you.

CHAIRMAN MACK: Thank you. David?

PROFESSOR WEISBACH: Thank you for inviting me to testify. I very much
appreciate the opportunity. I\'m going to basically continue where Bob
left off. I\'ll make three points. One is about the growth in financial
markets.

And, Bob actually talked about that, so, I\'ll just go over that very
quickly and talk about the incoherent scheme of taxation that we use to
tax these things and some of the piecemeal attempts we have to modernize
our tax system, to deal with it. And, then talk about the increasing
sophistication of taxpayers and their willingness to use financial
instruments taxable income.

Okay. So, Bob actually covered this, which is financial instruments are
a means of moving risk and return around the economy, allocating them to
people who can best bear those risks. I guess a couple points to mention
on this.

First is that in thinking about taxation of financial instruments, it\'s
very important to recognize how important they are to the economy,
because you want to get these things right, not only for the tax system,
but, also for encouraging and allowing financial innovation.

Perhaps the best example of this is the bankruptcy of Enron. You might
think that Enron\'s bankruptcy was, in part, caused by financial
instruments, but, what is important about it is a dog that didn\'t bark.
Which is when Enron went bankrupt, we didn\'t see massive problems in
the financial market themselves.

And, that\'s because the dealers and other people holding risks in Enron
were able to lay them off efficiently into the market. And so, the dog
didn\'t bark in Enron, and it\'s a great example of the importance of
new financial instruments to our economy.

The other important point I\'d like to make about the market as a whole,
is the fourth to the bottom, last to the bottom point there, which is
used by not only Wall Street, but by individuals as well.

Thanks to modern financial markets, each of us now has access to a
global revolving credit facility. And, it\'s all in your pocket. It\'s
called a credit card. All right, and without modern financial markets,
we wouldn\'t have the access to that kind of credit that we have today.

In thinking about the tax problems with the financial instruments, I
want to highlight three of them. The first is inconsistency, the second
is asymmetry and the third is indeterminacy.

So, think of inconsistency as the same economic position being taxed
differently depending on it\'s form. Or, you might say, similar but not
exactly the same thing is almost identical economic positions being
taxed differently depending on which side of the line they fall on.

They are debt or equity, depending on which side of the line they fall
on, can be taxed quite differently. The inconsistency in the tax law, in
the taxation of financial instruments stems from the basic distinctions
we have in the tax law.

Things like the realization rule for recognition of gain or loss. The
difference between ordinary income and capital gain. Between debt and
equity. Between U.S. source and foreign source. Between passive income
and non-passive income.

There are hundreds of these types of distinctions in the tax law. And,
these things are what drive the ultimate inconsistencies in financial
instruments.

The reason why, is because almost any kind of cash flow can be
financialized. So, we can take an asset like, Bob used cars, and we can
financialize it in terms of auto insurance, or, automobile lease
receivables. And, once you financialize it, you often get a quite
distinct tax treatment than holding the underlying asset directly. Or,
if you financialize it in a different way, you get a different tax
treatment.

And what that means is financial instruments make cash out of these
basic core distinctions in the tax law. And, there\'s essentially no way
to tax financial instruments coherently and retain these core
distinctions.

And, the problems with inconsistency are, it creates opportunities for
taxpayers to exploit them, and it creates pitfalls for taxpayers who
simply want to pay their tax and go on with their life. Because
depending on which way they do a transaction, they can be taxed quite
differently.

And, here\'s an example of an inconsistency. And, it\'s important in
thinking about this example to note that it\'s just one example, and
there are hundreds of these things. So, we can talk about how to fix
this example, but, that\'s not really the point at all. The point is
that there are hundreds of these. This is a typical one.

So, it\'s quite similar to the one that Bob talked about, which is, you
can create synthetic debt. So you can actually lend money and have real
debt. You can do the same thing using financial instruments and get the
same type of cash flow and have it be taxed quite differently.

So, one simple way to do it is simply to buy an asset, say, a share of
stock, or some other tradeable asset and agree to sell it at a fixed
price on a fixed date in the future. So, an the example of that, we buy
an asset for \$100, and agree to sell it in one year for \$110. That\'s
the same thing as lending \$100 at a 10 percent rate of interest. You
have exactly the same returns, exactly the same risk. And, therefore
you\'ve achieved synthetic lending, by buying and selling assets.

