UNITED STATES OF AMERICA

\+ + + + +

PRESIDENT\'S ADVISORY PANEL ON FEDERAL TAX REFORM

\+ + + + +

Monday, April 18, 2005

\+ + + + +

The Inn and Conference Center

University of Maryland University College

Adelphi, Maryland

\+ + + + +

The Public Meeting of the Advisory Panel convened, pursuant to notice,
at 12:30 p.m., Senator Connie Mack, Chairman, presiding.

PANEL MEMBERS PRESENT:

CONNIE MACK, Chairman

BILL FRENZEL

EDWARD LAZEAR

JAMES POTERBA

CHARLES ROSSOTTI

LIZ ANN SONDERS

PANEL STAFF PRESENT:

JEFF KUPFER, Executive Director

JON ACKERMAN, Senior Counsel

ROSANNE ALTSHULER, Senior Economist

TARA BRADSHAW, Communications Director

TRAVIS BURKE, Assistant to the Executive Director

KANON MCGILL, Special Assistant

JULIE SKELTON, Research Assistant

WITNESSES:

HARLEY DUNCAN, Executive Director, Federation of Tax

Administrators

TIMOTHY FIRESTINE, Director, Department of Finance,

Montgomery County, Maryland

KEVIN HASSETT, Resident Scholar and Director of

Economic Policy Studies, American Enterprise

Institute

R. BRUCE JOHNSON, Chair, Multistate Tax Commission

ANDREW LYON, Principal, PricewaterhouseCoopers LLP

ROBERT SCHWAB, Professor of Economics and Associate

Dean of the College of Behavioral and Social

Sciences, University of Maryland

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

12:50 P.M.

SENATOR MACK: And, again, I want to thank everyone for coming out this
afternoon. And I also want to express my appreciation for the University
of Maryland School of Public Policy for hosting us today, and for the
panel itself for their participation.

Now, at today\'s meeting, which is our seventh, we will continue to
explore some of the challenges presented by our current system, and
difficult issues that we will likely face as we consider reform
proposals in the coming months.

This also is our first meeting after April 15^th^, the tax filing
deadline for most Americans, and an excellent opportunity to think about
the need for tax reform. As you completed your taxes, I trust that some
of you ? I certainly did ? thought about how the process could be made
easier and ways our tax system could be improved.

We\'re very interested in your ideas and about how to make our tax
system better. We have asked that the people who have developed ideas to
reform our tax code, including suggestions to improve particular areas
of our tax system, to share their insights with us by responding to our
request for comments on our website - www.taxreformpanel.gov.

We\'ve posted the request, and the suggested framework, to help us
evaluate the proposal. We\'re asking that anyone who submits an idea to
us address how their proposal makes the tax code simpler, fairer and
promotes economic growth, as well as any information on how it might
impact revenues.

And to give us enough time to understand and evaluate the proposals, we
would ask that the proposals be submitted by the 29^th^ of this month.
Last week, we shared our preliminary thoughts about the state of our
current system.

In our statement, which is available on our website, we also summarized
six themes that emerged from our examination of the existing system. We
believe these six themes help define the shortcomings in our current
code and will guide our efforts as we consider options for reform.

And, let me just say, I\'m particularly appreciative of the work that
Elizabeth Garrett, Ed Lazear and Charles Rossotti made with respect to
summarizing what we had learned over those previous hearings.

And to put it in language that, very effectively, I think reflected what
we heard and also allowed the panel to speak with one voice.

In order to accomplish the massive effort of developing options to
reform our tax code, we will have to divide our work among the members
of the panel.

And we will be forming additional working groups that will be charged
with exploring particular aspects of reform and addressing specific
issues. In this way, we will be better able to focus our efforts and to
be more effective in drawing upon the diverse talents of the panel.

Now, a little about today\'s meeting, which will provide us a better
understanding about state tax systems and business investment. Our first
topic of discussion will examine how our tax system affects decisions by
American businesses to make investment in technological innovation and
to acquire new tools and equipment.

Drew Lyon, from PricewaterhouseCoopers, and formerly the Deputy
Assistant Secretary for Tax Analysis for the Department of Treasury,
will provide us an overview of the current rules for cost recovery and
depreciation, as well as the need for reform in this area.

I appreciate you being with us, Drew. And then Kevin Hassett, from AEI,
will explain how these rules impact investment decisions by businesses
and how reform might lead to greater productivity and economic growth.

And, again, Kevin, I\'m delighted that you\'re with us today as well.
And then, our second topic will focus on how state tax systems work, how
they interact with the federal system and lessons about tax reform that
can be learned from the experience of the states.

Bruce Johnson, with the Utah State Tax Commission, will provide an
overview of income taxes and sales and use taxes imposed by the states.
And Harley Duncan, who is Executive Director of the Federation of Tax
Administrators, will explain how a number of well-known proposals to
reform the federal income tax system, including the national retail
sales tax, the VAT tax or the flat tax would impact the tax system.

And then, also, we will be hearing from Mr. Tim Firestine, the Director
of the Montgomery County Department of Finance. And, as I mentioned to
Tim, again I do appreciate so much your being with us here today on such
short notice.

He\'s the Director of the Montgomery County Department of Finance, and
he\'ll discuss the impact on local governments on the deductibility of
state and local taxes and the exclusion of municipal bond interest from
income.

And, finally, Robert Schwab of the University of Maryland will provide
an economist\'s view of the intersection of the federal system and state
and local taxes.

As we have learned through our meetings and the comments we have
received, the problems in the tax code will not be solved with a quick
fix or a magic bullet. It will take a lot of hard work and imagination
to develop workable options that will provide a better tax system that
minimizes the burdens of complexity and compliance, promotes economic
prosperity and growth and disparity.

And, with that opening statement, we\'ll now turn to our panel - and I
think, Drew, you\'re up first.

MR. LYON: Okay, thank you very much for this opportunity to speak with
you. We might start by asking why you should concern yourself with this
topic of capital cost recovery allowances.

And as you proceed with your reform options, I know that some of the
broad reform models out there are pure income tax or pure consumption
tax, like a value-added tax, or a flat tax.

And, in my opinion, one of the main differences between those models is
how you account for the cost of business investment - how those costs
are recovered over time.

And, in a pure income tax, the model of an income tax is you want to tax
the return to a capital investment. And so, that\'s accomplished by only
allowing a deduction for the actual decline in value of an asset over
time.

In contrast, under cash-flow tax, like a value-added tax or a flat tax,
you provide an immediate deduction for the cost of a business
investment. And, by doing so, what\'s being exempted from tax is the
ordinary return from the investment or the opportunity cost of capital
from that investment.

And one way of seeing that is, for a marginal investment, the last
investment that a businessman can undertake and just break even, the
expected profits from that investment are exactly equal to the cost of
the investment.

And the cash flow tax provides a deduction for the initial expense and
later will tax the returns to the investment. But, because those returns
are equal to the upfront deduction for that break-even investment,
there\'s no effective tax being taken.

So, again, under an income tax, a basic model is that raw materials,
wages that are used up in current production, would be deducted
immediately. But for a long-life capital investment, what you would only
deduct is the amount of the asset used up during any period of time.

So, if you invest in a machine in January 1, at the end of the year you
still have the machine, but it\'s likely declined in value ? either the
physical wear and tear, the machine is less productive because its gears
have been ground down somewhat, it has to be taken out of production for
more service.

Or, an asset can simply become obsolete, even if it is technologically
works as well as it did on day one. And you can think of computers that
are no longer to run the latest kinds of software because they just
don\'t have the capacity to do that.

They become less valuable, new computers are made at a fraction of the
cost of the old computer - so that reduces the value of the existing
asset. In quantitative terms, depreciation is quite important.

If you look just at the corporate assets that are subject to either
depreciation or, a similar concept, amortization deductions, in 2002,
the latest figures that the IRS has available, \$10 trillion of tangible
assets were subject to these deductions.

So, that\'s about the size of the total economy. Deductions in 2002 that
were claimed, there were \$825 billion. And you might contrast that to
corporate income before deductions, which was \$1.4 trillion in that
year.

So, these deductions reduced taxable income by about 60 percent. That
2002 was, in part, an unusual year both due to low profitability, the
weak economy and also a special feature that was enacted into
legislation - bonus depreciation, which provided for enhanced
depreciation deductions during that period.

But even if you look back to the late 1990s, a period of very high
profitability, these deductions reduced taxable income by about 40
percent. So, they are a quantitatively significant component to the tax
system.

Depending on the advantageousness of these deductions, you can get any
effective tax rate on a marginal investment. And I\'ll refer frequently
to a marginal investment.

Again, it\'s the investment that the investor just breaks even on. You
can think of it as the last investment to be undertaken. Under a system
of expensing, you\'re not taxing any of the return from that breakeven
investment if you provide economic depreciation providing for the actual
decline in value of the asset adjusting for inflation.

Because if an asset appreciates only because of inflation, a pure income
tax would not want to include that increase in value in income. So,
depreciation deductions would be adjusted for depreciation.

With economic depreciation, you would be taxing income at the statutory
rate. So, it\'s the current 35 percent corporate statutory rate. If you
were just looking at corporate level taxes, you would get a 35 percent
tax on the returns of that investment.

With accelerated depreciation, more generous than economic depreciation,
but less generous than present value of an expensing, you can get any
effective tax rate between zero and 35 percent.

So you can really scale up how much the tax system is going to benefit
or hinder investment that is undertaken. Another point that\'s important
is, not only can you influence the total amount of investment in the
economy through these depreciation allowances - and I believe Kevin will
talk, to some extent, about how responsive business is to those
incentives.

In addition to affecting that total capital stock, you can affect how
it\'s allocated. And the simple idea here is if one piece of equipment,
for example, is permitted to be expensed, but another piece of equipment
is permitted only economic depreciation, you would end up with a
misallocation of investment.

There would be, relative to your total capital stock, too much
investment in the relatively tax advantaged asset, and too little
investment in the tax disadvantaged asset.

And that misallocation of capital comes at an economic cost. You get
less total output from production through that misallocation than if all
assets were treated equally.

And there\'s some simple ways in which you can tax the return to
investment equally. One method is expensing for all assets. That would
result in this zero marginal tax rate.

Economic depreciation for all assets is also neutral, resulting in the
statutory rate. Or you could provide certain combinations, such as
partial expensing, which is similar to the bonus depreciation that was
in place as a temporary measure.

