UNITED STATES OF AMERICA

\+ + + + +

PRESIDENT\'S ADVISORY PANEL ON

FEDERAL TAX REFORM

\+ + + + +

TWELFTH MEETING

\+ + + + +

TUESDAY,

October 18, 2005

\+ + + + +

The Panel met in the Amphitheater of the

Ronald Reagan Building and International Trade

Center, 1300 Pennsylvania Avenue, N.W., Washington,

D.C., at 9:00 a.m., Connie Mack, Chairman,

presiding.

PRESENT:

THE HONORABLE CONNIE MACK, Chairman

THE HONORABLE JOHN BREAUX, Vice Chairman

THE HONORABLE WILLIAM E. FRENZEL, Panel Member

ELIZABETH GARRETT, Panel Member, (via telephone)

EDWARDS LAZEAR, Panel Member

TIMOTHY J. MURIS, Panel Member

JAMES M. POTERBA, Panel Member

CHARLES O. ROSSOTTI, Panel Member

LIZ ANN SONDERS, Panel Member (via telephone)

PANEL STAFF PRESENT:

JEFFREY KUPFER, Executive Director

JON ACKERMAN, Senior Counsel

ROSANNE ALTSHULER, Senior Economist

A‑G‑E‑N‑D‑A

Page No.

Welcome and Opening Remarks

Chairman Connie Mack. . . . . . . . . . . . . . .3

Simplification and Reform of the Current Tax Code

Charles Rossotti. . . . . . . . . . . . . . . . .6

Elizabeth Garrett . . . . . . . . . . . . . . . 18

Progressive Consumption Tax Ideas

Liz Ann Sonders . . . . . . . . . . . . . . . . 69

Jim Poterba . . . . . . . . . . . . . . . . . . 77

Edward Lazear . . . . . . . . . . . . . . . . . 98

Continuing Discussion About Value‑Added Tax

William Frenzel . . . . . . . . . . . . . . . .140

Adjournment . . . . . . . . . . . . . . . . . . .148

P‑R‑O‑C‑E‑E‑D‑I‑N‑G‑S

9:03 a.m.

CHAIRMAN MACK: Well good morning,

everyone, and I\'d like to welcome you to the twelfth

meeting of the President\'s Advisory Panel on Federal

Tax Reform. Last February we held our first meeting

in this very auditorium.

Since then we have developed a thorough

understanding of the problems created by our tax code

and a conviction that tax reform is imperative. We\'ve

also explored a number of reform proposals that would

deliver a better tax system than the one we have

today.

Today\'s meeting represents a critical step

towards the conclusion of our process. We will have

three presentations that will present a number of

reform proposals in detail. The proposals we will

discuss are intended to be revenue‑neutral using the

President\'s budget as our baseline. In addition, the

proposals are progressive and will not substantially

alter the distribution of the tax burden under current

law. These presentations will be followed by panel

discussion to decide on the direction we will take in

our recommendations.

Our objective is to address the most

pressing problems presented by our current system.

Accordingly, we have focused on big picture ideas that

would improve the tax code for a large number of

Americans. The Panel\'s recommendations will be on the

first of many steps in what we hope will be a

successful tax reform effort. Undoubtedly, the

Panel\'s recommendations will be further refined by the

Secretary, the President and the Congress.

The President directed the Panel to submit

at least one option using the current income tax

system as a starting point for reform. Our first

order of business today is to discuss proposals that

will fulfill that mandate. Charles Rossotti and Beth

Garrett will make a presentation on behalf of the

working group studying major simplification and reform

of the current tax code. After the presentation, we

will discuss their findings.

We will then turn to more far‑reaching

approaches to reforming our tax code. Our second

working group has been studying fundamental reforms of

the existing tax system focusing on consumption tax

proposals. Liz Ann Sonders, Jim Poterba and Ed Lazear

will present reform ideas that would tax consumption

in a progressive manner. They will present two

separate approaches that would fundamentally change

our tax system.

And lastly, we will continue the

discussion that we began last week about the adoption

of a consumption tax that would be used to collect a

substantial portion of the revenue now collected under

our current income tax. And Bill Frenzel will outline

a possible approach that would combine a value‑added

tax with a smaller and more efficient simplified

income tax.

So with that introduction ‑‑

VICE‑CHAIRMAN BREAUX: Can I make a

comment?

CHAIRMAN MACK: Excuse me. Yes, John?

VICE‑CHAIRMAN BREAUX: Well, thank you,

Mr. Chairman. I would just say once again how much we

appreciate all the time and effort that you have put

into this effort as Chairman of this commission. It\'s

been a great challenge. We\'ve had meetings all over

the country and now we move towards a conclusions and

a recommendation. We, I think, have to go back and

remember that the original chore of our committee was

to simplify the tax code and we had to do it in a

revenue‑neutral manner, which is a real challenge,

because every time we found provisions that needed to

be changed or to be eliminated, we also were

challenged with the obligation of finding an offset.

So for everything that you give with one hand under

this process, we had to find a way to replace it. And

of course that\'s not easy and it\'s very difficult

politically.

But I think that we are moving towards

some very courageous recommendations that are

difficult and tough, but also very fair. And they

also meet the criteria of what we had to do under the

charge of the President to simplify the code. I think

our product will do that and I think it will do it in

a fair and a reasonably progressive way. Thank you.

CHAIRMAN MACK: Thank you.

PANELIST FRENZEL: Mr. Chairman, I want to

second his motion about your leadership and

stewardship, and we all thank you.

CHAIRMAN MACK: Thank you very much. It\'s

not necessary to go any further, guys.

Charles, I think we\'ll start with you.

PANELIST ROSSOTTI: Okay. Good. Thank

you. Thank you, Mr. Chairman.

As you mentioned, we\'ve had a working

group of four panelists studying simplification reform

of the income tax. And the first thing I want to say

is that I want to express my gratitude to my other

three panelists, Tim Muris, Bill Frenzel and Beth

Garrett who\'s on the phone. I can\'t remember ever

having the privilege of working with people who

contributed so much expertise and diligence and also

had a little bit of fun along the way, if you can ever

think of income taxes as fun. It was only the people

in the working group that made it a little bit light

from time to time.

We started, of course, with the three

broad goals the President gave us to make the system

simpler, our number one objective, more fair and also more

fostering of economic growth in the economy. That\'s

the charter that we had.

As we discussed these things, we came to

believe a few more specific ways of interpreting these

goals. On simplification, I think we came to believe

that our goal was not only to make it easier to fill

out forms, but to make the calculation of each

person\'s tax more understandable. You can use a

computer program; and many people do, to make

complicated calculations. But when those calculations

are so mysterious that people don\'t understand those

calculations, we think that\'s a very bad thing and it

fosters, you know, uncertainty and cynicism and just

bewilderment among the population which is not what

the tax system should be all about. So we wanted to

make it more understandable, less opaque.

Concerning fairness, one of the

instructions in the Executive Order was that the

system should be appropriately progressive, which the

current system of course is. It just gets there in a

very complex way. As we got through a lot of numbers,

we realized that we couldn\'t come up with any Solomon‑

like definition of fairness that was better than

simply saying that roughly speaking that the

distribution of who pays tax under the current system

should be roughly the same under the new system, even

though it would be a very system in the end, our goal

was to not change in any significant way the

distribution of tax. So that means that in our

proposal, after a lot of work, notwithstanding that

there are a lot of things adding and subtracting,

people at all income levels; and that means from the

very top income levels all the way to the very lowest

levels, would actually end up paying about the same as

they do under the current system, only they would be

doing that in a simpler and much more clear and

transparent way.

And as for growth, we believe that the

most important thing that we could do for growth was

to encourage savings, which is important both for the

economy and for the security, economic security of

families and individuals, and also business

investment. And we think that part of doing that is

to make the provisions that already exist in the code

more easy to understand and therefore more powerful.

So how did we go about this? Well, I

think of the income tax today like ‑‑

CHAIRMAN MACK: Can I just interrupt you

for just one second?

PANELIST ROSSOTTI: Yes, sir.

CHAIRMAN MACK: I just want to make a

comment with respect to the issue of progressivity and

the distribution tables and so forth.

We as a panel basically decided this, I

think maybe at our second meeting, that we were not

going to debate the issue of whether the present

distribution is in fact the right level of

progressivity. We concluded if we were to do that we

would be engaged in a discussion that would just take

us weeks and months and maybe never conclude. And the

feeling basically was, that\'s a decision that the

Congress ought to make. One could argue that the

distribution as it presently exists is what the

political system in the country has established. We

did not take on the effort of trying to figure out

what is the proper distribution and progressivity. So

I just wanted to make that kind of clarifying remark.

PANELIST ROSSOTTI: I appreciate that.

And I think, you know, in our panel, and I believe was

probably true in the other panels, we essentially

ended up taking that as a guideline. So, we said we

want, you know, no matter how you define it, within

reason; I mean, it\'s always small insignificant

differences, but by and large we wanted to say people

at the very top, people at the very bottom and the

middle, wherever they were, they\'re going to pay the

same as they do now pretty much. And so if you like

it as progressive it is, it\'ll be just as progressive

under the new system.

Now, how we went about it. I tend to

think of the income tax today like old‑fashioned

trading stamps. When I was a kid, my mother, I

remember, used to get these green trading stamps. You

went to the supermarket or the gas station and they

gave you these trading stamps and you would collect

them and you would paste them in these books, you

know? And I still remember these books. And after

you got a certain number of books, you could go and

get a free toaster or a set of dishes, or something

like that with these trading stamps. And of course

the whole point was this is a free toaster that you

were getting. Of course you were really paying for

that toaster in the price you paid at the supermarket

and you also had all the bother of keeping track of

these trading stamps as well as trying to figure out

what you could get and what you couldn\'t get with the

trading stamps. And that\'s the way the tax code is

today. It takes your money and the rates you pay and

then it gives part of it back to you in the form of

deductions, credits, exemptions and whatnot.

The difference is that unlike Green Stamps

where there was maybe one or two flavors of Green

Stamps, in the case of the tax code, there are so many

of these things that you\'d run out of colors in the

rainbow if you tried to have stamps for all of them.

But they all amount to the same thing. They\'re taking

your money and giving it back to you with a label on

it. That\'s what the tax code is.

Another thing about it is that it\'s pretty

deceptive in a lot of cases because the code, as it\'s

currently structured, give these so‑called breaks to

you in one place and then often in a way that\'s not so

obvious takes them back in another way. You may think

that you\'re saving on your taxes, your federal taxes

by deducting your state income taxes, but then that

saving for a lot of people gets taken back in

something called the alternative minimum tax. You may

think that you\'re deducting all of the interest on

your mortgage, on your home mortgage, but you may not

realize that part of that then gets taken back in

what\'s called the so‑called phase‑out of itemized

deductions that takes place over a certain level. And

you may even think you\'re getting a personal exemption

for you and some members of your family, but you may

not realize even that\'s taken back by another kind of

a phase‑out which requires still another form.

So going back to my Green Stamp story, I

think if you look at today most consumers have gotten

a lot smarter. You know, I don\'t know of anybody

pasting stamps in books. Most of the successful

retailers have found that it\'s more appealing to just

have everyday low prices and that\'s the way we

approached our job on the income tax. We started with

a clean tax base of income with no breaks at all, try

to make the rates as low as possible and as simple as

possible.

And of course as you know from our

previous panel, we expunged from our thinking the

dreadful idea of imposing not only one, but two,

parallel tax systems. In other words, we eliminated

the alternative minimum tax, which is just the back

door way of collecting back taxes that you gave in one

place and taking it back.

So that only left us with three big things

to work on as far as the individual taxes are

concerned.

One was how to recognize the fact that

families do vary in terms of size and

responsibilities. So we needed to find a way to

replace what are currently a large array of

exemptions, deductions and credits. And we came up

with two credits; two simple credits, a family credit

and a work credit, which I\'ll describe.

The second thing we had to do is we did

have to recognize the importance of three things; home

ownership, charitable giving and health care. So we

created on simple provision for each of those, which

would be available to every taxpayer, unlike the

situation today. And, Beth, my colleague will

describe those in a minute.

And third, as we said, we had to recognize

the importance of savings, as well as investment, in

the individual code. So we created some much simpler,

but I think more powerful ways for people to save tax-free. This also
enabled us through this

simplification to reduce the number of tax brackets

from six brackets to four and I should say that of the

four brackets, the lowest bracket, 15 percent, about

75 percent of the taxpayers will deal only with that

one lowest bracket, which is 15 percent. The other

four brackets are 25 percent, 30 percent and 33

percent.

I also should note that this enables us to

assure almost every taxpayer that they will actually

be in a lower marginal bracket, those that are above

the minimum bracket. And that\'s most obvious of

course in the top bracket because it\'s being reduced

from 35 to 33 percent, but the upper break points for

the 15 and 25 percent bracket will also be higher, so

many more taxpayers than currently will be in a lower

marginal bracket.

We\'ve also nearly eliminated marriage

penalties simply by making the tax brackets for

married couples exactly two times those of single

couples and also providing exactly double the family

credit for married and singles, as you will see.

Now, the one part of the tax code that

does affect every taxpayer is the part that deals with

families and dependents.

There are four major parts of the tax

code, each one of which is practically a tax code in

and of itself that is based on family attributes.

Even the simplest one, the standard deduction, has its

own peculiar form of complexity. Why is that?

Because if you want to be sure you\'re paying the least

tax allowable to you, you have to figure out whether

it is to your advantage to itemize or to take the

standard deduction. So you may have to first itemize

to find out you don\'t need to itemize. Furthermore,

there are still, notwithstanding some progress in the

last couple years, there are still somewhat different

definitions of the family attributes that people need

to have in order to qualify for these benefits.

In the simplified income tax, we\'ve

reduced all of these provisions, as you can see in

this chart, to one family credit, which is truly

simple to figure out. Every taxpayer selects one of

four situations for themselves, as shown in this

table. So, for example, if you\'re single, you get for

yourself a credit of \$1,650. If you are married, you

get exactly double that amount. And if you\'re

unmarried, but you have dependent children, you get

\$2,800. So that\'s just a matter of selecting which

one of those applies to you. You add to that base

amount for yourself and your spouse, if you\'re

married. You add to that a credit of \$1,500 for every

child dependent and \$500 for every other dependent.

And that\'s it. That\'s your family credit. You add up

that family credit and you subtract it from your tax

and that\'s all there is to it.

What does this do? First of all, it\'s

uniformly available to every taxpayer with no hidden

phase‑outs. There\'s no need to figure out whether you

should itemize or not because there\'s no need for such

a thing as itemizing at all. Four sets of complicated

rules are replaced with one, and that one basically

only has to define who is a child dependent and who is

a dependent other than a child. And although it\'s not

here yet in our report, we will explain that even

those definitions have been simplified considerably.

So that is the basis for replacing everything in the

code that has to do with current exemptions,

deductions and so forth related to families.

Now, the other major provision in the

current tax code provides a benefit for low‑income

working families in the form of a refundable credit.

There are two such refundable credits right now. One

of them is the Earned Income Credit and the other is

the Refundable Child Credit. They both serve the

purpose of attempting to supplement the income of low‑

income working families with children. In the EITC

case, it\'s also available to a limited extent to

working individuals without children. But the problem

is, each of these things is very complex. It requires

different definitions as well as complex calculations.

In the simplified income tax, we have

retained the same benefits for low‑income working

families as these more complex provisions do, but

we\'ve accomplished that in a much simpler way by

providing for a single work credit that builds

directly on the family credit which I showed in the

previous charts. As a matter of fact, it builds so

directly that after listing the family members for

your family credit, which is just you, your spouse and

your children, the taxpayer doesn\'t even need to

calculate the work credit. Simply by checking a box

and answering one question, a taxpayer will be able to

have the IRS calculate the work credit automatically.

So the taxpayer, if they want to, doesn\'t even have to

bother with the calculation. After they finish the

family credit, they can just check it and answer one

question and I\'ll show you how this works later.

So that summarizes what we\'ve done in that

whole area of credits related to family size and low‑

income working families.

VICE‑CHAIRMAN BREAUX: And the work

credit, Charles, is indexed for inflation?

PANELIST ROSSOTTI: Yes, it would be

indexed.

I would now like to turn it over to my

colleague, Beth Garrett, on the phone to explain the

rest of our proposal for the simplified income tax as

far as individuals are concerned. So, Beth?

PANELIST GARRETT: Thank you, Charles.

Since Charles thanked my other colleagues, let me

thank him. His work on this and getting to work with

him has been a real pleasure in this tax panel.

As he discussed, we really worked towards

simplicity as our major goal, because I think there is

a political constituency for simplicity. So it tends

to be a value that\'s sacrificed in Congress and the

political branches, and I think you\'ll see simplicity

in lots of different ways. You\'ve seen it in the

discussion Charles just offered, but for example, we

subjected all tax expenditures to a burden of proof.

We preferred a clean base and tax expenditures were

included only if we thought that they would change

behavior if they were constructed appropriately.

You see our dedication to simplicity in

the decision to eliminate virtually all phase‑outs

except when they we were absolutely necessary such as

with the work credit or with the saver\'s credit I\'m

going to talk about. And I think the decision to

eliminate the individual AMT was driven by simplicity

as well.