It\'s not taxed the same as lending. When you buy and sell the asset,
you buy an asset, you get tax basis, and when you sell it, you\'re going
to have \$10 of capital gain on that sale. Had you lent money in exactly
the same way, lending money, \$100 at 10 percent interest rate, you
would have had \$10 of interest income.

So, the taxation of these two identical transactions is completely
different. There are a lot of add-on tax rules that attempt to limit
this inconsistency, but, they fail. For example, straddle rules and
capitalization rules try and make these things as consistent as they
can. But, because of the core underlying distinctions in the tax law,
they can\'t make them the same.

Now, we can take the same synthetic debt and use it in a tax shelter.
And, this is a tax shelter that is a simplified version of a real
shelter that exists in the market. In fact, a shelter that the Treasury
Department has effectively blessed this year.

So, here\'s the idea. You create synthetic debt, but, instead of using
an asset, say, gold or some other asset that\'s separate from your
company, you do the same thing with the stock of your own company. So,
buy the stock of your own company in the market for say, \$100, and
agree to sell it on a fixed date at a fixed price in the future, for
say, 110 in one year.

That is synthetic debt. It\'s the same thing as lending \$100 and
getting 10 percent rate of interest. Now, take that same transaction,
and we\'ll borrow money at 10 percent rate of interest to finance it. If
we\'re going to lend the \$100 or borrow \$100 at a 10 percent rate.
What that means is that at any given date, there\'s no net cash flow.
Today, we borrow a \$100 and use it to buy stock. Cash flows today are
zero.

In one year, we sell our stock for \$110, and use that \$110 to pay off
our borrowing. Cash flows are zero in one year. This is a nothing
transaction, it\'s a complete nullity.

How is it taxed? When you borrow the money, you get an interest
deduction, \$10 of interest deduction on your tax return. What about the
gain from selling your stock back? That\'s entirely exempt from tax. So,
we have a zero transaction. No net cash flows at any point in time and
we generate interest deductions.

And, this transaction won\'t be done in such a naked fashion, instead it
will be hidden in a complex scheme with trumped up business purposes to
make it look legitimate and there\'s a decent chance it would survive in
court under today\'s tax laws.

Okay, the second problem as we\'ll see makes inconsistency worse, is
asymmetry. Asymmetry comes from the fact that what we try and do in our
tax laws is tax each individual taxpayer in a way that makes sense for
them.

So, for example, dealers are market to market. They take the change in
value of all the positions in each year, and include that in income, as
ordinary income. Investors get capital gains and capital losses,
possibly, ordinary income on dividends and interest.

Hedgers have their own special rules, they have to match the taxation of
hedges to hedged items. Tax exempts are tax exempt. Foreigners are
sometimes tax exempt, sometimes not, depending on how they make their
investment. But, what we do is try and match the taxation of each
individual to a scheme that\'s appropriate for them.

But, what that means is when different types of taxpayers on different
sides of the transactions, the different sides are taxed differently.
So, let\'s go back to the example of this instead of the synthetic debt
shelter where the corporation borrowed \$100 and bought its own stock
back.

Let\'s suppose that we take a dealer and put it on the other side of the
transaction. So, the dealer lends the money to the corporation, and gets
paid back \$110 in one year. And, also, sells the stock to the
corporation for that same \$100, and agrees to buy it back for \$110 in
one year.

Now, there are no net cash flows in any year at any time in this
transaction. But, the dealer lends \$100 but sells stock for \$100, so
it nets zero today. And, it gets paid back \$110 in one year, but, buys
back stock in one year for \$110. No cash flow for the dealer in one
year. Exactly mimicking the tax flows on the corporation.

Corporation, if you recall, got an interest deduction and no gain on
this transaction. What about the dealer? The dealer marks all his
positions to market, has no tax on this transaction at all. So, the two
sides of the transaction just netting circular cash flows, generating
interest deductions in the system and wiping out taxable income.

Indeterminacy is the third problem with taxation of financial
instruments. And, the problem here is that people often don\'t know how
new instruments are taxed. And, what that means is that it can slow, the
tax system can slow down financial innovation. And, that can cause
significant harms to the economy.