If bonus depreciation were enacted as a permanent measure, you would
have a neutral system across assets, with an effective tax rate
somewhere between zero and 35 percent, depending on how advantageous the
percentage bonus depreciation that was provided.

In the actual tax system today, there are set rules for how property is
to be recovered. If we first focus on plant and equipment, these assets
are assigned a recovery period - a certain life over which the costs are
recovered - and a recovery method.

And that\'s the rate at which those deductions are taken over this fixed
period of time. Equipment is classified in one of seven different
categories based on characteristics that were set in the tax system
going back to 1962 and earlier, almost back to the early 1930\'s.

Based on these characteristics, a certain life is established. And those
lives, for the most part, were last set in the 1986 Tax Reform Act.
Buildings are recovered over two different categories ? 27 1/2 years for
residential property and office buildings or other industrial structures
are recovered over 39 years.

Just some things to note about our actual tax system\... There\'s no
adjustment for inflation, unlike the ideal system. It can be modified,
for example, by including bonus depreciation as has been temporarily
enacted after 9-11.

For small business, we do provide for expensing of investment in
equipment currently up to \$105,000 of equipment investment can be
immediately deducted by a small business.

The value of the expensing amount is actually a temporary provision that
would expire after 2007 if not extended, and would then revert to a
\$25,000 amount indexed from a prior year.

I know you\'re focusing on the alternative minimum tax, perhaps largely
with respect to individuals. Business investment is also affected by the
alternative minimum tax, both for individuals and corporations.

Equipment is depreciated using a different recovery method, a slower
recovery method than for purposes of the regular tax. This requires that
all businesses keep at least two sets of tax books - one for the
alternative minimum tax and one for the regular tax that they\'re
subject to.

And while I\'ve been focusing on recovering the cost of the initial
investment, I should also mention the investment tax credit as another
method for incentivising business investment.

And prior to 1986, an investment tax credit of up to 10 percent of the
purchase cost of business equipment was permitted. The investment tax
credit is also something that one has to be careful to establish in a
neutral way, not to favor certain types of equipment over others.

And it actually requires a larger credit amount for long-lived
equipment, relative to short-lived equipment. While I\'ve been focusing
on tangible capital, there are also intangible investments which are
either immediately deducted, largely if they\'re self-created, or
written off over time if they\'ve been purchased.

Cost of land are generally not recoverable, and inventory costs are
recovered at the time they\'re sold. But let me just focus on the next
couple of slides, just for a minute or two.

Is there a need for change? There was an extensive study done in 2000 by
the Treasury Department, which reached the following conclusions. They
said that the current depreciation schedule is dated.

They noted that entirely new industries have developed since the methods
of recovering these properties were last adopted. And they admitted that
we don\'t know, with any degree of certainty, what actual depreciation
rates we should assign for tax purposes if we were given that ability,
because we haven\'t studied the assets sufficiently well.

And just as one example, during the 1986 Tax Reform Act, the economic
research that was available at the time dated to the late 1970s. And
when rates of recovery for computer equipment had to be set, people were
actually relying on studies of surplus government typewriters from the
1970s.

You might think that a typewriter may have a different pattern of
depreciation than a personal computer which hadn\'t even been invented
when these things were being studied.

And, in fact, more recent research suggests that computers depreciate at
twice the rate that typewriters in the 1970s depreciated.

SENATOR MACK: If you could, because of the time, why don\'t you skip to
your thoughts on reform.

MR. LYON: Okay, thank you. So, I think it is antiquated. There are many
arbitrary decisions. The same piece of property owned by one taxpayer
can get a different recovery period than if owned by a different
taxpayer, even if employed in exactly the identical use.

It\' difficult to get economic depreciation correct, because there\'s
always technological change. The researchers in the 1970s thought they
were doing a great job, and they were doing the best job that was
possible.

But it gets outdated over time, unless it\'s continually studied. And
the result is, you get an inefficiency because some assets end up being
taxed favored, simply by haphazard accident relative to other assets.

And so, either the system has to be continually evaluated or you move to
a system like expensing, which guarantees the neutrality regardless of
what happens in the future.

MR. HASSETT: Thank you, Senator, and members of the Commission. I\'m
fortunate to follow a former University of Maryland Professor, Drew
Lyon, whose excellent presentation laid the groundwork for much of my
presentation.

I\'m going to, in my 10 minutes, attempt to give a quick review of four
issues. The first is, where do depreciation rules fit into the theory of
tax reform? The second is, how big are the distortions associated with
current law?

The third issue I\'d like to address is, what do we know about the
affect of depreciation rules on economic activity. And, finally, I\'d
like to talk about, given the importance of neutrality which I\'ll
highlight, is current research credit good tax policy?

It\'s a very interesting point because, as you know, the research and
expenditure credit is one of the primary focuses of tax activity in the
House and the Senate every year.

Depreciation rules in tax reform proposals are motivated really by two
insights from the tax literature on the optimal design of a tax system.
The first is that a tax system should not favor one type of input over
another, because back to Diamond and Mirlees, and Drew mentioned how
depreciation rules, unless they get economic depreciation precisely
correct, will inevitably favor one type of asset over another.

And the second is that at tax system should not tax capital income
because taxes on capital income impose distortions that explode over
time. If you tax interest, then compounding something at five percent
will grow much slower than something growing at 10 percent, and the gap
between the two will grow over time.

And that gap, you can think of, is the distortion caused by the tax code
over time. Current depreciation rules violate both principals.

Depreciation rules and economic distortions.

Tax depreciation rules create economic distortions because the
depreciation allowance differs from true economic depreciation. And, as
Drew mentioned, this leads firms to substitute tax-favored types of
equipment for other types.

Current depreciation rules also introduce a non-optimal tax on capital,
because firms don\'t receive the full benefit of depreciation in the
year that they purchase an asset.

So, there are really two types of distortion. One, you could think of it
as being an inter-asset distortion. So, maybe we\'re going to choose to
use this type of equipment instead of that type of equipment.

And the other is that we generally are taxing capital because of the way
we do it, instead of allowing for expensing. And that higher rate might
cause an inter-temporal distortion, as economists would call it.

Estimates suggest that the economic costs resulting from the
differential tax treatment of capital goods is relatively
inconsequential. There\'s a landmark paper by Auerbach in the Journal of
Public Economics, in 1989, in reference to that, where he tried to look
at the damaged caused from the inter-asset distortions that Drew
mentioned, and found that it was hard to get that damage to be large.

But the tax on capital income, which includes the corporate and
individual income taxes on capital income, likely has very large
efficiency effects. Recent studies of the gains from a wholesale switch
to a consumption tax suggest that output could increase enormously, with
a healthy share of the gain attributable to a lower tax on capital
income.

It\'s not hard to find estimates of wholesale switch to consumption tax
that say that output will go up, say between 7 1/2 and 10 percentage
points after about a decade.

Accordingly though, almost all of the benefit from revising depreciation
rules would come from the associated reduction of the tax on capital
income if depreciation allowances were expanded in the direction of
expensing and not from an improved allocation of business investment
across assets.

So, if this panel decided to hire 5,000 PhD economists and had them nail
economic depreciation to remove the inner asset distortion, it\'s
unlikely that the benefit to the economy from that would be very large.

Current law - so, what does current law do? Well, current law gives
firms deductions that are lower in present value than what they could
take with expensing. How much lower?

In a National Tax article that I co-authored with Daryl Cohen from the
Federal Reserve and Pernil Hansen from the American Institute - we did
some sample calculations, and I pulled these from that journal article.

We found that, for a seven year tax life assets, the depreciation
deduction present value is worth about 84-cents on the dollar, about
88-cents on the dollar for five year equipment, and about 94-cents on
the dollar for three year equipment.

Since the value of the deduction is lower then that raises the cost of
buying new machines and I give you a sample calculation here. It\'s 11
1/2 percent higher cost of seven year equipment than you would get if
you had expensing, and a 8.7 percent higher cost for five year
equipment, and a 4.3 percent higher cost for three year equipment.

These costs are useful - these numbers, the 11 1/2, 8.7, are useful to
have in your head, because in the literature, which I\'ll talk about in
a minute, it\'s not crazy to use a back of the envelope elasticity of
investment to these costs of about one.

And so, well if you wanted to know how much more business fixed
investment in equipment might we get if we moved towards expensing, then
you\'d want to look at costs like these.

Okay, the effect of depreciation rules on economic activity is, I think,
one of the better understood areas in the tax literature, is a very
large literature that was recently reviewed by Glen Hubbard and myself,
in the Handbook of Public Economics, that looks at the investment
response to different types of tax policy in many different types of
settings - different models, different data, different countries.

And everybody finds - or almost everybody finds - more or less the same
thing. In fact, the agreement across all of the different types of
estimates suggests to me that the researchers are really onto something,
and have identified that elusive thing that economists call a deep
structural parameter - something that we actually believe might be true.

And a recently updated study, says yes, that\'s right, that\'s right.
But, for me, who spent my career studying, maybe there\'s nothing left
to study. I\'ll have to move on. A recently updated study in Brookings
paper that just came out, by Mihir Desai and Austin Goolesbee, really
updated this literature to a sort of most modern level with the latest
data, and found results very similar to these, in fact, maybe a little
bit on the large side relative to the literature.

Now, of course, economic science is an uncertain one, but I\'d have to
say that my reading is that the link between tax policy and investment
is one of the better documented and least disputed results in
literature.

And, if you were to do something that reduced the user cost, I think
even if you went to the most pessimistic people in literature, they\'d
tell you that you have an elasticity of maybe about half and you\'d get
a significant spur to investment from that.

Is it ever appropriate to favor certain types of investment? Well,
economic theory tells us that, under some conditions, it\'s optimal for
the government to subsidize, particularly, types of capital.

One of the most visible such subsidies is that for research and
development expenditures. But there are actually a number of things that
we could think about. The general idea would be, if some activity spews
poison, then we might want to tax it more.

And if it spews roses, then maybe we would want to subsidize it. One
example that really goes back to a 1933 paper by Joan Robinson talks
about how monopolists increase their profits by cutting back output.

And so, in fact, if you subsidize capital, you could maybe move the
economy towards a more desirable equilibrium. I don\'t anticipate that
that\'s very politically feasible, that we need to subsidize the output
of monopolists, but it\'s one example.

