UNITED STATES OF AMERICA

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PRESIDENT\'S ADVISORY PANEL ON

FEDERAL TAX REFORM

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TENTH MEETING

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WEDNESDAY

JULY 20, 2005

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The Panel met in the Grand Ballroom of the Renaissance Hotel, 999 9^th^
Street, N.W., Washington, D.C., at 9:00 a.m., Connie Mack, Chairman,
presiding.

[PRESENT]{.underline}:

THE HONORABLE CONNIE MACK, Chairman

THE HONORABLE JOHN BREAUX, Vice Chairman

THE HONORABLE WILLIAM E. FRENZEL, Panel Member

ELIZABETH GARRETT, Panel Member

EDWARD LAZEAR, Panel Member

TIMOTHY J. MURIS, Panel Member

JAMES M. POTERBA, Panel Member

CHARLES O. ROSSOTTI, Panel Member

LIZ ANN SONDERS, Panel Member

[PANEL STAFF PRESENT]{.underline}:

JEFFREY KUPFER, Executive Director

JON ACKERMAN, Senior Counsel

ROSANNE ALTSHULER, Senior Economist

A-G-E-N-D-A

[Page No.]{.underline}

Opening Remarks, **THE HONORABLE CONNIE MACK**, 3

Chairman, **THE HONORABLE JOHN BREAUX**, 11

Vice Chairman

Discussion of Issues Associated with Tax Reform

Complexity and Stability, **JON ACKERMAN**, 13

Senior Counsel

Distribution and Revenue Neutrality, 34

**ROSANNE ALTSHULER**, Senior Economist

Alternative Minimum Tax, **JON ACKERMAN,** 73

Senior Counsel

Understanding Tax Bases, **JEFFREY KUPFER** 100

Business 141

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

(9:04 a.m.)

CHAIRMAN MACK: Well, good morning everyone, I appreciate your interest
in the Panel\'s work.

I\'ll give you a sense about today, I\'ll make some opening remarks here
for a few minutes. At the conclusion of that, I\'m going to turn to the
staff, they will make a presentation on simplicity and complexity, the
issue of stability in the Tax Code. The Panel will then kind of respond,
or we will be engaged in discussion about that particular area.

When we conclude that, we\'ll move on to a second and a third, in most
cases there will be a presentation by the staff that will kick off that
particular area.

So, that\'s, generally, how we\'ll go. We have no set time for either
breaks, but I suspect we will take a couple, including lunch, and,
hopefully, we will finish no later than 3:00 today, but that\'s my hope
at this particular point.

Okay. I think what I\'ll do is give some review, if you will. As all of
you know, the President established the Panel with an Executive Order
back in January of this year. The Panel has been directed to provide
revenue neutral tax reform options that are simple, fair and pro growth,
and as some of you probably realize that we have a responsibility to
come back with at least one option that uses the current income tax
system as a base, and we are to report to the Secretary of the Treasury
by the end of September.

The nine panel members, I think, are fairly well known to most folks who
have been observing this, so I won\'t go through the names of those
individuals.

We, basically, had a series of hearings that fell into what I would call
two stages or phases. The first was a thorough evaluation of our current
tax system. We had seven meetings here and around the country, three in
Washington, and four in other locations. We had 52 witnesses, policy
makers, experts, practitioners, taxpayers, business owners. The topics
that we covered were complexity and compliance, business and
entrepreneurship, impact of taxation on taxpayer decisions, fairness in
families, economic growth and international competitiveness, business
investment, state and local interaction with the Federal Tax System.

Almost every witness that we heard from conveyed the message of what a
dismal condition the present tax code is in, and some of you who have
been following this since the beginning, you may remember that the first
presentation that we heard pretty much indicated that the tax system is
like an over built, dilapidated house, with conflicting architectural
styles. Others referred to the present tax code as a sick patient who is
about to expire. Others indicated it was like a factory floor littered
with too much garbage.

Out in San Francisco, Milton Friedman referred to it as, \"like a
blackboard with no further place to write.\" We\'ve had thousands of
written comments. Most comments reflect the sentiment of one family who
wrote, \"Tax reform is necessary and long overdue.\" There\'s no
question about how complex and constantly changing the code is. 60
percent of us use a paid preparer, \$140 billion a year in compliance
costs, and I might say that estimate is probably on the low end of what
most people have been talking about, equivalent to \$1,000 per family
per year. There are targeted provisions with different definitions and
phase outs.

We made a statement earlier on in the process that there were 15 common
tax benefits available to families, with 14 different phase-out levels
and nine different definitions of income. The one figure that has stood
out in my mind is that there have been over 14,400 changes to the tax
code since it was reformed back in 1986.

Our tax code makes it difficult to figure out whether you are complying
or whether you are not. It rewards those who have the means or the
inclination to find angles to reduce their taxes. I would say with this
issue of fairness, a lot of people think about it from the standpoint of
just the distribution tables, but I think that fairness really goes to
how each one of us individually feels about the present system, and we
kind of relate that to what we think others are doing. Most people think
that they are paying their fair share but nobody else is, and I think
that\'s something that we have got to address as we go forward.

Special provisions must be subsidized by higher rates on everyone else,
and there is, I think, common belief that our current system restrains
economic growth. The tax code causes taxpayers to devote more resources
to tax advantaged investments and activities, at the expense of more
productive alternatives. It impacts a wide range of business decisions,
such as how much to invest, how to finance the investment, and whether
to incorporate and take a company public.

Another kind of interesting figure, I think, there are 1.2 million paid
preparers in the United States. More resources could be devoted to the
development of new products and services, expanding operations, and
hiring new workers.

There were a number of themes that came through our hearings over the
last several months, but three that I would mention here. We have lost
sight of the fundamental purpose of our tax system, and that\'s to raise
revenue to fund the Government. A rational tax system would favor a
broad tax base, providing special treatment only, I would underscore
only, where it can be persuasively demonstrated that the effect of that
treatment justifies the higher taxes paid by all other taxpayers, and
there are clearly tradeoffs inherent in any tax system. But, meaningful
reform could deliver a system that is simpler, fair and more growth
oriented.

In Stage 2, we considered and evaluated specific reform options, and
again, those of you who have been following this you will recall we had
two meetings covering over three days with 35 witnesses. Every major
reform option of the last 20 years was presented, and then we heard
critiques of the proposals by leading tax experts.

And, once we concluded those hearings, we then broke into working
groups, and I\'d just like to take a second to talk about the rationale
there.

As you can imagine, there is a huge record to digest. I think probably a
larger record than most of us really thought that there was when we
began this, and what is interesting, as you all know, the folks on this
panel have been around the tax code from different perspectives for
many, many, many years, and I think it\'s fair to say that each one of
us has learned an enormous amount going through this process. So, there
are numerous issues to consider, and the panel members have full-time
jobs, and are located across the country. So, the ability to get nine
people together as often as would have been necessary to go through all
of this data just didn\'t work.

So, we ended up establishing four working groups. The first working
group focused on major simplification and reform of the existing Federal
Tax Code, and on that working group is Bill Frenzel, Beth Garrett, Tim
Muris and Charles Rossotti. Working Group 2, focused on fundamental
reform within the existing Federal Tax Code, and on that working group
is John Breaux, Ed Lazear, Jim Poterba and Liz Ann Sonders. Working
Group 3 focused on a complete replacement of the existing Federal Income
Tax Code, and participants are myself, Ed Lazear, Tim Muris and Liz Ann
Sonders. And, the fourth group focused on partial replacement of the
existing Federal Income Tax Code, and participants again, myself, Bill
Frenzel, Beth Garrett and Jim Poterba.

Now, just one additional note about this, having just gone through those
panels, or working groups, the fact that we have these groups doesn\'t
mean we will have four options, or that the panel will endorse one plan
from each group. It is a way for us to organize and consider the issues.
We are not going to take votes or make decisions on specific options
today. That will happen at a future time. Today we are going to discuss
issues and exchange views, something that we haven\'t been able to do as
a full panel thus far. And, the staff will present some information to
help us in our deliberations. And, although we are still developing
options for reform, I am confident that by the end of September we will
be able to present plans that will design a better tax system for our
country.

And, the last comment that I would make before I turn to Senator Breaux
for his comments, I think it\'s fair to say that as we go through this
process of developing a better system, better tax system for America,
that there will be five areas in which \-- five principles, if you will,
that will focus our effort.

The first is filing taxes will be straightforward and easy to
understand. Point two, our tax system will be fair and transparent.
Taxpayers will be able to understand their tax obligations, and have
confidence that they and their neighbors are all paying their fair
share. Hidden taxes and gimmicks will be eliminated. Third, our tax
system will be clean, no more complicated and inefficient tax breaks and
loopholes that benefit special interests and unnecessarily interfere
with taxpayers\' decisions. Fourth, our tax system will encourage
savings in a simple and efficient manner, saving for the future will be
straightforward and convenient. And five, and the last point, barriers
to competitiveness of American business will be torn down. Investment
will be encouraged to spur innovation, productivity and job growth, and
our antiquated international tax system will be updated to keep pace
with global competition and to make U.S. businesses more competitive
worldwide.

And so, John, I\'ll turn to you for any comments you want to make.

VICE CHAIRMAN BREAUX: Thank you very much, Mr. Chairman, and
congratulations for the work that you\'ve been able to outline for the
committee, and all of our colleagues on the committee for the work that
they have done. I think you\'ve provided a very good summary of what we
have done, and the challenges that we face.

You spoke about the President\'s requirement to try and simplify the
code, to make it fair, to make it reasonably progressive, to make it pro
growth, to make sure that our final product and recommendation meets
those standards. I\'m confident that we\'ll meet that challenge that
this committee has given, and I\'m confident we\'ll do it in the time
frame that we have now established to meet that recommendation to the
Secretary and to the President, and I look forward to that day.

We\'ve done a lot of work, and we still have a lot of work to be done.
I\'d note that after all the meetings and all the discussions that tax
reform and tax simplification is much easier when you have a big surplus
than it is when you have a deficit, because we have a requirement that
we have to do this in a revenue-neutral fashion, and that, indeed, is a
great challenge. It\'s easy to simplify the code if you have sufficient
amounts of money to pay for those simplifications when you deal with tax
expenditures. So, we have a real challenge, but we have a talented
group, and I think in the short future we are going to be getting down
to making some serious decisions and cuts on what and what we cannot
recommend. I\'m confident we can get the job done.

CHAIRMAN MACK: Great, thank you.

I think we\'ll turn to Jeff Kupfer, who will kind of set the stage for
presentations by the staff.

EXECUTIVE DIRECTOR KUPFER: Thank you, Mr. Chairman.

We are going to have a number of staff presentations today, and then
those will be followed by panel discussions of the various issues that
the staff is going to present.

Before we present the first one, I just want to thank the tax panel
staff for all the hard work that they\'ve put into these presentations.
A few of the staff will be up here, actually, doing the presentations,
others will not be up here, but everybody has pitched in and done a
really fine job of preparing this for today.

I also want to thank the Treasury Department staff who has helped us to
provide the information and to put together these presentations, Bob
Carroll, Eric Solomon and Jay Mackey, Jim Nunns, Alan Viard, and the
rest of the Treasury team of lawyers and economists have been central
for what we are doing today.

Finally, I would like to note that all the presentations that are made
today are public and they are on the Tax Panel web site as of now, and
will remain there, and so people will be able to access them at any
point going forward.

And, with that, let me turn to Jon Ackerman, who is going to do the
first presentation.

MR. ACKERMAN: Mr. Chairman, Members of the Panel, my presentation is
about complexity, and as you all know the complexity of the tax code is
legendary.

The tax law, as contained in the books, I keep on hand for reference,
spans 5,000 pages of code in two volumes, 93,000 pages of regulations in
six volumes and takes up one whole bookshelf.

To demonstrate complexity, many commentators, including Professor
Michael Graetz who created this slide, point out the number of words
there are in the tax code. Here you can see the tax code and regs have
nearly 10 million words. And, sometimes we\'ll compare that to number of
words in other great works, for example, there are ten times as many
words in the tax code and regulations as there are in the King James
Bible.

In many ways, though, counting words to prove that the tax code is
complex is like using a stethoscope to prove that a cannon is loud.
Americans know that the tax code is complex, and they also are
dissatisfied with that complexity.

A more important story about complexity is why it exists, and how it
affects taxpayers. For most individuals, most of the complexity is
created because of the piecemeal way that rules have been added to the
code over time. This process has led to duplicative and overlapping
provisions, phase-outs and expiring laws. All of these create
complexity.

This complexity imposes enormous costs on taxpayers and the economy as a
whole.

Numerous witnesses before the panel have described in public meetings
the complexity of our current code. On March 3, Nina Olson, for one,
described how the complexity created by the numerous and overlapping
education and retirement provisions leads to bad decision making because
there are too many choices.

One area that I\'d like to focus on today is phase-outs. As you can see
by this slide, almost every tax benefit available to taxpayers comes
with strings attached. The benefits are reduced when the taxpayer
reaches a specific income level.

Much of this complexity from phase-outs is due to the fact that no two
benefits are phased out in the same way. This slide shows there are at
least three common components to a phase-out. First, there\'s the
threshold amount, which is the income level where the phase-out begins.
Second, there\'s the phase-out rate, which is the speed at which your
benefits disappear. Sometimes there\'s a cliff, sometimes there are
steep declines, and if you are lucky, sometimes there are only gradual
descents.

One of the trickiest parts of the phase-out, however, is the way that
they define income. You can see that they use at various times AGI,
modified AGI, alternative minimum tax income. Not only does this
definition vary greatly from phase-out to phase-out, but providing a
special definition of income effectively causes taxpayers to have to
compute their income multiple ways just to determine how much of a
particular tax benefit they get.

On this slide, I\'ve provided just three examples of the technical rules
that are needed to carry out phase-outs. I selected these three
phase-outs just based on income levels, to show that they apply across a
wide variety of income levels. You can see the Social Security benefit
phase-out in Section 86 has a three-tier level system for determining
how much of your Social Security benefits are taxable. The IRA
contribution has a tier that applies at around \$70,000 if you are a
member of a retirement plan, and the child credit actually impacts
taxpayers on both the low end of the economic spectrum and the high end.

Now, what do these phase-outs mean to taxpayers? Well, to demonstrate
how taxpayers are affected, I went to the instructions and worksheets
that the IRS provides to help taxpayers navigate these. Here is the
Social Security benefits worksheet, you can see that it takes up an
entire page of complex instructions, boxes to be filled out and
computations. Taxpayers need to fill out 22 lines and make at least nine
computations. I\'ve also circled on there a couple of stop signs. If you
feel lost when you try and do taxes, you probably are not alone. These
stop signs have been added so that nobody gets hurt when they do their
taxes.

Now, the IRA deduction in this form is also complex and requires 21
boxes, ten lines of instructions per spouse, six computations, and here
we have one stop sign and just one caution.

Now, when I see a worksheet like this, it reminds me of the testimony of
Armand Dinverno back in Chicago. He is a professional financial planner
and described some of the difficulties that taxpayers face in making
decisions about how best to save for the future. He told the panel that
the tax code makes financial decision-making so paralyzing that it\'s
often easier for taxpayers to spend their extra money instead of saving
it for the future. Looking at this worksheet, I agree.

This is Form 8812, which is used for low-income taxpayers to compute the
amount of child credit that\'s refundable to them. This form is
separately provided. It\'s not in the 1040 instructions, and requires
several lines of instructions and blanks to be filled out, in addition
to its own page of instructions that have numerous references to take
you to a separate IRS publication for more information.

This is the worksheet that\'s used for the upper-income taxpayers to
compute the phase-out of the child tax credit. This form also is not in
the 1040 instructions, you need to go to Publication 972 to find this
one as well.

Although I\'ve put these worksheets and instructions up there, it\'s
worth noting that the IRS didn\'t create this mess, they are merely
trying to do the best that they can with a very complicated tax code,
and each year do a fairly good job of writing instructions and forms to
deal with the rules that have been handed to them by lawmakers.

Now, what do these complex phase-outs have in common? Well, each of them
raises marginal tax rates for people because they lose their benefits as
they earn more. This graph summarizes the progressivity of our current
system through gradually increasing rates. As a taxpayer earns more, the
amount of tax paid as a percent of income also increases.

This particular graph summarizes just the tax rates, personal exemptions
and standard deductions.

This graph, also known as a skyline, demonstrates what the tax system
actually does to taxpayers. Each blip on this graph represents a
phase-out that causes a change in taxable \-- excuse me, marginal tax
rates. For this taxpayer at the lower-income levels, they are below
zero, you can see that they receive \$40 of refundable credit for every
additional dollar that they earn working.

As the earned income credit phases out, the taxpayers face steep
marginal increases, and that\'s that long, steep ascent. In the \$27,000
to \$35,000 range, this taxpayer faces a combined 36 percent marginal
tax rate, 21 percent from the phase-out of EITC and 15 percent due to
the regular tax rate. That\'s 75 points higher than the marginal tax
rate that they faced down at the lower income level when they are first
taking up the EITC.

If you see the sort of flat spot that levels back out again just about a
third of the way over on the graph at around \$35,000, that\'s the first
point at which this taxpayer will actually have marginal tax rates that
reflect statutory tax rates. There they will pay tax at 15 percent above
\$35,000.

As I mentioned, economists refer to this graph as a skyline, because its
peaks and valleys look more like the profile of a large city than the
gradual graph of steps, upward steps, in the previous graph.

Chairman Mack mentioned at the outset, compounding the complexity of
phase-outs is the volatility of the tax code. At the panel\'s first
meeting, Fred Goldberg mentioned that our tax code is like an
out-of-control house, and based on those 14,400 changes the Chairman
mentioned it appears as though it\'s been under constant construction.
These changes make it impossible for anyone but tax professionals to
keep up, and even they have difficulty, as Willard Taylor confessed when
he was in San Francisco before the panel.

Not only do lawmakers constantly add new bells and whistles to the code,
increasingly they\'ve used a number of gimmicks, including phasing in
tax benefits over time, and enacting only temporary provisions.

As this table demonstrates, the tax landscape for an American family
will shift dramatically over the next five years. The first column
there, 2005, represents sort of the typical tax parameters that a
family, a married couple, will face today, and in 2011 on the far column
that represents what they will face in that particular year. As you can
see, tax rates change dramatically as the 10 percent bracket disappears,
and the top rate goes from 35 percent back to 39.6 percent. Also, the
child credit is halved, as is the IRA deduction. Marriage penalty relief
enacted in the earlier tax cuts goes away.

Also worth pointing out is the dramatically different treatment of
capital income between those two years. The dividends and capital gains
rates actually go down for lower income taxpayers, before increasing for
everybody again in 2008.

Looking at those, I have no idea how a rational investor, who is
attempting to maximize after-tax returns, figures these tax law changes
into their investment decisions. Should I buy stock that pays dividends?
Should I buy stock that will have large capital gains? Should I buy real
estate? Should I just call Armand Dinverno again and ask him for advice?
It\'s hard to see how taxpayers are able to plan for the future with a
tax code that changes as much as this does.

Now, the changes in this table are not the result of a one-year shift.
I\'ve put in parentheses in the first column next to the descriptions
the year in which these particular provisions expire. We now have
expiration dates for our food and for our tax laws. This will ensure
that we\'ll always have a fresh batch of tax law changes, and although
expiration dates are good for food, they are rotten for tax systems.