Here\'s an example of one, a credit default swap. It\'s a financial
instrument, it\'s called a swap, but, it could be called anything. And,
it pays off when a specified debt instrument or sometimes a portfolio of
debt instruments is in default. It\'s just like insurance, it\'s just
like a guarantee. Looks just like an option, in fact.

It\'s like all of these different things. And, if you go to a tax lawyer
like myself, and you say, how is this taxed, we haven\'t a clue. Because
it\'s sort of like all of them. It\'s something brand new and it
doesn\'t fit into any of our existing cubbyholes.

Well, when a bank says, gets an answer like that back from a tax lawyer,
they hesitate about issuing these kinds of instruments. Or, their
customers won\'t purchase these kinds of instruments even if they offer
substantial utility in the marketplace.

Okay, most tax shelters, not most, I would say many tax shelters now
take advantage of these things. So, if you looked at the list of
transactions, the list of designated shelters by the Treasury
Department, and try and figure out how many of them are financial
products driven, quite a few of them are.

That is, these subtle inconsistencies in the tax system, even if
they\'re tiny tiny things that no one would even have thought to notice
when drafting them, can be exploited by the use of financial
instruments. All you need is a microscopic inconsistency and then all
you do is design a transaction to take advantage of it, and put lots of
zeros at the end of that transaction.

And, it\'s cheap and easy to put lots of zeros at the end of the
transaction, because you don\'t have to do anything. In our synthetic
debt shelter, nothing actually happened, you could have made that as
large as you wanted with no cost whatsoever.

It\'s not like the real estate shelters of the 1980\'s where you
actually had to build a building. All right? In this case, you can just
shelter as much income as you want for free.

The last point I want to make, it sort of goes back to where I started
is, there\'s really no way to fix this absent significant reform of the
tax system. All right, the inconsistencies with financial products stem
from the basic inconsistencies in the tax system, from capital
gain/ordinary income distinctions, debt/equity distinctions, source
distinctions, realization distinctions.

If you want to try and get taxation of financial products right, it
requires re-examining many of the basic schemes you\'ve got in the
system. And, there are two basic directions that people have pointed to
for reform.

One of them is more mark to market. That is, just treat financial
instruments as accreting in value each year, so taxpayers would take
into account each year the change in value of those instruments, whether
or not they\'ve sold them. There would be no distinction between capital
gain and ordinary income, no source distinctions, everything would kind
of uniform, marked to market each year.

That\'s fairly complicated for two reasons. One is, you have to value
these things. You decide which ones you\'re going to try and value,
which ones you don\'t, there\'s lots of line-drawing problems with that.
And, second thing is, you have cash flow problems. People may have
significantly appreciated position in their stock, for example and be
unable to pay tax.

The other direction for reform is, perhaps, unintuitive, which is you
can just ignore financial instruments. All right? That is, take them
completely out of the tax system. So, make interest non-deductible and
non-includable.

This is how VAT\'s do it. VAT, you know, consumption tax, European style
consumption tax doesn\'t tax financial instruments at all. They\'re not
in the system. The intuition for this, is that financial instruments are
just ways of allocating real investment to different types of people.

So, debt and equity are ways of allocating the ownership of a
corporation to different types of investors. But, ultimately, those
claims have to net out in the economy to the real claims that are in the
economy, to the real assets that are in the economy.

So, if you ignore them, you end up in the same place as if you try and
tax them all perfectly.

So, the other direction to reform would be instead of trying to mark
them all to market, getting them all right, is just to ignore financial
transactions. Thank you very much.

CHAIRMAN MACK: I\'m not sure I want to say thank you very much or not.
That\'s a challenging presentation that you both made. But, thank you
for doing that and we\'ll let Jim make the first effort.

MR. POTERBA: Thank you both very much for sharing your expertise and
educating us all. There are a set of corporate tax reform proposals that
would date back to some of the work that was done at the Treasury in
blueprints in the 1970\'s, or the Mead Commission in the U.K. in about
the same time, that would essentially move toward trying to tax
corporate cash flow as a key element of what was going on.

And, those prototypes were developed prior to the revolution in
derivative technology, when it may have been an easier thing to specify
what corporate cash flow is. The question \-- both your presentations
are completely persuasive on the difficulties of trying to distinguish
debt versus equity and other things like that in the world today where
we\'ve got all these different technologies.