I think we\'ve got a lot of features that

I\'m going to discuss, but also worked towards

fairness. We prefer credits rather than deductions by

and large, which I think are fairer. We tried to

reduce the marriage penalty. We try to insist that

people who don\'t itemize are still eligible for tax

benefits. So, you know, I think that there are lots

of these things that you\'ll see as I go through the

individual side of this tax plan.

As Charles discussed, the simplicity is

apparent. Taxpayers will compute their income using

in most cases their W‑2s and their 1099s, they\'ll

compute their tax and then they\'ll compute their

family credit, subtract it from tax due and find out

what they owe or what they\'re going to have refunded.

There are very few deviations from this.

Before I get to those deviations though,

I want to talk a bit about income because we do change

that in the ways that we mentioned last week and some

ways we haven\'t yet.

We are changing the tax treatment of some

forms of compensation that are currently favored with

a preferential tax treatment. I think the most

important of these is one that Tim Muris discussed

last week and that is how we deal with health care and

health insurance. We are capping the exclusion for

income for employer‑provided health care with a cap of

\$11,500 for families and \$5,000 for singles. That cap

was chosen because it\'s the amount provided to members

of Congress. The cap was indexed to CPI. I think

that\'s one of the toughest calls here and it may be

something we want to discuss, whether indexing the

health cap to CPI is right whether it should be

indexed for health costs. But in the end what we

think is important is that tax preference for health

insurance be capped to this level.

Now, instead we entirely deducted by the

employer even the amount over the cap because it\'s

compensation and compensation is deducted for tax

preferences and the inclusion and that\'s what we\'re

dealing with. To respond to various concerns, workers

without access to employer‑provided plans will get a

deduction equal to the exclusion enjoyed like those

with employer‑provided care.

Another change in the way that taxable

compensation is the current treatment of fringe

benefits, which are tax favored in that they are

excluded from income. We will change that. Taxable

compensation under our plan includes most fringe

benefits currently excluded from income. For example,

child care, life insurance premiums, education costs,

etcetera. The only fringe benefit excluded from

income under our plan are in‑kind benefits provided to

all employees. So those are the changes in how you

determine income.

I want to talk a little bit about what our

additional deductions and credits are beyond that very

simplified system that I mentioned a few minutes ago.

The first thing I want to discuss is the

home credit, which is the proposal we would use to

replace the home mortgage interest deduction. In our

proposal, we would allow a home credit to all

taxpayers, and even those who do not itemize, so

there\'s no itemizing anymore, a home credit of up to

15 percent of mortgage interest paid to acquire,

construct or substantially improve the principal

residence only. So there\'s no more tax preference for

second homes and no separate tax preference for

separate home equity. All taxpayers are allowed this

tax credit.

It\'s limited, however, in that it\'s only

allowed for interest paid on mortgage indebtedness

equal to the FHA loan limit in the homes of others

area. We chose the FHA limit because it takes account

of regional variations of modest homes. In Oklahoma

it does not cost the same as a modest home in

California. The FHA loan limit varies from \$172,000

to about \$312,000 with the national average of around

\$255,000. Now we may want to discuss this cap. It

still may be too low for some regions. But I think

the important thing is that we need to have a cap

substantially under the \$1 million and we have to have

one that takes account regional variation in the price

of a modest home.

There\'s no additional complexity for

taxpayers in this proposal. They\'ll receive something

from their mortgage banker which will report the

amount of interest that is eligible for the home

credit. There are some additional computations that

the banker will have to do, but that also is not very

difficult, particularly since it\'s keyed to an FHA loan

limit that they\'re familiar with.

Now home ownership is still an advantage

under this proposal. We don\'t tax the imputed

original value of homes. We still exclude capital

gains on the sale of a principal home and I want to

talk about that in a minute.

But before we move to that, I want to just

go back and emphasize I think in the press coverage

the home interest mortgage deduction in our discussion

last week something important was lost, which is

although we are proposing to reduce the cap

substantially, we\'re allowing lots of the people who

do not currently benefit from the home mortgage

interest deduction to benefit from this home credit.

So I think we\'ve constructed a tax expenditure that

makes more sense, will change behavior in appropriate

ways and it\'s fairer.

Let me go to the capital gains however.

Right now capital gains on the sale of the principal

home are excluded up to \$500,000 for couples; \$250,000

for individuals. We would increase that exclusion for

couples to \$600,000 and we would index this exclusion for inflation. We
increased it because it hasn\'t been

increased since 1997 and it was not indexed at that

time. We also increased it because, as I and Charles

will discuss later, we\'re not providing preferential

treatment for capital gains outside of our integration

proposal, which affects corporate dividends and

corporate stock. So, because the remaining capital

gains on a home will be taxed at ordinary rates, we

did retain this exclusion of the capital gains up to

\$600,000.

One thing we may want to discuss, as you

all know, you\'re eligible for the exclusion now if the

home has been used as your principal for two out of

five years. I think we ought to consider discussing

increasing that requirement to three or four years so

that you can also receive the preferential treatment

if the home has been your principal residence for say

three or four out of five years.

We are proposing transitional rules for

current mortgages. This is a significant change and

we don\'t think it should happen overnight. So we are

proposing to phase in this new credit over five years

and it\'s capped over five years, moved immediately to

the credit. And I think that it\'s very important that

there be some sort of transition relief.

The second tax expenditure that we

retained is the charitable deduction. As you know it

was discussed last week by Charles. As with all of

our tax preferences, it would be available to all

taxpayers and the deduction would be allowed for

charitable contributions over one percent of the

taxpayer\'s income. So there would be a threshold.

We would also allow tax‑free distributions

from retirement savings vehicles after the age of 55

and we include a variety of compliance provisions that

Charles discussed last week to improve the rule for

valuing property and to improve the informational

reporting.

Now the third area that I wanted to

discuss was tax preferences for all taxpayers with

savings. The President told us that our proposal

should not only be fair and simple, but also that it

should be pro‑growth and encourage saving and

investment. And to that end, we are proposing a

savings package. One of the main goals of this

package is simplicity and to ensure that all taxpayers

receive incentives to save. We\'re also trying to

focus on some areas we think will actually increase

net savings in the country as opposed to offering a

windfall to taxpayers who would save anyway.

One thing I want to stress, this package,

which includes three savings vehicles and a tax

credit. This is a package, in our view, that needs to

move forward as a package rather than having one or

two provisions sent out without the rest of the

package. We think that it\'s should be sent only as

the unified whole.

So as I said, the savings package includes

three savings vehicles plus a refundable saver\'s

credit. The first savings vehicle is called Save at

Work. Save at Work accounts will replace all current

employer‑provided plans. So we have one set of rules

and one possible plan offered by employers to

encourage people to save. Save at Work accounts will

replace 401(k)s, simple 401(k), 403(b)s, 457s, SAR‑

SEPs and the Simple IRA. We have simplified the non‑

discrimination rule while still ensuring that they are

not geared to the highly‑compensated.

Another very important part of the Save at

Work account is something that we discussed and

decided to pursue in July, which is that we will

change the default rules in the Save at Work account

rather than to current employer‑provided accounts. We

call this provision Auto Save. What is Auto Save? It

has four components. First, every employee is

automatically enrolled in the employer‑provided Save

at Work account when that\'s offered by the employer.

So, there\'s automatic enrollment. There\'s automatic

growth over time as is appropriate. There\'s an

automatic investment in a diversified fund. And

finally, when the employee leaves the job, there\'s

automatic rollover into another tax‑deferred vehicle.

So in other words, the default rules have been

changed, so rather than opting in as under current

law, an employee has to opt out. And we think that

the literature suggests that this will result in real

behavior change and real increase in savings.

Any employee can opt out. We\'ve not reduced anyone\'s

autonomy; we merely changed what the default rules

are, and we think that will have a beneficial effect

on savings.

The second savings vehicle we call Save

for Retirement. Again, our primary purpose here is to

simplify. The Save for Retirement accounts replace

all current retirement savings accounts outside of

those provided by employers. So it replaces IRAs, Roth IRAs,
non‑deductible IRAs. We would replace deferred executive compensation
plans and tax-free inside build-up of cash value of life insurance and
annuity. This will be a way that people can save for retirement other
than the Save at Work accounts.

Save for Retirement accounts are back

loaded, like Roth IRAs are now. There is no income

phase‑out. That\'s a big change and we\'ve eliminated

income phase‑outs wherever possible for

simplification. And each individual can contribute

annually up to \$10,000 to a Save for Retirement

account. There are limited withdrawals allowed. One

can withdraw from a Save for Retirement plan only

after age 58 or upon death or disability and no other

purpose for withdrawal is allowed. Any other

withdrawal will be taxed and penalized.

The third savings vehicle is called Save

for Family accounts. This is a vehicle which replaces

all other current tax-preferred savings vehicles. It

replaces health and medical accounts currently in the

code, things like the Coverdell education savings

accounts, such as 529 accounts, HSAs, Archer medical

savings accounts, flexible spending accounts now

provided for employees.

Again, we have no income phase‑out and

again the contribution limit is \$10,000 annually per

individual. We do limit withdrawal from these

accounts. You cannot withdraw from these accounts for

any purpose and we did not support accounts that allow

withdrawals for any purpose. Instead, the withdrawals

can occur only for health and medical expenses,

education and training, buying a primary residence or

retirement.

We also allow withdrawals up to \$1,000 per

year for any reason. And the reason for that was we

didn\'t want to have to go through hardship

determinations to determine if that personal purpose

qualified for a withdrawal. We just say everybody

gets \$1,000, but that\'s it. Otherwise, all

withdrawals have to be for one of the specified

purposes.

Now in addition to replacing all of those

accounts that I mentioned, I think it\'s noteworthy to

mention here, we\'ve also eliminated all other tax

benefits for education so that these accounts are the

ways that we would suggest the tax code encourage

saving for higher education and other educational

purposes.

One final observation about these two Save

for Retirement and Save for Family accounts. These

savings vehicles are back loaded so the full revenue

offset is not going to be revealed in the 10‑year

budget window that we have. And because there will be

conversion from old accounts to new ones, there will

be offsetting revenue gains in the window. We

estimate that only one third of the present discounted

value of the revenue loss associated with these back

loaded savings vehicles will occur within the budget

window of 10 years. In other words, two thirds of the

revenue loss associated with these occurs outside of

our budget window.

Our proposed report will include a

discussion of the likely magnitude for

policy makers to consider. We also note that there

are revenue offsets outside the budget window for

other provisions that we\'ll be discussing today;

expensing is a good example, where the revenue loss is

actually front loaded and we hope the report will

discuss the magnitude of those effects as well.

The final part of our savings package, and

I think the nucleus of the package, is the refundable

saver\'s credit. The two vehicles I just talked about,

Save for Family and Save for Retirement, are available

to those people who have the resources to save and we

were concerned that all Americans should be encouraged

to save, and indeed for those Americans with a very

low income, their savings will be net needed savings.

We could say demonstrated that properly constructed

refundable credits can change behavior and our current

saver\'s credit is not optimally designed primarily

because it lacks refundability.

So we have proposed a refundable saver\'s

credit, 25 percent of every dollar, put into a Save

for Retirement account or a restricted Save for Family

account up to \$2,000 in contributions. In other

words, there\'s a maximum credit of \$500 which is

refundable. It is coordinated with the work credit

phase‑out to minimize complexity and we\'ve also worked

to minimize marriage penalties with respect to this

credit.

We have variations of additional current

accounts, current for compensation, current life

insurance and annuity. You know, we have worked to

ensure that those who have invested in those vehicles

are not harmed by these new rules, but we\'ve also

changed the code so that from now on all of the

savings activities should be going on in these

accounts.

The final, I think, important observation

about tax expenditures is that we eliminate the

deduction for state and local taxes, including

property taxes. So we would no longer in our plan

have that particular tax subsidy.

I only have two other quick issues; I

promise. One side issue I think we need to mention is

the tax treatment of Social Security benefits. It\'s

currently very complicated with an 18‑line work sheet.

There\'s bracket creep because the threshold where the

taxation kicks in are not indexed and there\'s a

marriage penalty. We believe that taxing some

benefits of those who receive Social Security that are

relatively well off is a good idea, but the current

system is much too complicated and has unfortunate

consequences, for example, in marriage penalties. So

we simplified and we\'re using thresholds that

eliminate the marriage penalty and are indexed above

the threshold which at this point is \$45,000 for

married couples and \$22,000 for singles. Social

Security benefit recipients will be taxed at between

50 percent of their benefits up to a maximum of 85

percent of their benefits, depending on their income.

And then finally, let me just talk briefly

about the treatment of capital gains under the initial

side. I think this is more appropriately discussed by

Charles because all of our tax preferences for capital

gains and for business income and in the aspect of our

integration proposal. So we see that aspect that

affects individuals as part of the overall plan to tax

corporate income and business income more fairly with

fewer distortions.

I just want to underscore what that means. What that means is that other
capital gains like capital gains not associated with corporate stock
would be taxed at the ordinary income rate. We don\'t have a separate
rate structure for capital gains other than for corporate stock and
Charles will discuss that.

And then in addition, as I mentioned, we

do retain the capital gains exclusion for sales of

principal residences and we increase the amount that is excluded.

That\'s it.

MR. ROSSOTTI: Okay. Thanks, Beth.

As Beth noted, the individual income tax and the

corporate income tax both affect how income from

business investments is taxed and therefore it has an

impact on investment activity in the economy.

For businesses that pay tax at the

corporate level, the longstanding problem is that that

income is taxed twice; once through the corporate

income tax and once through the individual tax, either

on dividends or capital gains. That situation not

only increases the tax burden on productive

investment, it also forces a certain amount of

unproductive and complicated structuring activity for

businesses and business transactions in order to avoid

this double tax, which in turn is one of the causes

for some of the complicated tax rules that we have

today.

Solving this problem though without

creating even more complications has been quite

difficult historically and one of the reasons for the

difficulty is that not all corporations actually pay

tax on all their corporate income, even those that are

nominally taxed at the corporate level due to may

complex provisions of the tax code that affect

corporate tax. The current tax code attempts to solve

this double taxation problem by creating a different

set of tax rates, a lower set of tax rates for

corporate dividends and for capital gains.

The flaw in this approach, as we heard in

some of our testimony during the hearings, is that on

the one hand it does not actually eliminate double

taxation of either capital gains of dividends derived

from corporations who actually pay the corporate tax.

On the other hand, it does provide a tax break for

some dividends and capital gains which are derived

from assets owned by businesses that never actually

paid any corporate tax. So there was no double tax,

but they\'re still getting a break.

In the simplified income tax, the double

taxation of dividend income from U.S. taxpaying

corporations would be eliminated. That\'s because

there would be a 100 percent exclusion from income

reported by individuals for dividends received on all

the U.S. income of U.S. corporations. So for

corporations who report all of their income in the

U.S., all of the dividends would be excluded.

For U.S. multinational corporations, each

year they would simply calculate the fraction of

worldwide reported income that is reported as taxable

in the U.S. and this percentage would be applied to

dividends paid to the subsequent year and would be

excluded from the individual income tax of their

shareholders.

Similarly, there will be a 75 percent

exclusion from income of individuals of capital gains

on sales of stock of U.S. corporations held over one

year. That means that the capital gains tax rate on

U.S. corporate stock sales will be reduced to a very

low range of only three and three quarters to eight

and a quarter percent, which I believe is the lowest

rate that it\'s ever been.

Gains on all other property will be taxed

at regular rates since, of course, there was no U.S.

corporate tax paid on income from this property and

hence there was no double taxation to eliminate.

As Beth indicated, with respect to

residences, however, they will continue to have their

capital gains excluded up to an increase limit of

\$600,000, which would be further indexed for

inflation.

Again, similar to the savings proposals

that Beth described, which we view as a package, we

view this whole proposal as a package together with

some of the provisions I will get to in a minute with

respect to corporate tax. We think it provides a very

powerful set of provisions for encouraging business

investment and it also permits very substantial

simplification of calculations. For individuals there

will no longer be any need for complex forms and

calculations applying multiple tax rates for different

kinds of property. Individuals will be notified of

the proportion of dividends they received that are

taxable and we\'ll just copy that onto their tax form.

And for capital gains on qualifying corporate stock,

they will just include on their return 25 percent of

the gain and that\'s it. That goes into their income

and that\'s the calculation.

Now, it\'s important to understand, and

this is where the package I think comes in, that in

the simplified income tax this powerful set of

provisions to eliminate double taxation of corporate

income in a rather, I think, straightforward and

reliable way, is possible because of the

simplifications we are proposing in how income for

large corporations who pay the corporate income tax is

taxed. I\'ll get to that in a minute.

In addition, this package, this set of

provisions also allows us to have a very powerful

simplification of tax reporting for small businesses

who pay tax at the individual level. So, let me go

into these business provisions now, starting with

small business.

And I think I have personally a little bit

of a special, maybe unusual, perspective concerning

taxation of small businesses and large businesses,

because I grew up in a small business family and I

certainly remember when I joined the IRS that my

parents were both deceased then, but I figured they

were probably looking down and rolling their eyes when

I joined the IRS because that wasn\'t their favorite

agency, for sure. I then turned around in my life and

started a small business which grew through being a

medium‑sized business and eventually a pretty large

business. And then I turned around and tried to be a

tax collector to collect money from all these all

different sized businesses. So, I saw this from most

of the different sides that you can see it from.