But another example that\'s more practical is that research and
development expenditures often lead to discoveries that might help other
people discover things. One recent study that looked at the private and
the social return to research and development expenditure in the U.S.
found that the private return was maybe about half the social return,
which means that private people, when they\'re deciding how much
research to do, might not fully incorporate all of the benefits to
society into their calculus.

And we might legitimately want to subsidize research activities, so that
more of it\'s done, because the social gain from activity is so high.
However, designing an efficient subsidy to encourage new research
expenditures is difficult.

Because if you\'re going to do that, you have to say, well who should be
doing the research? How much research should be undertaken? And so on.
Credits to encourage research activity through the tax code are
especially difficult to structure.

It requires not only picking the appropriate research activities to
subsidize, but also ensuring that the firms who should be undertaking
the beneficial research are the firms receiving the subsidy.

So, do you want to, for example, subsidize research into new types of
potato chips? Well, maybe we do. I like potato chips. But maybe we
don\'t. It\'s a very difficult call.

And as you start writing those rules, it turns into a complete mess. And
then, once you have rules that you think you kind of leave, what do you
do when two firms merge, and so on.

And so, I\'d have to say that, if you look at tax litigation, one of the
primary sources of it is just the definition of qualifying research
expenditures. And the current research and expenditure credit that
exists is really a temporary and incremental dinosaur to quote one
recent article in Tax Notes.

I\'d also have to say that there\'s another issue in research that makes
credit design difficult. And that is that many of the most important
research firms are small firms that maybe don\'t make much money.

And so, if you provide a credit for them against taxes, it might not
actually deliver any pecuniary benefit because they\'re not taxable yet.
Indeed in the recent study I did for the Biotech Industry Association -
and you can imagine why they\'re interested in this - I found that
something called Section 382 limitations made it so that most, or a very
large share of, firms found that, by the time they became taxable, they
weren\'t really allowed to take their deductions or get benefit for
their credits anymore because, when they issued new equity to finance
their research, it was called a change in ownership by the IRS.

And so, unless you sort of have like a big firm with lots of money that
has very predictable streams of cash flow, it\'s not exactly obvious
that if you have a research credit that it\'s going to be very
accessible.

So, in theory, a credit to encourage additional research may be
appropriate, but in practice it\'s really been impossible to get it
right. And I would guess that if you wanted to get it right on the
Commission, it might be the only thing you should do between now and
June, it\'s such a difficult problem.

And, with that, I\'d like to thank you very much for your attention.

SENATOR MACK: That was a discouraging comment right there.

(Laughter.)

Ed, do you want to pick it up?

PROFESSOR LAZEAR: I actually have a couple of questions, so I\'ll pick
one and hope that Jim or someone else on the panel asks the other.
Suppose that we were to allow for interest to be paid on depreciation.

So, in other words, think about expensing, but the alternative would be,
say, we\'re going to maintain something like the current system, but
your depreciation gets to be credited at an interest rate.

Obviously there\'s some issues with implementation, what\'s the
appropriate interest rate, and so forth. But if we abstracted from those
for the moment, would that handle most of the problems that you\'re
talking about, with respect to expensing?

MR. LYON: Yes, I\'d say you\'re primarily interested in the present
value. So, permitting interest to accrue on the deferred deduction would
get you to the same result.

David Bradford had proposed that as one variation of his x-tax, instead
of the immediate upfront deduction to allow the deduction over time. And
he promoted that as actually providing greater stability when there
might be risk of future tax rate changes.

MR. HASSETT: And this also, your idea is also something that figures
prominently in ideas of how to manage transitions towards expensing as
well.

PROFESSOR LAZEAR: That was the other question, yes. Thanks. Well, unless
Jim\'s going to do it. I guess the other question would be, if I think
about some of the issues with transition, one of the big things, of
course, if you went to immediate expensing, you have a stock of existing
capital that you guys identified earlier.

And the question is, how would you suggest that we think about dealing
with that problem?

MR. LYON: The transition costs are worth considering. Some of the
efficiency gain that\'s been pointed out of this, which is consumption
tax, is partly derived by what is thought of as a lump sum tax on
existing capital.

So, there can be winners and losers, unless transition relief is
provided. At the other extreme, one of the papers that Kevin referenced
has shown that if you go to a complete transition relief, a wage tax,
you capture only a fraction of the efficiency gains of the movement to a
consumption tax.

MR. HASSETT: Right. And so, it\'s important to, and this is not, as you
know, the only transition issue. But it is important to recognize that
the tax on old capital is part of the benefit of a consumption tax.

And it would be useful to compartmentalize the tax on old capital, and
think about which ones can be kept, as you move towards fundamental
reform. Because if you remove all of the tax on old capital, then you
might end up with no benefit from the reform.

MS. SONDERS: I suppose the question is for both of you, but it comes
based on something that Kevin said. Wholesale switch to expensing
suggests output would increase, I think you said, 7 1/2 to 10 percentage
points over the cost of a decade.

Can you talk about the impact of going to a model of immediate
expensing, as it would relate to global competitiveness? We\'ve heard
from a number of witnesses that so much of the bias against operating
here is a function of the tax code. And how much would that alleviate
that problem?

MR. HASSETT: Thank you for the question. I\'ll go first. And first, I\'d
like to clarify that the result that I cited was a wholesale switch to a
consumption tax, which would include expensing but some other things as
well.

The studies of the impact of these things on international activity
suggests that expensing rules matter. And so, it\'s more likely to have
activity located in the U.S. if we have more attractive expensing rules.

But tax rates matter as well. In fact, there\'s a study, which I could
forward to you after the hearing, that I think I can\'t think of the
authors right now where they looked at whether the average taxes, or the
marginal taxes to use economist-ease, were better predictors of the
location activity of firms.

And they found that the average taxes actually worked better. And that
result always suggested to me that firms have some ability to transfer
price profits to low jurisdictions.

And so, they find taxes attractive, low tax rates attractive over and
above just whether or not you get to expense equipment. But there\'s
another reason to, which is that when you\'re deciding to locate a
plant, when it\'s like a big lumpy decision like a plant, then economic
models would say that it\'s kind of the average tax that should matter
then as well.

SENATOR MACK: Charles?

MR. ROSSOTTI: I just wondered - looking at your chart that shows, I\'m
assuming, a 43 percent rate, how much more expensing would be than
depreciation. Did you ever do a calculation of how much the rate would
have to come down from 43 percent to whatever number it would have to be
to come up with an equivalent net present value of after tax income?

The one model, you keep it at 43 percent and you expense under the other
model you depreciate at an economic level, but you have a lower
corporate tax rate. And you can calculate a net present value of an
investment under either model.

And at some tax rate, they\'d be equivalent. Did you ever run that?

MR. LYON: I have not. You could do a combination 50 percent.

MR. ROSSOTTI: Yes, I was just trying to see if you\'d done the
calculation.

MR. LYON: Well, again, full expensing would take it to zero. So, you\'d
have to reduce the statutory rate to zero to get the same result for the
marginal investment. Again, that\'s really this investment that you just
break even on.

There are highly profitable investments for which changes in the
statutory rate would be more important.

MR. ROSSOTTI: Yes, I don\'t want to belabor it, that\'s fine.

SENATOR MACK: Bill?

MR. FRENZEL: I\'m interested in Kevin\'s comments on the research
credit, which I think you correctly identified. Although it is much
beloved in the Congress, it looks to me like the way it\'s structured,
it\'s really a price for having done something you were going to do
anyway rather than an incentive to have you do a little more. Is that
your understanding?

MR. HASSETT: Actually, that\'s not the way I think of it. But there\'s
so many things wrong with it, that that might be an equally correct way
to think about. The way I think about it is that it\'s a penalty on
people who are successful.

Because in order to get the credit, under the current law, you have to
do more research as a share of revenues than you did in the past. And
the in the past part is a very difficult thing to define.

And, for some firms, it\'s what they were doing in the 80\'s. And so, if
you\'re a successful firm that wakes up one day and suddenly you\'ve got
lots of sales, and lots of revenue and lots of profits, then it\'s going
to be very hard for you to do enough research to get the research
credit.

Because you didn\'t have so much profit last year, and so your research
as a share of revenues was much higher.

MR. FRENZEL: Thank you.

SENATOR MACK: Jim?

MR. POTERBA: The first question\'s actually for Drew on one of the
statistics that you reported. You suggested that there\'s about \$10
trillion of historic cost depreciable and amortizable assets in the
corporate sector at the moment.

If we were trying to think about the tax savings that will result from
the depreciation of those assets, are there any complexities - besides
saying well multiply them by 35 percent and call that \$3.5 trillion
worth of depreciation going forward: are there complexities that involve
firms that are in tax loss positions and can\'t claim depreciation
allowances on takeovers and other things, foreign firms?

Are there any things that we should be worried about if we tried to turn
that asset stock number into a value?

MR. LYON: There are a lot. It\'s historic costs that\'s one of the key
differences. It\'s the original costs, it\'s before depreciation and
deductions have been claimed on it.

So, there has been economic depreciation and obsolescence that has
reduced the value, as well as inflation that\'s worked to increase the
current value of those assets.

So, I think you\'d do better to work with flows of investment to build
up to a capital stack.

MR. POTERBA: If I could just ask one other question to both of you?

MR. LYON: Sure.

MR. POTERBA: There are two broad approaches to trying to reduce the tax
burden on investment. One is to work on the investment side, and your
comments focus on that.

The other, of course, is to work on the savings side, by moving towards
lower tax burdens on individuals who are savers. Sometimes the
investment approach is argued as giving potential windfalls to foreign
companies that are investing in the U.S. that would claim some of the
benefits that might be offered here.

Whereas, the savers approach does not run into that difficulty. Would
either of you want to jump in and address the saving versus investment
subsidies as ways of going at this to try to encourage growth?

MR. HASSETT: I can start. I think, first I would respond on the
investment side. To the extent that we attract capital of the United
States, that should be good for workers who have a higher wage because
of that capital.

The second thing I would say is that the link between the savers side
tax rates and actual investment activity is more or less unexplored.
That, in fact, there was a great paper by two fellows named Poterba and
Summers a long, long time ago.

MR. POTERBA: It might be discredited, I\'m sure.

(Laughter.)