All of this complexity makes our system more costly to operate.
Complexity makes it harder for taxpayers to understand the laws, and
more difficult for the IRS to administer them.

Chairman Mack summarized some of these figures in the outset. As Joel
Slemrod explained to the panel, this complexity is costing us a \$140
billion each year. That\'s about \$1,000 per household or the amount
needed to fund a substantial amount of the Federal Government, including
the Department of Homeland Security, the State Department, NASA, HUD the
EPA, the Department of Transportation, all of Congress, all of our
Federal courts, and all foreign aid. It\'s a staggering sum.

Most of this cost is due to the 3.5 billion hours that Americans spend
doing taxes. The 25 hours on average that each filer spends is over 60
percent of a work week done doing forms and record keeping, rather than
something more productive like spending time with their families.

Not surprisingly, Americans are turning to professionals for help. Over
60 percent of Americans pay someone else to do their taxes, and at least
another 25 percent more buy software to help them do their taxes on the
computer.

I understand that only one of the nine panel members here actually
prepares his own taxes. One in nine is close to the ratio of Americans
who still prepare their own taxes by hand.

CHAIRMAN MACK: Do we have to indicate who that one person is? Well, I
will just answer it myself, it wasn\'t me.

MR. ACKERMAN: Complexity doesn\'t just make the taxes more costly. It
weakens the foundation of our tax system by reducing transparency and
undermining faith in the fairness of our system. A sound tax system
would allow those who play by the rules to feel confident that they and
their neighbors are paying their fair share.

The complexity of our tax code breeds non-compliance and calls what
I\'ll call today in honor of the weather we\'ve been having in D.C. the
\"hazy tax.\" Also known as the \"tax gap,\" this is the amount of
non-compliance in the tax system as estimated by the IRS. In total,
it\'s costing us over \$300 billion per year.

Non-compliance is due to a variety of factors, such as inadvertent
mistakes, technical tax shelters and outright cheating, and although
some cheating is inevitable, complexity is also a large part of the
problem and provides the opportunity for non-compliance.

A less complicated tax code would make it easier for taxpayers to
understand and comply with their tax obligations and free up IRS
resources to better administer the tax system.

Tax reform brings the promise of a simpler and fairer tax code. Not only
would reform make the tax system more transparent and less intrusive, it
would yield meaningful benefits by lifting the burden of the \$140
billion \"complexity tax\" that we described and the \$300 billion
\"hazy tax,\" or tax gap, that the current system is forcing Americans
to pay.

Thank you.

CHAIRMAN MACK: Jon, thank you very much for that presentation, and that
kind of sets us up for our first discussion, if you will.

I think most of us have made a statement over the last several months
about the importance of dealing with simplification. There might be
motivations with respect to economic growth and other issues, but if we
don\'t address simplification and address the issue of fairness I don\'t
think we ever get to the point of discussing what do we do to create
economic growth.

So, we know that simplification has to be done. We know, though, in
fact, there are tradeoffs, there are difficult tradeoffs. As was
indicated in the presentation that we just heard, in trying to make the
system fairer, for example, by targeting provisions to lower-income
taxpayers you do add complications. If you do that at every step along
the way, everything that\'s added for one reason has a more complicated
effect.

So, again, recognizing there are tradeoffs we\'ve got to deal with this
issue I\'d like to throw it open for discussion with respect to these
issues.

And, I don\'t know whether Bill Frenzel or Charles Rossotti or John
Breaux would kick off our thoughts here.

MR. FRENZEL: Well, Mr. Chairman, obviously, we have to take all of those
goals in mind as we work forward. I suppose each of us has sort of a
different totem pole of which is the prime goal and which are slightly
secondary goals, but we have to do them all. So, I think we know what
the goal is here.

I would go back to your opener, where you cited the five goals of tax
reform that we were going to accomplish. My guess is that if we do that,
we will jointly be awarded the Harry Houdini prize for 2005.

But yeah, in my judgment, we have to keep them all in mind, and clearly,
simplicity is a good salesman, particularly, for individual taxpayers.
It may be less important to some of us than other goals, but it
certainly can\'t be abandoned.

CHAIRMAN MACK: Charles?

MR. ROSSOTTI: Well, I would just say, as you noted, we have a subgroup
that\'s working within the general confine of the income tax system, as
it is defined as an income tax system. And, I think one of the things
that we are trying to do with respect to simplicity is to deal with the
things that affect the most taxpayers in the clearest way.

And, I think there\'s at least three of them that were mentioned in the
staff presentation that I think there\'s a lot of progress that we can
make on, and one of them is the whole set of things related to family
deductions, credits and so forth. Those things that tend to be put in
the code to give appropriate recognition of people\'s family situations.
That\'s appropriate to have, we think, but right now it\'s done in a
very complicated haphazard way with credits, deductions, exemptions, and
phase-outs, so we are going to be working hard to try to come up with
something that gives appropriate recognition to people\'s family
situations, but in a far simpler way.

The other one is, as was noted, the whole issue of savings and
retirement incentives, which is, again, something that\'s very
appropriate to have, but which actually, I think, in some ways actually
works against its purpose now. Because there are so many choices and so
much complexity that sometimes I think people actually throw up their
hands and either do nothing or maybe even make the wrong choices. And,
even if they make the right choices, they may have to pay somebody to
figure out how to optimize among all these different provisions.

So, what we want to try to do there, I think, is, again, maintain the
idea of having these kinds of incentives for people to save, but in a
way that would make it far simpler and, hopefully, make it more
encouraging to people to actually use those provisions.

And then the final one would be, with respect to all these same
provisions, to do it in a way that we don\'t have to have these
complicated phase-outs, but people can just make a calculation and know
what it is. And, that\'s not the only thing we\'re doing by any means,
but I think all of us on the panel, the sub-panel, the working group
that we\'re working on, think that if we can deal with those, you know,
in a very simplified way, we would make a huge impact on the objectives
of this overall group.

CHAIRMAN MACK: Yes, Beth.

MS. GARRETT: I just wanted to underscore what Charles said. I\'m also on
that working group, and as somebody who was a tax aide, and now studies
the tax legislative process, one of the things that you notice is that
there\'s no organized constituency in favor of simplification. There are
organized constituencies in favor of almost everything else.

And, I think that one of the real contributions this panel can make is
for us to keep simplicity paramount as our main objective in the
proposals we bring forth. And, if I struggle with things that are
important to me, and as Charles mentioned some of those, including
savings incentives, and thinking about lower-income Americans thinking
about the tax burden on secondary earners, sometimes called the
\"marriage penalty.\" As I struggle with those issues, what I always try
to do is to say to myself, to try to solve them in a way that is roughly
just, but doesn\'t work to get perfection at the cost of a simple, more
transparent system.

And, that certainly is, I think as we\'ve discussed, the way we\'ve
approached our work.

CHAIRMAN MACK: Terrific \-- go ahead, John.

VICE CHAIRMAN BREAUX: Well, I just want to make a comment that after
seeing the presentation this morning and everything that we have seen in
all the hearings about the complexity issue, what\'s surprising to me is
not that 60 percent have to hire someone to fill out their return, but
that it\'s only 60 percent. I mean, the remaining 40 percent must all be
certified public accountants. And, you know, the fact that only one out
of nine of us, who is supposed to have a knowledge of the code, do our
own tax returns is pretty indicative. I bet if we were in the Congress,
if every member of Congress had to do their own tax return just one
time, I guarantee you there would be a real push for simplification, and
just a requirement that every single member for one year do their own
tax return it would be a real clamor for reform.

And, one other point about the phase-out. I mean, we can talk about it,
this is a difficult problem. The phase-outs are there because we didn\'t
have enough money to make them permanent. So, when you start doing away
with the phase-outs there\'s a cost associated, and it\'s easy to say
that phase-outs make it very complicated, and nobody knows what they are
going to pay in five years, or six years, or maybe even next year, but
the reason for it was that we didn\'t have enough money to make them
permanent.

So, when we talk about eliminating the phase-outs, and making all of
these provisions permanent, we also are faced with the problem of having
the revenues to make it work, and that\'s a challenge. That\'s why
Congress did phase-outs.

CHAIRMAN MACK: That\'s it?

VICE CHAIRMAN BREAUX: That\'s it.

CHAIRMAN MACK: All right, okay.

VICE CHAIRMAN BREAUX: I\'m not doing my own tax return.

CHAIRMAN MACK: Maybe picking up on what both Charles and Beth in their
comments, one of the things that struck me as I listened to Charles, and
one of the things that, frankly, I learned through this process, was how
complicated the Earned Income Credit is. And so, when we talk about
simplification, it seems to me that that, clearly, is an area we\'ve got
to try to address, and I assume that you all are doing that in your
working group.

Any other thoughts at this particular point with respect to this issue?

MR. ROSSOTTI: Well, I have a story after last night, because when you
talk about the people that use tax preparers \--

CHAIRMAN MACK: Can you hear him?

MR. ROSSOTTI: I\'m sorry, I ran into a friend that I hadn\'t seen for a
while, and I told him I was on this panel. He said, well, he always used
the tax preparer, but last year he decided for once that he really
wanted to understand what his taxes were. So he bought a copy of Turbo
Tax and he went through the whole thing, and he was able to prepare his
own taxes. When he got done, he didn\'t send it in because he was so
nervous he\'d made a mistake, he hired a preparer to audit his Turbo
Tax.

CHAIRMAN MACK: I suspect he\'s not the only person that does that.

MR. ROSSOTTI: I\'d never heard that one before.

CHAIRMAN MACK: Well, let me just play around with a notion here, and I
might have to draw John into this, I don\'t know. You know, we all
remember, I think when Ronald Reagan made comments back in 1985 - 1986
about his idea of the simple tax code was, where you\'d have a 3x5 card
with three lines on it, the first one listed how much do you make, the
second one was how much did you spend, and the third line was to send
all the rest of it in, something like that.

I don\'t think we are going to get a 3x5 card, but I sure would like to
think for a moment about the notion of, you know, a page or two, and
should we be focused on the page or two of the return, or should we be
interested or more focused on the various forms that have to be used to
back up all the different deductions. Give me a reaction where we should
focus our \-- is it really the size of the form or is it the back-up
material that we need to concentrate on.

MR. ACKERMAN: Well, I think I would say that it\'s the whole package
here. If you look at the 1040 itself, it really is a roll-up schedule,
if you will. It\'s sort of the backbone of the tax system. And, there
are over 100 different schedules and forms that go into the 1040. And
so, the whole package there, in terms of tax compliance is a very big
one.

I think in terms of the panel, thinking about a system that can be
administered you really probably should think from the top down, how can
we make the tax code as simple as possible. And, that, itself, will do
away with a lot of the complexity, both on the face of the 1040, but
also all of these hundreds of other forms that are needed for taxpayers,
and hundreds of pages of instructions, just to comply with their tax
liabilities.

MR. FRENZEL: Mr. Chairman, I have \-- I would endorse that thought. We
have enough trouble making the system work, or workable, and probably
the design of forms is a whole different realm that probably is not a
good area for us to get into.

I also wanted to add to the previous discussion, the point that often
these goals that we seek, fairness, simplicity, growth, et cetera, are
in conflict. And, as we in our group have found out when we tried to be
simple we found that we had difficulty with fairness, when we tried to
be fair we got back to an unsimple situation.

And so, you have to make these weighted judgments, and so there is no
perfect answer. We\'ll just have to make the most judicious solution we
can find.

CHAIRMAN MACK: Okay, very good.

I think, if we will, let\'s go ahead and move on to the next area of
discussion, the distribution of the tax burden, and again, the Executive
Order, and let me quote from it, says, \"Share the burdens and benefits
of the Federal tax structure in an appropriate, progressive manner.\"
And so, I\'d ask the staff to make a presentation on how we can evaluate
the fairness of the tax system.

And, I suspect, Rosanne, we are going to turn to you now?

MS. ALTSHULER: Yes.

CHAIRMAN MACK: Good.

MS. ALTSHULER: Mr. Chairman and Members of the Panel, I want to provide
some background on evaluating fairness in tax policy.

As we all know, there\'s no one definition of fairness for tax policy,
or one methodology for measuring fairness. I\'m going to talk about the
use of distribution tables.

Distributional analysis \--

CHAIRMAN MACK: You got a good subject to cover, didn\'t you?

MS. ALTSHULER: Oh, we could go on and on.

Distributional analysis shows how the economic burden of taxes is
distributed among individuals, families or households. Distributional
analysis can be used to study the existing distribution of tax burdens,
how the distribution has changed over time, and how tax policy changes
will impact the distribution of tax burdens, including who will gain and
who will lose.

Government organizations, non-profit organizations, and academics, among
others, produce distributional analyses, most of them right here in
Washington, D.C. It\'s important to point out that not all analyses uses
the same assumptions.

Just like there are different views of fairness, there are different
views on how best to present distributional tables. Ideally, one would
want to use a variety of approaches to evaluate equity.

Our working groups requested and received both revenue estimates and
distributional analyses from the Office of Tax Analysis of the Treasury
Department. Let me say a few words about the Treasury distribution
tables. You\'ll be seeing a lot of them later today.

Taxpayers are ranked by a measure of economic well-being, to approximate
ability to pay. This ranking is common to all distribution tables. The
unit of analysis in the Treasury tables is the family. The measure of
economic well-being is cash income.

I\'ve listed here what\'s included in cash income. Cash income consists
of a variety of sources of income, including wages and salaries, net
income from a business or farm, taxable and tax-exempt interest
dividends, rental income, realized capital gains, et cetera, et cetera.

The cash incomes of all members of a family are added to arrive at a
family\'s cash income, and then the families are ranked or sorted from
those with the least amount of cash income to those with the most.

For the purpose of distributional analysis, taxpayers can be grouped
into percentiles, quintiles, deciles, et cetera, or cash income classes.
Treasury has provided us with estimates based on 2004 income levels. At
2004 income levels, you might be interested to see what the cash income
quintiles are.

Just to explain this, looking at the bottom quintile, what this means is
that 20 percent of families had cash income of about \$12,000 or less,
and 20 percent at the top had cash incomes of about \$79,000 or more. We
can look at how the share of federal taxes paid is distributed across
income quintiles to understand how the tax burden is shared across
families.

We asked Treasury to share the distribution of Federal taxes paid under
2006 law and law enacted with the Tax Reform Act of 1986. The experiment
takes the 2004 economy and applies two different tax policies. First,
let\'s look at the distribution under 2006 law, and you\'ll be seeing a
lot of this today.

This is what we refer to as the current law distribution. It\'s based on
2006 law. We see that the top 20 percent of the income distribution pays
70 percent of total federal taxes. As a comparison, suppose we impose
the tax law that was passed by the Tax Reform Act of 1986, the last
major overhaul of the tax system, on that 2004 income distribution. This
would be the distribution.

Here\'s a comparison. The distributions are broadly similar, with the
exception that the highest quintile bears a higher proportion of the tax
burden under 2006 law. Note again, this is a comparison of tax law, it
doesn\'t reflect differences in demographics, or differences in income
inequality over time, differences in the economy over time. The
underlying income distribution is exactly the same. Tax policy is
different.

It\'s interesting and informative, I think, to do this type of
experiment, and we have Treasury to thank for allowing \-- for providing
many experiments that you\'ll see throughout the day.

Now, Senator Mack has reminded us that the Executive Order instructed
the panel to develop options that would share the burdens and benefits
of the Federal tax structure in an appropriately progressive manner.
Progressivity in our code is furnished in part through the standard
deduction, personal exemption, and refundable credits. Approximately,
two thirds of taxpayers take the standard deduction.

For lower-income taxpayers, these provisions, which we\'ve spoken about
already, exempt most earnings from individual income tax, and in some
cases provide an additional credit amount to offset other taxes paid.
For families with children, exemptions and credits, along with the
standard deduction, shield a significant amount of income from tax, from
the individual income tax.

As an aside, the structure of existing tax provisions for low-income
workers and children is exceedingly complex, as Jon has aptly explained
and the panel has already discussed this morning.

Given these provisions, one can ask two questions, at least two
questions. First, at what income level does a family of four start
paying positive income tax? This is called the tax threshold. And
second, what fraction of families are above the tax threshold?

Again, we\'ve done an experiment here. The table shows how changes in
tax law can impact the tax threshold, which here are given in real 2004
dollars. We see that 2006 law provides a higher tax threshold and,
therefore, more families are below the threshold than pre-2001 Act
and/or law, and 1986 law.

Now, some fraction of the taxpayers with no positive income tax
liability receive a refund of all withheld taxes, or an income subsidy
that exceeds the amount of tax paid. That\'s one fraction of those with
no positive income tax liability. The other fraction have less income
than the combined standard deduction, exemption, and credit amount, and
are, therefore, not required to file a return.

Again, all these figures are calculated on the same population. The only
thing that\'s varied is the tax law.

This concludes my brief discussion of distribution tables. There\'s much
more that can be said. The appendix provides more detail on Treasury
distributional analysis.

Thank you.

CHAIRMAN MACK: And, I suspect we will have a lot more discussion as time
goes on about the distribution tables.

VICE CHAIRMAN BREAUX: Can I ask a question?

CHAIRMAN MACK: Sure.

VICE CHAIRMAN BREAUX: I mean, you know we have statistics and we have
statistics, and you have distributional tables and you have other
distributional tables. My question would be, has the Department of
Treasury been consistent on the type of distributional tables that they
utilize from administration to administration, or does each
administration try to construct distributional tables that focus on
things that they would, perhaps, be more interested in, or not.

Is there one group in this city that has information on distributional
tables that do not have a political bias to it, because you pick your
distributional chart outside of Department of Treasury, and I can come
up with any kind of \-- and we\'ve all seen them, that this is, you
know, biased to low-income families, or it\'s biased against the
wealthier, or we all know how different they are. The question I have,
is there any one group, is it the Department of Treasury, consistent in
the way they construct distributional tables from administration to
administration?

MS. ALTSHULER: The distributional tables, what\'s shown can change over
time.

VICE CHAIRMAN BREAUX: Would this be the same like, I mean, from this
administration to the Clinton Administration. Did the Clinton
Administration use a different distributional table?

CHAIRMAN MACK: Well, in essence, is the formula for calculating
distribution, basically, the same?

VICE CHAIRMAN BREAUX: Yeah, I\'m just trying to figure out how they
change, or do they change.

MS. GARRETT: Just one thing that I noticed, I remember when Mark
Weinberger testified, he said that the tax burden tables, apparently,
that he was familiar with, did not distribute the corporate tax. You
know, again I don\'t know on what basis, but I remember his testimony to
that extent. One of the things I think is interesting that you can see
in the small print of the distributional tables is that these tables do,
in fact, distribute the corporate tax, and they also distribute the
payroll tax.

Now again, I\'m no expert on this, but that suggests that there may well
have been changes over time in how people do distributional tables.

MS. ALTSHULER: Methodologies used by the Joint Committee on Taxation and
Treasury Department have changed over time.

MR. FRENZEL: Well, may I \-- would you yield on that? I agree, and the
assumptions are quite different. It is fairly straightforward to assign
wage income to quintiles of affluence, but when you start distributing a
corporate income tax you get into a huge discussion and much disparity
of opinion, even among economists, and, of course, we have some here who
might comment. But, it does seem to me that when we are talking about
burden tables we are talking about a moving target.