And probably the most important conclusion

that I could draw from this experience is that it

borders on the absurd to try to apply the same rules

and methods of taxation to a tiny business with a few

employees and maybe \$100,000 of revenues and then turn

around and try to apply those to a multinational

corporation. It makes no sense. It is important, of

course, that all businesses, whatever size, pay their

fair share. But the rules and methods need to be

tailored to the reality of their circumstances. And

that I believe is what we have achieved, I think, very

effectively in our proposal in the simplified income

tax.

There are about 25 million businesses in

the U.S. of some sort that report business income,

either on their individual or their business tax

returns. Of those, 24 million out of the 25 million

have less than \$1 million of gross revenues. Some of

these are sole proprietors who report their income on

Schedule C attached to their individual return. And

most of the rest are small corporations, S

corporations or partnerships or what\'s known as LLCs,

who also report the income of these businesses on

their individual returns.

Under the simplified income tax all of

these businesses, which amounts to 22 million out of

the 25 million total businesses in the United States,

will report their taxable income the way they actually

tend to run their businesses, which is pretty much

based on their check book. In other words, cash in

minus cash out equals taxable income. All spending on

investment assets, except for land and buildings,

would be written immediately and there would be no

further need to keep records on assets or

depreciation, inventories or anything else.

Here, I think it\'s very important to go

back to the package idea and note that this drastic,

I believe drastic, simplification for small businesses

is only possible because of the provisions I noted

earlier concerning reporting of capital gains. Since

these small business assets are written off

immediately against current income, it is also

important that their sale be taxed at the same rate,

otherwise you would need so‑called complicated

recapture rules and all the attendant record keeping

in order to prevent people from simply claiming a

deduction at a high rate and then turning around the

next day and selling the property for a gain, which

obviously would not make sense. So, given the package

that we have, it allows us to allow 22 million

businesses in the United States to have the simplest

possible reporting.

Now, I should also note that with respect

to these small businesses fairness also plays into

this in a specific way. And that is, it demands that

all small businesses pay the same tax and that honest

and diligent small business people not be placed at a

disadvantage compared to those who fail to report all

of their income. And we know from IRS studies,

including recent ones, that one of the major causes;

certainly not the only one, but one of the biggest

causes of the \$300 billion plus gap between the taxes

that are on the books that should be paid as compared

with those that are not paid is simply unreported

income from small and medium‑sized businesses.

So under the simplified income tax, in the

interest of fairness, we\'ve proposed two new

provisions, neither of which would place any

additional burden of reporting on businesses

themselves. I stress that there is no additional

reporting burden on small businesses. All businesses

with receipts over a very minimum level which we have

yet to define, but a small number of receipts, would

be required to have a bank account separate from their

personal account in which all of their business

receipts and their business expenses would be paid.

At the end of the year, the bank will send to the

business and the IRS a summary of these receipts and

expenses. In addition, credit card companies will

send the IRS and businesses a summary of their

payments to businesses. These provisions will, I

believe, very significantly aid the IRS in determining

more accurately which businesses need to be audited

and ultimately I think will substantially improve the

fairness and compliance of the tax system. So that

deals with businesses and all those under a million

dollars.

Businesses that are slightly larger in

size, between \$1 million receipts and \$10 million

receipts per year, would use the same rules as the

smallest business with just two additional

requirements. They would be required to keep asset

accounts for equipment purchases and to depreciate

these assets over time. However, the depreciation

system would be greatly simplified by dividing all

assets, all business assets into only four categories

of which two would be for residential and non‑

residential buildings and the other two for other

types of assets.

And the small businesses under \$10 million

would not be required to keep records for each asset,

but only to maintain one account for each category

against which depreciation would be allowed as a

simple percentage each year. So even for the \$1 to

\$10 million businesses, it would be very simple

accounting.

In addition, as under current rules,

inventory‑intensive businesses such as retailers,

would be required to keep inventory accounts for cost

of goods sold. However, these accounts, unlike

current law, would be required only for physical

inventories, not other forms of current assets or

liabilities. So the \$1 to \$10 million‑size businesses

would be a little bit more accounting, but very little

more. Which leads us to the large businesses; those

over \$10 million a year in receipts.

There are only 135,000 businesses, and

that includes large partnerships, which is less than

a half of one percent of all businesses in the United

States, that are over \$10 million a year in revenue. But they account
for over 90 percent of the corporate

income tax. Many of these large businesses have

operations in many countries and they are all subject

to very, I would say, exceedingly complex rules

concerning corporate taxes. For historical reasons,

including attempts over the years to eliminate some

abuses, a huge array of rules have grown up that deal

with large complex partnerships, as well as

corporations, which adds to the complexity. And of

course, we know that over the years a large number of

special preferences for particular kinds of business

activities have been put into the tax code. Some of

these, such as the research and experimentation

credit, are substantial in size individually and

affect a significant number of businesses. Others are

smaller in size in terms of revenue and affect only a

few businesses, but they do have several things in

common, whether they\'re small or big.

Every one of these listed preferences

requires complex rules and regulations to define who

gets them and they are the source of enormous

controversy and often confusion between taxpayers. At

one point in the IRS, I believe, that over a quarter

of the audit resources on large corporations was just

used with respect to the research and experimentation

credit, just that one provision.

So, in addition, I also should note that

in today\'s world of increased requirements for

accuracy and scrutiny of financial reporting by

corporations, these various tax provisions and the

enormous differences and ever‑changing differences

between financial reporting and tax reporting are the

source of a lot of complexity and potential errors in

reconciling tax accounts with financial accounts.

So what did we do with the corporate

income tax? As we did with the individual tax, we

decided that the best approach was to start with a

clean slate for corporate income with no special

preferences for anything. This alone permitted us in

the simplified income tax to reduce corporate tax

rates for all corporations from 35 percent to 32

percent, which is almost a 10 percent across the board

reduction, while enormously simplifying the tax code

provisions. This clean tax base is also one of the

key factors that makes it possible in a simple and

reliable way to go back to our integration proposal to

allow elimination of 100 percent of the individual tax

on dividends from domestic income since we know under

this provision that corporations with domestic income

will actually be paying tax.

Also, under the simplified income tax all

large businesses, regardless of legal form, would pay

the same tax under the same rules at the corporate

level. This too permits great simplification of tax

rules while eliminating tax considerations as a factor

in deciding on the best legal form for a business.

And also I should add, closing down some of the most

popular methods that have historically been used for

creating tax shelters.

Large partnerships would suffer no tax

disadvantage under this method, I want to stress,

because of two reasons. One, the corporate tax rate

is slightly lower than the top individual rate; 32

instead of 33. And 100 percent of dividends from U.S.

income are tax free to the stockholders. So, if you

figure that out, you\'ll realize that there\'s no net

change in tax, it\'s just a simplification.

I should also note that small businesses

that are under the \$10 million threshold could elect

to report and pay taxes according to the large

business rules and pay tax at the corporate level if

they chose to. And then of course they would get the

benefits also of the 100 percent exclusion for

dividends on U.S. income as well as the 75 percent

capital gains exclusion on sale of their corporate

stock.

And finally, of course, the so‑called

alternative minimum tax for corporate income would

also be eliminated as it would for individuals further

simplifying and eliminating the need for corporations

to calculate their tax in two different systems.

In addition, the system for classifying

assets for purposes of depreciation, as it would be

for small business, would be simplified reducing from

nine classes and various other definitions to the four

that I mentioned earlier, two of which would be for

real estate and the other two for other forms of

assets. I should stress that reducing it to these

four categories would produce approximately the same

tax results, we believe, as the current more complex

system. But it would simply reduce complexity and I

could tell you it would reduce a lot of controversies

between taxpayers and the IRS without changing the end

result to any significant extent.

Now finally, the most complex area for

corporate taxation concerns multinational corporations

which today is mostly large corporations. I would say

that this area of taxation is like a perfect storm in

which all the forces that drive complexity reach

unprecedented peaks of intensity. I would say that,

except that a storm is actually a product of nature

and has certain internal logic that is driven by

physical principles that scientists can understand and

they can understand these principles and presumably

once they\'re discovered they remain constant

understood. But, in that sense, it\'s worse than a

perfect storm because it doesn\'t have those natural

characteristics. That is the international tax

system.

One of the especially peculiar aspects of

the current system is that while in theory it taxes

worldwide income of corporations, we found that it may

in fact produce no more and possibly somewhat less tax

revenue than a system which simply exempts most

foreign income. But it takes a heck of a lot of rules

and a lot of tax planning by corporations to arrive at

what amounts to essentially a null result and is also

one of the impediments that you would have to solve

this problem of eliminating double taxation on

dividends in a reliable and simple way because you

don\'t know what\'s being taxed and what\'s not being

taxed.

So under the simplified income tax U.S.

corporations would pay no tax on income of their

foreign operations, their active foreign operations,

except for certain highly mobile income such as

passive investment activities. All dividends from

income from active foreign business operations would

therefore be repatriated tax free to the U.S. after

the date of enactment of the simplified income tax.

This in turn means that the very complex system of tax

credits for foreign taxes would no longer be needed

except for credits against mobile foreign income which

was taxed by foreign countries. Under this system, of

course, a method of allocation of certain worldwide

expenses would be required so that the expenses of

producing foreign income would not be used to reduce

reported U.S. income.

Our Panel did not get down to the level of

detail of these rules. This would something the

Treasury would have to define. We do however

recommend that these rules, when they are defined, be

based on a few principles. One of these is that

interest and other financing expenses, we believe,

should be allocated on a worldwide basis to all in

income. We believe that general administrative

expenses should be allocated only to the extent that

internal charges to foreign subsidiaries do not cover

them, from foreign subsidiaries do not cover them.

And then R&D expenses should generally not

be allocated because they should be covered by

appropriate royalties, inter‑company royalties.

These are complex rules. Treasury will

have to work on them. We highly recommend that when

the simplified income tax is implemented and this

exemption for foreign income is enacted that Treasury

be given adequate authority and guidance to implement

rules that are appropriate and that will also prevent

abuses in these areas.

And finally, under the simplified income

tax, we recommend that the standards for defining

residency of U.S. corporations should be updated to

based not only on legal place of incorporation, but

also on the practical principal place of management

and control of these corporations. And under the

simplified income tax, conforming to this rule would

allow U.S. corporations to qualify for the 100 percent

exclusion of dividends from domestic income and the 75

percent inclusion of capital gains on the sale of

their stock. And in addition, of course, under the

simplified income tax U.S. corporations would not be

taxed at all on the active income of their foreign

operations.

So, that\'s the summary as far as business

taxes.

Let me just conclude by summarizing what

I think the bottom line of this entire exercise has

been. And I think it goes back to the guidance we

were given. I actually do believe that the simplified

income tax is simpler, fairer and more likely to

foster growth in the economy; which is what we started

out with, and I don\'t think it\'s a small move in this

direction. I think it\'s a huge move. The

calculation of taxes would not only be simpler, but it

would be something that anybody could understand, not

a black box that only a computer could calculate or a

computer could calculate without the taxpayer

understanding what the computer is doing. I think

instead it follows the sound design principles and

computer systems known by the buzzword of WYSIWYG,

which stands for What You See Is What You Get. That\'s

the way the simplified income tax works. WYSIWYG.

Deceptive provisions; which is my term,

but I believe it's accurate, like phase‑outs and

the AMT, which essentially take back benefits that

have supposedly been given somewhere else, are gone.

And I think quite interestingly most taxpayers will be

able to file on one page and pay at one rate. The

burden on small businesses, which really do bear the

brunt of record keeping and compliance under the

current law, will be drastically reduced.

While a myriad of conflicting and complex

provisions will be eliminated, three very important

tax benefits for home ownership, health insurance and

charitable giving will be available to all taxpayers

in a simplified way. Because of that and the overall

simplification of individual and business taxes,

taxpayers should have more confidence that everyone is

paying according to a uniform set of rules.

I want to go back to a very critical point

which our chairman sort of noted at the beginning, but

I think in our individual income tax we will see this

when the numbers come out; and that is, that the

bottom line, the amount of tax that is actually paid

will be distributed essentially the same way it is

now. And that goes from top to bottom. Taxpayers

with very high incomes, middle and upper incomes and

low incomes will pay about the same burdens. Of

course, some specific taxpayers may pay a bit more or

a bit less in any one year, but most taxpayers will

find that their tax is about the same and even if it

would be more in a given year, that it would be less

in a later year, but with a lot less hassle and a lot

less uncertainty.

There are four very powerful aspects of

the simplified income tax that will promote economic

growth, which we\'ve covered: a much simplified and yet

expanded set of ways for people to save tax free; 100

percent elimination of double taxation of dividends on

U.S. income and 75 percent exclusion of capital gains

from U.S. corporations; simplified and increased

incentives for investment by 22 million small

businesses; and lower marginal tax rates for

individuals and businesses.

Now let me finish up by showing you how

this will actually look to the average taxpayer when

they file returns. The most infamous form in America,

the 1040, will return to close to what it was when it

first came out; namely, one page. And what we have up

here is the 1040 as it\'s going to be required under

the new tax system. And as you can see, it literally

is one page and this is what most people will need.

If we want to go on to the next chart, you

can see that about 60 percent of taxpayers do not have

any other dependents other than themselves and their

spouse. And so they would not even need to have the

Schedule A family credit form. But for people who

have any dependents besides themselves, this is the

only thing they would need to fill out, and this could

be put on the back of the 1040 or could be a separate

page. But that would be the only thing you would need

to list your dependents, your child and non‑child

dependents in order to calculate your family credit.

And if you look at the bottom of that

chart, you\'ll notice that there\'s a question at the

bottom that asks if the taxpayer who might be eligible

for the work credit would like the IRS to calculate it

for them. And all they have to do is check that box

and their one piece of information and that\'s all they

have to do. Once they\'ve calculated the family

credit, they don\'t even have to do anything more if

they don\'t want to. Of course, they\'re free to.

There\'s a form for the work credit, if they want to

calculate it themselves, but it\'s not necessary. Once

you have the information from the family credit, you

answer some questions there on the bottom of this

form, check the box and you\'ve got your work credit.

I\'d like to go to the next chart here and

just show a comparison. Well, this is another way we

could do it. For people who don\'t have any dependents

except themselves or their spouse, you could even cut

this form in half and just make it a front and back

and it would be a half page form, just to show how

that would work.

Now, let me just go on to what I think is

the really important thing, which is the comparison of

the old versus the new. It\'s not just the 1040, it\'s

the whole system of forms. This is only for

individual taxpayers. What we have here is shown in

this chart is the array of complex forms which are

required under the current system for individual

taxpayers. And under the next chart you will see what

that reduces to. That\'s the sum total of everything

for individual taxpayers and you can\'t see some of

these supplementary forms, but we will have some of

them mocked up in our final report.

And I want to particularly just note one

of them because I think it\'s particularly important to

me. That\'s Schedule C‑EZ. That\'s the form that 22

million small businesses will be able to ‑‑ not 22

million, but those that are sole proprietorships out

of the 22 million will be able to report their income. This is the small
business that works a person by

himself, maybe, you know, just doing part‑time work

even full‑time work. The Schedule C‑EZ is even

smaller. It\'s just literally a few lines that

somebody puts in because all it basically is is cash

in, cash out. That\'s it. That\'s your Schedule C‑EZ.

And I can tell you that for small businesses, people

that work as individuals, this is a huge, huge

simplification. And of course, for slightly larger

businesses, those that have S corporations, it

wouldn\'t be a whole lot more complicated than that

either. So, I think that you can see visually from

the comparison of the last two charts that this really

is a drastic simplification. It\'s not just tinkering

with a few lines.

And that concludes my presentation, Mr.

Chairman.

CHAIRMAN MACK: Well, I want to thank you,

Charles and Beth, and I think that Tim, you served on

that ‑‑

PANELIST ROSSOTTI: Yes, Tim and Bill.

CHAIRMAN MACK: And Bill. A tremendous

amount of work. I think a great accomplishment. If

I remember correctly from a quick looking at the form,

you go from 75 lines in the present form to I think 32

lines in this new form; from 52 work sheets, forms,

other ‑‑

PANELIST ROSSOTTI: Schedules.

CHAIRMAN MACK: ‑‑ schedules, to 10.

That\'s pretty dramatic.

PANELIST ROSSOTTI: And even the lines, if

you look at the 1040, you\'ll find that, you know, even

probably a significant number of those wouldn\'t really

be used by everybody because, for example, if you have

Social Security, there\'s lines for Social Security.

But if you don\'t have that, you just don\'t worry about

it.

So, I mean, for most people they wouldn\'t

even use all those lines and certainly most people

would just use that one page schedule with maybe the

family credit.

CHAIRMAN MACK: And the interesting thing, maybe to put this in
perspective though, when you say

we\'ve gone from 75 to 32 lines. I mean, one of those

lines has to do with the AMT, for example. And that

one line, by eliminating it, takes the entire shadow

tax code out of the system, which I think again is an

enormous step.

Okay. Well, there\'s a lot on the table.

VICE‑CHAIRMAN BREAUX: Excuse me, Mr.