MR. HASSETT: Which is still the best work in that area. And I think
that, given where the work has gone, it\'s fair to say that we don\'t
know if, for example, you changed the capital gains tax rate, that that
maps precisely to more equipment investment by corporations. There
hasn\'t been a study that has made that link.

So, there\'s a significantly higher level of uncertainty concerning the
likelihood of success if that approach were taken, the saver\'s
approach.

MR. LYON: I guess I\'d add, the kind of theoretical models that we\'re
also working from the pure income tax and the pure consumption tax would
relieve the double taxation of corporate income that we have currently.

You\'d have an integrated tax system, so I think moving to some of the
pure systems would provide some savings relief relative to the current
system, in any case.

SENATOR MACK: Jim, do you have anything else?

MR. POTERBA: No, sir.

SENATOR MACK: Great. There are a couple of thoughts running through my
mind, with respect to your comments this morning. First, I clearly get
the impression that if we recommended the elimination of the investment
tax credit, or research tax credit, that that would be a good thing.

Is there any relationship between that notion and, say, full expensing?
I think one of the messages that I heard was, again, a sense of
neutrality. And so, should I be thinking about those two in the same
context, or are they two completely separate issues?

MR. HASSETT: If you were to move towards expensing, and remove the
research credit, then it would be important to estimate the net effect
of those two, on people who are doing the research and development.

My guess is, given the low benefit associated with the research credit,
that you\'d find that many firms that you wanted to help in this regard
would be better off at the margin with that measure.

But, it\'s a guesstimate right now. But that\'s the way that I would
like to address that question, to just look and see. There are countries
that have done a much better job of implementing research credits.

The Canadian example is one that people often allude to, that you could
look at. And a key component of that is allowing expensing. And so,
it\'s sort of all linked.

SENATOR MACK: Drew, do you have anything you want to add to that?

MR. LYON: I think the research credit is more effective than Kevin has
identified in enhancing research incentives. There may be particular
firms that receive no benefit.

I agree with Kevin that the structure of the credit can be improved. It
is based on a very out of date ratio of research to sales, similar to
the problems that depreciation had going back to the \`70\'s.

SENATOR MACK: If we were to do full expensing, though, does it make
sense to continue the research tax credit?

MR. LYON: Research expenses currently are fully expensed as well, so
they largely would not get any additional benefit from \--

SENATOR MACK: No, but I\'m thinking about it from the standpoint of if
we were to attempt some form of neutrality in the process in how people
spend their money.

MR. LYON: Right. You would be achieving neutrality. The historic reason
for providing additional benefits to research is that studies have shown
that the social return to investments in research are far in excess of
investments elsewhere in the economy.

So, it was, I think, an idea to provide a slightly intentional un-level
playing field, because the benefits for those activities were so much
greater.

SENATOR MACK: Did you have a follow-up? I think the last thing I would
ask, a lot of people have been talking about going to full expensing.
And there is a tendency, I think, to think that\'s a very simple system.

You get away from whatever problems there are related to depreciation,
amortization. What are the things we ought to be thinking about? Someone
mentioned rules with respect to expensing.

Can you give us a sense of what some of those rules \--

MR. LYON: Well, I largely agree with you. There are much fewer factual
determinations that have to be made under a system of expensing,
relative to the current system where you have to decide is it an asset
that is written off over time, and if so what are the time periods and
methods relative to writing off everything.

I think Professor Lazear identified one of the primary things is the
upfront cost immediately providing those write-offs. That could be
somewhat ameliorated over time by providing a system of interest
earnings on the deferred deduction.

So, you could in present value provide the same deduction, but not at
the immediate upfront cost.

MR. HASSETT: Right, because the firms aren\'t always taxable. Then you
have to carry this forward. And, in addition, tax lives end. Say, after
ten years, you could lose it.

And so it\'s very possible for a firm that\'s very capital intensive to
go a very long time without technically being taxable, because they\'re
making so many investment expenditures.

So you will have to, the thing that will be tricky would be the
interaction with the AMT and the interaction with taxable status and how
you deal with that.

SENATOR MACK: Very good. Any other questions from the panel? If not,
again, thank you very much.

MR. HASSETT: Thank you.

MR. LYON: Thank you.

SENATOR MACK: I appreciate your testimony this morning. And I think,
with that, we\'ll go ahead and go to the second panel. And, again, I
thank all four of you for your willingness to spend some time with us
and share some of your ideas. And, Bruce, we\'ll go ahead and start with
you.

MR. JOHNSON: Thank you, very much. It\'s a pleasure to be here to
address the panel. I\'m Bruce Johnson, Commissioner of the Utah State
Tax Commission, and also Chair of the Multi-State Tax Commission.

And I\'m actually here in my capacity as Chair of the Multi-State Tax
Commission. The MTC is an organization of state governments that works
to administer, equitably and efficiently, tax laws that apply to
multi-state and multi-national enterprises.

We were formed under the multi-state tax compact in 1967, and our goals
are to facilitate the proper determination of state and local tax
liability of multi-state taxpayers to promote uniformity and
compatibility among state tax systems to facilitate taxpayer convenience
and compliance and to avoid duplicate of taxations.

So, I think many of our goals are congruent with the goals of this
panel. We\'ve also been a voice for preserving sovereignty by protecting
the rights of the states to determine their own state tax bases.

We recognize the difficulty of the task that you\'ve been given, and we
applaud you for undertaking this. But, we hope in doing so that you will
recognize the importance of federalism and fiscal federalism, and the
importance of the states having the ability - and local governments - to
determine their own fiscal future.

Justice Brandeis, in 1932, said it\'s one of the happy incidents of the
federal system that a single courageous state, if its citizens choose,
serves as a laboratory and tries novel social and economic experiments
without risk to the rest of the country.

And, in this time of rapid global change, I think we need more
laboratories. I\'ve been asked to provide an overview of some of the
state and local retail sales and use taxes and income taxes in the U.S.,
and their administration.

I\'ve not been asked to address property tax, but I will add that
property taxes, the other leg of the three-legged stool that state and
local governments rely on. We tax wealth through the property tax,
income through the income tax and consumption through the sales tax.

The income tax is the only one of the three, frankly, that does a very
good job of matching the current economy, because most of our wealth is
no longer in real property.

So, the property tax is no longer an effective tax on wealth. And sales
tax tends to be limited to tangible personal property, and we\'re moving
away from that in our economy.

So, the income tax is really the one that most accurately matches the
economy that we have now. Sales taxes are very prevalent. 45 states and
the District of Columbia impose a broad-based general retail sales tax.

Only five states do not. In fiscal year 2003, those states collected
about \$185 billion in general retail sales tax. That\'s about 1/3 of
the total state general tax collections.

Now, I should point out that we\'re talking about generally applicable
sales taxes here, we\'re not talking about special or additional taxes
on motor fuel or alcohol or tobacco or those things.

We\'re just talking about generally applicable sales taxes here. Taxes
are also very prevalent at the local level. About 7,500 local
jurisdictions in 34 states impose a separate sales tax.

Those taxes generated about \$48 billion dollars in revenue for the
local jurisdictions in 2003. Ten states do not have local governments
that impose sales taxes. Alaska actually has a local sales tax, but not
a state level sales tax.

In most states, the local sales taxes are administered at the state
level. The Utah Tax Commission, for example, administers the local sales
taxes on behalf of our cities and towns.

Other than four states, Alabama, Arizona, Colorado and Louisiana, the
local governments are authorized to administer their own taxes. And, in
many of those states, there\'s also a difference between the state tax
base and the local tax base.

Here\'s a map that essentially summarizes what I\'ve just said. You can
see that the sales taxes are very prevalent throughout, and the state
level only taxes are found primarily in the northeastern part of the
country.

The rates vary greatly among the jurisdictions. For the states, the
rates range from about 3.5 percent in Virginia as the state-only rate,
to 7 percent in Mississippi, Rhode Island and Tennessee.

When combined with local sales taxes, the highest rates are found in
Alabama with 11 percent, Arkansas, Oklahoma and Louisiana all have
combined rates over 10 percent.

And, again, this doesn\'t include things like lodging taxes, where you
can get total sales tax or excise tax rates of 16, 17, 18 percent. Now,
the tax base is the sales tax, unlike the income tax, is imposed on a
limited base, which creates some complexities.

Income, we like to think we tax income from whatever source derived. And
then we have deductions from it. And those deductions are, in legal
terms, narrowly construed against the taxpayer.

The sales tax is different, in that there\'s a defined tax base.
Everything that is not included in tangible personal property, or
specifically enumerated services, is excluded.

So, real estate, intangibles and services are frequently excluded form
the sales tax. There are three kinds of exemptions from the sales tax.
Product-based exemptions are exempt no matter who buys them.

Typical product-based exemptions include food, clothing, prescription
drugs. Those are product-based exemptions that depend on the definition
of the product. There are use-based exemptions that depend on the use of
the product.

The most common of those being the retail exemption. To avoid
pyramiding, if a distributor buys something that the distributor\'s
going to resell, they don\'t sell a sales tax on it.

It\'s hoped that the sales tax is collected on the sale to the ultimate
consumer. But there are other use-based exemptions as well. Typically
property used in manufacturing may be exempt.

Property used in agriculture is frequently exempt. It may be
predominantly used in agriculture, or exclusively used in agriculture.
Those are matters that vary by state law. The other main kind of
exemption is an entity-based exemption.

That is, sales to the Federal Government, for example, sales to state
and local governments, sales to charitable institutions, sales to
educational institutions. Those are all exempt on an entity-basis.

As I mentioned, services are typically excluded from the sales tax
altogether. So, if this panel were to move, or federal tax reform were
to move, in the direction of a consumption tax, it would be incumbent on
us, I hope, to work closely together and ensure that we didn\'t, in the
name of simplicity, actually add complexity to the administration of the
sales tax, or make the sales tax unfeasible at the state level.

The states have been working together, I would note, cooperatively
through the streamlined sales tax project with a lot of business input
to make their own sales taxes more uniform and more simple.

And we hope that that good work will not be unavailing. Income taxes -
I\'m going to break down into personal income taxes and corporate income
taxes or franchise taxes.

In 2003, state governments collected about \$183 billion in personal
income taxes. And that\'s close to the sales tax number, about 1/3 of
their total tax collections. 42 states impose a broad-based personal
income tax.

Two states tax only interest and dividends. And seven states don\'t have
a personal income tax. The marginal rates range from a very low .36
percent in Iowa to over 9 percent in California and Vermont.