We are talking about somebody\'s estimate, and we have to be careful not
to be wedded to every tenth of a percent because we are talking
estimates, we are talking assumptions that are not shared by everyone,
and so I think we have to be extremely careful with them. They are the
only measure of fairness that we have used over the years in tax policy,
and, therefore, we are stuck with them. We have to use what Treasury
serves up to us, that\'s part of the charter that we have.

But, we don\'t have to believe them down to a gnat\'s eyelash, because
they aren\'t real.

VICE CHAIRMAN BREAUX: The reason why I asked the question is because I
remember when we were on the Finance Committee, we\'d have a tax
proposal that was presented by whatever administration it was, and the
next day I\'d get about five different distributional tables that told
me what it did. And, all five disagreed. So, I mean, my question is sort
of a factual one, I mean, where do we go for a distributional table that
is the least biased of all of them?

CHAIRMAN MACK: Well, I\'m going to let Jim make a presentation here in a
minute, but I\'ll just give you kind of my reaction to this, is that
before this process is over, and when I say process I\'m referring to
not only what we as a panel do, but it will then go to the Treasury,
from the Treasury to the White House, from the White House to the
Congress, and believe me, anyone who has got an idea about what a
distribution table should look like will let it be known during that
period of time. And, people will make their own judgments, make their
own determinations about what, you know, is the best approach to
determining the proper distribution.

So, we will use the distribution tables, whatever the panel decides, but
I suspect we are going to end up with Treasury. But, let me start with
Jim and let him \-- you\'ve written a lot of papers on this over time,
about how the burden of taxes is distributed across individuals and
families. So, maybe you might share with us some thoughts.

MR. POTERBA: Let me just jump in first, you know, on this question of
how tables may change over time. I think as sort of the received wisdom
on how tax burdens work, changes as tax lawyers and tax economists learn
more and change their views about things, there can certainly be changes
in some of the assumptions that are made in distribution tables.

Similarly, as the policy process focuses on different taxes, one being
the estate tax, for example, has at different points in time been
included or excluded from some of the distribution tables, and we may
see a total tax burden, and that may reflect, I think, largely the
change in demands of the policy process in terms of which taxes we focus
on. That can also lead to differences over time, but I think that most
of the distribution tables that we see, and certainly as my working
groups have interacted with Treasury, you know, this is a very
scientific process of trying to make the best available judgments about
how the tax burden falls on different individuals, and trying to do
something which is really very complicated. And, I think it\'s important
to remember when we see the distribution tables, and see five quintiles
and five numbers put on the screen, it makes it seem as though, you
know, this is just an exercise in measuring something which is almost a,
you know, constant of nature, and as long as we can get the right
instrument we are going to be able to pin down exactly what it is.

This is, in fact, a far more complex and fundamentally difficult problem
to grapple with. Just because \-- we know one of the old saws in tax
analysis is that people pay taxes, companies don\'t, and that means that
especially on something like the corporate income tax we are required to
try and figure out who the people are who ultimately bear that tax,
because we can\'t simply track who writes the checks and sort of then
just put that into a table and say, well, we are done with the analysis.

Let me just give you an example, you know, in terms of the numbers that
Rosanne has talked about. The table that Treasury currently produces,
and which the panel has been working with, focuses on individual and
corporate income taxes, payroll taxes, excise and customs duties, estate
and gift taxes, and on all of those taxes there\'s a need to figure out
how you go from the tax paying entity to the individuals and the economy
and link up those burdens.

And there are, of course, a set of assumptions that have to be made in
making that merger from one data set to the other, and some of those
assumptions are, frankly, open to some discussion. So, for example, on
the individual income tax, that\'s assumed to be borne by the
individuals who write the checks, by the payers. The corporate income
tax is assumed to be borne by all of the recipients of capital income,
from the non-housing sector, and I\'ll say more about that in a second,
because I think that\'s one of the places where there could be some
discussions and one could imagine making alternative distribution
tables, and people have in the past.

Both the employer and the employee side of the payroll tax are assumed
to be borne by workers, so that the wages and the self-employment income
are assumed to, basically, take the hit for those taxes. Excise taxes
and customs duties, for purchases by business, those are assumed to be
borne, ultimately, by both labor and capital income in proportion.
That\'s equivalent to saying that those are passed through to the
consumers, and, basically, paid by the people who buy the goods. It\'s
not the firms that import something that pay that excise duty or a
customs duty, but the people that buy that product at the end.

Estate and gift taxes are assumed to be borne by the decedents,
essentially, they float back to the people who died and left the estate
and, therefore, simply reduce their sort of financial wherewithal.

This is the death or taxes, this is you get death and the tax in this
case, right? Let me just focus on two of the broad issues related to
these distribution tables, and certainly within our subgroup working on
fundamental reform issues, you know, we\'ve spent a lot of time looking
at distribution methodologies, and I just want to, for the broader
panel, pick out two issues that I think are important and can provide
some education on what\'s involved in making some of these tables.

The first is the corporate income tax, and the second is the use of
current, this year\'s cash income, as a metric for identifying how
people\'s economic status works.

On the corporate income tax, which I think is probably the most
controversial of the taxes that one has to allocate in all of this, the
really critical question is, sort of within the corporate sector can one
think of the entire burden of this tax as falling just on corporations
and, ultimately, on the people who own those corporations, or does the
burden flow to other actors within the economy? In particular, do other
types of capital bear some of the tax?

Is there some adjustment in the investment process that leads people who
are thinking about investing in the corporate sector or the
non-corporate sector to, basically, alter their investment plans with
the corporate tax changes in such a way that some of the burden of this
tax is shifted to people who are investing in non-corporate capital?
There\'s a long tradition dating back to Al Harberger, the Chicago
economist of the early 1960s, thinking about how the burden of the
corporate income tax may be shifted out of the corporate sector, and
then there\'s a question of whether, particularly, in an economy with
mobile capital across borders, whether you can actually manage to tax
the capital in one country with a corporate income tax, you know, very
successfully at all, and whether, in fact, some of the burden of the
corporate income tax is shifted beyond the capital sector and may even
fall on labor. So that, ultimately, if a country has a high corporate
income tax burden, it may be that the amount of investment in that
country declines in such a way that wages, ultimately, fall, and the way
a public finance economist would think about that process and describe
that is to say that labor, ultimately, bears some of the burden of the
corporate income tax, that wages are lower, and, therefore, even people
who have nothing to do with writing checks for the corporate income tax
could see their economic status reduced as a result of this tax.

Well, as you can see from the description I\'ve just outlined, you have
to make some assumptions about what adjusts and where the burden is
going to fall in all of these things. And, those are assumptions which,
frankly, are subject to some debate by economists and other tax
practitioners, so it\'s very difficult to say, well, here\'s the right
way to do all this.

What we can do is to provide a little evidence, both on what\'s been
done now and what alternatives might look like. The current procedure,
as I described for the Treasury distribution tables is to allocate the
whole corporate income tax to the recipients of non-housing capital
income. So, that basically means that the non-corporate capital is
adjusted in terms of its return, but we are not pushing anything out to
assume, say, that the return on housing is different. We are not pushing
any out to the laborers and assuming that wages adjust.

A couple of years ago Alan Krueger at Princeton, and Vick Fuchs at
Stanford, and I did a survey of public finance economists in the top 50
Ph.D. granting economics departments, and asked people who taught public
finance the percentage of the current corporate income tax that\'s
ultimately borne by capital. The answers to that question were
surprising, at least to me, the average response was 41 percent, and
three quarters of the respondents said the answer was 65 percent or
less.

What that, of course, is suggesting is that a lot of public finance
economists are thinking that the corporate capital income taxes is
eventually shifted to labor in substantial part, and I think that
reflects a recognition that we\'ve got a very open capital market at the
moment where capital flows across borders to seek the highest rate of
return, and, ultimately, the workers who are less mobile may bear some
significant part of that tax.

I think the question that raises is, well, what\'s the implication for
distribution analysis? How would things, you know, and, in fact, this is
a place where even if one goes back to Joe Pechman at Brookings,
path-breaking work in his distribution analysis of taxes in the early
1960s, Pechman always produced several variants of his analysis, which
differed by how you distributed the corporate income tax, reflecting in
some sense the uncertainties, I think, in this part of the
distributional analysis.

And, if you were, for example, to distribute part of the corporate
income tax as falling on labor as opposed to on capital, that would make
this tax appear to be a less progressive tax. If you try to rank these
things, the ownership of corporate stock is more concentrated in the
U.S. economy than the ownership of all capital income generating assets.
That, in turn, is more concentrated than the recipiency of labor income,
so that depending on which of those three alternatives you chose, as a
way of distributing the corporate income tax burden, you would get
different kinds of distribution tables that would emerge.

I think that, at least, raises \-- in my own mind it raises the
possibility that the current approach that we see in the distribution
tables of allocating all of the corporate income tax to the capital
income, may somewhat overstate how far up into the distribution the
burden of that tax falls, and that, I think, raises at least a question
which we can think about as we try to analyze various reform options.

I think it\'s very important to remember in all of this that the time
horizon over which we consider a distribution table is not something we
discuss very much, but the distribution of a burden for a tax which is
enacted today, you know, if we change the corporate income tax today,
immediately there would be reevaluations of corporate stock, and people
would have gains and losses today from those changes, even by ten years
from now, by the end of the budget window, we might see investment
changes which alter things like the rate of return in other sectors and
alter wages, and certainly by an even longer term we might expect to see
other adjustments in the economy.

So, the distribution tables, which Rosanne has so ably described, are
static snapshots in many cases, and one might want to take a longer-term
perspective sometimes on how these things evolve.

Let me very briefly then talk about a second issue with distribution
tables, which is the role of current year\'s cash income as our way of
picking up the allocation of people to different income quintiles, and,
in particular, this is important if one thinks about the burden of, say,
excise taxes, or broad-based taxes on consumption, because those taxes,
because they are triggered by your consuming, the relationship between
consumption and income becomes a critical element in understanding how
those burdens will fall in the traditional distribution analysis like
what we see. In particular, a proportional tax on consumption will look
quite regressive in some of these distribution tables, because
consumption as a share of income tends to decline as one moves up the
income distribution.

That raises the question of whether this year\'s income is a completely
satisfactory measure of a household\'s ability to pay, and we know that
particularly at the top end and the bottom end of the income spectrum
for any given year there are households that may not be quite at their
long-run position in the well-being distribution.

Think, for example, about an unemployed worker who has very low income
this year, or a student who has low income at the moment, but expects to
have higher income after they graduate and become employed. Or, think at
the other end of the spectrum about an executive who is about to retire
from a firm, who does retire, and takes a one-time very large payout
involving exercising stock options or something else that makes their
income for one year look much larger than their income in most years
would be.

Well, I mean, all points in a direction of thinking may be in some sort
of measure of lifetime income, or multi-year income may be a better way
of trying to calibrate where households fall. Another approach is to try
to rank households by their consumption spending instead of by their
income. If you look at the sort of consumption, Milton Friedman, for
example, would argue that consumption reflects your long-term lifetime
level of income, that may be a different way of trying to put households
into different boxes, and if one ranks households by consumption rather
than by income, a consumption-oriented tax would look much more even
across the distribution than it does when one tries to look at
income-based measures of distribution tables.

I think although all of these suggestions there may be alternatives to
the distribution analyses that Treasury currently produces, I think, Mr.
Chairman, that at least for the moment our plan is to work within the
framework of the Treasury distribution tables, and just to try to be
mindful of some of these issues, as we look at the analysis that we\'ve
received.

CHAIRMAN MACK: John, you really \--

VICE CHAIRMAN BREAUX: I shouldn\'t have asked that question.

CHAIRMAN MACK: \-- there were a couple of thoughts.

I think everyone here will receive the credit for attending Jim
Poterba\'s class on income distribution, but you did, I mean, also the
other thought that struck me, I remember back in, I don\'t know if it
was the late \`80s or early \`90s, when Gorbachev was supposed to have
said, \"I believe in markets, but who sets prices?\" I understand the
complications with respect to the distribution issue, but I think what
you came to a conclusion about was that Treasury is where we start.
Clearly, we are going to have lots of different distribution tables and
analysis that will take place over time.

Does anybody have any thoughts with respect to the distribution tables,
whether we should use something other than Treasury?

Ed?

PROFESSOR LAZEAR: I have a comment, not so much on the predicted or
actual distribution tables, but on what the appropriate benchmark is,
because when we are doing all of our analyses, obviously, we are
thinking about structuring rates in terms of some benchmark category.

I\'d just like to point out that when you think about that, you can use
the current distribution of taxation, you can use some historical
number, you can use some average, or you can use some conceptual way of
thinking about what\'s an appropriate benchmark for distribution tables.

I think that there is an inclination to use the current one, in large
part because any deviation from the current one means that individuals
have to alter their plans, and they have already planned in the past
based on some notion of what their taxes were going to be.

But, when we do think about fairness, and all the definitions of
fairness, we do have to think about what\'s the appropriate benchmark.
So it\'s not just a question of measuring the future, it\'s question of
measuring the future and then comparing it to some base.

CHAIRMAN MACK: Yeah, Beth?

MS. GARRETT: If I could just follow up on that. I wanted to make a
couple of observations about distributional analysis, and one very much
follows up on Ed\'s comment, and that is, often people talk about
distributional neutrality, that is, they want the policy to look the
same in terms of tax burden, as now, and that\'s called neutrality, just
like when we talk about revenue neutrality.

And, I think the important thing, which Ed\'s comment suggests, is
that\'s not neutral, what that is, is it\'s replicating the status quo,
and the status quo is not neutral. For example, the current tax burdens
include in it the current AMT, which may be being borne now, and
certainly in the future, by people who it was not intended to be borne
by. It includes the recent tax bills, and there are some on those who
find the current \-- the recent tax bills to be a step backwards in
terms of fairness.

So, those are reflected in the status quo tax burden analysis.

I wanted to say just a couple of other things about tax \-- I think we
must use the Treasury\'s tax burden analysis for our work, that is, you
know, we are using the Administration\'s baseline, Treasury are the
people who are staffing us, and tax burden analysis is an accepted way
of thinking about policies and comparing them. But, as we use them, I
think we have to keep in mind that they are limited tools, they are not
complete tools. They have the kinds of limitations Jim has talked about.
They have some other limitations as well, in that they don\'t fully
reflect all of the kinds of questions you want to ask.

They are a snapshot of the current year, and you can pass changes that
will have very different distributional effects in future years. I think
some about some of the President\'s savings proposals, and I know we\'ll
talk about it later, which in the short run may not have the same effect
that they\'ll have in the long run because there\'s a churning effect,
as people would change current IRAs into back-loaded kinds of accounts,
and that\'s going to have one tax burden in the short run, and will have
a very different tax burden in the long run.

As Rosanne pointed out, we\'ve got the unit of analysis is family, so we
look at families as a unit. Well, families are very different. Sometimes
a family has two people earning money, and the second earner is going to
have a very different tax burden than that same family would have if
there is just one person earning money. So, in a way they are blunt
tools you don\'t get in all of the sort of \-- elderly is another good
example, people who work and get Social Security are going to have a
very different kind of tax burden.

And then the final thing is just to underline something that Rosanne
mentioned, the tax burden tables do not take account of fiscal and
economic changes. So, for example, if, you know, in a way when you think
about progressivity or regressivity of the tax code, you actually
wouldn\'t want to just look at the tax code, you\'d want to also look to
see how the revenue is being spent, right, and look at the overall
regressivity or progressivity of the whole government.

If you believe that over time less of the revenues are being spent for
lower-income Americans, then the fact that the tax system remains
unchanged may still mean that we have overall a less progressive
government system of raising and spending revenues. If you believe that
the economic background has become progressively \-- if there\'s
increasing inequality of wealth as the economic background, then again
the tax code not changing is not neutral, it\'s stayed unchanged in the
background of fiscal and economic conditions that have changed. And
that, of course, is not reflected in the tax code, but I think all of
that is important to take into account as you think about fairness.

CHAIRMAN MACK: Good.

Rosanne?

MS. ALTSHULER: One other point I wanted to make, specific to Jim\'s
comments, and others about the snapshot nature of this, and how we
measure income, is whether it\'s taking corporate income and trying to
figure out how to distribute it, but I\'ll use a real-time example of
the problem again in using a snapshot approach, is how, of course, we
define income. And, it\'s not a function of changes in taxes, but it\'s
also a function of changes in the domestic economy and the global
economy, where we are getting our compensation from.

The latest statistics on average hourly earnings, which is one way
economists look at income, not from a tax perspective, but just in
general, is only up about 2-1/2 percent, but personal income is up about
7 percent, and that\'s because of how much more inclusive it is, and
adds in things like bonuses, and commissions, and we have to think about
the changing nature of our economy, how people are employed, whether
they are self-proprietors, and how that income is calculated, because
it\'s very different than some of the traditional numbers that we look
at that measures income.

So, it\'s not just changes in taxes that affect this, but it\'s changes
in the nature of the economy that does as well.

CHAIRMAN MACK: Okay.

I think it\'s fair to say, unless others would disagree, I think it\'s
pretty much the conclusion of the panel that we are going to use
Treasury\'s distribution tables, with understanding the flaws that are
in it.

MR. FRENZEL: Whether we like them or not.

CHAIRMAN MACK: Whether we like them or not, right.

And, I think that \-- so, I assume from that that also in the working
groups, as you are working on different ideas, that you are kind of
using the Treasury tables as kind of a benchmark to kind of judge the
plans you are pursuing.

There\'s only one other area to raise, and we will do this quickly. One
of the things that Rosanne pointed out in the presentation, which was on
page 9, or the ninth slide, was this notion that there really are about
40 percent. We now have an income tax system in which we have quite a
significant fraction of Americans that pay no income tax, which is about
40 percent. I just wanted to know whether there\'s anybody who has got
any kind of reaction to that.

MS. GARRETT: Do we know how many of those \-- how many of those pay
payroll taxes? For many Americans, the payroll tax is their most
significant burden, and their contribution to government.

I think to be fair, you have to think about this 40 percent as many of
them paying payroll taxes.

CHAIRMAN MACK: Oh, yes, and that\'s why I clearly said income tax.

MS. GARRETT: Yeah.

CHAIRMAN MACK: Because there is a notion, I mean, you hear it quite a
bit, most people \-- or a lot of times you hear that phrase used, 40
percent don\'t pay taxes, well, 40 percent don\'t pay an income tax,
probably most of those people are paying payroll tax, but I don\'t know
that.

Anyway \--

MR. FRENZEL: Mr. Chairman, I think Beth has it right. She pointed out
that while our income tax burdens under Treasury assumptions look hugely
progressive, she pointed out that other government expenditures might
change that, and, of course, now she\'s introduced the employment taxes,
which change them completely.

I think all we can do, however, is to \-- we are only in charge of the
income tax, and so, we\'ll have to stay with that.

My own feeling has been that over the years we have been in a great
hurry to make changes with respect to the very lowest income people by
sweeping them out of the income tax system. And, usually, the reason has
been that we have put in some savings incentive or reduced taxes in the
higher brackets, and had really no recourse other than to take people
off the bottom end so that you would not disturb whatever were then the
burden tables.