Chairman. I was impressed, Charles, with the fact

that you basically said that the tax burden would be

about the same under this simplified system as far as

the burden on the individual taxpayer. That\'s

important.

PANELIST ROSSOTTI: You know, this was one

of the constraints; really not a constraint, it was

really one of the conclusions. The guidance of course

from the President said, you know, appropriate

progressive, but we concluded it was just as the

Chairman said, we didn\'t think we were smart enough to

figure out whether, you know, somebody in the top 10

percent should pay a little bit more or a little bit

less. It\'s a progressive system. Some might argue it

should be more or less. We said let\'s just try to

keep it, in the distributional sense, the same.

If the Congress or the President decides

they want to tweak it to make more progressive or less

progressive, that\'s very easy to do. You don\'t have

to anything to our system. You just have to change a

few of the brackets and the rates a little bit. But

it\'s very clear, you know, what\'s happening and who\'s

paying. And everybody from the very top down to the

bottom, within minor differences, would pay about the

same.

CHAIRMAN MACK: I\'d raise an area to see

if there\'s any reaction, because I think it\'s the

first time that we\'ve talked about the state and local

tax deductions, eliminating that.

I wonder, Bill, Beth, anybody want to

express an opinion as to why we\'re proposing this?

PANELIST GARRETT: Sure. I\'m happy to

talk about why we decided to eliminate that tax

subsidy. It\'s a tax subsidy for those who live in

higher tax areas and enjoy the benefits that higher

taxes provide. It\'s a subsidy those people enjoy paid

for by those taxpayers who live in lower tax areas and

have decided to live in a place with lower taxes and

lower services. So we questioned that the federal tax

system should be providing that kind of subsidy with

respect to decisions about taxing and services.

It\'s also a case that it\'s available only

to those who itemize. It\'s one of those upside down

provisions that benefit higher income Americans more

than lower income Americans.

And then finally, because of the

alternative minimum tax, numbers of taxpayers who had

been claiming the state and local deduction in

previous years have not be able to claim it in the

last couple of years. So eliminating it has a very

different effect now than it did say 1986 when it was

on the table but rejected by the Congress.

PANELIST POTERBA: I just wanted to

underscore what Beth just suggested about the AMT

interaction with the state and local deduction.

Even today, as more taxpayers face the AMT

and realize that their state and local tax deductions

are not an allowable deduction under the AMT, that\'s

just the tip of the iceberg we know of what the AMT is

going to look like going forward. Under current law,

the AMT will catch the vast majority of taxpayers

within incomes between about \$75,000 and \$500,000 within the next five
and or six years. And for those

taxpayers, essentially the AMT will take away the

state and local tax deduction under the operation of

the current legal structure. So, many taxpayers who

have not yet seen their state and local deductions

disappear, will see that happen soon under the current

law.

So I think the contrast between what the

working group has just proposed and the status quo is

I think easy to overstate.

CHAIRMAN MACK: Any areas that other

members of the Panel would like to discuss further

with respect to the proposal?

PANELIST ROSSOTTI: I was just going to

say, just one further comment on the state and local.

And again, this may not be precisely true for every

taxpayer, but remember, we\'re not only distribution.

What we\'re really saying is that people that are in high income
brackets, which tend to may the most state and local taxes and also have
the biggest deductions, when you net the whole thing out, you know,
roughly

speaking, their bottom line is going to come out the

same because yes, they\'re losing this one deduction,

but they\'re gaining in a lower rates, for example; the

lower marginal rates they\'re gaining in terms of the

integration proposals. And, you know, when you net

all this out, you know, I would say to every taxpayer,

really what you really care about is not whether

you\'re losing a particular line on a form, but what

your bottom line is. And for most people the bottom

line is going to be about the same, just easier.

CHAIRMAN MACK: Liz Ann, I think you had

a comment.

PANELIST SONDERS: Can you hear me?

CHAIRMAN MACK: Yes, we can hear you fine.

PANELIST SONDERS: Okay. Great. I want

to, first of all, just concur with the comments on the

state and local deductions, because obviously I think

that\'s going to be arguably as controversial an issue

as we found the mortgage deduction to be over the last

week or so. But I think it is important that in

general the deduction creates higher rates for

everybody, but the benefits are obviously not shared

equally.

And I want to kind of keep on that subject

and make a comment and/or ask for comments from your

Panel members on some of the education deductions with

the decision not to retain some of the tax preferences

for the cost of higher education and comment on the

notion that a lot of the tax benefits that

historically have been part of the reason why some

colleges and universities have been justified or

believe to be justified in increasing tuition and fees

because of some of these costing offsets for the tax

code. I think that\'s an important distinction to

make too and wonder if anybody has any further

comments on that.

CHAIRMAN MACK: Beth or Charles maybe?

PANELIST ROSSOTTI: I think Beth would be

better ‑‑

PANELIST GARRETT: Sure. I think Liz Ann

has raised one of the issues that is implicated by tax

preferences for education. There is reason to believe

that it allowed higher tuition and fees to be charged

so that the taxpayer\'s really not much better off.

But I think it\'s also the case that we had

testimony that the current structure of educational

incentives is enormously complex. There are different

income thresholds, there are different requirements,

you know, to be quite sure until after they\'ve made

all these decisions what are the main educational

benefits that are going to qualify for so it\'s not

changing behavior in any appreciable way and we

believe a tax subsidy should change behavior.

But I also emphasize that we believe our

plan does encourage people to save and invest in very

important higher education because our Save for Family

accounts can be used for education and training

expenses and those are quite generous. They\'re not

phased‑out for higher income Americans, so all people

can use them and can save up to \$10,000 per

individual. So the important thing is what we

believed was that the very complex provisions we have

now are doing what they ought to be doing and instead

we worked for a simplified way to encourage savings

and savings that could be used for education and

training.

CHAIRMAN MACK: Does that address your

concern, Liz Ann?

PANELIST SONDERS: Yes, it does.

CHAIRMAN MACK: Okay. I may have just one

other point that I want to just clarify under the

business tax, the small business. There were two

provisions that you said. This would be on the less

than a million. I think there were two provisions.

They must have a bank account?

PANELIST ROSSOTTI: Very, very tiny ones.

We haven\'t got a number, you know, but some small

number. Above that cash level, they would have to have a separate
business bank account, separate from their personal accounts. And the
bank would at the end of the year simply report a summary of the amounts
in and out of that bank account to both the business and the IRS. And
also, the credit card companies. A lot of transactions now go through
credit card companies,

that they would report to the IRS the amount of

payments from the credit card company to the business.

CHAIRMAN MACK: Bill?

PANELIST FRENZEL: Mr. Chairman, I want to

thank Charles and Beth for a wonderful exposition and

to inquire of Charles, that most of the hard numbers

that you gave us were intended to be indexed, were

they not?

PANELIST ROSSOTTI: Yes.

PANELIST FRENZEL: Particularly the \$1

million small business?

PANELIST ROSSOTTI: They would be indexed.

PANELIST FRENZEL: I just wanted to be

sure that was clear.

We didn\'t descend to every level of detail

in the tax code and it was not our intention to do so.

And we\'re going to leave a lot of those wonderful

decision to others. But, where we have established

hard amounts, I think it\'s important to know that they

are all indexed.

PANELIST ROSSOTTI: I know all of them

would be indexed.

PANELIST FRENZEL: Thank you.

CHAIRMAN MACK: Tim?

PANELIST MURIS: I just wanted to add that

I very much appreciate the work of my fellow panelists

on this. And Jeff and the staff did a terrific job

and I wanted to thank them too.

VICE‑CHAIRMAN BREAUX: I had raised

questions earlier about the capping of the health

premiums to employees and I\'ve looked at it

extensively and it\'s interesting that most of the

health economists, who really look at this from the

economic standpoint, have concluded that this is the

right way to go. And I mean that the unlimited

deduction has encouraged so‑called Cadillac health

plans, when they may not be necessary. So I think

that a cap is reasonable in the sense that it tracks

what federal employees have. And I think it will

bring about a great awareness of the costs associated

with health care and make people better educated

purchasers of health care and perhaps maybe even some

more competitive markets out there. So I think that

it\'s a movement in the right direction.

CHAIRMAN MACK: All right. I sense from

some, that it\'s time to take a short break and that

we\'ll come back in just a few minutes and continue on.

Again, Charles, Beth, thank you very much.

(Whereupon, at 10:20 a.m. off the record

until 10:30 a.m.)

CHAIRMAN MACK: Let\'s go ahead and get

started again. Beth and Liz Ann, are you still with

us?

PANELIST SONDERS: I\'m here.

CHAIRMAN MACK: I heard one voice.

PANELIST GARRETT: Yes, I\'m here. That

was Beth.

CHAIRMAN MACK: Oh, okay. Thanks, Beth.

Yes, listen, you raised an issue with

respect to real estate and the two‑year holding period

and raised either a concern, an issue, an idea. Do

you want to put that back in the table for some

discussion?

PANELIST GARRETT: Well, we\'ve been sort

of informally discussing this over the last few days

in our group. Right now to qualify for the exclusion

for capital gains of what is now \$500,000; but we

would propose to increase that to \$600,000 and index it, you have to
use the home as your principal residence for two out of the last five
years. And it seems to me that if what we\'re trying to do is encourage
home ownership, real home ownership, then it would not be unreasonable
and I personally think it would be a good thing to increase that
requirement to three or four years of the five. What we don\'t people to
do is to churn through homes with the ability to be used as rental
property or investment property and qualify for this exclusion. So I
think tightening up that holding period would be a good idea,
particularly in light of the tightening that we\'ve done with what\'s
now the home mortgage interest deduction and what would become the home
credit.

CHAIRMAN MACK: Okay, Jim?

PANELIST POTERBA: Yes, I mean, I would

just support that general direction of a modification

in the rule. You know, prior to 1997 we had

essentially a once a lifetime exemption for capital

gains that people had received on home ownership.

That seems more in the spirit of trying to encourage

people to have a home and to hang onto that and, you

know, at some point when they then choose to downsize,

be able to realize the gain. Or if they move from an

expensive market to a less expensive market, I think

one could even make a case for going longer than the

three to four years that Beth has suggested in trying

to lengthen the horizon a bit further.

VICE‑CHAIRMAN BREAUX: I was just

wondering, in today\'s highly mobile society where

people move all the time, I mean, in your state you

got people by the tens of thousands moving in every

day and everybody just about moved out of my state of

Louisiana. I mean, I was wondering how does that

address the question of a very mobile society which is

becoming more and more that people don\'t stay in one

place for 20 years. I mean, they\'re moving from place

to place. I mean, I\'d just make that point. I mean,

I\'m not sure I disagree with what\'s been said, but I

just would make the point that a lot of people move,

and very quickly, particularly young families.

PANELIST GARRETT: Well, the more quickly

they move, then the less the capital gains would be,

because there wouldn\'t have been as long a period of

time for the value of the home to have increased.

But, you know, I think it\'s not unreasonable to say

you have to lived in the house three or four years

before they give you an additional tax benefit to home

ownership. Remember that this is just one way you can

invest your money. And we already favor quite a bit.

We\'ll still favor under the simplified income tax. I

think we really want to see people investing and

living in real homes as opposed to people churning

through homes.

PANELIST ROSSOTTI: You could also have

the provision which I think was in the code; I don\'t

remember, awhile where you could roll it over. You

know, if you bought another home within some period of

time, you know, you could roll it over into another

house. But that would take care of your mobile

society issues.

PANELIST FRENZEL: Mr. Chairman, we\'re

getting into a level of detail into which we don\'t

normally descend, and maybe this doesn\'t make too much

difference as long as we\'ve had this discussion.

Others are going to, if this is ever enacted, make

that decision.

But I\'m inclined to agree with Beth and

Jim that this is a huge deduction, or exclusion. It\'s

a good one, but it ought not to be given without some

substantial attachment to the home. And two out of

five may not be enough. So I think I would go with

Beth on this.

CHAIRMAN MACK: Well, I think if we could,

why don\'t we just instruct the staff to come back with

a proposal or two for us to look at in this area and

we can determine whether that\'s something we want to

add to this proposal.

Any other areas that the Panel wants to

raise for discussion?

(No audible response.)

CHAIRMAN MACK: If not, then what I gather

from again the tremendous, I think, presentation that

was made by Charles and Beth, that the Panel is saying

that this is a recommendation that we want to make and

include in our report, and a recommendation we want to

make to the Secretary. Is that a fair conclusion?

VICE‑CHAIRMAN BREAUX: Yes.

CHAIRMAN MACK: All right. With that

then, we will move onto the next presentation. And

who begins that? Liz Ann?

PANELIST SONDERS: Okay. First, before I

get into this, I also want to express my gratitude to

our working group, Jim Poterba, Eddie Lazear and

Senator Breaux, and I just want to thank everybody for

their hard work. It\'s been an incredible experience

over the last couple of months and I will definitely

say I have learned a tremendous amount, so thank you.

And I also second what Tim said, which was to express

my thanks for the staff, which has just worked

absolutely tirelessly in the last nine months and it

made a pretty difficult task a little bit easier as a

result of how many work days they put into this, so

thank you, Jeff and everybody else.

I am going to start this morning with a

discussion of a true fundamental reform that can be

best thought of certainly as pro‑growth tax. We have

thought of it internally as well as a progressive

consumption tax. And we evaluated in our working

group various approaches for addressing the problems

in our current tax code and we began by considering

more fundamental, more comprehensive reform of the

existing tax system with a focus on consumption tax

proposals.

And before I get into the details of

those, it\'s must important to remember that the

primary benefit of any kind of consumption tax is the

extremely positive impact it would have on investment

decisions and on savings decisions, given that that

family would not be taxed when they save or when they

invest and only would pay tax on what they take out or

what they consume out of the economy for their

spending. So that\'s the very, I think, important and

primary incentive behind the benefit of a consumption

tax.

The proposal we\'re going to talk about,

and I will start with the individual side and then

turn it over to Jim and Eddie to talk about the

business side and some of the more complicated issues

therein. But the proposal overall is similar to quite

a few other well‑known proposals, many of which we

heard about, and including one studied by the Treasury

about 25 or 30 years ago. And it provides the

economic benefits of a consumption tax, primarily

those that I mentioned a moment ago, but our proposal

also has advantages over some other consumption pack

alternatives. Some of those benefits notably would be

that the tax would be more easily collected and it

would be collected in a progressive manner.

I\'ll go back to what I believe it was

Charles who suggested there are lots of ways to plug

distribution tables and then make an assessment of

progressivity, but we need to approach this with a

view that the existing distribution tables, the

structure of our productivity right now is about what

we were targeting when we went through the process of

coming up with this plan.

It also utilizes the tax structure that\'s

already in place. So in other words, families

continue to file returns and pay taxes directly and as

a result it doesn\'t require the creation of a

completely new collection system, which was one of the

problems that we addressed last week.

Again, I will start now with the

individual side of this fundamental reform option and

then turn it over to Jim and let him finish. We will

also talk a little bit later about the variations for

this proposal.

Now as consistent with the goals of this

Panel overall, the goal of our forum recommendation is

to make filing taxes as straightforward and as easy to

understand as possible. And as I touched on before,

it tried to encourage savings in a very simple manner

and a very efficient manner and to make our tax system

as fair and just as important make it transparent as

possible.

We were looking to remove many of the

complicated tax breaks and the loopholes that very

clearly benefit special interests and quite frankly

interfere with taxpayers\' decisions therein

necessarily. And finally, we expected to encourage

business investment and to improve the competitiveness

of American business.

Now this idea of a progressive income tax

is very much like our current system in one way. It

allows the inclusion of many of these features deemed

most important like progressive rates, like

adjustments for family size. But the key feature is

that families would not be penalized for savings. You

can consider it like an unlimited Roth‑style IRA in

that there will be no tax on return from savings, so

there will be on tax on capital income. It will

remove the incredible bias in our current system

against savings and incentivizes investments and

incentivizes the expense of consumption, which is

something still clearly missing in our current system.

Now moving on to the rate structure. We

would recommend three tax brackets instead of the

current six and they would be 15 percent, 25 percent

and 35 percent. And like we discussed with the

simplified income tax, it would reduce marriage

penalties by making all tax rate brackets for married

couples exactly twice the amount for singles. And of

course, as we know in fact in July, like any other

plan we were proposing, it eliminates the alternative

minimum tax both on the individual side, also on the

corporate side.

The important thing, we are starting from

a completely new consumption tax base and we see

adding in only those tax preferences that the Panel

overall deems important for policy reasons, many of

which were discussed earlier in today\'s meeting. It

certainly would allow the incorporation of the work

credit that Charles discussed. Also the family credit

could also be available. And again, there would be

one easy set of eligibility rules which would replace

the four sets under the current law.

Moving on to what has been a hot topic

here today, but certainly was at last week's meeting,

this plan could also adopt the home ownership credit

as well what had been detailed during the course of

this morning. And we also, our panel, recognized the

variability of how the credit is across the country,

across regions and we\'ll concur with not only the

lowering of the amount of mortgages eligible for the

credit, but with the idea of regional adjustments to

that in that and that need to be more conscious of

certain areas that go well beyond that regional limit,

so we\'re very open to that flexibility. And also very

importantly, our plan was to provide appropriate

transition relief for existing mortgages and that

really could be similar to what not only was touched

on last week, but what was discussed with a little

more detail today.