Most states use federal adjusted gross income as the starting point in
determining state taxable income. Some states use federal taxable
income. I\'ve mentioned the marginal rates.

So, let me just give you a personal anecdote here, as far as complexity
and compliance. For reasons that are a little difficult to explain, but
have to do with my being a state employee, I can file electronically.

But the state will not prepare my taxes for me. So I\'m probably one of
the few people in the nation that actually does my taxes with a pencil
and paper and then files electronically.

I would not want Commissioner Rossotti to think I didn\'t file
electronically. But I also had the privilege of doing my mother\'s taxes
and my mother-in-law\'s taxes. And neither of those ladies are people of
wealth, but they have a few investments and municipal bonds, etc.

It took me less time to prepare the Utah tax return for those two ladies
than it did for me to work through the federal schedule determining how
much of their Social Security was taxable.

It\'s simply the matter of making a couple of very simple calculations,
and I can compute my Utah income tax, once I\'ve gone through the very
considerable effort of trying to figure out how to compute my federal
income tax.

So there\'s a tremendous amount of savings at the state level and at the
taxpayer level from being able to tie into the federal tax system.
There\'s the map that shows the personal income tax.

Corporate income taxes are slightly more prevalent than individual
income taxes. They\'re imposed in 46 states. They collect about \$28.6
billion - that\'s 5 percent of total tax collections for the states.

Almost all of those states, they use taxable income from the federal
form. But because most businesses, or at least many businesses, are
multi-state businesses, there\'s an additional level of complexity there
in apportioning that taxable income among the states once the income is
determined.

I see that my time is up. I would just appreciate very much your
willingness to listen to the state and local government perspectives on
this. We can all benefit by the work that you\'re doing.

If we can simplify the federal tax system, that will increase
compliance, which will help the states, both in reducing the gap, but
also in providing a perception of fairness to the taxpayers.

And as a self-reporting system, we rely extensively on the good will of
our taxpayers. And if they perceive the system to be fair, they\'ll
redouble their compliance efforts and hopefully be able to do so with a
reduced burden and at reduced cost. Thank you, very much.

SENATOR MACK: Bruce, thank you. And Harley will go next to you.

MR. DUNCAN: Thanks, very much, Mr. Chairman, members of the Committee.
It\'s a pleasure to be here. My name is Harley Duncan. I\'m the Director
of the Federation of Tax Administrators, which is an association of
state revenue departments in the 50 states, the District of Columbia and
New York City.

What I\'d like to try to do today is to give you an overview of some of
the state tax impacts of various types of federal reform proposals that
are being discussed. And, essentially, address the question of, given
the interrelationships between state and federal income taxes in
particular, that Bruce outlined, what are the implications of some of
these reform proposals for the states.

I don\'t, certainly, would not want to be considered as advocating for
or against any particular proposal, but rather to simply identify some
issues that we believe need to be addressed as you consider reform
proposals.

And I\'d be remiss if I didn\'t say that I think that having of this
hearing, the holding of this hearing, and considering the questions is
an important first step. I\'ve been around too long, and most of the
prior discussions of federal reform have paid scant, if any, attention
to this particular set of questions.

So, we appreciate that. I think the punch line of the remarks at a high
level really go like this, that fundamental federal reform could
substantially alter state tax bases and state tax authority.

Some of those reforms would serve to broaden the state tax base. Some
would broaden state tax authority. Others would be restrictive. Some of
them will present difficult issues to the states, of should we conform,
should we not conform, what are the costs of conforming, what are the
costs of not conforming.

There are also certain of these proposals that really hold the
opportunity, if we do it right between the federal and state government,
to improve state tax structures in particular in terms of dealing with
the broader base, and dealing with the various types of transactions
better.

And to achieve more coordinated administration. What we really need is
to continue this dialogue, so that we don\'t make missteps and we are in
a position to take advantage of the opportunities that are available to
us.

As states look at the federal reform, the fundamental operating premise
that we have is that state tax bases must necessarily follow the federal
tax base. Certainly, in an optimal situation they would.

And the income tax arena, I think, is a clear example at the present
time of why this is true. If we have different tax bases for the federal
and state purposes, we automatically increase the taxpayer\'s burden and
the difficulty that they face.

That then raises issues of compliance. If we could have a single set of
rules that are straightforward and are capable of being followed, we
improve compliance at the federal and the state level.

States, at least under the current federal system, as the Commissioner
well knows, rely extensively on federal compliance efforts for
compliance at the state income tax level.

Some significant proportion of all state compliance initiatives drive
off of information that we receive from the federal government that\'s
reported to them. And without the conformity and interrelationships, we
wouldn\'t have that opportunity.

The third relationship that\'s important is in the third-party reporting
structure. If we don\'t have a third-party reporting structure for a
comprehensive income tax base, that is dealt with at the federal level
as it is at the present time, we think it\'s extremely difficult and
expensive to replicate that at the state level.

And it\'s probably impossible to replicate. The corollary, or the bottom
line, to that is that we would argue, I think, that without a federal
income tax, there is not the option of the states to continue a state
income tax.

Certainly our position would be not at the cost that we do at the
present, and not of a comprehensive nature. We could probably deal with
some wage-based taxes. But a comprehensive income tax that deals with
gains, dividends, interest, and deals with it as efficiently as we do
today, is probably not possible if there isn\'t a federal income tax on
which we can build.

When we look at the reform proposals, we ask really sort of four
questions, or four assessments that we make. First of all, what are the
conformity implications? What are the structural impacts there?

The second is, does the reform proposal tend to move the Federal
Government into a tax base that has traditionally been used at the state
and local level? We refer to it as crowding out.

I heard it referred to as crowding in the other. I suspect that\'s just
sort of a different end of the glass. But we share some base today, in
particular the income tax. We, at the state level, make primary use of
the consumption tax base.

If now we start sharing that base, there becomes a question of what\'s
the overall burden that we\'re putting on that base. So that\'s a
question we ask. On the sovereignty side, we look at what options does
the federal reform leave for the states?

What range of choice does it leave for us? Or does it tend to preclude
and close some of those? And then, finally, we look at what
opportunities does it give to improve our tax structure?

In the presentation, I\'ve gone through several pro-forma types of
reforms, and won\'t do that entirely here. But I wanted to mention a
couple. Now, the first is, looking at various types of reforms, one
would be something like 1986 and broadening the current income tax.

A second proposal would be a consumed income tax, of where we try to
eliminate the tax on capital income, move it down to primarily a tax on
wages and salaries at the individual level.

Also look at a retail sales tax, and a value-added tax, of a transaction
style and what their implications are. And then a flat tax, and I don\'t
want to, there\'s a large number of proposals that get wrapped up and
call it a flat tax.

I\'m looking at one that would comprehensively tax all income, at least
identify all income, tax it at least at one level, either the entity or
individual level. On the reform of the current income tax structure, I
think the issues there are relatively straightforward.

Most of it would be of a base-broadening nature that would increase our
flexibility. It would enable us to bring down some rates, much the same
way that we did in 1986 to some degree.

It would retain the current comprehensive tax reporting system and,
therefore, really wouldn\'t be constraining on our choices. And I think,
with the base-broadening, we could improve some equity and improve the
administration.

There is one caveat that is important for us to make, I think, at the
state and local level. And that is if all of the base-broadening is
achieved through the repeal of the state and local tax deduction, or
some significant component of it, that raises some serious fiscal
federalism issues for us.

And there becomes this crowding issue, and it really raises the price of
state and local services relative to what it is in the
inter-governmental fiscal system at the present time.

And that then raises issues for what flexibility state and local
governments have to deal with raising the revenues to meet the service
demands that they have. If these revenues from the base-broadening of
the repealing of state and local tax deduction are used to deal with the
alternative minimum tax, that has a mixed impact.

But it\'s an important question that needs analysis as you go through
this. The retail sales tax and the value-added tax, I will consider
together. Because from inter-governmental perspective, while they\'re
very different taxes from the perspective that we\'re looking at, they
really have the same implications and raise the same issues.

I think, to put it succinctly, the federal adoption of either a retail
sales tax or a value-added tax of a transaction variety would raise some
very difficult issues for states.

I think we would understand and recognize that opportunities for
improving our taxes, the optimal situation for sellers, would all argue
that we would conform to the federal tax base and try to build our
consumption tax off of the federal base.

That certainly produces the right answer from a number of perspectives.
That does have the effect though of very much constraining choices about
what\'s in the tax base that each state, as Bruce mentioned, have made
independently up to this point.

On the one hand, the benefits of the consumption tax are maximized by us
conforming to the federal tax base. That would raise the most serious
issues, though, for the states and how we would go about doing that and
what the implications are.

I think, though, that we would recognize that with a federal consumption
tax, as has been outlined in at least some proposals, there are
significant improvements for state sales taxes.

We would deal better with the taxation of services, most likely. We
would deal better with not imposing tax on business inputs. And we could
probably do a fair degree of coordination with the federal
administration.

So there are plenty of opportunities for improving state taxes and
federal taxes if this Federal Government were to move to a consumption
tax. They just would have to be sorted through carefully.

We also need to be cognizant of the potential for compliance issues and
rate issues. Much of the discussion is about replacing the federal
income tax with the consumption tax.

As I\'ve said, I think, we\'d believe that if you replaced the federal
income tax, you also have to replace state income taxes. And when you
begin to look at the rates, it\'s our calculations that any rate that
would be revenue neutral at the federal level, for replacing the federal
income tax, would have to be increased by 50 percent to account for
state income taxes and state sales taxes that would be funded off of
that same base.

With that, I will close very quickly. On the consumed income tax and the
flat tax, the questions there are essentially, how broad is the base
that is in the federal tax, as that has implications for us?

And does the tax retain the third-party reporting that would be
necessary for us to retain a comprehensive income tax? Those are sort of
the prisms through which we would put those particular proposals.

So, to conclude, I think, as I\'ve said, there are plenty of awfully
important considerations and implications for state taxes that would be
occasioned by a fundamental federal tax reform.

Some of those reforms really hold the opportunity to improve our taxes,
and we need to be in a position to take advantage of those
opportunities. Others would be constraining.

And we would hope that, as Bruce said, that when you view these you
would view them from the inter-governmental fiscal system that we\'re
all trying to finance a series of services at three levels.

And I appreciate the discussion and look forward to continuing it.