In my judgment, we\'ve taken that as far as we want to go, and I don\'t
believe that Americans necessarily need the harassment of a tax report,
or pay income taxes, but I think it is not inappropriate for more
Americans to share in the income tax, and so I am not one of those who
favor every time we take something off the top we have to take another
10 million taxpayers off the bottom of the scale. And, I hope we are not
moving in that direction.

CHAIRMAN MACK: Any other thoughts?

If not, I think we\'ll move on then.

Which I think our next area of discussion then will be revenue
neutrality, and, Rosanne, are you going to cover that as well?

MS. ALTSHULER: Yes, I am.

CHAIRMAN MACK: Again, the Executive Order, basically, said that we have
to present a plan that is revenue neutral, or that we should have
options that are revenue neutral. And so, the staff has, in fact,
prepared a short presentation on how our plans will be scored.

So, if you want to take it.

MS. ALTSHULER: Yes, thank you, Senator Mack.

As Senator Mack has explained, the panel has been tasked with presenting
options that are revenue neutral. Simply put, this means that the tax
plans the panel puts forward cannot raise any more or any less revenue
than the current system.

The Treasury Department estimates the revenue implications of our plans.
Now, the starting point for any revenue estimate is a revenue baseline.
What the baseline does is, it serves as the benchmark for measuring the
effects of proposed tax law changes.

Treasury uses the Administration\'s ten-year projection of Federal
receipts as the baseline in the revenue estimates they prepare for the
working groups. The Administration baseline assumes that the sunsets in
EGTRRA, the 2001 Tax Act, and JGTRRA, the 2003 Act, are repealed, and
the temporary AMT provisions expire in 2005.

It\'s important to note that Congress does not use this baseline.
Congress uses the current law baseline from CBO, which assumes that
sunsets do occur.

Revenue estimates are reported as a single number, and not a range of
numbers, and are calculated in nominal dollars. Revenue estimates are
provided over a ten-year period, often referred to as the budget window.

As an example, Jon will report a Treasury revenue estimate of the cost
of AMT repeal over the budget window in his talk. I don\'t want to steal
his thunder and reveal the cost, but the number he reports is the sum of
revenue losses over each year of the ten-year budget window. The
estimates for each year are simply summed, there\'s no discounting.

Now, Treasury uses what are called conventional revenue estimating
techniques. Conventional revenue estimates hold the macro economy fast.
In other words, changes in tax law are not allowed to change GDP for
total employee compensation, for example. It\'s important to note at
this point that conventional revenue estimates are not static, but
microdynamic. This means they do take into account taxpayers\' likely
behavioral responses to proposed changes in tax law, holding the economy
fast.

These estimates consider a variety of responses to tax changes,
including changes in the timing of transactions and income recognition,
changes in entity form, shifts of activity across business sectors,
shifts in how you hold your portfolio, shifts between taxable and
non-taxable consumption, and tax planning and avoidance strategies.

I hope this very, very brief presentation is helpful, and it helps the
discussion that will follow.

CHAIRMAN MACK: Tim, I\'m going to turn to you on this one, I think.
You\'ve had some experience over the years on these issues.

MR. MURIS: Sure, it\'s part of a misspent youth. My first experience was
in 1981 when I worked for the Presidential Task Force on Regulatory
Relief, President Reagan signed an Executive Order that required major
regulations to be subject to cost analysis, and the initial response
from the Treasury Department was, they didn\'t have any impacts on the
economy, they just raise the revenue. Again, you can\'t blame them for a
nice try, because having to go through OMB was not regarded as something
that every regulator wanted to do.

But, the same kind of issues that you mentioned in your opening remarks,
Mr. Chairman, the same kind of issues apply in estimating revenues. We
learned from Nobel Laureate James Heckman, he provided when we were in
Chicago various estimates of the impact of various sorts of tax reform,
in terms of economic growth. Conventional scoring, as Rosanne was
talking about, conventional scoring, although it considers some
behavioral responses, and it is microdynamic, doesn\'t consider the full
range of things that can happen.

And, if you are looking at what normally is involved in Congress with a
few individual suggested revisions to the tax code, that\'s much more
sensible than if you are doing something like what we are doing, which
is providing various, I hope at the end of the day, and we haven\'t
decided yet, but major options for revising the tax code, some of which
at least I think could have very large so-called \"fully dynamic\"
effects.

And so, what I think that we ought to do is provide a range of
estimates, use the conventional scoring, and also have other estimates.

I\'ve always believed, you know, in ranges, and there\'s this belief
among people who want life simple that they ought to have a point
estimate for whatever the effects are, and point estimates always come
with implicit ranges, and it\'s much better to make them explicit I
think, so policymakers have, you know, a full view and understanding of
what\'s going on.

CHAIRMAN MACK: Any other thoughts?

Beth?

MS. GARRETT: Yes, just as Tim has mentioned, the revenue tables do not
include macro economic effects, and it would be, I think, a good idea
for our report to talk about those, although use the conventional
scoring.

The other thing, of course, that the conventional scoring does not do is
to estimate revenue loss outside of the ten-year window, it\'s a
ten-year budget window, and to do estimates outside that window is to
become more and more speculative, because we don\'t know what\'s going
to be the case. The assumptions are more important, things are very
sensitive.

But, I do hope that our report will underscore some of the out year
losses of some of our proposals, depending on what those proposals are.
Again, I\'ve mentioned savings accounts, I know we are going to talk
about savings later, some of the savings proposals that are under
discussion are back loaded, whether they are the President\'s RSAs, or
LSAs, the Roth IRAs, et cetera, and those have out year revenue losses
that can be significant, the tax policy center estimated the
President\'s RSA/LSA proposal with the cap of \$5,000 as losing .3
percent of GDP after 25 years.

So, you know, who knows if that\'s exactly right \-- I doubt it is, but
I do think that it suggests that there\'s a magnitude of loss in out
years with some of these things, and I think we would be more
responsible to underline those, particularly, at a time when the country
is going to be facing losses in entitlement programs and other kinds of
fiscal pressures.

CHAIRMAN MACK: Bill?

MR. FRENZEL: I think this has been a very helpful discussion. We are
obliged, under our Charter, to use the President\'s baseline. That may
or may not be enacted, and that will immediately change all the numbers
in our report, and make it skewed, at least over the \-- at the end, the
far end of the ten-year window.

And, Tim has told us that because of the way we are going to be
estimating, or the Treasury is going to be estimating, if our report
were to be adopted it would probably have stronger growth effects than
are predicted. We have seen that it may look fairer or less fair,
depending on where you sit, than what our estimators tell us it is. And,
I have the feeling that whatever it is, it will look a lot less simple
to the public than we think it is, as we look at it relative to the
current plan.

So, it seems to me that we need to integrate all of this into our
report, to understand what we are dealing with and the fact that we are
dealing with a big shadowy piece of smoke here, and describing it as
best we can, but knowing that that description is probably going to be
inadequate and certainly more inadequate each year as the real world
unfolds before us.

CHAIRMAN MACK: Well, I get the sense again that we\'ll end up where Tim
has suggested. I do have one question, kind of, you know, if we are
going to give ranges, kind of where do we develop the information about
the range, does Treasury provide us with that, or do we have to use
outside sources, to give a range of what the economic growth might be,
and what effect it might be in a given area, kind of where do we look
for that.

MS. ALTSHULER: The staff has had some discussion with Treasury, and they
are going to be able to provide us with some dynamic revenue estimates
of our plans.

CHAIRMAN MACK: Okay, all right.

And, just one thing to say, Beth, in response. There\'s no question that
whatever is done in a given year has effects as long as it is the law.

I, frankly, have concerns with all \-- with a budget window that\'s even
ten years. I mean, you know, it is incredibly difficult to come up with
estimates that are close even two and three years out, because of the
changes that take place.

So, I think if we are going to talk about the potential out year effects
beyond a ten-year period, I think it\'s got to be very clearly stated as
to, I mean, these are really wild, almost wild guesses.

MS. GARRETT: Well, I agree in the large part. I just think there are
some proposals, and I don\'t know that we\'ll be adopting them, but
there are some proposals that we\'ve heard about that we know are going
to have very different long-range revenue implications than the
short-range revenue implications.

CHAIRMAN MACK: Sure.

MS. GARRETT: And I think it\'s very important for us to underscore those
so that people have a realistic sense that what you are seeing in the
ten-year budget window may not accurately reflect the reality of those
provisions in the long run.

There may well be some that raise more money in the long run, hard to
find those often, but that could be the case as well.

MR. POTERBA: Well, an example of that is, if you move to more
accelerated depreciation, what that does is it costs you more in the
near-term budget than it does over the long term.

CHAIRMAN MACK: Okay, I think that unless there are some other thoughts
about that area, we\'ll move on.

Actually, this is a natural kind of lead in to our next discussion,
which is about the AMT. The baseline assumes that the AMT will hit more
and more taxpayers each year, so I think it\'s important for us to talk
about the AMT, and as before we are going to start with a presentation
made by staff, and, Jon, why don\'t you go ahead and begin.

This one could turn out to be a fairly lengthy discussion.

MR. ACKERMAN: Thank you, Senator Mack.

During the course of its meetings, the panel has heard a lot about the
AMT, both the corporate and the individual level AMT. Both are very
complex and inefficient taxes.

For these purposes, though, I will just focus on the individual AMT. The
AMT was first enacted in 1969, with much fanfare it\'s worth noting, in
response to a Treasury Department report that 155 taxpayers avoided
paying tax in 1966. Those 155 taxpayers had income above \$200,000 at
the time. That\'s above a million dollars in income in today\'s dollars.

Amongst those people who didn\'t pay tax was Mrs. Dodge, and that\'s
sort of an apocryphal story in tax lore. Today, however, the AMT is a
second parallel tax system, that has its own exemptions, its own tax
rates, its own credits, and a definition of income that is broader than
the definition used in the income tax.

The AMT requires taxpayers to do their taxes a second time, by adding
back many income deductions to the regular income tax. The largest
preferences under the AMT currently are the state and local tax
deduction and preferences for personal exemptions that are not allowed
in the AMT.

After completing the parallel AMT tax return, taxpayers compute from \--
subtract from the AMT taxable amount their exemption, and then figure
their taxes based on two tax rates, 26 percent or 28 percent.

Like most of the rest of the code, the AMT exemption, though, phases
out, and so this creates additional marginal tax rates within the AMT of
32-1/2 percent and 35 percent, before settling back down to 28 percent
when the exemption is completely phased out.

After going through all of those complex computations in comparisons,
taxpayers then compare the amount of AMT to the amount of regular tax
and pay whichever is larger.

This graph, which was provided to us by the Treasury Department,
summarizes the upcoming growth of the AMT. As the title of the slide
indicates, more and more taxpayers will pay the AMT. The AMT exemptions
in the tax brackets are not indexed for inflation, which causes more
taxpayers to be in the AMT each year.

Over recent years, there have been temporary fixes, also known as
patches, to the AMT to keep the exemption level higher, but the \$58,000
exemption for married couples this year expires and next year will be
only \$45,000.

The result of that is that the AMT affects 3.8 million taxpayers this
year, but after the expiration of the exemption, it goes up to 20.5
million, as you can see on the graph. The AMT continues to climb, and by
the end of the budget window that we\'ve been discussing, in 2015, 51
million taxpayers will pay the AMT. That\'s roughly 45 percent of all
taxpayers who have income tax.

The AMT will increasingly affect middle-income taxpayers. Currently, 13
percent of taxpayers who have incomes above \$100,000 and below
\$200,000 pay the AMT. Next year, by 2006, more than 75 percent of these
taxpayers will pay the AMT. By 2015, almost all of them will be paying
AMT, and, in fact, 75 percent of taxpayers who have income above
\$50,000 and below \$1 million will pay AMT in the year 2015.

It\'s worth noting that Treasury has provided us much of this data, and
it\'s posted on our website under the tab for the March 3^rd^ meeting,
if you want more information.

So, who pays the AMT? Well, mostly it\'s middle-class families. Large
families especially are hard hit because of the personal exemptions. In
addition, the AMT has a substantial marriage penalty. The exemption
amount of \$58,000 is only 37 percent larger than the exemption amount
for single couples, and this creates a particularly big problem for
married couples in terms of AMT.

Now, the AMT can be thought of as an elaborate and complex phase-out,
that takes away many tax benefits that are disfavored by lawmakers. In
this way, the AMT strikes a compromise between outright repeal of a
provision and reducing the tax benefits for some. For those who actually
are hit by the AMT, the result is higher taxes and for the government
higher tax revenues.

The revenues raised by the AMT are growing rapidly over the next ten
years, as Rosanne alluded to. In 2004, the AMT raised \$15 billion. The
Treasury Department expects that in the 2015 the AMT will raise \$210
billion. All told, the Treasury Department estimates that using the
Administration\'s baseline that Rosanne just described, the total cost
for repealing the AMT over the budget window is \$1.2 trillion.

Now, the AMT collects this money by increasing tax rates over the
regular income tax rates, and it is, in fact, a stealth tax increase.
The chart I\'ve put up here demonstrates what would happen if we
repealed the AMT and made up the lost revenue that it\'s currently
bringing in by raising marginal tax rates. The yellow bars on the graph
represent what the new tax rate would have to be if you had an
across-the-board tax increase to pay for the \$1.2 trillion repeal of
AMT.

As you can see, it\'s about an 11 percent tax increase for everyone. The
25 percent tax bracket would go up to 28 percent, the 35 percent tax
bracket at the top would be up above 39 percent.

In addition to creating tax increases, the AMT is complex. It\'s not
just the extra set of tax forms and computations that make complying
with the AMT difficult, however, although these forms are quite detailed
and nasty. It\'s the complicated interactions between the AMT and the
regular tax that really make taxpayers\' lives difficult.

CBO provided an example when they testified before the Finance Committee
about how choosing between taking the itemized deduction and a standard
deduction, one of the most basic decisions a taxpayer has to make, is
now incredibly complicated under the AMT, as some of the itemized
deductions are not allowed. This creates up to four different
computations that taxpayers, who are potentially in the AMT, have to
make in order to determine whichever tax liability is less for them,
whether they have itemized deductions or take the standard deduction.

The AMT is also unfair. For many taxpayers it creates unpleasant
surprises. For example, there\'s been some recent stories in the
newspaper about how the low rates on dividends and capital gains have
created unpleasant surprises for taxpayers, because it causes the AMT
exemption to phase out.

The AMT is also ineffective. It began as a way to make sure that the tax
system was fair, to make sure that all taxpayers at least paid some tax.
But, since then, millions of taxpayers are being hit by the AMT.

As the \"Tax Mam\" Claudia Hill, who testified before the panel on March
3^rd^ noted, \"The AMT has drifted so far from its objective that it now
rarely hits its target.\"

In sum, I think that Len Burman best summed up the AMT when he testified
before the panel, also on that date, he said, \"The AMT is just an
all-around failure. Good tax policy is simple, efficient and fair. The
AMT doesn\'t meet any of those criteria.\"

Thank you.

CHAIRMAN MACK: Thanks, Jon.

I think that I will just turn to Jim again, are you prepared to kind of
lead us through a discussion on this issue, Jim?

MR. POTERBA: Sure.

As Jon \-- let me just ask one question first, do you know whether we
have a distribution table to reflect Chart 7? In other words, it shows
if you were to pay for AMT through higher marginal \-- or higher tax
rates, do we have a distributional table on that?

MR. ACKERMAN: No, we don\'t. We\'ve assumed for this purpose that the
increase would be proportional across all taxpayers.

MR. POTERBA: Okay.

Well, depending on, at some point we may want to take a look at that.

Let me, Mr. Chairman, just say a little bit. I think Jon has very ably
summarized the prognosis for the AMT as it expands rapidly in the next
ten years. Let me just say a little bit about what the options are, in
some sense, for addressing this going forward.

My sense of what our witnesses have told us about the difficulties with
the AMT, in terms of understanding where the unhappiness with this is, I
think it comes from sort of three different places. One is the
deep-seeded unhappiness with having two parallel tax systems running at
the same time, the taxpayers potentially have to bounce back and forth
across, which creates all the uncertainties about whether certain
deductions will be received during the year and creates a lot of tax
planning problems for people.

Second, of course, is that as this tax moves into lower strata of the
income distribution it will raise marginal tax rates on wage earners in
those areas.

And, the third is that it undoes some of the features in the existing
code, for example, the lower tax burdens on dividends and capital gains
are taken away if one falls into the AMT regime, so that in some places
it can raise tax burden on capital.

What do we do about it? I think there\'s sort of three options. One is
outright repeal, and that, you know, takes off the table all of the
difficulties associated with the AMT, but it carries with it a high
price tag. We know that that will cost about \$1.2 trillion under the
window that we\'re looking at for revenue neutrality, and I think it\'s
extremely important, and Jon\'s comments make this point, it\'s
extremely important to underscore that complete repeal, as part of the
package, will require finding the revenues elsewhere in the package to
try to cover that \$1.2 trillion. So, that\'s a very big thing to do.

The other two alternatives, I think, would be to operate either by
changing the rate structure within the AMT or changing the base of the
AMT. The rate structure issues, I think, could be thought of as the
continuation of the patching strategy that\'s been used since 2001. For
example, in 2005 there\'s a temporary provision that sets an AMT
exemption of \$58,000 for a joint filer and \$40,250 for a single filer.
After 2005, that\'s scheduled to expire, and that\'s in our baseline,
and it reverts to a \$45,000 exemption for a joint filer and \$33,750
for a single filer.

Well, one could, basically, try to push forward those kind of patches,
and continue, you know, those fixes.

Alternatively, one could index for inflation the places, the breakpoints
in the AMT and the exemption levels of the AMT, that would, of course,
substantially reduce the rate at which the catch of this tax goes up and
reduce the number of people who are affected by it going forward.

Another option would be to redefine the AMT base in some way. That would
be, for example, to allow people to include the personal exemption, or
the state and local tax deductions that they take, or the standard
deduction as part of the AMT base, and what that would amount to doing
is, basically, lowering the number of people that would fall into the
AMT category by allowing a more generous exclusion from the AMT, and
kind of move it back up toward the higher end of the income
distribution.

Those are \-- I think that both of those in some sense do not resolve
the ultimate problem of having two tax systems working at the same time,
and they do require a constant attention to how do we tweak this thing
and play with it, but I think that, basically, covers the waterfront in
terms of the options. It\'s full repeal, indexation, or rate or
structure change, and then base broadening for the AMT.

MS. SONDERS: May I comment?

MR. POTERBA: Sure.

MS. SONDERS: I want to start just by going back, Senator Mack, to what
you opened with, which is the point behind a tax code, and the ability
to fund government in a reasonable way and, hopefully, broad-based,
lowest rate. And, I go back when we think about the various reform
options or repeal to what the original purpose was of the AMT, which was
really to try to catch those high-income taxpayers that were somehow
avoiding paying tax. And, you think of what it is morphed into by virtue
of increasing participation rates.

The problem is that it really hasn\'t served the benefit of catching
many of those high-income taxpayers who are avoiding tax, yet at the
same time the cost has turned into something that is eating into a lot
of the middle class, particularly, because of the biases, it\'s really
hurting families and families with children.