So this progressive consumption tax also

would work well with the charitable deduction

adjustments that had been discussed last week for

which all taxpayers would be able to receive a

deduction for charitable giving. Again, it would work

with an alternate deduction for total contributions

exceeding one percent of income and we would also

recommend consistent with discussion last week, much

better oversight of exempt organizations.

Now, when we originally studied this of

option; moving onto health care now, we discussed the

possibility of a lower health coverage tax than what

was discussed last week and earlier today, but there

is flexibility here under this plan. Under as the

plan as it sits now, everyone would get the benefit of

tax free health insurance up to \$8,400 for families

and \$4,000 for singles. Now, we came up with that

number because it is the share of health costs paid by

the Federal government for employees. In other words,

it\'s not the total cost of insurance, but the

employer\'s share, not the employee\'s share. And it

would also allow a deduction for the purchase of

health insurance in the individual market for those

who do not have coverage provided by their employers.

Now, I didn\'t go into a lot of detail on

the specific provisions; they\'re all very important

and they\'re open to discussion. We have done as a

group our own independent analysis, but admittedly

we\'ve been relying on some of the judgments coming out

of presentations last week, coming out of

presentations this morning and also deferring to the

simplified income tax subgroup in terms of defining

things like the family credit. And at this point we

would propose to have many of their same basic

features in our plan. Some of the details are not

fully worked out as we again knew we were going to

hear from that subgroup on what the provisions would

look like. And I would expect and I would guess that

our subgroup additional Panel members would concur

that we would like to be able to embrace many of the

provisions in our plan. Now that we know their

specifics, we can bring a more detailed proposal to

the plan.

But I\'ll just conclude before turning it

over to Jim and just reiterating that the benefit of

a consumption tax in terms of the impact it would have

on savings and investments and there have been

numerous studies and I would absolutely agree that a

such a consumption tax would have a very large, very

beneficial impact on economic growth and would have a

tremendous impact on productivity growth, particularly

with how businesses are treated on this, and Jim will

talk in more detail about that, and we know that

higher productivity growth is the key to higher

standards of living. And so, I think this is a very

important proposal that we\'re putting forth. The individual side is a
little bit more straightforward. So I\'ll now turn it over to Jim for
the much more complex task of going through the business side of the
plan. Thanks.

CHAIRMAN MACK: Thanks, Liz Ann. Jim?

PANELIST POTERBA: Thanks very much. I

will start also by first thanking my other Panel

members, who it\'s been an absolute delight and

privilege to work with through this year, our terrific

staff and also the staff at the Treasury Department

who has worked with our staff and our Panel members

very closely to provide us with much more information

than I suspect they ever would be called upon in their

wildest dreams to provide about the workings of the

current system and various alternatives.

I\'d like to describe for you the basic

provisions on the business tax side associated with

the progressive consumption tax that our working group

has focused on. And I think I should emphasize before

I start into the details that unlike the plan that

Charles described a few minutes ago where one could

focus on specific reforms within the current

structure, some of the basic approaches in the

progressive consumption tax that we\'ll describe, while

the ideas have been discussed for a long time, they

were proposed, as Liz Ann suggested, by the Treasury

Department at one point in the 1970s in a very close

form that\'s similar to what we\'ll talk about today by

the Meade Commission in the United Kingdom at about

the same time. And there\'s been a lot of academic and

legal discussion of these kinds of plans. They

haven\'t been run in practice, so they are in some

sense a larger change from what we have at the moment

and that will mean I suspect as one listens to the

proposal that we outline, that there will be more

places where we won\'t be able to say exactly, you

know, change this line, but there will be issues, and

Eddie will talk about some of these in a couple of

minutes, where I think there are some difficult issues

that we need to work through on implementation.

But the basic concept is relatively clear

as one tries to think through what this tax will do.

It\'s essentially designed to combine a cash flow tax

at the business level with the progressive tax that

Liz Ann described at the individual level. So the

provisions on the business level which are key are,

first, one would allow the expensing of all new

capital investment at least of purchases that are made

from other taxable businesses. And I should say that

while that sounds like it\'s just a change in

depreciations rules; and in some sense it is, that is

a fundamental line of demarcation between an income

tax and a consumption tax. With an income tax one is

trying to keep track of the depreciation on

historically‑purchased assets and to decide how much

of those assets can be deducted as a cost of business

today and measure the business\' income. With a

consumption tax, you essentially allow the business to

claim and immediate write‑off when it purchases the

assets and that moves you to a really fundamentally

different structure than what we have operated with

heretofore. So that\'s I think the big change that one

sees with this type of proposal.

I should mention in terms of, you know,

the revenue consequences of this, picking up on

something Beth alluded to earlier this morning, that

when you think about switching from a world with

depreciation allowances to a world with expensing and

you focus as we do in most of our analyses on a finite

revenue window, say 10 years, when you think about the

budgetary consequences of different plans, that

expensing in some sense within the 10‑year window

looks more expensive for revenue costs than it will be

over the long indefinite future. The reason being

that you see the difference between all of the

investment over the next 10 years being fully written

off and what would have happened under the alternative

current system where there would be some depreciation

allowances left to claim after the end of that 10‑year

window. In some sense, the expensing puts your costs

up front. So it\'s more expensive over the 10‑year

window than over the longer horizon. Nevertheless, we

will operate within the framework of trying to be

revenue‑neutral within that 10‑year window.

The first provision is capital expensing.

The second is that we would tax corporate cash flow at

a 35 percent rate. And cash flow is defined as the

sales of the business less the capital purchases and

other purchases from other businesses, less wages and

compensation.

Now, I should note that there is a close

relationship between a plan like this and a value‑

added tax‑type of structure that\'s used in many

countries. With a value‑added tax, the wages are not

deductible and the component of value which is created

by workers within the firm is taxed under the value‑

added tax. The difficulty with that approach is that

it\'s very difficult to build in progressivity so that

those who earn less are being taxed less simply

because the value‑added tax is essentially like a

sales tax that\'s paid ultimately by the consumer.

With the structure that we use, the progressive

consumption tax, by allowing the firm to deduct wage

payments and then retaining the structure that Liz Ann

described, which is the progressive tax structure at

the household level, you\'re able to essentially build

in a lower tax burden on the wages of those who earn

relatively little and a higher tax burden on those who

earn relatively a lot. So we\'re able to achieve a

degree of progressivity which is difficult with other

types of consumption tax structures. That\'s why we

call this the progressive consumption tax.

The third important provision on the

business side is that we eliminate interest deductions

for non‑financial businesses. And this will seem to

many like a major change relative to the current

system; and it is, but I think it\'s important to

understand why it\'s a natural component of the

progressive consumption tax structure.

Once we have moved from the current world

of depreciation allowances of physical investments to

a world in which expensing is allowed, effectively

that means that the Government is allowing you when

you purchase an asset to get 35 cents back on the

dollar at the time you make that investment. When you

then earn the cash flows in the future that are

generated by the project that investment is used for,

you\'re going to pay 35 percent of those cash flows

back on the back end. That makes the Government

essentially a partner in your deal. But it also means

that any project that would be worth undertaking in a

world without taxes at all, will still be worth

undertaking in a world with this kind of a structure

because you\'re going to give up 35 cents of the cost

of the project and you\'re going to give up 35 percent

of the cash flows on the back end.

If you couple that type structure, the

expensing structure with a system in which there are

interest deductions for debt that\'s undertaken to buy

the physical assets, you actually move from the

situation in which projects that would be undertaken

in an untaxed world are still always undertaken in the

taxed world, to one in which some projects which are

uneconomical in the no‑tax world become attractive in

the world when you get both immediate expensing and

interest deductions on your borrowing. And we don\'t

want to go to a place in which the tax system is

encouraging firms to undertake investments that they

would not in a completely no‑tax world and therefore

it becomes essential to combine the expensing on new

physical assets with the provision that eliminates the

interest deductions.

Now, one of the difficulties here is

exactly how one sort of implements this structure for

financial firms, and that\'s one of the hard

implementation issues that Professor Lazear will take

up in a few minutes. I\'m leaving all the heavy

lifting in his court, as you\'ll see.

The fourth key provision of the business

tax is that we will try to eliminate the discrepancies

in the tax treatment of different kinds of business

entities. One of the things that our Panel heard much

testimony about is the complex rules that govern C

corporations versus partnerships versus LLCs and the

way in which the treatment of different business

entities creates a lot of difficulty for the business

sector in general in computing its tax liability and

planning its affairs. So the progressive consumption

tax will apply the same tax structure to all business

entities with the exception of sole proprietorships.

And this picks up on Charles\' comment

earlier that, you know, the small business sector, the

sole proprietorships in many ways are a different

animal than the larger part of the business sector.

The sole proprietorships will just be brought into the

individual or the household\'s tax return as though

their earnings were sort of wage income. That also

means that instead of facing the 35 percent flat rate

of the business sector, the sole proprietorship\'s

earnings would be eligible for the progressive

structure that applies on the household side.

Now, one of the difficulties with moving

toward a cash flow‑type approach to taxation is that

there is likely to be more variation from year‑to‑year

in the total reported cash flow for a given business

entity. In the event that you undertake a large new

physical investment project, you might have large

negative measured cash flow. In a year when you make

large sales, you might have large positive cash flow.

And that volatility might well be greater than it is

under the current income tax system. That puts

additional pressure on thinking about how one handles

the firms who generate losses in a given accounting

year and what one wants to provide in the way of loss

offset relief.

One option would be to essentially allow

losses to be fully refundable in the year when they

are incurred. That is an option which our subgroup

felt would lead to a risk of some abuse within the

system and might be difficult to police. What we

therefore do is to propose moving to a more generous

structure than the current system, which allows

essentially loss carry forwards, but doesn\'t credit

you any interest on the carry forwards. And propose

that one moves to a loss offset, to a loss carry

forward with interest regime so that a firm that has

a loss this period will indeed carry forward that

loss, but the value of the loss will be incremented in

future years by an adjustment for interest, given the

return that was available in the capital markets.

That has the effect, at least for firms

that don\'t go out of business and lose the loss

completely, of making the loss more valuable when it\'s

incurred because it enables the firm to expect that it

will be able to claim that in the future at some rate

of return relative to what it\'s earning today.

So those in some sense are the key

elements that one needs to put together on the

business side to implement the progressive consumption

tax.

Let me say a little bit about, you know,

the attraction of this plan, the justification and why

one wants to think hard about something which moves us

from an income tax base to a consumption tax base for

the U.S. revenue system.

Liz Ann, of course raised the central

point, which is that a plan like this is very much a

pro‑investment, pro‑saving plan. It dramatically

reduces the tax burden on capital investment. And in

fact, for new business investments, given the analysis

that I suggested about no project that makes sense in

a no‑tax world would be turned away in a taxable

world, it moves from the current system where various

estimates suggest that the tax burden on new projects

in the business sector is variously maybe between 20

and 25, 30 percent, depending on exactly the project

and its type. It moves literally to a world where

those tax burdens would be zero, so that we would have

no incremental distortion to the investment decisions

that firms would be prepared to undertake. The net

effect of this of course is likely to be a long term

increase in the size of the capital stock and that

will have concomitant benefits in terms of

productivity growth and the level of GDP.

Now, as you all know, most economists come

with two hands, and those who have studied proposals

that involve a move toward a consumption tax system

are no exception. In looking at the available

evidence on how a plan like this might effect the long

run level of economic growth, the long run size of the

economy, there are a number of different studies using

different modeling approaches and different

assumptions about the way the economy would evolve

after a plan like this was adopted. They don\'t reach

a single, you know, uniform conclusion, but the broad

consensus appears to be that plans like this would in

fact be pro‑growth over the long haul. The exact

amount by which they might raise the long run level of

output varies depending on the study, but could be on

the order of three, five, seven percent of GDP once

these plans are fully phased in. And that of course

is a very important benefit in terms of the long run

impact this would have on the U.S. economy.

With the low tax burden that this would

impose on capital investment, the U.S. would not only

become an attractive place for U.S. households to

invest their savings, but would also become a very

attractive place for those abroad to think about

channeling their investments and placing their

investments here.

I should mention that there is an

important trade‑off to think about here; and this

again is one of the tough issues that Ed will take on

in a moment, and that concerns the transition and the

size of the economic efficiency gains. One of the

delicate problems of moving from an income tax

structure like the one we have to a new system like

this is the nature of the relief that ones provides

for the investors who\'ve made investments under the

current structure. The more relief one provides, the

smaller some of the estimates suggest the long run

gains will be in terms of efficient just because of

the need to make up the revenues that are associated

with some of the transitions. But we\'ll take that up

more in detail.

What I\'ve just described is in some sense,

the whole economic pie would be larger under a system

which tried to focus on a consumption tax.

There also will be an efficiency gain from

leveling out the playing field across various types of

activities that are undertaken under the tax

structure. So debt versus equity, for example, would

be placed on an equal footing under this plan. The

gaming that goes on at the moment of trying to define

a particular kind of a security as a debt security to

qualify for favorable tax treatment would essentially

be eliminated because debt and equity would be taxed

in the same fashion. I alluded to the fact that the

differences across sectors between LLCs and C corps,

for example, would be eliminated by this.

The differences across different kinds of

assets that are engendered by differences in their

depreciation lifetimes relative to their true economic

lifetimes that are due to differences in their ability

to use debt finance versus equity finance, those kinds

of intersectoral distortions, distortions by the way

which were a very important motivating factor in the

run‑up to the 1986 Tax Reform Act, those are

essentially eliminated by moving to a world in which

all assets are eligible for immediate write‑off

because the tax burdens turn out to be the same on all

of these different types of projects. So those are

also likely to be a very important source of

efficiency gain going forward as we manage to sort of

place everything on an equal footing.

The final component of advantage here, you

know, speaking besides just the economic growth

effects is that there\'s a tremendous amount of

simplification built into a structure like this. Not

only does one eliminate the difficult problems of

trying to measure the capital income that\'s associated

with the individual members of the household sector,

at the business level the corporate cash flow

structure will eliminate a lot of the difficult and

complicated accounting that is currently part of the

income tax structure. And essentially what one moves

to, you know, with various investments is something,

as Liz Ann suggested, which is like the current Roth

IRA‑type of structure, which is that taxes are

collected when income, for example, is earned as a

wage earner, and then beyond that there is tax

collected at the business level and the cash flow tax

applies there, but you don\'t have to keep track of

everything else because at the individual level the

capital income is no longer taxed.

Now we\'ve talked about simplicity. We\'ve

talked about growth. The last issue that our Panel

has focused on of course is fairness in distribution.

And let me say a little bit about that with respect to

this plan.

One of the traditional concerns with all

kinds of consumption taxes is that they might be

regressive, placing a higher burden on those at the

bottom end of the income distribution for several

reasons. One is that consumption outlays in any given

year relative to income tend to decline as one moves

up the measured income schedule and that just means

that the consumption tax burden relative to an income

tax burden may be higher at the bottom. Secondly,

because some kinds of consumption taxes, but not this

one, often have the problem of not allowing you to do

something to reduce tax burdens on those with low

levels of income and/or consumption. And finally,

particularly if you move to a world with no taxation

of capital income at the individual level, there will

always be some individuals who will show up with

nothing but capital income and who will look as though

they are paying no taxes at the individual side of the

tax structure.

And I should say as a kind of follow‑on to

Charles\' comment earlier about the distribution tables

that while we have worked very hard to try to preserve

the broad allocation of tax burdens across groups, it

is always possible to construct examples of

individuals who will pay higher taxes or lower taxes

under an alternative scheme relative to the current

system. And in some sense, you know, those individual

cases are aggregated and kind of wash out when we look

at the distribution tables.

But because there are some concerns about

some types of individuals one can think about paying

lower tax burdens, that is always an issue that

emerges in thinking about this. We have tried to work

very hard to keep our distributional analyses looking

similar, but our subgroup has in fact been concerned

about whether for some taxpayers at the very top of

the income distribution we might end up with a

situation where there are low tax burdens, as reported

under this system, would be an issue.

The income that\'s earned, the capital

income, is of course being taxed in most cases at the

business level. So part of the problem here is that

the locus of the taxation rather than the total tax

burden is changing around, but this has been an issue

that we have thought about.

Senator Breaux, who\'s one of the members

of our subcommittee, has been particularly helpful in

our thinking about this set of issues. So I\'d like to

turn to him for a second to just kind of, you know,

put a point on these issues and then come back and say

a little bit about other structures that one could

think about.

VICE‑CHAIRMAN BREAUX: Thank you very

much, Jim. And congratulations for the presentation

that you and Liz Ann made. I think it\'s very, very

helpful.

I would raise two concerns, I think. We

had talked about the health deduction and I take it

that in the simplified plan that we\'re talking about

a cap of about \$11,000, which is the average for

federal employees\' premium benefits that are not taxed

now. And I take it this one is a little lower than

that, \$8,500 or something I think we\'re talking about. And that would
give me some concern. I mean, maybe we

need the money to make it all fit, but I\'m concerned

that going below what is an average contribution on

health care is a direction that gives me concern when

the health care costs in the country are just moving

in the opposite direction. So anyway, that\'s one

point.