SENATOR MACK: Harley, thank you, very much. That\'s very helpful. And,
Tim, we\'ll turn it to you next?

MR. FIRESTINE: Thank you for the opportunity to address the panel. I\'m
Tim Firestine, the Director of Finance for Montgomery County. And I\'m
here representing a point of view of local governments, in conjunction
with the Government Finance Officers Association, the National League of
Cities, and other association that are affiliated with a group called
the Public Finance Network.

I\'ve worked in local government finance for 27 years, and I also teach
public financial administration here at the University of Maryland in
the School of Public Policy.

And, I guess, basically I\'m here to say, don\'t forget about us in
local government. I know there\'s a lot of emphasis on the states. Local
governments, as you know, are creatures of the state.

And a lot of times we sort of are at the mercy of decisions made at
other levels. And any changes you make to the federal tax system, we
know, will have ramifications at our level.

Well, what we ask for is just the ability to have some independence and
some flexibility to meet the needs in our local communities. There are
10,000 different tax systems in our country.

And if you start making changes, I think it\'s important that local
citizens understand how those changes affect what they do at the local
level. I\'m not here to necessarily address specific reform proposals,
but I guess there are some broad reform measures that I\'d like to talk
about.

There are over 82,000 local government units in this country. And local
tax systems, like state tax systems, are tied to the federal system. One
example, in Montgomery County, Maryland, allows local governments to
have a local income tax.

As a matter of fact, they mandate a minimum local income tax rate for
each jurisdiction. And we think that has served local governments well.
And, in terms of ties, one of the things Montgomery County instituted
about four years ago is a local earned income tax credit, which is tied
to the federal earned income tax credit.

And Maryland actually has a state earned income tax credit, because we
believe it was the most effective way to provide relief to those who
need it most. I think we\'re the only jurisdiction actually in the
country that has that, but I know the City of New York was looking at
that as a possibility.

But, again, there are these connections that we have to be careful
about. As I said, we are creatures of the state, and we\'re very
dependent and state governments, not only for the authority to do the
things that we do, but in a lot of cases, for the collection and
administration.

The state collects the local income tax, in Maryland, and distributes
that to the localities. To a certain extent, we\'re at their mercy. In
the early 90\'s, we had coming out of the recession, there was a
difficult time that the state was having.

There were some shortfalls and, during one fiscal year, the state went
through seven budget revisions, all of which impacted local governments
in Maryland, because the first place to cut were local revenues.

And they also started to withhold our income tax, taxes that we levy,
take the heat for, were actually held by the state during that time. And
as recent as last year, the state, in trying to solve the budget
problem, retained some money from our refund account, that was a local
government refund account.

So, again, we\'re pretty much at the mercy of the states. I\'d just
reiterate, with those 82,000 local government units, we are the first
responders. Local governments do hire the teachers and the police
officers and the firefighters.

And we have to create the buildings and infrastructure for those public
employees. Interesting, when I first got into this local government
finance arena, I had an Assistant to the County Executive who told me
early in my career that it\'s important that we do it right, in that in
the morning citizens put their trash and the kids out by the curb, and
at the end of the day they want to get one of them back.

(Laughter.)

And it\'s the front line stuff that we do that\'s very important. And
what allows us to do that is this diversity and flexibility of our
revenue stream. As I said, Maryland is generous with its income tax
authority.

Montgomery County is a very diverse revenue stream. And it\'s that
diversity that has allowed us to meet needs over time. For example, in
the 1980s, as we\'ll see shortly, at the end of the 1980s with the
downturn in the real estate market, we struggled during the 1990s
because property tax revenues did not grow because home values didn\'t
grow.

But because we were fortunate to have the income tax as another source
of revenue, it offset that as we moved into the late 1990s and the stock
market increased dramatically because of capital gains receipts.

Also, if you make changes, we need to just make sure that consideration
is given to the time that it takes to make changes at the local level.
For example, sometimes if you want to change tax structures at the local
level, you require local voter referendums and things like that.

We talked about sources of revenue. This is just a chart which displays
only tax revenues, which account for about one-third of the revenue at
the local government level.

And, of that, it\'s clear that property taxes provide the largest source
at the local level. And, again, sales taxes are important. They\'re not
as useful at the local level.

Again, in Maryland, with diversity, the state does allow us to have some
types of sales taxes, as long as they\'re not general sales taxes. But
we do have an energy tax, we have a telephone tax.

So there are some types of excise taxes that would fall into this
category where we do have authority. I think the key point we want to
make is, as you seek change, clearly the area that we heard most about
that I think our concern is the potential elimination of the
deductibility of income, sales and property taxes.

Unlike other deductions, for example charitable contributions where you
can make a decision about whether or not you do that and get the
deduction, clearly when you pay your state and local income taxes, sales
taxes and property taxes you really have no choice to do that.

And so, since they\'re not discretionary, our concern is why tax taxes?
It does a lot of things, we\'ve talked about these, but it increases a
citizen\'s overall effective tax rate, which we\'d be concerned about,
especially in those states that have fairly high taxes to begin with.

Also, on this same subject, it\'s important and puzzling to us that
Congress would implement the ability to deduct sales taxes, recently,
after taking it away in the past.

And so, maybe we saw a little hope that there is a future for income and
property tax deductibility. The other point I made earlier is the fact
that property taxes are our largest source of revenue for local
government.

And basically our main costs at the local level are for education. And
if you think about the impact of the No Child Left Behind Act, one of
our major costs, again, in Montgomery County, but in a lot of local
jurisdictions, has been the need to provide services to meet those
requirements.

For example, school buildings to house all-day kindergarten. You can\'t
just move to an all-day kindergarten program unless you have the
facilities to do that.

It\'s cost us a lot of money. Again, we\'ve been able to meet that
because we do have a diverse revenue stream. You also have to have the
teachers to teach the kids in those classes.

Alternative Minimum Tax: I think a lot of what we\'re talking about is
already happening under the alternative minimum tax, in that state and
local tax deductions are becoming less important when paying federal
taxes.

And, as you know, more middle income families are getting hit by this.
One note, I\'m going to talk in a minute about our issue of tax
exemption and how it allows us, when we issue bonds, to pay for the
infrastructure.

Right now, under AMT, private activity bonds, which are tax exempt, in
effect are becoming taxable because they are subject to the AMT. And,
right now, we know how much more it costs us, because AMT bonds increase
financing costs 25-40 basis points over time.

Just at a macro level, if serious consideration is given to a
consumption tax again, the need to protect local government revenues.
And just one point here that, the last point on this slide, there\'s a
great concern that under a flat or national sales tax system all
services and goods would be taxed.

And that would include things like emergency rescue services, school
buses and all of that would increase the costs for local governments.
Again, as these things increase costs to local governments, the concern
is we just can\'t do as much as we could under the current arrangements.

Just mention briefly that municipal bonds are the primary vehicle for
local and state governments to build their infrastructure. There\'s over
\$2 trillion worth of outstanding tax-exempt bonds.

And they do pay for our schools, jails, prisons, transportation, water
and waste water facilities. Montgomery County issued \$2.5 billion worth
of bonds over the last 10 years, and we issue about \$200 million, or
are projected to do that going forward, again, to provide mostly
education facilities.

Just a couple of points. If you eliminate the exemption, clearly it
would cost us more. And, again, at a time when federal and state aid is
decreasing to local governments.

You can tell by the amount of tax-exempt bonds being issued right now.
There\'s, in 2003, a record \$383 billion worth of bonds issued. So,
it\'s clearly the efficient way, or the way that most local governments
do, to provide this infrastructure.

We also have a note in our appendix. There\'s a lot of work done when
you issue bonds, and we\'re encouraging simplification of some of the
rules that apply to tax-exempt bonds, again, to free up resources to
provide those services at the local level.

So, basically, to wrap up, again, thank you for allowing governments to
be represented here today. We feel you have a vested interest in keeping
local governments strong, and that any time you look at changes just
keep in mind local governments and the fact that we do provide those
direct services and we need to have flexibility with our revenue
streams. Thank you, very much.

SENATOR MACK: Thank you, too. I appreciate your testimony. And, Bob,
we\'ll go to you last.

PROFESSOR SCHWAB: Thank you, very much. I\'d like to focus on four
issues: the links between federal and state income taxes, deductibility
of some state and local taxes, tax-free municipal bonds and separation
of sources of revenues across different levels of government.

We\'ve already heard a fair amount today about the link between federal
and state income taxes, so I\'m going to cover this a little bit more
quickly than I had planned. The point that I do want to focus on is the
following question.

When the federal government has changed federal tax policy, how have the
states responded? There\'s been some research on this issue. In
particular, there\'s an interesting 1993 study, by Alan Ladd, that looks
at the decision the states made in the aftermath of the Tax Reform Act
of 1986 - TRA86.

If the states had not changed policy following TRA86, many would have
realized significant increases in tax revenues as a result of the
broad-basing initiatives that were incorporated in the act.

The states, of course, could have undone the affects of TRA86 by
changing tax rates or other elements of state tax policy. Ladd found
that states retained about 40 percent of the windfall that federal tax
reform generated.

What will we likely see in the future? Well, again, major future changes
in the federal tax code will leave the states with various options. At
one extreme, the states could decouple their tax code from the federal
tax code.

And, as we\'ve heard today, it\'s quite likely that this would lead to a
significant increase in compliance costs - the move to a federal
consumption tax is the clearest case.

At the other extreme, the states could choose to be passive and
implicitly change their codes when the federal code changes.

Let me now turn to the deductibility of state and local taxes, and just
go back and think about the history of deductibility for a moment.

Before the Tax Reform Act of 1986, property sales and income taxes were
all allowed as itemized deductions. Under the Tax Reform Act of 1986,
the property and income tax remained deductible, but the sales tax no
longer was.

Under the American Jobs Creation Act of 2004, it continued to be the
case that the property tax was an itemized deduction, and taxpayers
could claim either the income tax or a sales tax, but not both.

This is a tax expenditure. The Federal Government gave up about \$46.2
in tax revenues in fiscal 2003. Compared to some of the other tax
expenditures, this is certainly one of the largest that we\'ve seen.

Why should the Federal Government allow people to claim a deduction for
state and local taxes? We hear various rationales. Many have argued that
the base for the income tax should be a comprehensive definition of
income, the Haig-Simons definition, for example.