But, is the concept of cash flow something which is well-defined, or,
would there be the opportunity using some strategies to basically make
cash flow move across time in a way where one side of the transaction
was not visible, or, using counterparties that were in other countries,
or, exempts or something like that?

Are there concerns that in a world with an ample derivatives market, we
should be worrying about, if we were to think about a tax which was
trying to move to sort of corporate cash flow as its basis?

PROFESSOR WEISBACH: If you think about how that works, that ensures that
if there\'s a deduction on one side, a credit that is being a
deduction\'s the same thing, that they have a piece of paper showing the
other side\'s a taxpayer. That\'s the invoice mechanism.

So, I think with a proper invoice mechanism you can do this. You can
either do it as a, on a real transaction basis, so if you want to do it
on a full cash flow basis, looking at all cash flows, interests,
inclusions all that kind of stuff. I think, if you have a credit invoice
type system, to make sure you know who the other side is, you can get
pretty close.

Because as long as the other side\'s taxable, and rates are not too
progressive with, at least at the business level, than things should
basically work out.

MR. POTERBA: Well, the implementation of credit invoice that financial
markets require that the other party be part of the system, so that you
have to have documentation that when you borrowed from HSBC or somebody
that they got, that they sent you the money and that \--

PROFESSOR WEISBACH: Well, they\'re real transaction based. So, they just
ignore financial transactions. But, you can imagine the same kind of
thing with a system that looks at financial transactions as well.

The Treasury reform, the CBIT reform, is the one I like the most. And,
that goes in the last direction which is to ignore this stuff. Looks
more like a VAT than a cash flow kind of system.

MR. POTERBA: Okay, and so I guess the most specific question is, you
think that CBIT is in some sense, you know, immune to these kind of
game-playing issues in a successful way.

PROFESSOR WEISBACH: It\'s been inconsistently \-- insufficiently
studied. One of the problems with Seibit was trying to identify hidden
interest income, and disallowing deductions or depreciation for that.
And so, there\'s lot of transactions that have, that combine service
income and interest income. And, the problem is separating those two
things.

I think it\'s got promise, but I think it\'s been insufficiently
studied.

PROFESSOR MCDONALD: Yes, just getting back to your original question,
what I\'ve been sitting here trying to think about is whether there is
some way to, you know, hide the, hide income the way you\'re describing.
And I think if you track net cash in and out, I think, I mean, I think
that should work. I don\'t think it\'s going to be, it\'s when you draw
these kinds of distinctions that I think you run into the biggest
problems.

CHAIRMAN MACK: Okay. John?

VICE-CHAIRMAN BREAUX: Well, let me thank you also as well, and I assure
you that your comments and the comments of the other panelists will be
taken back to Washington and debated and discussed by all of the staff
as well as all of the other additional members of this panel to try and
be able to reach an agreement on direction, recommendations we\'re going
to make.

It seems like everything you went through today, all totally legal, all
totally extremely complicated, but, instrument that are used every day
in the business world. I mean, for those in the business world, these
transactions, as complicated as they are, are well understood. They are
carefully screened and they are utilized every single day multiple
times.

The question is, should the tax code be an instrument that determines
what is the best business transaction? It seems like, it\'s like a tail
wagging the dog. Is a business practice first, or, is it a tax code
first and you try and fit something into it.

I mean, there are some who argue that the tax code should not
distinguish between debt and equity and making one more advantageous as
a means of financing, and the other written fact, it does. So, I mean,
do you have any thought about that, for some who would say look, the tax
code shouldn\'t be the driving force on business decision. But, in fact,
it is. Because some things are done one way it\'s more advantageous as
opposed to the other way, not because of the merits of the transaction,
or the business, but, because of the tax consequences. Do you see what
I\'m trying to ask, anyway?

PROFESSOR WEISBACH: Yeah. Couldn\'t agree more. Right. And, that\'s the
problem, which is you have tax lawyers structuring these transactions
instead of business people structuring the transactions. And, that can
add enormous value under the current system. Ideally, we\'d put them all
out of business, all the tax lawyers.

VICE-CHAIRMAN BREAUX: Yes, the question is, is the country or society
and business better off, you know, with the merits of the business
venture dictating what is done and how it\'s done as opposed to the
parameters of what is allowed and what you can squeeze through the tax
code.