And, the other point is what you alluded

to, is the question that under the consumption tax

where we have no tax on dividends or capital gains or

interest earned by an individual, it just seems to me

that in presenting that type of a proposal you\'re

going to have some people who have no tax burden at

all as an individual in this country and many of them

would be at the very, very top of the income stream

and I just don\'t know whether I\'m very comfortable

trying to sell that. I mean, I\'m just being very I

guess perhaps political or have a political concern

here, but it\'s also a fairness concern, that if a

person ‑‑ I know some, that have only income derived

from capital gains ‑‑ I\'m looking at you, but I\'m not

saying that\'s you. I don\'t mean you. Some very

fortunate people who that\'s all they have is capital

gains and dividends and interest earned. And under

the proposal as it currently stands, would pay no

federal contribution to running this country. And I

just think that I understand the economic concept

behind it, but there are also legitimate interests

that factor in here and I just have a real concern

with having a zero tax for many of those that would

fit into that category; fortunate for them, but I

think I really would like to see if we can find a way

to address that.

And a final point, Mr. Chairman, to see if

we can\'t get some nomenclature here that says what

we\'re talking about. I mean, we have, I take it, the

simplified income tax and then we have the uniform

capital tax, which Jim has referred to as the

progressive consumption tax, so at some point perhaps

everybody out there trying to figure out what we\'re

talking about to have clearly defined, you know, what

we\'re going to call these two proposals I think would

be helpful.

CHAIRMAN MACK: Let me address the third

one and then I\'ll allow the other Panel members to

address the other two. You know, we will in fact do

that when we get our report out. We will clearly

identify what we\'ll be calling this progressive

consumption tax or pro‑growth tax. But we will

clearly identify that when we get our report out.

Appreciate that.

Any Panel members want to chime in with

respect ‑‑ Beth, did you want to say something?

PANELIST SONDERS: There are always trade‑

offs obviously between the benefits of the growth and

I think Jim only touched on it. But in a prior

meeting, I believe back in July, he did a more, and I

think, very excellent discussion about this notion

that there\'s the optics some of the upper end

individuals not paying, but that in fact the tax is

paid, it\'s just paid on the business side and it may

be worth, you know, spending on that discussion again. It certainly
would be worth it at some final point in

this process where we will explain the benefits in a

more pure version of this. But then you have the

trade‑off in terms of what you get from productivity,

which is admittedly difficult to get under a more pure

structure and that\'s the reason why we will, you know,

talk today about some options that would I think

alleviate some of your concerns, Senator Breaux.

CHAIRMAN MACK: Beth, did you have a

comment?

PANELIST GARRETT: Yes, I just wanted to

echo both of the concerns that John Breaux raised

because they\'re concerns I share and may be a bit

worried about this particular proposal.

The first just with respect to the low cap

on the exclusion for health benefits. I do think that

the exclusion has to be capped, but we have to be

realistic. The tax policy is only one aspect of

what\'s driving higher health costs in this country and

because we cannot address health care generally, but

are limited to dealing with the tax code, what we run

the risk of with such a low cap is really putting

people in the right mind to pay for health insurance

is reasonable and modest. If you add to that that

it\'s indexed solely to CPI as opposed to health cost

increase, I\'m very concerned that we\'ve gone a bit too

far in the turning of the health exclusion here.

The second concern I have is one that I

share with John and some of the others. It\'s not just

because of the optics of not taxing individuals on

their investment income, but it\'s the fairness of a

system, as a consumption tax is, that eliminates or

substantially reduces the tax on capital. You know,

I think that if the country were to move to a pure

consumption tax, what Jim and Liz Ann have detailed is

the way to do it; not a national sales tax, not a VAT

by itself, but this progressive consumption tax is the

way this country could have a true consumption tax if

it chose to do so. I would hope we never choose to

have a pure consumption tax for fairness

considerations. But the fairness consideration I

discussed is the a pure consumption tax, taxes for

income much heavier than it taxes capital income. And

for, you know, Americans who are already taxed on

through payroll taxes, that\'s going to strike them as

unfair and undesirable and my guess is, although we

don\'t have the tables, is that this tax would reduce

the tax burden on higher income Americans. That\'s not

just an optical problem. That is a real problem,

particularly for some who believe that we\'re all

already sufficiently progressive with the current tax

burden because of changes made over the past tax

bills.

So I just wanted to underscore that I

share both of John\'s concerns and I have very serious

reservations about this kind of a plan.

CHAIRMAN MACK: Okay. Let me go to Ed and

then I\'ll go to you, Bill.

PANELIST POTERBA: Let me say, before we

begin the general discussion of some of these plans,

I think there are some details of the business side

that Ed needs to lay out for us, and I think that

would be next thing to do.

CHAIRMAN MACK: Do you want to make some

comments with respect to the issues that John had

raised, or would you want to go into ‑‑

PANELIST LAZEAR: Why don\'t we hold off

and then address that in a more general discussion?

So, I think we\'ve got technical stuff that we still

need to get through.

CHAIRMAN MACK: Okay.

PANELIST LAZEAR: And it\'s not as

interesting as this discussion, but we probably ought

to lay it out so that we have everything on the table

and can then discuss it.

CHAIRMAN MACK: Okay. What I would intend

to do then is you go ahead and make your presentation. Then we\'ll come
back to this issue and deal with it in

more detail.

PANELIST LAZEAR: Okay.

CHAIRMAN MACK: Go ahead.

PANELIST LAZEAR: Thanks very much. Let

me just start by mentioning what other panelists have

mentioned, and that is that many of you are aware that

we\'ve pushed back the reporting date on this report,

starting from July 31st to September 30th, and then

because of some obviously unfortunate events

associated with the hurricane, we had to move it back

to November 1st.

There\'s a theorem that says that work

expands to fill any time available, and as a result of

that, I think we\'ve put in a lot more hours than we

actually expected to do. But, one of the nice

features of that is that we\'ve gotten to know each

other a lot better. And in particular, we\'ve gotten

to know and to work with the staff who\'ve been just

extremely helpful and it\'s really been a delight, and

I would like to join my colleagues in thanking them,

particularly in sticking with us through this extended

period of time that they hadn\'t bargained for. So,

thank you again.

Let me just talk about some of the issues

that Jim raised. He said he was going to pass the

heavy lifting to me, and he certainly has. These are

among the most difficult technical issues that we\'ve

had to deal with. I\'m not going to address them in

all their gory detail because my guess is that three‑

quarters of the audience would be asleep and I\'m not

even sure that I could stay awake through it.

But, what I\'d like to do is talk about two

particular issues. One has to do with the taxation of

financial institutions and the other has to do with

taxation of international entities. Then I\'m going to

close this section by talking about transition issues

which Jim has touched on, but I think are extremely

important and I\'d like to go into those in a bit more

detail.

Let\'s first start by considering the

financial institutions. Dealing with financial

institutions is one of the more difficult aspects of

the tax system. In a consumption tax, it\'s

conceptually inappropriate to tax financial

transactions by real businesses because those are

inputs into the production process. So we wouldn\'t

want to tax, for example, a computer software start‑up

for the capital that it receives, nor would we want it

to deduct the dividends paid out. But for financial

institutions, the product that they actually sell is

financial services and to be consistent with what

we\'re doing with respect to other real businesses,

we\'d like to tax financial institutions on the value‑

added associated with those services that they

provide.

There are two big problems, unfortunately. The first one is that the
price of the product that

the financial institutions charge is often implicit

rather that explicit. The easiest way to see this is

to think about something like a checking account where

you earn lower interest on the checking account than

you would on other securities or on other assets. But

what you\'re getting in return, of course, are the

financial services, the services from the bank that

are transferred to you and that\'s why people are

willing to accept the lower interest. But the lower

interest is in a sense a payment. The difference

between the interest that you would have received and

the interest that you actually receive is a payment to

those institutions and we\'d like to recognize that in

a consumption tax as part of consumption.

Second, Jim described the business tax

system where firms are not taxed on financial

transactions. Now under this system, financial

institutions would end up having perpetual tax losses. The reason is
that they would ignore all financial

inflows and the financial inflows are the primary

source of their revenue. So what they\'d be doing is

they\'d be deducting the cost of running the business.

They\'d deduct their labor cost, all other input costs. They\'d have
lots and lots of costs, but they wouldn\'t

have any revenue. So it would like these firms are

always taking a loss and as a result, we wouldn\'t be

able to tax those firms. And that\'s a real problem.

Now, if you look at other entities that

have dealt with consumption taxes, like the states or

foreign governments that have value‑added taxes,

retail sales taxes at the state level, for the most

part they\'ve essentially given up on taxing financial

institutions. Because it is so difficult, they\'ve

basically said we\'re not going to deal with it. We\'re

just going to ignore it. And that\'s an option. I

mean, that\'s obviously something that we could do. We

could simply say that\'s just not going to be part of

the tax code. We\'re going to just give up on it.

An alternative approach is to use

something that equivalent to the approach that Jim

described, but slightly redefine it. And that is to

do taxation on cash flow of financial institutions

where cash flow is defined in what\'s called a real and

financial basis, or sometimes referred to as an R plus

F basis. This takes care of the problem of perpetual

losses and of no implicit payments that aren\'t taken

into account because all revenues and all costs are

then taken into account by the financial institutions. So for example,
here revenues would be taxable, all

revenues would be taxable, all out flows would be

deductible. So income generated by the financial

services would be taxed. When a financial institution

makes a loan, it gets a deduction for the principal on

that loan. When the loan is repaid, it\'s taxed and

the principal and interest would be taxed on it.

Now, conceptually this is a very clean

system and it parallels the nice structure that Jim

described for real businesses. And as a result, we

recommend it as one possibility for consideration.

But I\'d like to point out before closing on that, that

it is not without its difficulties. The biggest

technical difficulty arises because there\'s a

different treatment of financial institutions with

respect to taxation and deductibility of interest than

you have for real businesses. And whenever you\'re

treating one business different from another business,

that creates an arbitrage opportunity. It creates an

opportunity for businesses to declare themselves one

thing or the other simply so as to lower their tax

burden. So, that\'s a feature of a tax system that we

never like. Whenever you have the ability to go one way or the other
simply to evade taxes, that\'s not a great feature. And unfortunately
that is a feature of any system that treats real businesses differently
from financial institutions.

So, instead of the cash flow treatment, we

could use the current system; simply do what we do

now, which is to treat only explicit fees and interest

as taxable or deductible to financial institutions.

This presents other problems, some of which can be

managed as they are under the current system, but that

too is not without its difficulties and I could go

into detail about some specific examples of things

that firms could do under one plan or another, but I

don\'t think it\'s useful to do that at this level.

Bill keeps cautioning us that we shouldn\'t be spending

too much time on the details, and I think he\'s right

on this.

I think that the general principle that we

take away from this though is that whichever system we

use, it will be necessary to have rules that

distinguish between real and financial businesses.

We\'re simply not going to be able to avoid that.

That\'s the case now and it will be the case under any

structure that we choose, and I think we have to be

cognizant of that.

I also think though that it\'s important to

remember that there\'s nothing inherent in the

consumption tax per se that requires one treatment of

financial institutions over another. The actual

choice between say a cash flow system or the current

system that we use requires a close examination of the

trade‑offs consisting of distortions and incentives to

engage in bogus transactions against the effect of the

value of collecting revenue from this sector. So, our

sub‑group has not made a firm decision on the choice

as to which way we\'re going to go on financial

institutions up this point.

Let me turn now to the issue of

international considerations. This is also one of the

messier aspects of the plan and of any plan that

involves consumption taxes.

Under a consumption tax, items consumed in

the United States should be taxed and those consumed

outside the United States should not be. What we mean

by consumption, when we talk about a consumption tax,

is domestic consumption. That\'s the way that

consumption is defined. So something produced outside the United States
but consumed here should be taxed in

the United States. Conversely, something produced

here but consumed elsewhere should not be taxed in the

United States. That\'s the way the system works. And

in fact, that\'s the way the typical VAT system works.

When something is shipped from one country to another,

there is a tax adjustment at the border. The firm is

given a credit for that and is not required to pay tax

on that. Conversely, imports pay a tax into the

country in which they are imported. So exports are

not taxed.

Not only is this the conceptually

appropriate way to go, it\'s an approach that virtually

all economists who\'ve studied this situation believe

does not result in penalizing imports. And that may

surprise you because it sounds like what we\'re doing

is taxing imports and crediting exports. So you\'re

initial reaction would be that this penalizes

importers relative to exporters. In fact, that\'s not

likely to be the case. And the reason for that is

that a change in the system from an income‑based

worldwide system where imports are not treated

differently from exports, induces exchange rate

adjustments and leaves things neutral. And as I said,

virtually every economist who studied this issue

believes this. So we are convinced that over the long

haul, and we don\'t expect the long haul to be too

long, exchange rate adjustments will occur that will

remedy any kind of problems associated with that.

However, to the extent that these

adjustments don\'t occur immediately, and we are

concerned that the, sort of the text book analysis;

and it\'s not only textbook, there\'s actually evidence

on this that people who study international trade have

examined, but to the extent that there may be some

slowness or some rigidities in bringing these

exchanges about, we propose that we think about some

kind of a transition plan associated with border

adjustability. And by the way, that\'s a code word for

taxing imports and crediting exports. And so there

are a number of different kinds of plans that we could

think of in terms of border adjustability, but

something along the lines of giving importers a credit

based on their past experience up to the point of

their past level of imports and then phasing that

credit out over time would be something that would

allow importers and markets to adjust in a smoother

way. We are concerned that we don\'t do something

that\'s so abrupt it might cause certain businesses to

go under simply because of the provisions of the plan. So we have worked
out some specific details about

phasing rules on border adjustability. And I can talk

about those more in detail, if you want. But, let me

just say that that\'s the approach that we\'re thinking

about taking.

Let me also point out that in the short

run the taxation of imports and the exclusion of

exports also will bring some revenue into the

Government. And the reason is, that in the short run,

currently, as almost everybody knows, we are running

a trade deficit, which means that imports exceed

exports. Well, if imports exceed exports, you tax

imports, you credit exports, it means you\'re taxing

more than your crediting, so there\'s net gain there in

terms of revenue generation.

Our subgroup of the Panel did not view it

as appropriate to build into our revenue calculations

that credit. And so, when we asked Treasury to score

the plan for us and to make sure that we had

provisions that were revenue‑neutral, we did not build

into our calculations any assumptions about border

adjustability. If those come and if they do bring in

additional revenue in the future, of course we\'ll be

thrilled to see that, but we\'re not building that in

in our calculations, and I just want to make that

clear, but we do recommend as a subgroup that we

think about a destination‑based tax system with border

adjustability.

Let me conclude this section of my

discussion by talking about transition issues, which

many people may view as among the most important

things that we have to consider.

We\'ve talked a lot about mortgage interest

and that came up last week and has already generated

a good bit of discussion and controversy. One of the

things that we have to worry about is if we cap

mortgage interest deductibility, then people who\'ve

borrowed with the idea that they could afford their

house taking into account the tax breaks associated

with the mortgage deductibility may find that they can

no longer afford this. And I\'m particularly sensitive

to this issue. I come from an area where housing

prices are extremely high. Families who move say from

Pennsylvania to California might find that they end up

increasing the size of their mortgage literally by

half a million dollars and they stretch and figure

that they can make it simply because they have this

tax break. If you go cold turkey and just cut off tax

break for them, you\'re going to create some real

significant problems for certain families. And we

were very much aware of that and our sub‑group thought

very hard and carefully about that.

So, one of the things that we would like

to build into the plan is transition relief for

existing mortgages that predate the presentation of

this plan. Mortgages currently in effect would get

interest deductions under the old scheme phased out

over some period of time to be determined, but all new

mortgages and those that change in terms of their

mortgages would be treated under the new rules. This

would then provide for coverage for individuals who

did make decisions based on the old regime and are now

faced with the new regime, and I think would remove

much of the pain associated with going to the scheme.

Let me just briefly touch on the business

transition issues. Depreciation is a very important

one. Under the new scheme there\'s full expensing;

there is no depreciation, so the question is how do we

treat existing balances of depreciation? Again, a

firm might have built the plant yesterday; Charles

brought this up I remember in one of our earlier

hearings. He was quite concerned about, you know,

maybe a big power plant or something that was built

yesterday and then you consider one built tomorrow.

The one built tomorrow gets full expensing. The one

yesterday loses their entire depreciation. Again,

that could cause bankruptcy for those organizations

and that\'s not something that we want to encourage.

So in order to ease the burden of this

hardship, we\'ve thought about plans that would give a

credit to some portion of the existing depreciation

allowance that would exist under the current rules.

And again, we would phase that out over time, but do

that in a pattern that would be sufficiently slow so

that firms could adjust to this, take this into

account and make modifications to their financial

structure that would enable them to survive without

going into bankruptcy and having to reorganize.

A similar situation arises with respect to

interest deductibility. Again, under the new plan we

don\'t allow for interest deductibility. And

if you don\'t allow for interest deductibility, the same thing could
happen. You could have someone building a big plant yesterday. They
financed it with debt capital, they borrowed, thinking that they would
get to deduct the interest during the first years and that\'s basically
how they were going to stay afloat while their revenues were relatively
low and then over time as their revenues grew, they\'d be able to afford
the repayment of the principal. That\'s the standard way that people
borrow. If we go immediately to a regime where we don\'t have interest
deductibility, we cause problems for them. So again, we could think
about some kind of a phase‑in plan that would allow some interest
deductibility in the short run and then phase that out over time.