So, we often think of the AMT in numerical terms and the cost of
repealing it, but there\'s a tremendous cost to the average taxpayer of
keeping it in. And, if you do a non-monetary cost benefit analysis we
are seeing an excessive amount of cost with very little benefit, based
on the original purpose of putting this in there.

So, I think it\'s important to look at various reform options, but as a
full group I would much rather start at the point of repeal, and only
worst case scenario back into a reform option. I think we have to
approach this with, let\'s get rid of this and figure out whether it\'s
workable in terms of the numbers.

CHAIRMAN MACK: Excellent, excellent comment.

I do have a question. Do we have \-- we know what full repeal would be,
\$1.2 trillion, do we have some idea of what these other costs might be
if we were to go with, in essence, a continuation of the indexing? Do we
have a figure for that yet?

MR. ACKERMAN: I don\'t have it with me, Senator. I could provide that
for you after the meeting.

MR. FRENZEL: Mr. Chair?

CHAIRMAN MACK: Yes.

MR. FRENZEL: I am inclined to agree with Liz Ann, and I thank Jim for
that splendid exposition.

My memory of the history of this thing may begin to stink, but when we
were mad at Mrs. Horace Dodge for not paying taxes her principal income
was derived from municipal bonds, the income from which was tax exempt.
The House at that time repealed the tax exempt nature of municipal bond
income. The bond market sank, the Senate ran up the white flag, Russell
Long said, \"We are not going to do that,\" and somehow the Congress and
the people got left with this awful alternate minimum tax without ever
touching the element of income that caused the spark in the first place.

It was, of course, noticeably worsened in the Tax Reform Act of \`86 and
\`87, and without indexation it\'s come to the pass that Jim describes.

It may be possible to amend it, but I\'m with Liz Ann, I think we have
to bite the bullet. It makes our task enormously more difficult, because
if we, for instance, had a scheme in which we got rid of a lot of tax
preferences that would enable us to lower the tax rate and that would
look very attractive to everybody in the world.

On the other hand, we\'d have to use all that money to kill the AMT,
maybe we wouldn\'t lower the tax rate at all. So, it is a huge burden
that we take on, in terms of the attractiveness of our plan, if we kill
the AMT, but I think we simply are obliged to do it.

One other thought I have is that, I\'m told that the Treasury values the
repeal at about \$1.2 trillion, but on the other hand the CBO and the
folks in Congress are talking about a number half that big because of
different assumptions, baselines, et cetera.

So, it describes our quandary. We are taking the worst of all possible
worlds, but my judgment is the same as Liz Ann.

PROFESSOR LAZEAR: If I could just follow on Bill\'s point. One of the
things that I think is important to point out is that implicit in our
revenue neutrality calculations is the notion that these patches or
fixes that we have in the current plan are going to expire, and what
that means is that we are assuming a very large tax increase over the
next couple of years. In particular, we are assuming that there are
going to be approximately 20 million more taxpayers affected by the AMT,
and we have to fund that in terms of our revenue neutrality assumptions.

Now, if we look historically, and we ask what is it that Congress has
done in the past, it\'s not clear that Congress would be inclined to
allow that patch to expire. And, in fact, if we looked at past behavior
we might say that one definition of the status quo would be to think in
terms of those patches as being extended.

If we were to do that, that would give us a very different notion of
what revenue neutrality means, and it seems to me that we, at least,
have to think carefully about that in going forward.

CHAIRMAN MACK: Yeah, John.

VICE CHAIRMAN BREAUX: I would just ask sort of a general question on
this issue. I mean, I think all of us agree that the AMT, as it
currently is applied, certainly covers a huge, substantial number of
individuals and families that no one ever thought it was going to cover.

Well, suppose we eliminate the AMT completely, and we find ourselves in
a situation where there is a substantial and significant number of
taxpayers, not in the middle and upper middle income, but in the very
top that have income that is totally non-taxable, how do we address that
from the standpoint of being reasonably progressive? What do we do? I
mean, I think everybody agrees that a family of modest income means, and
I\'m talking about the \$75-\$100,000 family mean income that no one in
Congress ever intended to cover. But, by eliminating it we also allow a
situation where very wealthy individuals have only tax exempt income.
How do we address that?

CHAIRMAN MACK: Well, I think that Bill\'s reaction was that the issue
really is to address what caused the income taxation, or lack thereof,
in the first place, that the likelihood is, if we attempted to try to
recraft a new alternative minimum tax we probably would find ourselves
in the same position a few years from now with it affecting people that
we did not intend for it to affect.

So, I think the lesson learned is that, while the AMT was well intended,
it clearly had, and is having, an extremely negative effect. That would
be my first point.

Second point is that, my reaction at this point is that if \-- we\'ve
already heard that we are going to try to follow the distribution or the
tax burden of the present code, which says to me if there were a
substantial number of people in this upper quintile that we would have
to address whatever relief they got in order to keep this burden equally
shared across the quintiles. But again, that\'s an
off-the-top-of-my-head kind of reaction.

VICE CHAIRMAN BREAUX: Because we\'ve had some suggest, and I\'m not \--
I don\'t have any idea whether we are going to accept those suggestions
or recommendations or not, but we\'ve had folks that have come before
the panel that have suggested, for instance, that there be no tax on
dividends, interest and capital gains.

CHAIRMAN MACK: No tax at the individual level.

VICE CHAIRMAN BREAUX: At the individual level.

CHAIRMAN MACK: The tax would be collected at the corporate level.

VICE CHAIRMAN BREAUX: So, an individual who has income only from those
three sources, with no AMT, and maybe substantial income, would have no
tax burden at all.

I\'m not saying we would accept that, but we\'ve had people suggest that
to us in presentations over the last several hearings.

CHAIRMAN MACK: Beth.

MS. GARRETT: John raises an interesting point, and it\'s something that
the tax burden analysis that you mentioned might obscure, because tax
burdens look in the aggregate. And, what could happen, I suppose,
depending on what the reforms are, is that you might have still isolated
individuals who have particular tax situations where they, I mean, I
guess theoretically could avoid paying taxes, and that, I do think,
erodes the confidence in a tax system. That was the whole reason for the
AMT in the first place.

So, what I would be interested in, and I actually had not thought about
it until John raised that, is we have learned a lot from this AMT,
we\'ve learned how to construct a bad AMT that over time hits people
that we didn\'t intend it to hit.

But, one imagines that one could construct, just at the very high income
levels, for the people that you are concerned about, as John suggests,
an AMT \-- a much less, one that\'s indexed, one that will not hit as
much, it\'s just something I\'m throwing out.

I would support repealing this current AMT. I would be worried about a
situation where there are very high income Americans, however they make
their income, who avoid paying tax entirely. That\'s not fair, it
strikes me, and it\'s not a legitimate tax system. So, I would be
interested in knowing, maybe we should talk about it in our working
groups, whether there\'s a much smaller, sort of back stop that one
could consider.

MR. POTERBA: Let me just pick up on Senator Breaux\'s question and
Representative Frenzel\'s comment about Mrs. Dodge. It illustrates, I
think, some of the issues about the difficulties of doing distribution
analysis with taxes.

For example, in the example that someone who has got dividends, if you
had a scheme where dividends were not taxed at the individual level, if
there were still in place some sort of a corporate level or entity level
tax, I think it would be very important to trying to do the distribution
analysis. The way that person would show up in the Treasury\'s
distribution table, if they would have some part of the burden of taxes
that were collected on their corporate source income attributed to them,
despite the fact that they would never write a check to the Treasury
when they ultimately receive those dividends.

So, there are many ways to collect the taxes at different stages in the
process on that kind of capital income, and it\'s, I think, important,
although it\'s very difficult to interject into the public process, to
remind people that you can have the taxes collected earlier, even if you
don\'t pay at the individual level.

The same thing, in some sense, with a longer stretch, applies in the
case of someone who receives tax exempt interest from municipal bonds.
One could say that that person has paid no taxes and, in fact, they\'ve
written no check to the Federal Government that year, but given that the
municipal bond market typically equilibrates in a way that the yields on
those bonds are lower than the yields on taxable bonds, there is what
sometimes is called an \"implicit\" tax that those people have paid. So,
in some sense, you know, Mrs. Dodge was giving up some of the return she
could have earned, maybe not all of it, but certainly some of it, if she
had held taxable bonds, because she was holding tax exempt in return for
paying a tax payment to the IRS, she was in some sense, you know, taking
a lower return and paying that implicit tax along the way.

Both of those are examples of how the distributional analysis is
complicated.

CHAIRMAN MACK: Charles.

MR. ROSSOTTI: Well, I was going to say to Senator Breaux, I think that
even with the current alternative minimum tax, and you can ask the staff
this, I believe that there still are some taxpayers that are not paying
any tax, for the very same reason, probably the same reason that went
back to \`69, primarily, the municipal bond interest. And, we are not
talking about corporate minimum tax here, but you could say exactly the
same thing on corporate minimum tax, which was done for the same purpose
and fails equally badly, because there are corporations that,
notwithstanding that tax, are earning substantial amounts of money under
some definitions and still not paying tax. Which leads me to say, the
alternative minimum tax has been one of the few things that has been
clearly proven as it doesn\'t work.

I mean, if you want to really come up with a good tax plan, you have to
come up with a good tax plan and think through the implications of the
provisions that you are putting in. If you are putting in certain types
of incentives, like municipal bond, tax free interest, or dividends, you
have to think through when you are doing that what is the implication of
this for different people or taxpayers. And, if you don\'t think what
you want, then you change it, but don\'t try to put it in and then come
up with this back stop, because we\'ve had that for 30 years and it
clearly hasn\'t worked.

CHAIRMAN MACK: Liz Ann.

MS. SONDERS: I just want to reiterate what Jim said, and what Senator
Mack, you said during your class that you gave before, but I think it\'s
a particularly important point, and I would suggest that, and I\'m
volunteering you to write the chapter here, when anything we put out
that puts across this perceived notion that there\'s going to be this
category of folks not writing a check, I think we will serve the public
extremely well if we explain the nature of tax burden, and how in some
cases its direct and in some cases its indirect, because I think that is
something that is generally very much misunderstood by the public.

CHAIRMAN MACK: I think that I sense that, basically, the committee, the
panel has come to the conclusion that we ought to repeal the AMT, and
that as you work through your different proposals you work with that
assumption, that we are going to repeal the AMT.

The issue is still open as to how we, in fact, are going to pay for it,
but I think it\'s pretty clear that everybody understands, given our
charge with a revenue neutral proposal we are going to have to figure
out just exactly how we are going to pay for making that decision.

Is that a fair analysis?

VICE CHAIRMAN BREAUX: I still have just got to say that I have a
concern. That we have a situation where there would be a significant,
substantial number of individuals, because of our recommended changes, I
would find them having to make no contribution to running this
government. And, you know, I think AMT doesn\'t work, I think it was
designed improperly, inappropriately. I\'ve still got my Russell Long
demeanor here, I just feel that people who are fortunate enough to be at
the very top have an obligation to make a contribution to running this
government.

I\'m not sure how we do that, but it\'s a concern that I have.

MR. ROSSOTTI: I think part of that answer is that when we have
provisions that, I think not part of it, I think really the main answer
to that is, when we have provisions in the tax code that provide, you
know, some form of a tax incentive, if you will, or a tax reduction for
an individual, even though they may have indirect benefits, or the
person receiving the those benefits may be contributing indirectly, as
with municipal bonds, we do have to be cognizant of that.

I agree with that, we do have to be cognizant. I think, you know, the
link between what you pay directly is very clear. The link between what
you implicitly pay because of foregoing some higher return you could
have gotten elsewhere is a lot less direct. So, I do think we have to be
cognizant, but I think the right way to do it is not to have a back stop
alternative, because it doesn\'t work anyway. I mean, it doesn\'t work
right now, even after all this.

Instead, we have to really just think through what the implications are
on various groups of taxpayers when we put certain kinds of provisions
in that have a good rationale, but could have this side effect.

CHAIRMAN MACK: Yeah, and I think again, I think I would say, both to
John and Beth, I mean you both voiced a concern about this, in our,
let\'s say, decision to repeal it does not keep us from looking at,
well, how do we address this question as we go forward.

VICE CHAIRMAN BREAUX: I agree with that.

MS. GARRETT: I think that\'s Charles\' articulation of how to deal with
that explicitly.

CHAIRMAN MACK: Okay.

VICE CHAIRMAN BREAUX: Right, I just think it has to be addressed.

MR. ROSSOTTI: All right.

Well, it should be the case, given that when we look at distribution
tables that compare status quo with alternatives, you know, at least at
some higher degree of \-- you know, lower degree of resolution if we
look at the top couple of percent of taxpayers, whatever their burdens
are under the status quo, which included the AMT, we\'ll be comparing
alternatives against that.

That doesn\'t have the granularity to get you the few folks who may have
a particular configuration of income that might fall into this, but at
least some of this should be handled in the distribution analysis.

CHAIRMAN MACK: All right.

Well, I think this is an area for further discussions within the working
groups.

I\'m sensing maybe this might be an appropriate time to just take a
short break and let us kind of rethink the balance of the schedule, see
what our timing might be.

(Whereupon, at 11:01 a.m., a recess until 11:22 a.m.)

CHAIRMAN MACK: All right, let\'s go ahead and get started again.

The panel has reached a consensus on another major issue, and that is
rather than have a lunch break that we\'ll just probably go ahead and
just, assuming we can make the same progress that we did during the
first session, we\'d just go ahead and probably work through a lunch
break and try to finish up some time, 1:00, 1:30. So, I just wanted to
give you all a heads-up warning of what we are up to.

We are now going to move on to a discussion on what we refer to as a
clean tax base, another way of looking at it is a broad tax base. Alan
Greenspan pointed out the benefits of using a broad base with low rates
as being the simplest and most conducive tax structure to enhance
growth. Other witnesses explicitly proposed options with broad or clean
bases.

The staff thought it would be an interesting idea for the working groups
to look at our tax system in this way, and the staff asked Treasury to
estimate how tax rates would change under clean bases. In particular, we
asked them to start by cleaning the code of all tax preferences that
currently exist, and the staff has prepared a presentation with the help
of the Treasury Department to help us understand the implications of
using a clean tax base.

So, with that, Jeff, I\'ll turn to you and let you make your
presentation.

MR. KUPFER: Thank you, Senator.

Starting off, it\'s important to understand what is in a tax base. And,
as Jon explained earlier, there are numerous deductions, credits,
exclusions in the current tax code. Many are designed to make the system
more progressive. Many are intended to encourage behavior, many are
targeted at specific groups.

Regardless of whether they achieve their intended effect at appropriate
cost, they all narrow the tax base and they require higher tax rates for
everyone else.

The term tax expenditures was coined in the 1960s, and since 1974
Congress has required that it be used. There are about 146 tax
expenditures in the code. Most are administered through the individual
code.

As you mentioned, we asked Treasury to conduct the following, what
we\'ll call a policy experiment for us, which is holding the current tax
brackets constant, what tax rates could be revenue neutral. And also,
what single rate would be revenue neutral.

We decided to do this first with the broad income tax base, which is
further explained in our appendix. But, basically, as we all know, the
current income tax, or current code, is a hybrid. We call it an income
tax, but we do not follow all the classical definitions for defining
income.

So, for this experiment we asked Treasury to use a more comprehensive or
a more pure income tax base. The first working group that you described
has been working within the existing income tax code, and so looking at
reform and simplification.

Here\'s what the comprehensive income tax base would include. First of
all, we retained the standard deduction and personal exemptions at their
current levels, and that means that only people who have taxable income
above those amounts would pay tax.

A pure income tax also would not have an AMT. Since there would be no
preferences in a comprehensive or a pure base, there would be no need to
have such a system.

There would also be no exclusions for employer-provided fringe benefits,
employer contributions to retirement accounts.

Finally, a pure income tax base or a comprehensive income tax base would
have an integration between the corporate and the individual tax, so
that all earnings would be taxed once.

For the corporate income tax, we decided to do the same thing, which was
to have a clean or pure base, so we eliminated the credits, the special
provisions, graduated rates, and the AMT. We also eliminated any
accelerated cost recovery. In other words, there is economic
depreciation in this base, as opposed to current law where there
actually is accelerated depreciation, and also no manufacturer\'s
deduction, something we\'ve heard about during some of our previous
meetings.

Also, Treasury set the corporate rate equal to the top individual rate.

In order to compare, it\'s important to know what our current law rate
brackets are. This slide shows what they are for married, filing
jointly, and you see there are six rate brackets ranging from 10 to 35
percent.

In order to see what a broad income tax base would do to the rates,
Treasury made this calculation. You can see that if we keep the current
law rate brackets, in other words, the threshold for those rate brackets
remain the same, we\'d be able to reduce all of the rates by about a
third, meaning that the bottom rate would go from 10 percent to about
6.6 percent, the top rate would go from 35 percent to 32 percent. This
is a proportional reduction in tax rates, and it will have some
distributional consequences which we will explore later.

VICE CHAIRMAN BREAUX: That\'s the way it would be to maintain the same
amount of revenue inflow?

MR. KUPFER: That\'s correct.

VICE CHAIRMAN BREAUX: Okay.

MR. KUPFER: Building on that, if we were going to raise the same amount
of revenue inflow having a single rate, that rate would be a 15 percent
rate. I\'m going to call this a single rate, as opposed to a flat rate
or a flat tax rate, just so we don\'t get confused when we talk about
some of the other things that we\'re going to do later in the morning.

I alluded to the fact that it would have a different distributional
analysis. Let\'s just run through that quickly. So, Treasury put
together these charts for us. This is our current table, this is what
Rosanne talked about earlier.

If we had a proportional reduction in those rates, this is what the new
distribution table would be. As you can see, the top quintile goes from
paying 70.2 share of Federal taxes to a 66 share of Federal taxes.

CHAIRMAN MACK: So again, this is just showing the distribution of the
previous notion of the broad base and the lower rate.

MR. KUPFER: That\'s correct.

CHAIRMAN MACK: And, it\'s the graduated rates. Okay.

MR. KUPFER: Correct.

And, this is comparing it to our current system.

CHAIRMAN MACK: Right.

MR. KUPFER: If we had a single rate, the 15 percent rate that I
mentioned, that\'s what is shown in red, this is what it would do to the
distribution, and you can see from the three lines there, the blue, the
yellow and the red, how the distribution changes.

The top quintile, instead of paying 70.2 under our current system, would
pay 61.3, and you can see its effect on the other quintiles as well.

Our next experiment that we asked Treasury to work out for us was to use
the Flat Tax proposal. This is a proposal that\'s been presented to us
at one of our meetings, and we decided to use this and see what the tax
rate would be.

As you know, the Flat Tax proposal replaces the current and the
individual corporate income taxes with a flat tax. A Flat Tax encourages
savings and investment, by eliminating the double tax on business
income, and also the tax on the return to savings, which is capital
gains, dividend, and interest, at both the individual and the business
level, accordingly, the base for this type of tax is much smaller than
what it would be in the broad income tax which I described earlier.

The specifics on the base are in Appendix A, but, basically, this would
retain a standard deduction and personal exemptions. These amounts would
be higher than under the levels of the broad income tax, meaning that
once again taxpayers who have taxable income above those rates, or above
those amounts, would be the only ones who would pay tax.