And, that\'s what we\'re going to facing, I think when we try to make
these recommendations.

PROFESSOR WEISBACH: Well, I think it\'s important to realize also that a
lot of these transactions take a particular form, but, they don\'t
necessarily guide the business decision.

So, you may have, for example, a bank that needs to raise money. And,
it\'ll do it in a particular form that seems to be tax advantageous and
advantageous from a regulatory perspective and it looks complicated and
it uses derivatives technology, and it exploits the tax system. But,
they would have had to raise money one way or another.

VICE-CHAIRMAN BREAUX: Yes, but, I mean, there\'s a million different
mergers and acquisition that are done strictly because of the tax code
and not because of the advantage of one company acquiring the other from
a business standpoint, or a productivity standpoint, but, it\'s an
advantage because of the tax code.

PROFESSOR WEISBACH: Absolutely. Companies acquiring other companies with
equity rather than with cash because they can get advantage of the \--

VICE-CHAIRMAN BREAUX: Yes.

PROFESSOR WEISBACH: Absolutely.

VICE-CHAIRMAN BREAUX: Okay, well, thank you. I mean, you\'ve really
highlighted this huge challenge we have, I appreciate it.

MR. MURIS: Thank you very much. Having watched the professor for whom
your chairman is named teach tax Socratically, I could just imagine what
he would have done with this.

But, actually, let me ask Professor McDonald what he thinks of page 13
of Professor Weisbach\'s treatment where he says there\'s no easy fix,
and he\'s got some suggested \-- I\'m sorry, I guess you don\'t have
that in front of you, but.

PROFESSOR MCDONALD: So, the suggestions for reform?

MR. MURIS: Right.

PROFESSOR MCDONALD: Yeah, no, I basically agree with what Professor
Weisbach said, I wasn\'t \-- I saw his slides, I wasn\'t sure what he
was going to say about mark to market, but, I totally agree with his
reservations about marking to market.

I think it, there are a host of problems with pricing things for the
purpose of marking to market. Deciding where to draw that line between
what is and what isn\'t marked to market.

And, also the problem of, what if you have to mark something to market
and you don\'t have the cash to pay the tax? And, there is one variant
of this that I think has a lot of the same problems, but, perhaps, not
as extreme, which is that you would impute interest income to all
assets.

So, you know, the taxation of debt in recent years has gone in the
direction of saying that if somebody issues a bond, even if it pays off
in some complicated way, there\'s still effectively interest being
earned on the bond.

And so, an alternative would be to say that every asset to the extent
you\'ve invested in it, has a time value component, and you could tax
the return, that implicit time value return.

And then, if you were to ignore the additional capital gain or loss,
that would be a variant of marking to market that wouldn\'t have the
problem of people having to, the government having to fund losses or
people having to pay taxes on unsold assets that had big gains.

CHAIRMAN MACK: Professor Weisbach, do you want to \--

PROFESSOR WEISBACH: Can I make one point about marking to market which
is key, which was not in my presentation. Which is, if you\'re seriously
going to think about expanding mark to market, you should keep separate
increase in the tax and capital income, which is what mark to market
might do, and marking the market.

That is, you could mark to market at a tax rate that kept the overall
level of tax and capital income either the same or whatever you wanted,
higher or lower. So, for example, right now, the nominal tax rate\'s
around 35 percent on top rate people, but, because of various benefits
of taxation like capital gains rates with deferrals, you know, the
realization rules, the effective tax rate might only be five or ten
percent on their capital income.

If you were to move to mark to market, on most of their capital income,
you wouldn\'t want to do it at 35 percent, unless you wanted to
significantly increase the tax on capital. So, if you were going to move
to mark to market, you might want to do it at a rate that reflects
roughly what current law does.

So, what you think is the right rate for taxing capital income. Zero,
five, ten, whatever you think. So, those are two separate distinctions
that\'s often lost in thinking about mark to market.

CHAIRMAN MACK: Professor McDonald, that chart that you showed on page
ten?

PROFESSOR MCDONALD: Yes?

CHAIRMAN MACK: Or graph? Pretty dramatic change of say the \'97-\'98. I
suspect it\'s something that we did back in Washington that created
that, but, can you tell me what it was?