On the other side, of course, some firms

have made existing loans and they under the old rules

would have been taxed on the interest payments that

they receive and we would like to phase that out as

well.

All right. Let me just reiterate

something; I\'m going to close now, but let me

reiterate something that Jim made, because I think

this is an extremely important point. We are going to

have to make very hard choices on transition rules.

Jim mentioned that under the current plan we can

expect GDP growth somewhere between three, five, seven

percent, were the numbers you mentioned. One very

prominent tax expert suggested that it could raise GDP

by as much as nine percent. We don\'t know which

number is going to be right. But what we do know is

that most or all of the gain will be lost if we give

complete transition relief; that is, if we essentially

undo the plan by paying off all old capital, we are

going to lose the advantages of growth. And that

means that we need to worry about fairness and the

disruption of households and businesses. But we can\'t

give complete relief, because if we give complete

relief, we\'ve essentially given up the plan.

So we believe that the approaches that we

have taken and the specific items that we have

targeted for transition relief are those that are in

the most urgent need and we believe that they will

cause the least distortion and bring about the most

fairness.

CHAIRMAN MACK: Jim, did you have any

further comments that you wanted to make before we go

back into the discussion?

PANELIST POTERBA: I think we can now

return to the discussion of distribution and other

things. We have a modified version of this plan which

I\'d like to describe, but I think we may want to open

for general discussion first and then I\'ll do that.

CHAIRMAN MACK: Did you want to make a

comment with respect to the issues that John and Beth

raised?

PANELIST LAZEAR: My preference would be

to let Jim go ahead and I\'ll close the discussion.

CHAIRMAN MACK: All right.

PANELIST POTERBA: Okay. Perfect.

CHAIRMAN MACK: Since I\'ve gotten to know

this group pretty well, I think there were some fairly

strong comments that had been made with respect to

both the health care and the tax on capital, if you

will. And so, yes, I\'d be interested in your ‑‑

PANELIST POTERBA: Okay. So let me pick

up in some sense with the comments that Senator Breaux

raised and also with Beth\'s concerns about the

distributional issues. And this is something that our

working group has really wrestled with throughout out

discussion of this kind of a progressive consumption

tax structure.

What we\'ve tried to design is a modified

version of the progressive consumption tax, which

essentially is a hybrid of the progressive consumption

tax and the current income tax structure which is

explicitly designed to address these distributional

and progressivity concerns, particularly about the

very top end of the distribution and people who may

have mostly capital income there.

And before describing where we would go,

I should emphasize that, you know, at the moment the

current income tax that we have is itself a hybrid

system because as soon as one introduces something

like an individual retirement account or a 401(k) plan

where some types of capital income at the moment are

essentially untaxed when they accrue to individuals,

that\'s building in a component of a consumption tax

within a structure which is otherwise a broader income

tax.

What we have done in some sense in

crafting this alternative suggestion is to start from

the progressive consumption tax and then say well,

let\'s sort of layer back in some elements of an income

tax; in particular, an income tax on capital income

flows and then see whether that can be used as a way

of addressing some of the distributional concerns.

It is also important to recognize that

that sort of hybrid systems are more complex to run

than pure systems or as a consumption tax. So that one of the costs that
one incurs in moving to the structure, I\'ll just describe, is that
instead of being able to administer essentially just a consumption tax,
one now has to administer a consumption tax in tandem with part of an
income tax and that\'s going to add some opportunities both that will
create, you know, some tax administration issues potentially for
taxpayers, but that\'s the price one pays, a bit of a loss and
simplicity, for trying to achieve some of the fairness objectives which
might be focused on here.

Okay. So how would we do this?

Essentially, we would take the progressive consumption

tax structure that we\'ve already defined and we would

add on at the household level a 15 percent flat tax

rate on all interest, dividends and capital gains. So

that would preserve an income tax treatment of those

capital income flows at the household side and

essentially it would raise the burden on capital

investment projects because there would be a tax

collected at the individual level on, for example, a

project which was undertaken in the business sector

which generated cash flows that were ultimately paid

out as dividends, or were realized as capital gains by

the individual.

We would note, under this modified plan

one can no longer make the strong statement that any

project that would be undertaken in a no‑tax world

would still be undertaken in this modified‑tax world,

however, it is the case that the tax burden on new

investment projects in this modified world would be

much lower than the current tax burden on projects

particularly in the corporate sector. So that feature

of the advantages would be there.

Now, once you\'ve restored a tax at this 15

percent on interest, dividends and capital gains, it

raises the question of what does one do about the sort

of structure of tax‑preferred savings vehicles which,

for example, were outlined in the presentation of a

previous working group with their savings package.

So, what we would propose to do is to essentially

retain something that would allow the majority of

households to continue to save in what would

effectively be an untaxed way. We would propose a

\$10,000 per year per individual contribution limit

essentially the type of savings plans that were

described earlier, so you would have expanded versions

of sort of current level savings plans which would

allow people to contribute and then save in a pre‑tax

way. Again, these would be done on a Roth‑type

structure, so they\'d be a prepayment structure where

the accounts would accept after‑tax dollars and the

returns would not be taxed going forward.

In terms of the rate structure, to make

all of this go, what we would propose doing is

combining the new tax burden on the individual capital

income with something of a reduction in the corporate

level capital burden to go down to a 32 percent rate

structure on corporations while moving to a four‑

bracket, 15, 25, 30 and 35 for individuals. Okay.

Remember that the 15 percent is the schedule rate for

capital income, for capital income that is not earned

within the specialized savings accounts that are

there. And this would, of course, also retain the

full structure of the corporate side, the corporate

cash flow tax that Eddie described in some detail and

that I outlined. So all of those provisions

essentially continue to operate with this.

When we have looked at the distributional

analysis of a plan like this, it again, like the

previous, the progressive consumption tax, it is able

to track very closely the current distribution of tax

burdens through most of the distribution of incomes.

But by virtue of having the tax on capital income in

place for individuals, it avoids the situation of some

high‑income households with primarily capital income

paying less at the individual level than their tax

burdens by a substantial level under this plan and

under the current income tax structure. So this plan

isn\'t something that\'s designed to respond very

precisely to the concerns that Beth and that Senator

Breaux were raising about the pure consumption tax.

And I think, you know, our working group

in some sense, you know, want to tee up both of these

as plans that the full Panel can think about because

for precisely the reasons we\'ve talked about all day,

the fact that making these judgments on progressivity

and fairness are so difficult that we didn\'t feel that

we could, you know, foreclose one option in preference

to the other.

As I said, this does result in a somewhat

more complicated system than we have at the moment,

but it also retains many of the advantages of the

progressive consumption tax structure. And I think I

want to turn back maybe to Eddie for a minute to now

come back in and sort of summarize some of the broad

advantages here.

PANELIST LAZEAR: Okay. Thanks very much. Let me just make some closing
comments on this before

we turn it open to discussion. I would like to

comment on some of the issues that you were worried

about, Connie, but let me do that after because I\'d

like to again keep this more of a coherent discussion.

Let me first say that I was extremely

impressed by the presentation of the simplified income

tax. I thought that was not only a terrific

presentation, but also a terrific plan and I think

that both plans are going to be ones that we\'re going

to feel quite comfortable putting forward. I think

they\'re both vast improvements over what we see right

now.

I\'d like to return though to the specific

plan that we\'re talking about at this point and ask

why is it that we call this fundamental reform?

Because you know if you kind of look at the thing and

you say, you know, what\'s the big deal, what\'s

different here, on the business side this pretty much

looks like the plan that we\'re talking about as a

simplified income tax with two exceptions and the two

exceptions are first full expensing and second, non‑

deductibility of interest. So those are the

differences.

PANELIST ROSSOTTI: Border adjustability

also?

PANELIST LAZEAR: Well, the border

adjustability, you know, I\'m sort of thinking of those

as details, but the sort of the fundamental ones, we

can discuss that after, Charles.

The fundamental ones that I wanted to

point out though would be the full expensing, the ones

that affect real businesses for the most part that are

doing most business with the full expensing and non‑

deductibility of interest, but certainly the border

adjustability is an issue.

Now full expensing, to my mind, is

fundamental and the reason it\'s fundamental is for the

reasons that Jim pointed out before. We think of

investment as being a key component of our plan and so

the plan is very much a pro‑growth plan. And my

personal view is that growth should be the most

important goal for this panel. That may be heresy

because most people, I think, think in terms of

simplification as being the most obvious

characteristic of any kind of income tax reform. And

certainly simplification is an important component and

I think we will embrace all of the simplifying changes

that Charles\' group made, certainly most of them; I

thought they were quite impressive, but remember that

the economic effect of growth will dwarf the economic

value of simplification after a few years, that when

we\'re talking, when we\'re looking out four or five

years from now and we say gee, how much do we save in

GDP by completely simplifying the system, taking into

account all the time saving by individuals, all the

hassle, all the expenses on getting your taxes

prepared, take that all into account and then compare

that to the amount that we get from having a higher

rate of growth and growth is simply more important and

over a relatively short period of time.

So why do we think that growth is

important? Well, it\'s absolutely clear that wage

growth depends directly on productivity growth. That

is the most important variable affecting productivity

growth. So if we think about increasing the standard

of living of every worker, we have to think in terms

of wage growth. That\'s simply the way it is. There\'s

only one way to get wage growth and that\'s

productivity growth. Productivity growth in turn

depends on high rates of investment in both human

capital and physical capital. Investment is highest

when the tax rates on an investment are low. The

progressive consumption tax plan that Jim outlined,

even in its blended form, has much lower tax rates on

new investment, reducing the rate from 17 percent to

about four percent on the margin. And this will

result in high levels of investment and those high

levels of investment, it\'s my view, will create wage

growth and that wage growth will be enjoyed not only

by high wage workers, but by all of the workers in

this country.

Let me make one more point that\'s also

been made earlier, but I think it\'s an important one;

and Charles made this at the end of his discussion,

and that was that when we assess any plan, we need to

consider it in total. You don\'t want to consider it

provision‑by‑provision. Let me give you an example,

a particular example.

Let\'s think about the construction

industry. One of the things that we heard talk about

during the week after there was mention of capping

mortgage deductibility was the construction industry

was quite worried about that. Now, if you think about

the plan that we just presented where there\'s full

expensing of all capital, including a \$50 million

commercial building, we believe that that\'s going to

be a boon not only to investment, but also to the

construction industry. So what we see perhaps is a

slight shrinkage; and I personally don\'t think there

will be much, on the residential side I think will be

more than offset by anything on the commercial side.

So the point is that when we think about a plan and we

think about the provisions of the plan, what we need

to do is we need to take into account the entire plan

and think about all of the provisions and not just one

aspect of it.

Let me conclude. The progressive

consumption tax, to my mind, has three virtues. The

first is that it\'s pro‑growth. It not only encourages

saving, but it also changes the net return on

investment making the United States a more attractive

place to put capital, both for Americans and for

foreigners.

Second, it\'s fair. The blended plan in

particular that Jim just outlined results in a tax

burden by income group that\'s very similar to that

under the current system. As a result, we create very

strong investment incentives without burdening the

middle class or the poor unduly.

And finally, it is simple. Although the

blended plan adds some complexity as compared with the

straight progressive consumption tax plan. Even the

blended plan is vastly simpler and more

straightforward than the current tax code. This will

allow both businesses and individuals to calculate

their taxes in a direct manner.

Thanks very much.

CHAIRMAN MACK: Okay. Thank you. Liz

Ann, did you have a comment?

PANELIST SONDERS: Yes, thank you. I

wanted to reiterate what Ed was saying about pro‑

growth being a very important area. There is a couple

of ways you can go about trying to stimulate growth.

You can stimulate investment, you can encourage

savings and I think those are very important. But

there\'s a difference between the two and I think the

encouragement in investing is one that we probably

want to consider a little bit more strongly.

When you encourage savings, which is a

wonderful thing, you have to make the assumption that

the money will make it through investing and/or that

the money will be invested in the United States; of

course, there are plenty of options for that, as

opposed to encouraging investment. You\'re more likely

to have that physical capital here and to make the

investments here in the United States. So I just

wanted to specifically make that point in terms of the

distinction between encouraging savings and

encouraging investment.

CHAIRMAN MACK: Good. Thank you. And

back to the issue that has really kind of come to the

forefront here with respect to making some

modifications to your original proposal. Are there

other members of the Panel that want to make ‑‑ Tim?

PANELIST MURIS: Well, I just wanted to

say that obviously we\'re charged with considering

economic growth and we\'ve talked about it in great

detail.

Moving toward this plan, in whatever form

we can get consensus, would have a strong beneficial

effect on the economy. And it\'s important to remember

that effect isn\'t a zero sum game. Most of us;

indeed, probably close to all of us, benefit when we

make the pie larger.

We\'ve talked about the entitlement crisis. Growing the economy is one
of the most important

solutions to that problem. When people about

unfairness, I think you could argue that it\'s unfair

to be inefficient, it\'s unfair to not adopt and

recommend proposals that would maximize growth. For

whatever reason; and we could debate, that the

concepts of distribution that are used in the tax

world, the so‑called distribution tables, I think are

static, they\'re wrong‑headed and they ignore the

tremendous upward changes among quintiles that take

place in our economy and I wanted to just note that

for the record.

CHAIRMAN MACK: I appreciate it. Bill?

PANELIST FRENZEL: I had the problem with

the burden question as well, but that was before Jim

and Ed laid all their cards on the table and told us

of their modified plan.

When we started this game, we decided that

fairness would be measured by approximately what the

distribution of burden was between the quintiles of

income and that may or may not have been a good idea.

I think had we not made that decision, we\'d still be

at that meeting arguing about it, so it was worth

something from that standpoint.

On the other hand, I do not believe that

ultimate fairness is measured by exactly what we have

today. Because, what we have today is a fairly lousy

tax system and we\'re trying to change it to make it

better. And so if there are some variations in the

distribution of burden, that\'s not going to take the

proposal out of bounds as far as I\'m concerned. And

if you have in your modified version, or even in your

full version, which I must say it looked terribly

attractive to me, I\'m certainly willing to take a look

at it. But we know from past experience that when we

create a Mrs. Horace Dodge, we create a terrible

reaction among the public and whatever good we\'ve done

in taxes gets wiped out. We saw it again in 1987 when

we had 28 percent rate that suddenly escalated back up

to nearly 40. So we know we can\'t overstep however

desirable the economic growth is and I agree with Ed

that it\'s prime in my book. We still have to be

careful that we don\'t create a system that Americans

don\'t want to live with.

So, I was really pleased with the latter

half of that discussion where you brought out your

modified system. I further agree that expensing is

just a marvelous aspect, something that we have needed

right along and I think we\'re moving in the right

direction.

One of the lessons for this Panel is that

we don\'t have to achieve Nirvana right now. What we

need to do is set a direction so that over the years

America can keep improving its tax system and I think

we are on the way to doing that. So, I am really

pleased with the discussion of the last hour and

awfully glad to be a member of this Panel. Thank you.

CHAIRMAN MACK: John?

VICE‑CHAIRMAN BREAUX: I think it has been

a very helpful discussion and I think that Ed and Jim

in their discussions and Liz Ann have, I think, make

some suggestions perhaps that I think still give us a

very pro‑growth and fair proposition with the

modifications and if it is appropriate, I think that

it may be a good idea for us to consider the

progressive consumption tax as modified by the

suggestions that were outlined, Mr. Chairman, if you

think that\'s an acceptable proposal at least.

CHAIRMAN MACK: Just so that each of us

understands what we would be doing here, we\'re

basically saying with respect to the health cap that

we would go back to basically the same proposal that

Charles had outlined, which is the \$11,5000 and

\$5,000, that we would go to four brackets instead of

the three that Jim outlined, which would be, if I

remember correctly, 15, 25, 30 and 35. We would

establish a 15 percent, in essence, capital rate; a

tax on capital at 15 percent. And we would have

corporate rate then at 32 percent.

And I would just say at this point, there

are some pretty strong feelings about these issues.

I mean, if two or three of us were to get together, we

would come up with a particular plan or two or three

others would come up with another. We\'ve attempted to

take the approach through this entire process to

develop a consensus position. Also, I remember very

clearly one of the things that Secretary Baker said to

us at one of our early hearings and that was, \"If

you\'re going to have tax reform, it has to be

bipartisan in nature.\" So my sense is that we ought

to adopt this blended approach, even though some of us

have some very strong feelings in the opposite

direction. And if that\'s the case, I mean, let me

just look around, does everyone agree with that? Does

anyone object to that?

PANELIST GARRETT: This is Beth, Connie.

I\'m certainly happier with the blended approach from

the concerns that I raised and it is quite likely that

it would be the case that I could join a report that

says something like this. It\'s an improvement over

the current system. I\'m very enthusiastic about the

proposal that our working group came up with. But I

would need to see some more data about the tax

burdens. I think that Bill is right. We took

progressivity off the table because I think we would

not have been able to reach a consensus otherwise, so

we decided to replicate current tax burdens. But it

is my view that the current situation is not

sufficiently progressive because of growing inequality

in wealth. So I would as least have to be content

that we do no worse under this system than we\'re doing

now.