Once again, there would be no credits, above-the-line deductions,
itemized deductions, there would be no AMT, and as I mentioned before,
we\'d exclude dividends, interest and capital gains from individual
taxation. There would also be no exclusions for employer-provided fringe
benefits.

On the corporate side, it would be a cash flow tax. There would be no
interest deduction. Once again, dividends, interest, and capital gains
would be excluded. We\'d eliminate the credits, the AMT, and since it is
a cash flow tax we\'d replace the accelerated cost recovery with
expensing, meaning that a business would get to deduct 100 percent of
all their investments. There would also be no manufacturer\'s deduction,
and the corporate rate would be equal to the individual rate.

Treasury calculated that for a Flat Tax to bring in the same amount of
revenue as what we do under the current system, we would need a 21
percent flat rate.

We then ran the distribution of this flat rate, compared to our current
tax law, and as you can see the highest quintile pays a 64 percent share
of all Federal taxes. This is as compared to a 70.2 percent share under
the current law.

We also asked Treasury to provide us some information on national sales
taxes. What we asked them to do was to replace the current individual
and corporate income taxes with a sales tax. In line with our previous
experiments, we decided to choose the broadest possible base that we
could, and so we decided to use the base that\'s been proposed by the
\"Fair Tax,\" who has testified to the panel and has a specific plan. It
is a retail sales tax, it\'s a tax on sales of all goods and services to
individuals, except for educational services, expenditures abroad by
U.S. residents, food produced and consumed on farms, imputed rent on
owner-occupied and farm housing.

This base, I should note, does not exempt a number of things that many
other systems exempt, and which we will explore later, such as health
care, government expenditures and food. Also, for this calculation we do
not have a rebate, or as the \"Fair Tax\" proposal refers to it a
prebate, and that\'s something that we will return to later.

Finally, the rates that we are showing depend on assumptions about
compliance. We have asked Treasury to provide a range of estimates,
ranging from

the current level of evasion that we have in our system to two times the
level of evasion. We present those numbers, not to suggest that the
sales tax would result in that much evasion, but simply because many
commentators and others have predicted increased evasion with the retail
sales tax, and we thought it would be useful to present the numbers in
this way and in this range.

I also want to point out that we are presenting numbers using two types
of rates. A \"tax exclusive\" rate is how most people think of a sales
tax, and the \"tax inclusive\" rate is how we think of the income tax.
The tax inclusive rate is always lower than the tax exclusive rate.

An example would be, assuming a good cost \$100 before tax, and there\'s
a \$25 sales tax, the tax exclusive rate is 25 percent. That\'s the
mark-up at the cash register, the \$100 cost and then the \$25 in tax.
The tax inclusive rate would be the proportion of the tax to the overall
amount that the consumer is paying, so that would be the \$25 to \$125
ratio, and that would be 20 percent.

The calculations from the Treasury Department for a revenue neutral tax
inclusive rate for replacing the corporate and the individual income tax
range from 18 percent with our current level of evasion to 21 percent
with double the level of evasion that we have currently. The tax
exclusive rate would be 22 to 27 percent.

We also thought it would be useful to present a VAT rate, a value-added
tax rate, for replacing the complete income tax system. As the Panel
knows, in a VAT all businesses are taxed on the difference between the
value of their sales and the value of their purchases. Although a VAT
and a retail sales tax are collected at different places in the business
cycle, they tax the same thing. Therefore, with the same base, which is
what we are assuming here, a replacement VAT would be 18 percent, which
is the same as the retail sales tax rate. That 18 percent rate, I will
note, assumes current level of evasion.

We also wanted to present to the Panel another example using a sales
tax. As I mentioned earlier, most sales tax bases are not as broad as
the base that we have assumed for the retail sales tax numbers that I
just gave you. Accordingly, we asked Treasury to run some numbers using
a traditional state sales tax base. As you see from the slide, every
state exempts prescription drugs, most exempt some food, and most do not
broadly tax services, such as financial services. State sales taxes
generally exempt governments and charities. So Treasury took what the
typical state tax base would be and ran the numbers needed for a sales
tax to raise the same amount of revenue as our current system, and those
rates run from 39 percent to 46 percent from a tax inclusive basis, and
64 percent to 87 percent on a tax exclusive basis. Once again, those
ranges are current law evasion to double evasion.

We also asked the Treasury Department to look at replacing portions of
our income tax system with a broad-based VAT. We\'ve heard a number of
proposals that have been presented to the panel that have suggested
doing so, using the same broad base that we described earlier with only
education and a few other things excluded. Treasury estimated the
following rates, so you can see from the slide replacing the individual
and the corporate AMT would necessitate a 1 percent VAT rate over the
period of the budget window, replacing the individual and corporate AMT
and reducing individual and corporate rates across the board by 50
percent would necessitate a 10 percent VAT rate, and replacing the
corporate income tax would necessitate a 3 percent rate, all to raise
the same amount of revenue as we have in our current system over the
budget window.

All right, that\'s all for now, Mr. Chairman.

CHAIRMAN MACK: There was one question I wanted to ask before about the
value-added tax. I\'m trying to equate the value-added tax with the
broad \-- your comments here with respect to the revenue neutral tax
inclusive rate for the national retail sales tax under what I guess
would be a narrower base than is in that 39 plus range. So, I assume the
value-added tax, if you use the same base, would have the same rate.

MR. KUPFER: That\'s correct.

CHAIRMAN MACK: I mean, if you did the same thing to the base for a
value-added tax, Treasury, basically, would say that you are looking at
a 39 percent tax inclusive rate.

MR. KUPFER: That\'s correct, with the same base.

CHAIRMAN MACK: Okay.

Well, as you can see, the clean tax base really does affect the issues
with respect to distribution tables, and as we discussed before, that is
something we need to be very sensitive to.

Ed, you\'ve been a member of a group looking at the Flat Tax, and also
you are a labor economist, would you mention some of the ways that we
can think about adding some progressivity to a Flat Tax and also
describe some of the issues surrounding the Earned Income Tax Credit?

PROFESSOR LAZEAR: Let me start by making two observations.

First of all, the Flat Tax \--

CHAIRMAN MACK: Your microphone is not on.

PROFESSOR LAZEAR: \-- two observations, first the flat tax \--

CHAIRMAN MACK: No, it\'s still not on. There\'s something wrong with his
microphone, can we \-- is that working?

PROFESSOR LAZEAR: Okay, thanks.

Two issues to start with. First of all, I think it\'s important to point
out that the Flat Tax, as it\'s been presented to us by Bob Hall, is not
flat. It\'s a two-bracket tax, it starts out with a zero bracket and
then goes to another bracket that\'s flat throughout the rest of the
range.

But second, and probably the more important point that is brought out in
Jeff\'s presentation, is that there are features of the Flat Tax that
are somewhat more fundamental than its flatness, and that is that the
Flat Tax is equivalent to a consumption tax. So, when we think about
adding progressivity, we want to think about what are the kinds of
things that we could do to add progressivity in the context of another
kind of consumption tax, say, like a GST or a VAT.

And, you know, you can think conceptually about how one would go about
doing this. You could think, if you went to a store and you carried a
card with you, and that card was blue, green or red, and that would tell
them what sales tax rate they would charge you, and that would be based
on your income, that would build in some progressivity.

Now, of course, that\'s an absurd system, no one would ever think about
doing anything like that, but the question is, can we do that in an
equivalent way? And so, one way that people have thought about to do the
equivalent thing, which wouldn\'t require having these different cards,
is to do something like David Bradford\'s \"X-Tax,\" and what the X-Tax
does is, it builds into a flat tax structure, which has most of the same
features as, say, the Hall and Rabushka Flat Tax, but it builds in
progressivity. And it has a variety of different rate brackets. That
would be the simplest way to build in some kind of progressivity.

So, one of the things that we might consider would be some different
rate brackets, more rate brackets associated with this.

Now, of course, any time you add additional brackets you add complexity,
and, you know, that\'s an issue that we would have to think about. But,
it seems to me that\'s an easy way to do it.

Any thoughts on that?

CHAIRMAN MACK: Yeah, any \-- Charles? Beth?

MS. GARRETT: Well, I wondered also, Ed, if you could talk a little bit
about, you mentioned the Earned Income Tax Credit.

PROFESSOR LAZEAR: Sure.

MS. GARRETT: Because I know with consumption tax there\'s another issue,
in addition to the progressivity of rates, which an X-Tax allows you, it
seems to be a necessary part of a \"Fair Tax.\" There\'s also the
question of those who have no choice but to consume with all their
income and how that affects the lower income American.

PROFESSOR LAZEAR: Absolutely.

The Earned Income Credit, or Earned Income Tax Credit Programs, as you
know, transfer income to individuals who tend to be in, say, the lowest
quintile of the distribution of income. And, these programs have been
viewed by many of our experts, many of the people who have testified, as
being quite effective in doing two things. One is, transferring income
to people who need that income, and second, doing it in a way that also
incorporates increases in labor supply, that is, get the individuals
into the labor market, and does so in a relatively efficient way.

Now, no one likes the complexity associated with the EIC. There have
been many complaints about the number of forms that you have to fill
out, and the difficulty of the forms that you have to fill out in order
to get there, but the basic structure of using an EIC, where you
transfer income and associate it with a phase-in range that is
incorporated with work, and then a phase-out range, seems to be
something that has attracted positive comments from most of the people
who have studied this, both in terms of labor supply and the ability to
bring about fairness.

CHAIRMAN MACK: Yeah, one thing that struck me, though, is that, again,
the phase-in/phase-out, again, adds all that complication to it.

PROFESSOR LAZEAR: It does. Again, there are two issues here. One is the
phase-out range implicitly raises the tax rate, so we are calling it a
phase-out, but, in fact, what that\'s doing is, it\'s raising the tax
rate in that range, so the skyline that we saw earlier becomes more
jagged when you have these kinds of phase-outs. And, in fact, we can
think about consolidation of many of our credits that would also have
other phase-outs, and if we did that, of course, what we would be doing
is creating higher implicit rates during those phase-out ranges.

So, not only is it complex, but it also creates some adverse incentives.

One of the nice things, though, that I think we did hear about the
phase-out range on the EIC, is that most of the people who have studied
this believe that the effects of phase-out on labor force behavior, that
is, on reductions in labor supply, dropping out of the labor market
because you are losing your EIC, that those effects have been minimal.
And so, that, actually, is a nice feature of that program.

CHAIRMAN MACK: Jim.

MR. POTERBA: So, is it fair to characterize that body of work as
suggesting that the subsidies to wages for people at very low numbers of
hours are successful at getting people into the labor market, but that
the distortions associated with higher marginal rates as the thing is
phasing out tend to be much more muted and much more difficult to find?

PROFESSOR LAZEAR: That\'s what the evidence shows.

CHAIRMAN MACK: Beth?

MS. GARRETT: Well, I wanted to underscore that I think it\'s important
that we have refundable credits at the lower ends of the income
brackets, and I think we have to be very concerned about the complexity
of those, not only because we are aiming toward simplicity, but if they
are too complex the people we want to help can\'t use them.

And, we have to think about these phase-out issues. I was very much
struck by the testimony we had in New Orleans about the effect of
phase-outs. While I generally think that one of the things that we ought
to be doing, and we are doing in our working group, is eliminating
phase-outs when possible, because many of them were compelled by budget
considerations, as Jon mentioned, or by trying to save revenue, or in
some cases by raising taxes in a non-transparent way.

You can see the phase-out of itemized deductions is just a way to raise
taxes, but hope people don\'t notice it.

I do think for these kinds of things phase-outs are very important, but
the key is to try to coordinate the phase-outs for refundable credits so
you don\'t have a plethora of them, you don\'t have different income
measurements, et cetera.

CHAIRMAN MACK: Okay.

Any other comments? Charles?

MR. ROSSOTTI: I would just say that I think that having wrestled with it
now in our working group, and having worked on it a little bit when I
was a Commissioner, I think if you are going to have some sort of a
work-subsidy program, like the EITC, you have to recognize that since
it\'s not going to apply to everybody, it\'s designed particularly for
people that are working at low income, something like a phase-out of
some sort is inherent. I mean, that\'s not a manmade complexity, that\'s
something that is just inherent, and I think there\'s a broad consensus,
or at least I\'ll speak for myself, that some form of that is both
positive from an economic point of view, as well as from a social point
of view, and notwithstanding that there are compliance problems and
everything, it is actually a relatively low-cost way of doing that.

So, I think it belongs in, certainly, an income tax proposal, and
probably many of the other proposals, and it is going to have some level
of complexity, just by the way that it doesn\'t go to everybody so you
have to figure out who it goes to.

Having said that, I think it\'s very important that we, and we can, I
believe, reduce the complexity dramatically by just making sure that if
we are going to have a phase-out we have one, and if we are going to
have one kind of a refundable credit we have one, we don\'t need a
plethora of them.

And, the definitions can be coordinated with the family credits of
whatever sort of family kind of subsidies that we have.

So, I don\'t think we are there yet to figure out how to do it, but I
think we kind of know what the broad outlines are of where this belongs
in the system.

MR. FRENZEL: Mr. Chairman?

CHAIRMAN MACK: Yes.

MR. FRENZEL: May I ask Ed and Charles, there is, or apparently is, some
kind of a high error rate with this program, and, in effect, it is a
Federal spending program bereft of any audit procedure. Do we simply
accept a fair amount of spillage in the program to take the advantage of
its benefits, or is there a way that we could make some improvement on
that?

MR. ROSSOTTI: Could I answer that, because I spent a reasonable amount
of time on that.

There is a certain amount of error rate. Some of it has to do with
complexity and all that, which, I think, we can do something about in
this group. There\'s another element of it, though, which just has to do
with eligibility and, particularly, since most of the eligibility has to
do with whether you have what\'s called a \"qualifying child,\" somebody
that lives with you and met the other relationship criteria. That is
something that\'s a little different than we normally have in the income
tax system. I don\'t think it\'s inevitable that you have to have this
high error rate, but I think if you want to reduce it you have to have
some additional certification requirement or some additional
documentation requirement for that one element. And, that\'s just
inherent in the fact that any program which is going to give people with
a certain family definition money, has to have something that checks to
see that they really have that family, in other words, that the children
really live with them, or whatever criteria there are.

I don\'t think it has anything to do with the fact that it\'s \-- well,
it does have something to do with the fact that it\'s part of the income
tax system because this is something that\'s different than you normally
have in an income tax system.

So, if you want to be able to achieve the objectives of this program,
which I think Ed summarized well, I think that the two things that can
be done to make it work better are what we are doing, number one, in
this panel, which is to simplify the definitions and simplify things so
you eliminate those kind of errors, but that wouldn\'t entirely solve
it. You would have to do some additional things on the administrative
side with the IRS, which I think they are known what needs to be done.
They do apply a little bit more burden, both in terms of the IRS and the
recipients of the program, to make sure that people actually qualify for
what they are getting. And, that\'s a decision that\'s outside the scope
of this panel, but it\'s not something that can\'t be done.

MR. FRENZEL: Thank you, Charles.

Ed, do you agree?

PROFESSOR LAZEAR: Yeah, I was just going to add one thing, and that is
that the phase-out structure actually does build in some additional
incentives to be less than perfectly honest, and one way to think about
that is that if I\'m in the range where I\'m earning an EITC, and I\'m
earning a credit there, I am getting benefits from the government. So,
if I can somehow disguise or postpone some of my income, say, to another
period, another year, I can get the EITC and then pick up the income in
another period.

So, these phase-outs are not without their problems either. So, you have
a number of potential distortions that can come into play.

Again, the evidence on this seems to suggest that although there are
these problems, there is some behavior that we wouldn\'t want to
encourage. It doesn\'t seem to be worse than other programs, and, in
fact, it looks like it\'s better. The EIC is one of the programs that
most people feel is well administered and among the better of the
government transfer programs.

MR. FRENZEL: Thank you.

CHAIRMAN MACK: All right.

With that, I think I\'m going to move us on to another area of
discussion, and again, it\'s under this notion of clean bases. Jeff\'s
presentation earlier would indicate that all savings incentives and
taxes all income at ordinary rates, so it repeals the savings
incentives. And, as we\'ve heard from numerous witnesses, as an income
tax creates large biases for current spending instead of savings, and so
should an income tax provide incentives to alleviate bias against
savings, and if so, how much, and how much would we be subsidizing?

So, with that, I want to throw this discussion open about savings, and,
Beth, if you are prepared to \--

MS. GARRETT: Sure.

Our group, Group 1, has been considering savings proposals within the
context of an income tax system, and in a much more simplified fashion.
And, some of the things that we\'ve been talking about flow from the
President\'s budget, which, as you know, has for some years has sort of
tripartite structure of ERSAs, RSAs and LSAs, that had different
contribution limits in the various budgets, at one point of \$7,500 for
the RSAs and LSAs, \$5,000, one can imagine different contribution
limits, lower, \$2,500, higher, \$10,000.

I dealt with one of the issues that\'s important, I think, for us to
consider, which is the out-year losses, but I wanted just to highlight
some of the other issues that I think the panel ought to talk about.

One of the main advantages of a proposal like this is simplification.
What we have now are just numerous savings incentives, both that the
employers provide and that are available outside the employment context.
They are confusing for people, there\'s no good reason to have all
these, just take the employer-provided you\'ve got 403Bs, 457Bs, 401Ks,
there are more than those.

The ERSA approach says that we are going to have one employer-provided
account, an Employer Retirement Savings Account, and it would construct
one account taking the best things of all the ones that we have.

In addition, one of the things that we\'ve been talking about a lot in
our group are changing some of the default rules. One of the things that
we know from behavioral economics and cognitive psychology is that the
default rules matter to human behavior, and default rules now are set in
a way that may not sufficiently encourage savings.

So, for example, one could have automatic enrollment, so the default
rule is you are enrolled, that doesn\'t force anyone to enroll, you can
opt out, but it changes behavior so changing the default.

You can have automatic escalation of contributions over time, automatic
investment in an appropriately diversified fund, and something I think
is very important, automatic rollover when you leave the job so that it
rolls over into another account.

Those, it seems to us, have a proven track record of, or at least it
seems to me, I would not want to talk for the rest of my panel, but it
seems to me, to have a proven track record of changing behavior.

There is in the RSA proposal, the Retirement Savings Account proposal,
which is intended to replace all of the various retirement accounts that
one can have outside of the employer context. Again, I think the best
advantage to this is simplification. It would be one account. It would
be simple, you\'d have to deal with the contribution limits and the
generational implications.

There are other issues as well, though, that one would have to discuss
as one thinks about these proposals. Do you require all current IRAs and
Roth IRAs to be converted into an RSA kind of account? Not a big deal
for the Roth IRAs, because they are back loaded as well, it would be a
big deal for the IRAs, or do you just make that an option?

Right now, many of these accounts have phase-outs, and we\'ve already
talked about the problems of phase-outs.

There\'s also an interaction with ERSAs. There\'s at least been some,
and Jim may be able to discuss this more, there\'s been some discussion
in the scholarly literature that some employers may be less ready to
offer employer-provided accounts if there are more generous accounts
available outside the employment context. And, one thing we know is that
employer-provided accounts do increase savings, so we\'d want to think
about that.