Under this definition, income would be equal to consumption plus any
change in net worth. Some people view state and local taxes as
involuntary non-discretionary reduction in an individual\'s ability to
consume.

And, therefore, they would conclude we need to subtract state and local
taxes from money income, in order to derive a measure of comprehensive
income.

From this standpoint, your state and local taxes are very much like a
hurricane. Both are non-discretionary reductions in your ability to
consume. Alternatively, we can simply think of these deductions as
implicit grants to lower levels of government.

Again, I remind you, it\'s about \$46.2 billion in fiscal 2003. And this
is large, relative to the explicit grants that the Federal Government
offered to lower levels of government.

So, for example, the Department of Transportation, which includes
federal highway administration, made grants of about \$38.9 billion.
Well, then we come to the question, why should we provide these grants
to lower levels of government?

We hear various rationales once again. One is that state and local
governments provide goods and services that benefit residents of other
communities. You wouldn\'t expect local governments to take those
benefits into account when making decisions.

And we, therefore, need to provide state and local governments with
subsidies, in order to induce them to make the appropriate decisions.
Certainly not all economists would agree with any of the arguments I\'ve
set out so far.

Many would argue that people vote with their feet. That is to say they
choose a community that provides a mix of services and taxes that best
meet their needs. From this perspective, state and local taxes are
payments for publicly provided goods and services.

That is to say they are benefit taxes. So, you might send your child to
school and pay tuition. If you sent your child to a private school, the
property taxes you pay are simply the tuition you pay in a public
school.

If you follow this line of reasoning, this would imply that a deduction
for state and local taxes would make no more sense than a deduction for
expenditures on pants and shoes, they\'re simply different types of
public services.

What would, how might state and local governments respond to changes in
federal tax policy? Well, once again, TRA86 provides a nice natural
experiment. Recall that TRA86 eliminated the deduction for sales taxes,
but retained the deduction for income taxes.

Now, if federal tax policy has a significant impact on the way states
structure their expenditures and taxes, then what you would have
expected to see is states switching from sales taxes to income taxes.

There\'s not much evidence, however, that TRA86 did, in fact, lead to
this sort of switch. This slide shows the percentage of total state tax
collections coming from sales, income, corporate and property taxes for
four years.

In \'85, the year immediately preceding tax reform, 31.5 percent of
state tax revenues came from the sales tax. After tax reform, the sales
tax generated a slightly larger share - between 32.3 and 33.8 percent of
total tax revenues in the years that I am looking at here.

Municipal bonds. Interest on municipal bonds is not subject to federal
taxation. And since interest on municipal bonds is not subject to tax,
interest rates on municipal bonds is lower than the rate on private
bonds.

The following example makes this clear. Suppose the corporate rate were
5 percent and the federal tax rate is 28 percent, then we would expect a
municipal bond rate to be 3.6 percent, everything else equal.

Investors would be indifferent between one lending at 5 percent and
losing 1.4 percent in federal taxes and, two, lending tax free at 3.6
percent. The facts aren\'t that inconsistent with this little numerical
example.

This graph shows - the blue line in this graph shows Moody\'s Corporate
AAA Bond rate, and the red line shows state and local 20-year bond
index. Two things become clear?

First of all, consistently, municipal bond rates are below the corporate
rate. And, secondly, the gap between the two has narrowed. And that, of
course, is exactly what you would expect to see, given the sharp
reduction in federal tax rates that we\'ve seen since 1980.

How does the rationale for exempting interest on municipal bonds compare
to the rationale for allowing a deduction for state and local taxes? Let
me offer several points here.

Certainly, there\'s no parallel to the uninsured casualty loss argument.
Municipal bonds are not like a hurricane. We can all choose whether or
not to buy municipal bonds.

Certainly, we have much less choice in whether or not to pay our
property taxes. Second, it\'s important to recall that there\'s a double
subsidy involved here. Interest on municipal bonds is tax exempt.

And, therefore, interest rates on municipal bonds are lower than on
private bonds. Moreover, any interest that the state does pay is folded
into state and local taxes, which in turn are deductible.

And, third, there\'s a concern here that this subsidy to state and local
governments is larger than it needs to be. There are benefits that
inframarginal taxpayers.

So, to go back for a moment to the example I offered before, the
taxpayer in the 28 percent tax bracket is indifferent between the
taxable and non-taxed instrument. Taxpayers in higher tax brackets, the
35 percent tax bracket, in fact are significantly better off by
purchasing municipal bonds.

Suppose we were interested in neutrality. Suppose we were interested in
leveling the playing field, so that we neither favor private goods nor
publicly provided goods. What would we need to do?

The argument here, I would claim, is really very similar to the argument
in the way that we might treat owner-occupied housing. What we would
need to do is to tax the imputed income, not just from the houses that
we own, but from the streets that run in front of those houses.

And so, in fact, what neutrality would require is we tax municipal bond
interest, we eliminate the deduction for state and local taxes and we
tax the imputed net income from public capital.

Having said that, I am certain that there is zero chance that we would
see tax reform -

SENATOR MACK: The gentlemen at the other part of the table are relieved
to hear you say that.

(Laughter.)

PROFESSOR SCHWAB: Yes. This is one on which I speak with some
confidence. Finally, let me turn fairly quickly to this question of the
separation of sources of revenues across levels of government.

Some have argued that each level of government should have its own
source of revenues. So, for example, what this argument might tell us is
that local governments should continue to rely on the property tax,
given that states rely primarily on income taxes and sales taxes.

Where does that take us here? The problem is that the argument would
tell us that the Federal Government should tax an activity that\'s not
taxed heavily by lower levels of government.

And it\'s not clear exactly what we would tax in that case. As you see
here, the states get about a third of their tax revenue from the
individual income tax, about a third of their revenue from general sales
taxes.

And so whether the Federal Government were to rely on income taxes or
consumption taxes, one way or another, they would be intruding on a tax
base that the states already take advantage of. Thank you, and I\'d be
happy to answer any questions you may have.

SENATOR MACK: Thank you, very much. And let me just say, collectively,
you have given us a lot to think about today and a lot of information.
We appreciate that. And we\'ll turn now to Jim, if you would, to ask the
first question.

MR. POTERBA: Let me pick up on one of the statistics that was in Bob\'s
presentation, which showed that after the \'86 Act, the use of sales
taxes as a share of total state and local revenue seems to have gone up,
despite the fact that they were no longer deductible.

I think that almost all of the standard economic models that public
finance economists would use to look at the state and local sector would
have yielded a very strong prediction that, in the absence of
deductibility for state sales taxes, we would have seen a massive shift
taking place in the revenue raising in the direction of income taxes in
the aftermath of \'86.

Could I just ask if there\'s a, sort of, standard traditional wisdom on
why we don\'t see that kind of flexibility and how one squares that with
the centrality of the state and local deduction in the determination of
state and local tax policy?

PROFESSOR SCHWAB: I once ran into this problem. I was asked to offer
some advice on how Maryland might change its tax policy. And my
suggestion was, in the aftermath of the \'86 Tax Reform, that we ought
to deemphasize the sales tax and emphasize the income tax and people
laughed.

And the argument that they offered was, we really need to compete with
other states, not in terms of total tax liability, but on a tax-by-tax
basis. And so, it was important that, not that you pay in total more
taxes or less taxes in Maryland than in other states, but that your
sales tax be no higher than in other state or your income tax be no
higher than in other states.

And I understand your possible skepticisms. This is the argument that we
do here.

MR. DUNCAN: I think that that\'s probably right. A couple of other
issues to consider is that when you look and you see the two bars at
roughly the same level, those would have very different impacts on
individual tax burdens with repealing them.

I know it\'s not a good thing to the public finance economists, but
about something like 40 percent of the total sales tax burden is on
business purchases. So, it\'s not a direct tax, indirectly it rolls
through, but it\'s not direct.

So when you repeal the deduction for sales tax, it didn\'t have the same
impact that it would if you repealed the individual income tax
deduction. The other is simply the traditional, what is referred to as
the popularity of the sales tax.

All of the surveys that were done over time, people tended to favor that
tax or disfavor it less than other taxes simply because it paid small
amounts at a time when you were spending money.

MR. FRENZEL: Gentlemen, thank you very much. I guess the message you\'re
giving us here is that every time the Federal Government acts, states
and locals have to react sometimes in ways that are very uncomfortable
to them.

I guess a number of the states haven\'t finished whatever reactions they
need to make to the inheritance tax difficulties that befell them when
the Federal Government last changed.

What is it that we can do that is best going to insulate you? Is it to
give you notice, or what are you most afraid that we\'re going to do to
screw up your lives?

(Laughter.)

MR. JOHNSON: Well, I\'ll start with that. I think an example might be
the bonus depreciation. When the Federal Government enacted the bonus
depreciation, that caused an impact on state taxable income.

I know that the investment tax credit has been not spoken of
particularly favorably here. But a one or two percent investment tax
credit at the federal level could have arguably had the same economic
impact to stimulate investment at the federal level, and would have
completely unaffected the state tax bases.

So, it\'s simply, we would prefer not to be in a situation of having to
react to whatever you do. We would like to be in a position of being
able to help you accomplish your goals in a way that has the minimum
impact on us, and work cooperatively so we can figure out alternative
ways to best accomplish those goals. That would be a simple example.

MR. FIRESTINE: I think we\'re also saying that there are certain aspects
of the current structure that have a benefit to us because they do
provide federal support, but they give us the flexibility at the front
line to implement things the way we need to implement them.

If somehow those subsidies, if those benefits are turned into federal
aid, or have strings attached to it, it really makes it less flexible at
the local level. And the answer is yes, if you do make changes, please
give us sufficient time to understand what those impacts are so that we
can adjust.

SENATOR MACK: Harley?

MR. DUNCAN: And just one other quick comment would be to look at
vehicles and institutions for making sure that the impacts at the state
and local level are known and Congress is made aware of them when
they\'re considered.

There\'s no federal institution, at the present time, that has that as
part of its responsibility. Now, I suppose you can argue it\'s part of
ours and we try that, but to make the information on what the impacts
are a regular part of the process, I think, could be helpful then in
recognizing that we share the tax base maybe there are alternatives,
maybe some transition time is helpful.

SENATOR MACK: Thank you.

MS. SONDERS: I want to go to something, Bruce, you quickly touched on,
but get anybody\'s perspective that has an opinion on this. You talked
about the services exclusion, and the fact that very few states tax
services.