PROFESSOR MCDONALD: Well, I think, I think a lot of, you know, I can\'t
tell you exactly what happened in \'97-\'98, but I think a lot of, I
think a lot of what\'s happened is that the, you know, there\'s been
improvements in communication and computer technology that have made it
a lot easier for dealers to do their business. There\'s been an
improvement in the understanding of financial markets and how they work.
And, volume and liquidity have deepened.

And, you know, for example the swaps market, the first swaps were traded
and sold in the mid-1980\'s and I think you had a period of time when
people were trying to understand how to document them, how they were
taxed. There was a lot of uncertainty. And, I think part of what we\'re
seeing is just a big growth in people being comfortable with the
instruments.

CHAIRMAN MACK: So, your reaction is that it\'s just that people got more
comfortable with these types of transactions, more people became aware
of how they could be used. The technology made it much easier to present
and to manage, more than say, some specific thing that Congress might
have done with the tax law in \-- you would think the lines wouldn\'t,
changes wouldn\'t be that abrupt.

PROFESSOR MCDONALD: Well, I\'m not aware of a specific tax law change
that triggered the growth in these markets.

MR. POTERBA: Could I ask a corollary to that question which is, if you
were going to estimate how much of the volume in derivatives markets is
due to tax motivated trading? I think I\'ve heard my colleague, Steve
Ross, at one point, say he thought it might be a third. But, I have no
idea if, you know, how he arrived at that. Is there any way of trying to
judge that, the answer to that question?

PROFESSOR MCDONALD: There\'s a real lack of data. The people who do
these transactions try to keep them quiet. I\'m not aware of any good
estimates of this. You certainly can find lot of anecdotal evidence
about tax motivated transactions. David, do you have any \--

PROFESSOR WEISBACH: I think it would be very hard to figure out because
everything\'s usually mixed motive. There\'s no box to check saying tax
or not tax, they\'re just doing transactions. So, I think it\'s probably
almost impossible to get that data. But, the number doesn\'t sound wild
to me.

CHAIRMAN MACK: Did you, David did you want to make a comment with
respect to why that changed so dramatically?

PROFESSOR WEISBACH: No, I\'m puzzled, too. Actually, I\'m a little
puzzled why, you know, the story I always tell my students is Black,
Scholes, Merton, was that \'72 or something like that?

PROFESSOR MCDONALD: Seventy-three.

PROFESSOR WEISBACH: Seventy-three in fact, the graph is pretty flat from
\'73 to \'93. And it\'s a little curious about that. But, no, I can\'t
think of anything. 1986 we had the REMIC rules and so we saw a huge
increase in the market for REMICs, but, that was the month it was
developing. And, \'86 we came in and got rid of the tax impediments
there. But, that\'s not on this graph anyway.

Options, there\'s been no change in options taxation in decades. So, it
would be hard to imagine it would be anything the tax law did on the
option line on that graph.

CHAIRMAN MACK: In one of the earlier briefings that I had, one of the
things I focused on was the different cost of capital as a result of
taxation. Is this, are we talking about same kinds of issue, or the same
issue?

PROFESSOR WEISBACH: Yes, same issue.

CHAIRMAN MACK: And, so, if you\'re in a high cost capital area, you try
to find some instrument to reduce that cost. Is that what we\'re
fundamentally talking about, here?

PROFESSOR WEISBACH: Well, whoever you are, regardless of whether
regardless of your cost of capital, you want to then minimize it using
whatever tax instruments are available.

CHAIRMAN MACK: So, here\'s where I\'m going, and this might be wrong.
So, if we ended up taxing all forms of capital the same, would we
accomplish anything?

PROFESSOR WEISBACH: Oh yeah. Yeah, you would eliminate the need to hire
people like me to structure your transactions to minimize your cost of
capital. So, it would be taxable at the same \-- set it at a rate, that
we think is the right rate.

We\'d eliminate the inconsistencies, you\'d eliminate the sheltering
opportunities so you could raise an enormous amount of money with that
you could use for reducing overall rates or the rates on capital
transactions. Yeah, you could significantly increase the efficiency of
the system.

CHAIRMAN MACK: Okay. Any other questions? If not, thank you very much.
We appreciate all of you coming today, it was valuable input.
Challenging issue.

(Whereupon, the above matter was concluded at 1:00 p.m.)