And then finally, in the President\'s proposal there\'s what they call
the LSAs, the Lifetime Savings Accounts, which would replace all other
tax benefitted savings accounts with one, under the President\'s
proposal, that would have absolutely no restrictions on withdrawals.
And, it seems to me that that\'s something we would need to discuss
seriously.

One of the concerns I have with savings incentives, is that we have to
be very sure that what we are doing is increasing savings and not
encouraging people to shift savings that\'s already occurring from
regular accounts into tax benefitted accounts.

One of the things that we said in April is that we don\'t think that
there should be provisions in the code, unless there\'s very good
evidence that it\'s going to change behavior.

So, what we have to be very concerned about in these is, does it cause
you to shift savings that you would otherwise do? And, of course, if you
can have a limited withdrawal, the substitution effect is much more
likely.

In that case, it\'s a windfall for people who would be saving anyway.
One of the things we could think about is changing that withdrawal
option from the President\'s proposal so that there would be
restrictions on withdrawal. But again, having only one account so that
you don\'t have education accounts, health accounts, other kinds of
accounts, but one account where you save for things like home ownership,
education, health problems, maybe some de minimus thing that you can
withdraw a bit every year so you don\'t have to do the hardship kind of
analysis you might do.

I think there are real gains in simplicity to a program like this, but
the questions I\'ve raised are ones I hope this panel thinks very
seriously about.

I also just want to plug for a minute, I think that one necessary
component of a savings package is a very serious consideration of a
refundable savers credit. One of the things that all of these provisions
that I\'ve discussed do, is that they allow those who have money to
save, but for those who do not have income to save they provide no
benefit. I think from a fairness perspective it\'s very important that
we encourage all Americans to save, it\'s arguably more important for
those who have less income to be thinking seriously about savings, and
we can be sure that it will be net new savings if it comes from groups
that would not have money already.

So, I think we have to think very seriously about a savers credit. There
has been a field study that the Retirement Security Project did with H&R
Block, that studied the effects of a matching incentive for IRA
contributions, mainly focused on low and middle income taxpayers. They
found in the study that matching rates can have significant effects on
IRA participation and contributions.

I think that the study suggests that a refundable credit can change
behavior, can help low income Americans, but I think it also suggests
the current savers credit is not the best design. We want to think very
seriously about the current design, and we also have to be careful if
there\'s going to be a government match you would not want that to go
into an account where the taxpayer could immediately withdraw the money,
right, that\'s not the idea of the savers credit in the first place.
There may be interactions with other means-tested transfer payments that
you\'d want to consider. You wouldn\'t want people who are saving
suddenly to find themselves ineligible for other means-tested accounts,
but I think it\'s something that we ought to very seriously consider,
but again keeping in mind simplicity, we\'d want phase-out rates, et
cetera, to be coordinated with any other refundable credits that we
have.

CHAIRMAN MACK: Terrific, thank you, thank you.

Jim.

MR. POTERBA: Let me just jump in and add two things on this.

First, the concept that Beth just described and the whole LSA/RSA/ERSAs
are sort of variants on a more general approach, which is one of the
ways of trying to move toward a consumption tax oriented system,
something called a \"savings exempt\" income tax. Which, in the extreme
case, is sort of like what was in the USA tax that was discussed,
Nunn-Domenici, in the mid 1990s, would, essentially, allow a deduction
from something like a current income tax structure for all the money
that you put into a qualified savings account. And then the question is,
do you limit that at all at these proposals, or do you allow that to be
unlimited? In which case, someone could by saving all of their income in
a given year manage to avoid any tax liability in that year, because we
are trying to give the credit toward savings activity.

So, I think it\'s just important to link this with that broader approach
that\'s out there.

Second, I think Beth raises this important issue of how we might exploit
the default options within the system to try to encourage behavior. This
is certainly a place where a lot of economics, not just tax economics,
but economics has increasingly become aware that the rational optimizing
individual is not always the way people make decisions. Even though
that\'s the way a lot of our models tell us they should, but it does
seem as though the sort of path of least resistance is often very
important in the behaviors that we observe. And, harnessing that to try
to do things on a savings margin may be something that\'s a constructive
way to work.

The last thing is about this substitution issue, which, of course, is
always critical. Any time one is providing these types of savings
incentives the question is, do we, in fact, get more saving as a result
of whatever we do?

I\'ve been a participant in the research on that issue for about a
decade now, and while there is some controversy I think that the
consensus is moving toward thinking that at least programs, like 401Ks,
that we fund now for close to 20 years in the U.S. have on balance
raised the amount of private savings. Individuals are saving more,
because these programs are available, than they would otherwise. The
amount of additional saving is, in fact, enough to, not just make up for
the lost revenue that we face because the Federal Government is, of
course, losing money on these things because it\'s providing a tax
subsidy at the time, but there\'s more new saving that\'s been done than
there is lost revenue on these things, that on net they\'ve actually
contributed to raising actual savings.

So, I think that\'s sort of my read on some of the evidence on that key
issue.

CHAIRMAN MACK: Okay.

Yeah, Liz Ann.

MS. SONDERS: I have a number of comments I want to make, tying in with
mostly what Beth was talking about, and I\'ll start on the LSAs, RSAs
and the ERSAs. Then maybe highlight some additional benefits to the
structure of these, totally agreeing with the simplicity aspect of it,
and the fact that in theory anyway they should stimulate a little bit
more savings.

In the case of Lifetime Savings Accounts, one of the issues that studies
have shown is that a lot of lower-income taxpayers have such a great
fear of penalties associated with the current system that that\'s a
disincentive for them to even participate in these savings. So, when you
remove some of those potential penalties you increase the incentive.

You also have current IRAs that allow for withdrawals for non-retirement
reasons, based on the current structure. So, having a separate RSA from
an LSA should help individuals plan for both non-retirement and
retirement needs.

And then, going to the ERSAs for a minute, Beth talked a little bit, but
from a different perspective you have now the ability for more small
businesses to cover their workers, for the simple reason that a lot of
small businesses don\'t set up existing plans because of the expense and
the compliance costs associated with it. So, under a more simple
structure you eliminate a lot of those compliance costs.

And, in addition, when you eliminate those compliance costs, ostensibly
you are adding earnings, you know, hopefully into the system, so it
benefits workers from that perspective, too.

But, moving on to the potential of a refundable savers credit. I think
we\'ve all talked about it in the past, and agreed that we have to be
cognizant of additional credits to an already complex system right now,
and that that complexity often results in taxpayers and participants in
these taking less advantage than they otherwise would, and, of course,
the concerns about using the tax code for targeting and the problems
that that bring.

You know, over the last 30 years there have been 20 unique tax breaks to
encourage savings. The problem is our savings rate has gone from 10
percent to less than 1 percent over that same 30-year period of time, so
there\'s not a lot of empirical evidence to suggest that these things
have been particularly good.

And, I\'ll conclude by absolutely agreeing that if you are offering
incentives that are only for certain types of savings, or certain
targeted groups, all that really does is incentivize shifting, it does
not, in the aggregate, raise the overall savings rate. So, I think we
have to be cognizant of all those things when we think about these
things.

CHAIRMAN MACK: Beth.

MS. GARRETT: Thanks, Liz Ann, and that actually raises, I think,
something I had forgotten to say about the RSAs and LSAs. I share your
concern about shifting and substituting savings. I do not see that as a
concern at the lower income, since by their very nature they are not
saving now because they have to consume with all their income.

So, the one thing I\'m pretty certain, I would feel more confident,
about is that a savers credit would actually increase savings. Whereas,
I worry very much that particularly the President\'s LSA merely
encourages people like us to shift savings that we\'re already doing
into tax-benefitted vehicles, and if that\'s the case then we ought not
to have them at all, because that is just a windfall for behavior
that\'s already occurring.

It\'s very interesting the thing that they point out, that even with all
these savings vehicles we haven\'t seen a net increase in savings,
again, which in my mind raises questions about their efficacy increasing
savings. I agree with Jim, that the data seems to suggest that
employer-provided savings accounts do have a real effect on net savings.
I think the evidence is much less certain with RSAs and LSAs,
particularly, an LSA kind of thing, which might draw into question
those, and that\'s certainly something we are thinking about in our
working group.

The other thing I wanted to underscore is the distributional effects of
RSAs and LSAs. If the phase-outs are removed, then that means that those
who will take full advantage of whatever the contribution limits are,
those who have the money to take advantage of that, and those will tend
to be the higher-income Americans, so that one reason we put phase-outs
on some of the IRAs, et cetera, was for budget reasons, but sometimes
they were for distributional reasons as well, and I just wanted to
underscore that that\'s something that we have to consider, counter
balancing that, the problem and complexity of phase-outs.

CHAIRMAN MACK: I think that \-- well, let me raise one question. Both of
you mentioned the notion of the default rule. Any reaction from the rest
of the panel with respect to the notion of the default rule, positive,
negative, whatever?

MR. FRENZEL: Yeah, I think it\'s a wonderful idea. Apparently, what
recent \--

CHAIRMAN MACK: Turn your mic back on.

MR. FRENZEL: \-- what recent, perhaps, just beginning research is
showing is exactly as Beth described it, that if there is a default rule
people go into it. I think it\'s been discussed a lot with respect to
the question of private accounts and Social Security as well, and I
think it would be a very positive aspect of any of these programs, but,
particularly, those directed at low-income individuals.

CHAIRMAN MACK: I think where I\'m trying to go with this is to see
whether there is a consensus on the panel at this point. If I get a
feeling that there is, we can move forward on it. If not, then we\'ll
just continue to deal with it with our other discussions with respect to
savings.

MR. ROSSOTTI: I think it\'s one of those rare things that doesn\'t cost
a lot and has a significant benefit. You know, there\'s really hardly
\-- I mean, it\'s just an example of where a complexity of making
choices and deciding things causes people to hold back and not make a
decision that\'s clearly in their interest to do it.

So, I think my view is that this is a relatively easy one. Maybe
somebody will disagree, but it\'s one of the those rare ones where it
doesn\'t cost a lot, it\'s beneficial, it\'s got some empirical base
behind it, and it just makes a lot of sense.

MR. POTERBA: One issue that the research on the default option has
raised is that, it\'s very important to consider what the default option
is when people are automatically enrolled in something. So again, this
is really the private sector 401K experience with default plans, but
it\'s been very common, I think, for firms to use money market funds or
something that\'s relatively a low risk investment vehicle. As the
default option, when they do offer these 401K plans that automatically
enroll people unless they opt out, and what you observe in that case is
that the choices amongst assets that people are investing in when they
are in the default plans shifts dramatically toward the default option.

So, if you compared a firm which, in fact, had no default and a firm
which had a default, in the no default firm you might find that 45
percent of the workers were participating, and that 40 percent of them
were investing in broad-based stock funds. In a firm that has a default
option, which is the money market plan, you discover that 80 percent of
the workers are participating, and that 55 percent of the workers now
have money in money market funds.

So, in fact, what you do is, you move where the money is going, and I
think that what it suggests is that there\'s a somewhat paternalistic
issue here that one has to think through where the default will put
people, to make sure that it\'s in a place where you want them to be,
because they are going to go there. And, you know, you just need to make
sure the default is well defined, I think.

PROFESSOR LAZEAR: Let me second Jim\'s point, that one of the concerns
that I\'ve always had about this is that when you do this, this is kind
of like saying advertising matters. We know that advertising matters. We
know that you can affect behavior by changing the structure and the ways
in which things are presented.

I think we are probably a lot less confident about our ability to tell
people exactly what they should be doing, rather than about our ability
to affect what they actually do.

And, Beth raised the point, I think, in her discussion where she said
she felt more comfortable about this for higher-income people, and maybe
a little less comfortable about this for lower-income people, because
you don\'t necessarily want someone who is in a situation, perhaps, a
transitory situation where their income is very low, that might not be
the best time to be saving, and you may not want to set things up in a
way that encourages that.

So, I think this is something that we probably want to think through at
a slightly deeper level.

CHAIRMAN MACK: Okay. Yeah, okay, I think that\'s good.

MS. GARRETT: I would give credit when we might want to look at this, the
Retirement Security Project has an automatic 401K proposal that I took a
lot of what I talked about from, and it might be worth looking at that
and looking at some of the other proposals that have more detail.

CHAIRMAN MACK: Okay, good. I think this was a good discussion, and so
I\'m now going to attempt to move us on to the next area of discussion,
and that\'s the notion of a clean Flat Tax structure.

And so, could someone who has been part of that group discuss how it
would treat savings?

MS. SONDERS: Let\'s make the emphasis on clean. There\'s a lot of
derivations of this, but in a clean system all business income is taxed
only at the entity level, so capital income is not taxed at the
individual level. So, automatically at the outset it removes the
distortion against savings, and makes it easier to save. We know there
has been a big distortion against savings, and that\'s part of the
reason why we have seen the savings rate decline so dramatically.

It also allows economic decisions on the part of both corporations and
individuals to not be distorted by the tax rules. Of course, it means
that business income is taxed once and only once, and that was one of
the purposes at least behind the \`03 Act and part of the way on that
path was lowering the rate on dividends and capital gains. And, it
really balances the biases toward debt and equity, and you even those
biases out.

Under a clean system, all business entities would be taxed. In some
cases, all except maybe the most tiny business out there, and it removed
the tax disadvantage currently faced by corporations relative to
non-corporate businesses.

And again, under a clean system, all employee compensation would be
taxed. I think Jeff talked about this maybe in his presentation, such
that there\'s no preference favoring fringe benefits over cash wages.

And again, you\'ve got investor return capital gains not taxed and debt
not taxed favored. Now, this, of course, is a very, very dramatic
change, so it would have to be handled extremely carefully, in terms of
what it means for balance sheets.

CHAIRMAN MACK: Any reactions to that? Any other thoughts with respect to
the flat tax notion and savings incentives?

All right. I think that there are a number of other issues on the
individual side that we could go into, but I\'m going to suggest that we
delay it and go into those discussions a little bit later. What I\'m
referring to are in the Executive Order: issues like charitable
contributions, home interest deductions, and we were, in essence,
directed to be sensitive to those, and I\'m going to be so sensitive to
those today that I\'m going to put that off to a later time for
discussion.

So, I think at this point we\'ll go ahead and move to the business side,
and again, in this context of a clean base, the clean bases have
eliminated all corporate tax expenditures.

In contrast, the current system is likely to \-- we talked about this
like being a littered factory floor. Complexity is costly to firms and
to economic growth.

In addition, many taxpayers use the complexity in the tax code to their
advantage by engaging in tax shelters to reduce or eliminate their tax
liability.

So, I think \-- could we have a discussion about the tax clean base,
with respect to the corporate side, which I think really raises the
issue about the AMT, and other areas of complexity?

So, whoever feels \-- Charles, are you prepared to \--

MR. ROSSOTTI: Well, I think that the complexity on the business side is
not as visible to most individuals, but it\'s definitely even a greater
order of magnitude. As a matter of fact, if you look at the \$140
billion that is cited as the cost of compliance, actually, if you count
businesses, including small businesses that may report their business
income on their individual return, a very substantial portion of that
\$140 billion is actually related to reporting of business income and
compliance related to that, as opposed to what we\'ve been talking about
so far in this panel.

So, I think a movement, hopefully, a very substantial movement, towards
a clean base that eliminates a lot of the complexity that\'s associated
with, inevitably, defining all those preferences, would be highly
beneficial, but also enable us to lower the rate.

And finally, we did talk a little bit about the AMT briefly on the
corporate side. You know, I think that if there\'s a case for
eliminating it on the individual side, it\'s even stronger on the
business side. It\'s not clear to me that it achieves any objective on
the business side.

The reality is, there are corporations today that pay very little or no
U.S. Federal tax, notwithstanding the fact that there\'s a corporate AMT
on the books, which I think is proof that whatever objective it may have
had is not being achieved. And yet, it does create very unpredictable, I
mean, and very difficult even for tax accounting people to predict what
the benefits are, and what the impacts are.

So, I think the general strategy of moving towards a clean base,
eliminating as many of the preferences as possible, if not all of them,
perhaps allowing us to reduce the corporate rate as a result, which has
benefits in economic growth and competitiveness, and also would allow us
to eliminate the corporate AMT.

I think those are some of the things that certainly in our group on the
income tax we are looking at how far we can go in those directions.

CHAIRMAN MACK: Okay.

Bill, how about you, have you got any thoughts on the AMT at the
corporate level and the complexity?

MR. FRENZEL: Do I?

CHAIRMAN MACK: Yes.

MR. FRENZEL: Yeah, it seems to me that if simplification is at all
important, if cleaning out unnecessary junk is important to us, and if
we want to have a simple, clean system, if we are going to get rid of
AMT for individual, it doesn\'t make a whole heck of a lot of sense to
leave it in for corporate.

Again, you\'ve got to figure out how you make up the revenue loss, and
that poses a lot of questions for us, but I think it needs to go.

CHAIRMAN MACK: Any other input? Are we \-- are we in a position to say
at this point that we want to eliminate and repeal the AMT for the
corporate, or am I pushing this too fast?

MS. GARRETT: My own view is that it is probably a tax that we want to
eliminate. It tends to work in a sort of counter-intuitive and
counter-cyclical way, but at least in our working group we are talking
about it as part of a larger package of really changing the corporate
tax base so that it is broadened and the tax rate is brought down.

And, I\'d like to see it decided in that context, with the strong
feeling that it\'s a bit of a crazy idea.

CHAIRMAN MACK: Okay, I think \--

MR. POTERBA: I want to second that because I think, in part, it\'s a
fundamental reform discussion. You know, this kind of a tax does not
feature, as a natural design element, many fundamental reform plans, but
it\'s easier to get in the back doorway.

CHAIRMAN MACK: Yeah, okay, I\'m quite comfortable with that.

Let\'s talk a moment also about the international taxation issues. The
clean base notion, again, that Jeff outlined earlier, would, basically,
tax income earned abroad by U.S. nationals in the year that it earned
it.

The current system, as you know, allows U.S. multi-nationals to defer
tax payments on active income earned abroad until that income is
repatriated. International taxation is an area that should, I think, be
addressed in our reform, and so I know that in several of the groups
these discussions have taken place.

MR. ROSSOTTI: Yeah, well we certainly have been in our group, and I
assume probably in the others, and this is one of those areas where, you
know, there are parts of the tax code that are complex, because it\'s
been manmade, so to speak, or Congress-made, I guess would be the right
term.

This is an area where there actually is some external inherent reasons
why there is complexity. I mean, we are talking about a global economy
where multi-national corporations operate across borders, and they are
operating in sovereign countries, multiple sovereign countries that each
have their own taxing policy. So, that, inherently, is difficult.

And, as our witnesses indicated, there are two broad approaches that you
can have. You can tax worldwide income of a corporation, and then offset
it with credits to avoid double taxation from other countries, or you
could try to go to what\'s sometimes called a territorial system, or a
system where, essentially, you try to define how much of the income
multi-nationals earn in the home country, in this case the U.S., and
just tax that.

Those are broadly the approaches. Unfortunately, as our witnesses also
testified, the U.S. has managed to achieve a system which seems to have
disadvantages to both of them, and complexities with both of them,
without really having a system that\'s in tune with the modern world.