But, obviously, we all know that we\'re seeing a significant change in
our economy - more service-oriented versus durable-oriented and
goods-oriented. I was wondering, aside from any proposals that we might
put forth on overall federal tax reform, what is changing from the
perspective of how states look at taxing services?

Is there anything we need to consider, as we go through our thought
process, in terms of how you view the need to potentially tax services?

MR. JOHNSON: I was engaged in a project last year, for our former
Governor, to completely revisit Utah\'s tax structure. And it seemed
like a no-brainer to me, from the very beginning, to say, well we need
to, our state tax base is declining.

It\'s gone from, depending on which numbers you use, 50 percent of
personal income to about 40 percent of personal income over the last 20
years. And it\'s kind of a no-brainer to expand that to services.

But we also wanted to be business-friendly. And we didn\'t want to
increase one of the biggest problems in the sales tax, as it currently
exists, and that is pyramiding.

Even though you\'re exempting goods purchased for resale, to the extent
that the people in the line of the manufacturers on their filing
cabinets and the distributors on their trucks, and all of those people
are also paying sales tax, those sales taxes are also incorporated in
the final purchase price.

So, you have the ultimate consumer paying taxes on taxes. And, as Harley
mentioned, 40 percent of the sales taxes are paid by businesses. So, in
expanding the base to services, which I think we\'re all going to do
over time, we have to recognize that a lot of those services are going
to compound the pyramiding problem unless we exempt business-to-business
services. That was our proposal, to exempt business-to-business
services. But, in order to get where you need to be from a revenue point
of view, that creates a tremendous amount of pressure on the services
that are most commonly purchased by most Americans.

And that is medical care, child care. Those kinds of services that are
born primarily by the private sector by households have been protected.
And it\'s a difficult matter of tax policy to say that we\'re going to
increase the tax on medical care so we can get pyramiding out of our
system.

So I would say that\'s something you really need to look at. You need to
make sure that you\'re not making your businesses uncompetitive,
vis-à-vis foreign competition, or in the state level vis-à-vis another
state\'s businesses by increasing the tax on services that could be very
counterproductive.

SENATOR MACK: Very good. Ed?

PROFESSOR LAZEAR: All of you have touched on two aspects of state
finance that could be affected by actions that the Congress might take.
One has to do with the deductibility of state taxes, and the other has
to do with municipal bonds and their favorable treatment.

If I thought about these two, and I thought about elimination, say, of
taxation of capital not directly affecting the states, but obviously
indirectly affecting the states by changing the interest rate structure
and raising the cost of capital that states would have to pay.

Which one of the two is your worst nightmare? Is it losing the
deductibility of state tax, or is it the elimination of the differential
that we see between municipal bonds and other kinds of capital?

PROFESSOR SCHWAB: I have a conjecture, and I can\'t claim that it\'s
more than a conjecture. I would think that the deductibility is a much
clearer case. This is an obvious way of helping to satisfy particularly
homeowners and relieving part of the burden of their tax bills.

It\'s quite obvious. In terms of tax expenditures, I think the tax
expenditure on the deductibility of state and local income taxes is
about twice the magnitude of the tax expenditure associated with
municipal bond interest.

And so, I think they are on a somewhat different scale.

MR. JOHNSON: I hesitate to give you an answer that is as unsophisticated
as it\'s going to be given the level of the presentations there. But I
will say, at a certain level, and I have to speak for myself, I\'m
certainly not speaking for the Multi-State Tax Commission or the State
of Utah.

Those of us on the panel, and certainly those of you on the Commission
are keenly aligned to the difference between federal, state and local
governments. I will say to you a lot of people that I deal with on a
day-to-day basis, government is government.

And when they prepare their individual income tax returns, they like to
deduct state income taxes. They don\'t like to feel that they are paying
federal taxes on their state income taxes.

And, in Utah, we have a deduction, albeit only one half of the federal
tax deduction, that is, at least from a public relations psychological
point of view, important to our taxpayers.

I won\'t say it\'s sound economic analysis, but it\'s real.

SENATOR MACK: That\'s helpful. That\'s really helpful, I appreciate
that. Ed?

PROFESSOR LAZEAR: I think I have two areas that I\'m particularly
interested in, but I\'ve now forgotten who said this. But, in essence,
when the tax base was broadened in \'86, about 40 percent of that
increased tax flow to the states was retained, and the balance was
returned.

Does anybody refute that? Is that a fair conclusion?

PROFESSOR SCHWAB: There has been some other work that comes to roughly
the same conclusions as the Ladd paper did. I think what would be
important, and I haven\'t seen research that\'s done this, is to look
beyond the two or three years immediately following tax reform.

You certainly wouldn\'t, I wouldn\'t be surprised if the effect in the
long run were different than in the short run. In the short run, you can
imagine the states capturing quite a bit of this windfall and they might
capture quite a bit less in the long run. But I don\'t know the answer
to that.

SENATOR MACK: Harley?

MR. DUNCAN: I was just going to say the same thing. I certainly
wouldn\'t question Alan Ladd\'s work, but I happened to be in Kansas as
head of the Revenue Department at the time and it passed in \'86.

We had a gubernatorial election, and we also had a very difficult fiscal
situation facing us, so we had an incoming administration and a budget
hole to fill and, not to put too fine a point on it, but the
base-broadening and not changing our rates was sort of like manna from
heaven.

It enabled us to get through a transition and fill that budget hole. We
subsequently came back then, in the following session in the \'87 and
the \'88 sessions, and enacted a fairly broad reform of our income tax,
where we not only followed the base-broadening, we broadened it further.

And we moved down our rates significantly. But we did use the windfall
to really take a glide path into that and get to a tax structure that
both supported our expenditure stream.

So, we used it for a short term, but it was a transition issue.

MR. JOHNSON: I\'d like to speak to that just a little bit, also, not as
an economist, because I can\'t refute the numbers or fail to refute the
numbers. I simply don\'t know.

But I will tell you that I think it\'s instructive to look what the
states have done in the last few years. During a time when the state
revenues declined, states were facing the worst fiscal crisis they\'ve
faced in years, there was almost no talk anywhere about actually raising
tax rates.

That was, a few states raised a few taxes. There was a lot of talk about
raising tax on the sin taxes. But there was virtually no discussion on a
general tax increase. I think Idaho might have raised its income tax by
a percent.

We\'re in a very different political environment now than we were in
1986, and the people of the states are holding us much more accountable.
And I can tell you how the Utah legislature would react if they thought
we were getting a windfall.

And I think that is a situation that is much more prevalent now than it
was in 1986.

SENATOR MACK: Okay, thank you. The other area, and I\'m sure there\'s
data out there, I\'m just not familiar with it, is the experience with
respect to, as sales taxes go up, do you experience more compliance
problems?

MR. JOHNSON: As sales taxes go up, what we see, more than that, really,
is pressure at the legislative level for additional exemptions. If the
local sales tax is on a retailer who\'s collecting tax on a broad
variety of goods, no exemptions, not doing much in the way of selling to
manufacturers, selling to people like that, that tax is relatively easy
to administer.

The cost of administering that tax would be maybe one percent for the
retailer. But, as you get smaller retailers, those costs go up. And a
Washington state study shows that those costs are about 7 percent for
retailers that have \$100,000 - \$250,000 worth of sales.

But there isn\'t a lot of pressure at the register. There\'s a lot of
pressure for industries now to say I have to have an exemption, because
I can\'t afford an 8 percent tax, 7 percent was bad enough.

And so, you get increased tax planning, you get increased requests for
exemptions, which further reduces the tax base and ultimately has the
counterproductive effect of putting additional pressure on increasing
rates. So, I think that\'s where we see it more.

MR. FIRESTINE: Can I also add, just the change to the use of the
internet, and how it has affected state governments and their tax
collections inability to collect those taxes has eroded quite
significantly the state sales tax bases.

SENATOR MACK: Very good.

MR. DUNCAN: The only other point I might make, Mr. Chairman, is that
studies of compliance in the sales tax, of course looking at taxes that
are in six or seven, maybe eight, percent range, I think you can get
different results if you look at some of the evidence in the excise tax
area, particularly cigarettes, where taxes may comprise 30, 40, 50
percent of the product price.

You have larger compliance issues that will arise there.

SENATOR MACK: Very good, very good. Again, any other questions from the
panel?

MR. POTERBA: Harley, could I just draw you out on that specific issue,
since the experience of the states may be very helpful for thinking
about, say, a national retail sales tax.

I mean, if one thinks about a broad-based sales tax in the range of
25-30 percent, does the experience with some of the excise taxes lead
you to think that there would be potentially difficult compliance issues
there?

MR. DUNCAN: I\'m not sure exactly how to dance on that particular
question. I think we simply don\'t have the experience of the
broad-based sales tax at that particular level where you\'ve got an
opportunity of outlets to purchase cigarettes in a non-taxed, or
basically a lower-taxed.

We know that those compliance issues arise. I think we can also say that
based on some experience at the state level in dealing with particular
types of products, particular types of service providers, we would
expect compliance issues at rates that high.

MR. JOHNSON: Let me give you a quick practical response to it, even much
lower rates. When I was in private practice, I had a client that wanted
to buy a hospital.

The hospital had about \$600 million of tangible personal property
involved. It was a relatively simple matter for us, even though the
rates were in the 6 percent range, to say well let\'s incorporate a
subsidiary and have the seller sell you the stock.

Then you buy this hospital, but you\'re buying the subsidiary, you\'re
buying an intangible, so there\'s no sales tax. The cost of that
transaction, incorporating the subsidiary, were dwarfed by the tax
savings.

We had a different tax base for state and local purposes in that
particular state. And the deal worked for state tax purposes, and it
didn\'t work for city purposes because they didn\'t have another
exemption for incorporating a subsidiary.

But the fact of that matter is, it\'s still relatively easy to plan
around major purchases if you don\'t extend the tax to intangibles as
well.

SENATOR MACK: Again, thank you so much for your participation today. I
think that this discussion was quite helpful. Thank you. And that will
conclude our meeting. I might suggest that sometime in May, we will have
some additional hearings where we will start to look at the various
alternatives that have been proposed.

And, so, we will make that information available as the date and the
participants have been nailed down. Again, thank you very much for your
participation today.

(Whereupon, the meeting was adjourned at 2:49 P.M.)