PANELIST ROSSOTTI: I agree with the way

you summed it up very well, and I think as far as I

can tell, you know, subject to seeing more numbers, it

would deal appropriately with progressivity.

I do think also I want to say that I think

both Jim and Ed have, you know, done a very fair and

excellent job of laying out not only the benefits of

this, but some of the unresolved issues that still

exist on this and I think we should, when we forward

this as a recommendation, we need to recognize that.

And it\'s not a function of lack of diligent work

because I know they\'ve worked diligently and there\'s

been a lot of work done it. But just simply the fact

that some of the aspects of this are simply so

different and so new that they\'re not fully developed

yet and they\'re not comparable in the level of detail. So there\'s a
lot more work, I think, on mainly the

areas that Ed mentioned that we need to acknowledge.

I do want to in particular ask Ed though

about two things, just to make sure I understand them

correctly and see that everybody else does.

One has to do with the ‑‑ you know, we

were chuckling about border adjustability. You said

that was a mere detail. It seems a little bit bigger

than that to me. I just want to make sure first that

I understand how it would work. And secondly, one

particular, I think, result of that, as I understand

it, in the progressive income tax system for business

it would work simply that ‑‑ I mean, essentially they

would report like they do now with income and expense,

but that if I have a purchase from overseas, an

import, I would simply not get a tax deduction for

that. It would not be considered and expense. You

know, I have revenues and it would be not expensed in

my reporting?

PANELIST LAZEAR: Right.

PANELIST ROSSOTTI: Okay. And conversely,

if I have an export, it would not be counted as

revenues?

PANELIST LAZEAR: Correct.

PANELIST ROSSOTTI: And your belief is

that in the instantaneous, as you pointed out, this

would mean that all importers that had a significant

amount would be operating at a cash loss because their

taxes would go up and that would be affected

eventually by the exchange rates. So I think that\'s

an important point to understand because without that,

I think everybody that as a significant amount of

imports would be, you know, really, really in trouble.

The other point though is, it\'s my

understanding that this type of a system would not be

considered acceptable under the existing trade

agreements with all of our trading partners. So,

before you could implement this, you would have to

renegotiate I guess essentially all of our trade

treaties. Is that right?

PANELIST LAZEAR: Well, it\'s not clear

that it\'s right. Again, we\'re not the lawyers in the

group, but we have thought about this a good bit. Our

view is that because this is a consumption tax and it

is the equivalent of a VAT, it should be treated as a

VAT. VATs are border adjustable. So, the principle

behind our progressive consumption tax should be that

this is like any VAT and as a result should be border

adjustable. Whether it is or not is a question. And

it was in large part for that reason that we didn\'t

want to build in the revenues associated with that as

part of our revenue calculation for exactly the points

that you raise. So, we believe it should be, but we

are not assuming that it will be.

PANELIST ROSSOTTI: Okay. And I think

that\'s a pretty big point because without having that

you couldn\'t implement the system.

The other thing I wanted to ask you about

with respect to the financial services, and I think

you did sum them up very well. I mean, especially in

today\'s economy where, best as I know, financial

services are more than 20 percent of the economy.

This is not a small item. But I wanted to ask you

about any thought you had or did you give any

consideration to conglomerates or companies that are

both financial services and non‑financial services?

Because again, from my experience, there are many

companies that are engaged in both sort of activities.

PANELIST LAZEAR: Yes, I mean, we gave a

lot of thought to it. There are many problems that

you can think of, and not only that you can think of;

you know, you\'re sort of the best tax cop in the

world, so you\'ve certainly thought about these things. But, the obvious
kind of problem is within‑firm

transactions from one entity, one arm of the firm to

another arm of the firm that are treated differently

by the tax code. An obvious one would be something

like a conglomerate that has a production arm and a

financial arm. And so what you do is you have the

financial arm make a loan to the real arm of the

business. The real arm then goes out, builds

something, expenses it, you know, then simply defers

the interest and repayment forever. Well, under the

cash flow system, the financial arm gets to deduct

that and then the real arm doesn\'t pay any tax on it,

so there\'s a gimmick there.

The way we would handle that would be to

declare all within‑firm related party transactions to

have not occurred. So what we would say is that that

transaction in this context did not occur for the

purpose of tax. Obviously, it did occur, but if it

didn\'t occur for the purposes of tax, then you don\'t

get this tax break. And that would be one way to

handle that. Now, that\'s an example of one of many

things that one could think about. We\'ve gone through

a variety of them and tried to address a number of

them. We don\'t feel confident that we\'ve caught all

of them. As you said, you know, we\'re in new

territory here.

PANELIST ROSSOTTI: I think that\'s fair.

I just think that we just need to acknowledge that

this system, just by the virtue of its newness and

some of the, you know, complex features that it has;

not so much that they\'re complex, but they\'re just

very different and don\'t really know how to handle

them, is going to require, you know, I would say a

material amount of work to put into before you could

even say that you had a plan that you could actually

implement. But that doesn\'t mean that I don\'t agree

with your conclusion that we should forward this as a

recommendation or something that should be given

serious consideration.

PANELIST POTERBA: Let me just say,

Charles, you know, as Ed said, we spent a lot of time

trying to think about these issues. You know, there

are two approaches one could take. One is to try, as

we have suggested, to define entities as either

financial or as non‑financial and then essentially use

different rules for the different kinds of entities.

The other is to go below that level of detail and say

let\'s look at the transactions and say is this a

financial transaction or this is a non‑financial

transaction? And there, the problem is that there are

many transactions where they\'re in fact hard to

categorize. You know, leases or prepaid, you know,

forward sales, things like that. And because these

business transactions are fundamentally partly

financial and partly non‑financial, you\'ve run into

this very great difficulty in trying to split them and

decide how to treat them.

CHAIRMAN MACK: All right. Yes, Bill?

PANELIST FRENZEL: I have one question of

Jim. You were talking about loss carry forwards where

you propose to add interest. What if you made those

tradeable, would you still need to do the interest?

PANELIST POTERBA: Making losses

tradeable, we think of as tantamount to making them

refundable because we think that that would probably

lead to an active market in which firms would trade

their losses and, you know, the firm generating the

loss might not be able to get full dollar‑for‑dollar

credit for it, but we\'d expect that in a pretty

efficient market that they\'d get pretty close to that. So, tradeability
we think of as more or less going to

the immediate refundability with whatever difficulties

of enforcement come along with that. Tradeability

would, however, give you a situation in which even for

a start‑up firm that might potentially have a short

life time that might go bankrupt at some point, you

would in fact be able to get the full benefit of that.

We decided that might just be too

difficult to police and therefore thought the carry

forward with interest was probably a safer way to go.

But again, that\'s not an inherent or fundamental

feature of the plan.

PANELIST FRENZEL: Thank you.

PANELIST POTERBA: Okay.

PANELIST MURIS: Yes, I just wanted to add

that compared to the discussion we had last week,

we\'re talking about an entire replacement system here

and not adding something to what we already have, and

that to me makes a tremendous difference.

PANELIST POTERBA: One last thought. This

echoes something that Charles and Beth said as they

were presenting the simplified income tax.

There are some pieces of this plan that

have to go together as making the reform to the

consumption tax. Just as Charles emphasized, for

example, in thinking about the savings package, you

know, it was a package and you don\'t want to unpack it

and take various pieces. The one that I would just

point to as an example in thinking about this is the

combination of expensing with a limitation on interest

deductibility. And one of the things that frankly our

subgroup has thought a bit about without any clear

resolution is, how does one avoid a situation in which

we\'ve put together a proposal which together moves us

to a new system that makes a great deal of sense and

avoid the situation where the proposal is cherry

picked and someone says this looks like a good idea.

Let\'s go with it.

In particular, the expensing and interest

deductibility illustrates that, because if someone

were to say well, let\'s just take the expensing part,

you don\'t get part of the way to the consumption tax

that way. You get to a situation where you end up

with net incentives for people to do projects which

are uneconomical without the tax incentives. So, we

want to try to, you know, emphasize that this thing

all fits together as a holistic part.

CHAIRMAN MACK: Okay. Liz Ann?

PANELIST SONDERS: (Audio cutting in and

out.)

CHAIRMAN MACK: Unfortunately, Liz Ann,

something went wrong with our telephone system here,

so I would suggest that you call Jeff and restate that

for him.

If it\'s okay with everyone else, I think

we need to move on. I sense from the discussion of

the acceptance of the blended approach and certainly,

Beth, I understand your concerns. I think that when

the distribution tables are available, I think you

will feel comfortable.

And I would like to again say at this

point that unless there\'s an objection, this is a plan

that we will recommend be included in the report.

PANELIST GARRETT: If I could just say one

more quick thing. I just want to say thanks to the

members of the working group. This is the most

serious work I\'ve seen on a very important and

fundamental reform toward a consumption tax. This is

a real remarkable effort, a very serious effort to

build on that work in a way that has practical

implications. So I don\'t want my comments to be taken

as not being very supportive of that work and those

attempts, particularly if the country decides to move

more toward a consumption base.

CHAIRMAN MACK: Okay. Good. Thank you

very much for that comment.

I think that we\'ll just keep going. If

people need to take a break individually, just go

ahead and get back. I\'m beginning to feel some time

pressures on some of the things I have to do later on. So, Bill, why
don\'t we turn to you then

for this discussion about the value‑added tax?

PANELIST FRENZEL: Thank you, Mr.

Chairman. I guess I have been appointed the captain

of anticlimax here.

At our last meeting there was a consensus

not to recommend a value‑added tax that one subgroup

had been working on. I described it then as a 15‑15‑

15 plan; that is, a 15 percent European‑style VAT,

together with a 15 percent maximum individual income

tax and a 15 percent corporate maximum income tax. At

the time, I suggested we weren\'t quite sure with those

numbers. Since that time, Treasury has reported and

we are at least working with those numbers and we have

others that go along with them.

It was a broad‑based single rate border

adjusted system and the chair suggested after we were

unable to reach consensus that we should continue to

work the problem and particularly get more information

from Treasury.

When we adjourned last time, we had

examined carefully a number of the problems, the

allegation that it\'s a money machine, the idea of

having two operating tax systems with double chances

for amendment, double chances for compliance problems

and double administrative difficulties. Tim Muris

gave us the public choice argument. We had the

problems noted of coordination and integration with

state systems, replete with the Canadian example. We

had problems with price level adjustments,

transitions, definitions, visibility and ultimately

fairness, because you will recall at the time our

burden tables were not working out exactly for it.

On the other hand, Jim Poterba reminded us

that the system contained a lot of pluses, principally

that the low rates encouraged savings and investment

and growth, the border adjustment was supposed to

enhance U.S. competitiveness. The system was supposed

to make the U.S. more competitive for investment right

here in our own market. And I think while I did not

see then and don\'t see now any consensus, I think we

perhaps spent a little too much time beating the thing

to death and not enough suggesting that it had some

important advantages.

Now, the new information that has come has

not, I think, helped us greatly. It has confirmed the

15‑15‑15, but it confirms our difficulties with burden

distribution. We have used a tax system for

individuals of five and 15 percent. We have laid on

most of the wonderful features of Charles Rossotti\'s

simplified income tax and we still get a system in

which we do very well for the lowest two quintiles.

The third and fourth quintile have to pay more taxes

and we don\'t like that very well. And the highest

quintile gets a significant reduction in what it has

to pay.

Now, that system can be tweaked, as we

have already done. We\'ve already messed with

breakpoints and credits upping and downing. But it

seems to me, Mr. Chairman, that we have taken this

about as far as we can go and short of some great

enthusiasm on the part of the members, I think we

probably ought to do what you suggested at our last

meeting; that is, to indicate that this is a system

that we want to keep on our radar screens that needs

to be written up with the suggestions of the pluses

and minuses, but is not something that this committee

wants to move forward at this time.

And I don\'t know, I think Beth Garrett

perhaps, at least in the past, has had some thoughts

on this matter and maybe she would express them.

PANELIST GARRETT: No, I\'m comfortable

with your presentation, Bill.

PANELIST FRENZEL: That\'s the best I\'ve

done in weeks.

CHAIRMAN MACK: Again, I guess I would

just pose the question and then I think, you know,

probably conclude the discussion about this.

But I mean, on one hand, the notion of

having rates; I think they would be 15, 10 and five on

the individual side, you know, is fairly appealing.

UNIDENTIFIED SPEAKER: Fifteen and five,

actually.

CHAIRMAN MACK: Fifteen and five?

UNIDENTIFIED SPEAKER: Yes.

CHAIRMAN MACK: Yes, 15 and five. Okay.

Fifteen and five with the corporate rate

at 15 and a value‑added tax of 15. I mean, it has

great appeal on the surface. But I guess the marginal

tax rate of 15 percent at the top, you know, you have

to take into consideration that those individual are

also paying a fairly substantial amount of tax on

their consumption.

PANELIST FRENZEL: You\'ve still got two

systems.

CHAIRMAN MACK: Okay. I give up.

PANELIST ROSSOTTI: I also think that you

have a timing issue. I think that if the

administrative and compliance issues, I mean, frankly

the IRS is not ready to implement a VAT. It is not

ready to implement a VAT without some substantial

investment to make it more effective at implementing

the income tax. So I think that if we were to let\'s

say go forward, we could also think about this as

something that could be thought of as a longer term

solution. For example, if there was a need to have

somewhat more tax revenue without losing our

competitiveness and our tax rate, a reasonable

strategy, I think a very reasonable strategy would be

to implement let\'s say the simplified income tax in

some form together with hopefully some investment in

systems and effectiveness of the IRS that would make

it better. And then you would be, if you wanted to,

in a position to I think consider something that might

not be a 15‑15‑15, but something that, you know, dealt

with your distribution issues and also had the

attractiveness of being able to raise the money

through the VAT. But I think it\'s very wise not to

propose this as a solution today.

CHAIRMAN MACK: Okay. Let me just clarify

my \"I give up\" kind of. I felt that the discussion

about the VAT and the interest in the VAT has been

around so long that it would not be right for us not

to give it full consideration. I have never been a

real fan of the VAT, but I really felt that as a

result of the work that this Panel has been engaged in

that it should give serious consideration. And I

think ‑‑

UNIDENTIFIED SPEAKER: You\'re very fair.

CHAIRMAN MACK: ‑‑ I\'ve been very fair.

So, I think that we can conclude that we

will not include this as a recommendation, however, we

will have some material in essence reviewing what this

proposal would look like. It\'ll be part of that

report.

And I think that, you know, wraps up our

major areas or discussion and just maybe a couple of

closing comments on my part.

I too want to express to the staff, you

know, the work that you all have done has been

extremely important and helpful to us. We could not

have done what we\'ve done without you. You know, you

took on a position that was supposedly short term in

nature, and by all discussion it\'s still short term,

but it was lengthened out to some degree by various

events. And so, you\'ve already heard from members of

the Panel about our appreciation. I just want to

underscore that because you\'ve done a tremendous

amount of work. The amount of time that you\'ve spent

has just been enormous.

I want to say to my Panel members, because

we probably won\'t be back in a public forum quite like

this before we conclude, I remember our first meeting

in which there was some angst about well, what are the

rules in which we\'re going to operate in the sense of

are we going to have amendments and are we going to

vote, and you know, are we going do ‑‑ and my reaction

was one in saying well, listen, let\'s not make these

rules right away, because I have a tendency to think

that sometimes rules divide people, and my interest

has been to try to find a way to bring all of us

together in an effort to develop some meaningful

alternatives for the Secretary and the President to

take a look at.

And we have avoided those kinds of rules

and I think that again your involvement, the work that

you\'ve done, the willingness to listen to the other

person\'s point of view in your working groups has just

been outstanding and I just want to tell you how much

of a pleasure it\'s been for me to work with all of

you.

VICE‑CHAIRMAN BREAUX: If I can add to

that.

CHAIRMAN MACK: What\'s that?

VICE‑CHAIRMAN BREAUX: Since I was one of

the ones that talked about the rules and how we were

going to operate, I mean I think the number of rules

that a committee needs is directly related to the

cooperative attitude of the members of that committee. The less
cooperative they are, the more rules you

need.

UNIDENTIFIED SPEAKER: Just like the tax

code.

VICE‑CHAIRMAN BREAUX: Yes. That\'s right. And I\'ve served on
commissions where we needed a lot

of rules and I\'ve served on this one and it\'s been a

real pleasure to be able to work in a cooperative

fashion, and I think that says a lot about the people

that we had the honor of serving with. Thanks.

CHAIRMAN MACK: Terrific. Just last

points now and then we will conclude.

There are some things that the staff needs

to work on. Obviously, there are still lots of

details that have got to be complete before this

report is finalized and I think each of you has

scheduled October 27th. We will do a phone call to go

over whatever items we need to at that time.

And I don\'t think there\'s anything else I

need to say at this point, other than for those of you

who have been with us at virtually every one of these

meetings, again, we appreciate your interest. And

again, I thank the Panel and our meeting has now come

to an end.

(Whereupon, the meeting was concluded at

12:17 p.m.)