So, I think it isn\'t easy to come up with a good solution. I think
broadly, the solutions are to either move to more clean \-- relatively
more cleanly, it\'s not necessarily clear you can be 100 percent one way
or the other, but move relatively more cleanly to one which really taxes
all the worldwide income on a current basis, with credits for the
foreign taxes paid in a comprehensive way that would allow you to reduce
the rate, the overall corporate rate significantly, or in the absence of
that to move to a system which really just tried to define how much
income is earned in the U.S., and not tax income when it\'s repatriated,
not worry about the worldwide income, just worry about defining how
income is actually earned in the U.S. and tax that.

And, we are still working and wrestling with this in our working group,
and I suspect this may be one of the tougher ones to wrestle to the
ground before we get there.

But, I am confident that we can come up with something that\'s better
than what we\'ve got now, because what we have now really does tend to
really combine all of the disadvantages without too many evident
advantages.

CHAIRMAN MACK: John?

VICE CHAIRMAN BREAUX: Well, I think as we try and simplify the system,
obviously, we have to also be mindful of the incentives that would occur
if we say we are only going to attack your earnings here, I mean,
incentives for moving overseas, we see more and more of our companies
are locating their manufacturing operations overseas. And, I think we
all should be mindful, and I\'m sure we are, any incentives that we
recommend that would encourage that process in even greater detail than
it is now, a greater outflow of manufacturing.

MR. ROSSOTTI: I think the problem that we have is, although what we have
on the books now is a system which taxes worldwide income, it doesn\'t
tax it until it\'s brought back. It allows you an indefinite deferral,
and there are various devices where you can effectively bring back the
money, even without paying the tax on it. So, even though on the books
you have this worldwide system, you are not really raising a lot of
revenue from it. You are actually creating a disincentive to some
degree, to ever bring the money back to the United States, because
that\'s when it is taxed, without really raising a lot of revenue or
really dealing with the problem you are dealing with.

In other words, what we really have is, we\'ve got to construct a system
that, in my view, to some degree combines the worst features of all
these, including the issue that you are raising related to incentives.

CHAIRMAN MACK: I think this is a significant issue, and it has got
plenty of attention in our hearings. It\'s a very complicated one. I
could be wrong about this, my sense is that we haven\'t heard a lot from
the corporate community saying this is something that really needs to be
changed.

While it\'s very complicated, I think we\'ve figured out how to work
with it, but it does seem like this notion of a system that, in essence,
encourages the keeping of capital off shore doesn\'t really make sense.

But, I can tell as I look \--

MR. FRENZEL: Mr. Chairman \--

CHAIRMAN MACK: Yeah.

MR. FRENZEL: \-- I\'ve been working with Charles under his brilliant
leadership in our subgroup, and you are right, particularly, the
sophisticated corporate tax community always prefers a known horror to
an unknown horror. And so, it\'s naturally going to be very careful.

Also, every company, every sector, is going to look at this in a little
different way and want a little different change.

The good news on this program is, the current system is so terrible that
we can probably improve it, if only by accident, but no matter what we
do it\'s not going to be anywhere near a perfect solution. There are
going to be, whatever we come out with, other panel members are going to
find fault with, and we hope you can improve it, but we\'re going to
give it the old college try.

CHAIRMAN MACK: Okay. All right.

Well \-- oh, Jim.

MR. POTERBA: One other thing that has come up, and our subgroup is
trying to become more educated about international tax issues, is just
the tremendous heterogeneity of firms and the importance of the
particular business circumstances of different companies in the way that
they are affected by different types of international tax rules.

So, this is a place where I think it\'s very difficult to speak with a
single voice on these kinds of issues, and talking about how particular
tax rules will affect the corporate sector, just because there\'s a
great deal of divergence out there.

CHAIRMAN MACK: Yeah, okay, good.

And, I think that I\'ve gathered now, as I\'ve looked around, I think we
are ready to move on beyond this one, the various working groups
haven\'t really moved far enough along with it for us to pursue it any
further at this point.

So, I think the next area that we\'ll move into is, again, still
business taxation, but in the area of efficiency. We\'ve heard from our
witnesses that the corporate tax distorts a number of important business
decisions.

The clean bases would lower the tax on corporate income. Jim, again, I
want to turn to you and ask you if you would lead us through a
discussion of benefits of lowering the tax on corporate income.

MR. POTERBA: I will try to lead, but not lecture this time.

The starting point for this is in thinking about economic growth. One of
the key drivers of growth is the level of investment, and the tax system
gives us a lever to operate on that level of investment, because if we
can lower the total burden on new investment projects that will
encourage the investment activity and, presumably, over the longer haul
give us a higher level of both investment and, therefore, growth.

So, at least our subgroup has spent some time trying to understand and
analyze the nature of the distortions that the tax treatment of
investment income at the present time produces.

Part of the reason this is complicated is, you can\'t focus just on the
corporate income tax. There\'s not a single parameter out there in the
tax code that summarizes how we tax investment income. And, at a
minimum, you need to recognize that the statutory corporate rate is
important. The tax treatment of investors is important, so is the tax
treatment of debt holders and of equity holders. That means you need to
think about both dividend taxation, interest taxation, and capital
gains, and the depreciation rules that are put in place for various
kinds of real investments, expensing for R&D, accelerated depreciation
or the lack thereof for physical investments. And, all of these things
come together in determining the total tax burden on different kinds of
investment projects.

As I list out these different components of the tax code that matter, it
should become clear that there is no single tax burden on investment,
and therein some sense lies a lot of the distortion that occurs here,
because we tax different things in different ways.

The panel has heard a lot about the double taxation of corporate income,
and the fact that equity financed investments in the corporate sector,
because they bear both corporate income tax and then potentially
dividend taxes or capital gains taxes at the shareholder level, are
taxed more heavily than other kinds of investments. They are taxed more
heavily than debt financed investments in the corporate sector. They are
taxed more heavily than investments that are made outside the corporate
sector, for example, in S corporations or in partnerships.

So, we end up with a playing field which is not level for these
different kinds of investments, both across the types of sectors,
between the corporate sector and the non-corporate sector, across
different financial margins between debt finance and equity finance
projects, and across organizational form, even within the corporate
sector, C Corps versus S Corps, for example, at the moment would attract
different kinds of tax burdens.

But, the impetus for moving toward lower tax rates on dividends and on
capital gains in the 2003 Tax Reform was to try to lower the total tax
burden on investment activity that took place within the corporate
sector, and those rate reductions do, in some sense, lower those tax
burdens and move us toward a situation in which the tax burden on
capital has been cut.

The dramatic response we\'ve seen since the 2003 reform, for example,
the rapidly increased level of corporate dividend payments, I think does
suggest that firms are responsive to this. The response to accelerated
depreciation and bonus depreciation in the corporate sector also
suggests that firms do, in fact, respond when we provide these kind of
incentives.

So, I think the broad issue here, in some sense, is that we recognize
that different activities at the moment are taxed differentially. One of
the advantages of some of the comprehensive reform plans is that they
would, basically, move toward putting everything on the same footing,
and ideally do that in a way which also lowered the total overall tax
burden and, therefore, provided the stimulus to growth.

Let me stop at that point for a bit. Then we may want to talk a bit
about some of the integration options, in particular, in the dividend
issues.

CHAIRMAN MACK: The notion of a cash flow taxation, tell me how that fits
into this discussion?

MR. POTERBA: Okay.

Let me sort of back up for a second, because cash flow taxation is a
more dramatic step toward lowering these tax burdens than integration,
which was where we were headed in the 2003 discussion.

Broadly speaking, the question here is, how can one try to reduce the
tax burdens that are paid on investments in various kinds of investable
assets. If one is focused just on the corporate sector, and trying to
reduce the double tax on dividends and the corporate tax burden, then
the natural thing to do is either to try to reduce the corporate tax
burden or the investor level tax burden on those kinds of projects. You
can do that by providing a dividends paid deduction at the corporate
level. You can do it by providing a shareholder exclusion for dividend
income at the investor level. You can do it as some European countries
do with an imputation system, which the shareholder gets credit for some
of the corporate income taxes that have been paid along the way.

Those three plans all focus on just the double tax margin and getting
the corporate sector equity finance projects treated in a particular
way.

The cash flow tax is a somewhat broader approach to doing all this. In
some of its incarnations, which would, basically, try taxing the
business entities, not just corporations, but all entity-level activity,
by defining what the inflows and outflows of those entities are, and
levying a tax on the difference. Okay. So, what that would also usually
be connected with is, saying all the tax burden on the corporate sector
and on entity sector will be at that level, and it might be combined
with not taxing that kind of income when it is received by the
investors, whether they be debt holders or equity holders.

So, back in that sense it shares some features with an integration type
system, but it goes much further. For example, it would also typically
disallow, in many cases, the interest deduction at the corporate level,
so that you would not have situations where firms would be borrowing,
taking deductions, and then paying out non-taxable dividends on the
other side.

So, that would be part of, for example, the CBIT proposal, which is the
Comprehensive Business Income Tax, which was raised in the 1992 Treasury
Report on integration and other issues. Basically, everything gets taxed
once at the entity level, you disallow interest deductions at that
level, and then any distributions, whether they be interest payments or
dividend payments that are made CBIT entities that are received by other
investors, those are no longer taxable when people get those payouts.

CHAIRMAN MACK: Do we have some reaction to those comments, or other
thoughts?

MS. GARRETT: Just a quick underscore.

As we start thinking about these issues of expensing, reducing the taxes
on investment, I do think that one thing that we have to be very aware
of, and Jim\'s comments really underscored it, is how you treat the
interest deduction.

We are focusing here on the corporate side, if you think about the
individual side, interest deductions are limited on the individual side
to home mortgage interest deductions, so there\'s less ability to
leverage in order to save, but it\'s not really savings when you are
borrowing to save.

But, I think on the corporate side, if we move toward expensing, or
toward some of these things, we have to very seriously consider the
interest deduction. One of the flaws, I think, in some of the recent tax
proposals that have moved toward expensing, in some instances, is that
there has not been a corresponding reduction in the ability of
businesses to borrow and take the interest deduction.

MR. ROSSOTTI: Yeah, I just have two comments. I think that there are
some issues on the integration side with getting into the question of
whether we are simplifying. Because one of the problems with the
dividend proposals that were made at one point by the Administration is
that they got extremely complex at the corporate level, in order to make
sure that, in theory, you are paying tax at the corporate level so you
exclude at the individual level. The problem is, you may not be paying
tax at the corporate level because of a variety of reasons, including
international tax, tax preferences, and various other things.

And so, in order to compensate for that, at least to deal with that
problem, they got into some complex proposals to make sure that people
were paying tax, how much tax was being paid at the corporate level
before you got the benefit at the individual level.

I think to the extent that we can clean up the corporate base, and we
can do some things that make it more clear that people are actually
paying tax at the corporate level, then it makes it easier to build some
of these integration proposals. But, whatever way you do it, you really
do have to be careful that you don\'t get into something that says you
are giving 100 percent, or a large percent, as a dividend exclusion at
the individual level based on the fact that tax is already paid at the
corporate level, and you find out it wasn\'t paid at the corporate level
so it wasn\'t paid anywhere.

I think a different kind of an issue comes up with respect to interest
deduction elimination. There clearly is a bias in some ways towards debt
in the way the tax system works now, but the difficulty that I\'ve heard
from our witnesses, and in all the proposals I\'ve seen, is that if you
go as far as completely eliminating interest deductions, and also
eliminate interest income, or financial income as a factor in corporate
income, you run into two problems that I haven\'t heard good answers to
yet.

One of them is firms that are in the business of making their business
income based on net interest margins, like credit card companies and
some banks, for example, really may end up not having any practical way
of being taxed. That\'s point number one.

And, point number two is the extent that you have certain kinds of
business that are not being taxed because they are making their money on
net interest margin, you will have a corresponding incentive for more
people to characterize their business in that same way. So that, they
find out that the way to get out from under paying tax is by having most
of your profits earned on a net interest margin which is not taxed. More
and more people, based on my experience in both business and in the IRS,
will try to find a way to get in under that umbrella, which could then
erode a much bigger percentage of the tax base than was maybe
anticipated when you started out.

MR. POTERBA: Let me just follow that, because I think those points are
extremely well taken. The simple definition, to go back, Senator, to
your question before, about what a cash flow tax is. It sounds very
simple when you describe it, because a cash flow tax is comprehensive
business income tax married to expensing or physical assets. So that,
basically, the firms are not keeping track of depreciation allowances,
and you disallow the interest deduction, and you tax all the entity
level income once at the entity level, and that doesn\'t move you
substantially in the direction of simplifying the way we tax business
income, but it\'s very hard to get it to a super simple system for just
the reasons I think Charles has described. In some places in the
business world, and I very much like the earlier suggestion that this is
a place where the world is complicated, and, therefore, puts taxes in
place also is complicated.

You know, the financial institution sector and the international area
are areas where it seems almost inherent to have some complexity in
whatever you design, even under alternative plans, which seem like they
are very simple.

MS. SONDERS: Let me just ask you also, Jim, to comment, if you would,
under cash flow taxation pass-through entities, and I\'m thinking in
particular about the real estate industry and the impact there.

MR. POTERBA: That\'s, frankly, something where I don\'t think that our
subgroup has gotten to the point yet of having a very clear sense of how
best to proceed on some of those issues. These are the kind of design
issues that, as one tries to think about alternatives to the current
system, make you realize they are the hard issues that one has to try to
sort through.

CHAIRMAN MACK: Any comments with respect to, I mean in the sense of a
VAT tax or a goods and services tax is a cash flow type tax as well,
isn\'t it? I mean, are we dealing with the same issues there?

MR. POTERBA: Many of the same things do come up when you try to define
what the definition is for a firm that has the standard VAT discussion
is you take sales minus the cost of inputs, and that seems at one level
an extremely easy and simple tax definition to use for all of the
business sector.

But, you know, as Liz Ann\'s question raises, or as Charles\' comments
on the financial sector raise, when you think about firms that are doing
\-- it\'s very easy in the text book examples of the baker who buys
flour and sells bread, but when you think about a lot of real world
firms, what they do is more complicated. As Charles has pointed out
occasionally, if the bread gets sold with some credit financing along
the way, how do you treat that part of it? You know, we get to some very
complicated issues.

MR. ROSSOTTI: I think this becomes a harder issue, something like VATs
and sales taxes, if you try to make it 100 percent of your tax base,
because in most of the countries that have VATs, or as far as I know all
the major countries that have VATs, they also have corporate income
taxes and individual income taxes, so they have all three. Which raises
the issue, is it more complex or less complex to have three taxes than
two taxes, which I\'ve never totally understood why that would be.

But, if you go to the point of trying to get the total simplicity,
saying, well, if we are just going to do a VAT, or just going to do a
sales tax, and we\'re just going to make it simple by having that one
tax, you then run into these kinds of problems, which Jim is talking
about. Which is extremely important, because if you don\'t solve those
problems you can really cause tremendous erosions of the tax base and
tremendous fairness of distributional problems. And, we don\'t have the
experience, that I\'m aware of, of any major country that has gone 100
percent in one of those directions. They have all three of these, so
one, kind of backstops the other, and when you get to the point where
you only have one of them you then you are sort of in uncharted
territory that nobody has seen before.

CHAIRMAN MACK: Ed?

PROFESSOR LAZEAR: There are many similarities between a GST and VAT, and
cash flow tax. There are some differences as well.

I mean, the GST and VAT, as you know, is widespread, most countries in
the world have something like that, and what the GST does is, it taxes
wages at the business level, which, again, kind of goes back to what Jim
was saying earlier, it\'s a little subtle, but not that subtle, because
if we just think about how that works, wages affect costs, costs affect
prices, and then prices are what we see being taxed.

So, the workers aren\'t actually writing the check, but they are the
ones that are actually bearing the burden of the tax, and it just works
through the GST structure.

But, there are some differences. One of the differences that might be
relevant is that the GST is clearly border adjustable, which means that
it gives credit to companies for their exports, but taxes them on their
imports. Border adjustability is an issue that\'s come up, Charles, when
you were talking about whether we think about territorial or
destination-based tax structures, that\'s going to be central.

The other thing that you may recall is, there was a proposal by Michael
Graetz to use a partial replacement GST as a way to lower the corporate
income tax and then to increase the zero bracket on the personal side.
There have also been proposals to eliminate business taxation altogether
and to replace them with a GST, and at the same time limit the amount of
the personal income tax.

So, those are other issues that we, I think, would want to think
through.

CHAIRMAN MACK: Yeah, there has been a fair amount of tension on this
border adjustability issue, and I do think we need to get focused on
that as well as we move forward on the business side.

Tim, did you have a comment?

MR. MURIS: Yes, there are a couple of, probably at least two, related
political issues that the VAT raises about the size of government.

It\'s interesting, there\'s an agreement, sort of across the spectrum,
about the efficiency of the VAT, that people draw two completely
different implications from that. We heard in our very first day of
testimony that one of the benefits of the efficiency of the VAT is that
putting it in place and then raising it would help with the baby boom
problem. Then there are other people who say they sort of follow Milton
Friedman\'s view that taxes should hurt. He said the worst thing he ever
did was invent withholding, and that the efficiency of the VAT would
make it too easy to avoid dealing with some of the spending side issues.

The empirical evidence on this issue is interesting, does the VAT lead
to bigger government? It\'s clear that when the VAT came in, in Europe
it quickly went up, but whoever has the burden of persuasion on this
issue would lose. If you had to prove that the VAT led to bigger
government, sorting out cause and effect as it is in lots of empirical
issues is very hard to do.

CHAIRMAN MACK: Okay.

PROFESSOR LAZEAR: Let me \-- oh, I\'m sorry.

CHAIRMAN MACK: No, go ahead.

PROFESSOR LAZEAR: I was just going to follow on Tim\'s point.

I think that the notion of having partial replacement of an income tax
system, whether GST or a VAT, has some virtue, but I think these
political economy concerns are really very important. If you look at the
evidence on this, the VATs started out much lower than they are now,
they started out in the 6 percent range, they quickly went up to the 15
to 20 percent range. They\'ve been very stable at that level for a long
period of time. We actually asked staff to investigate that for us, and
we\'ve seen some evidence on that. But, the problem is that you do see
this significant increase.

Now, one way to get around that, of course, is to start high and say,
hey, you aren\'t going to have an increase because you are already
there.

CHAIRMAN MACK: I assume you are suggesting if you start high you
eliminate a lot of other taxes in the process.

PROFESSOR LAZEAR: That was my point.

CHAIRMAN MACK: I just wanted to save you from that.

PROFESSOR LAZEAR: If you start high, then coupled with that would be a
decrease in the marginal rates on income tax, and that\'s something to
be thought of.

But, again, that\'s a hybrid system that we have to think through,
because, again, it\'s neither fish nor fowl, and in terms of some of the
features that we are thinking about in an ideal tax system, we have to
ask whether they accomplish those things.

Then the final point, sorry, Charles, just one last point and then I\'ll
stop. We can think about the full replacement system, of course, with
the VAT or GST, and that has \-- I think that has much to recommend. The
key consideration here, of course, is whether changes in the
distribution of taxes that are paid by various income groups would
require additional kinds of credits, or additional kinds of transfer
programs to bring them more in line with our current notions of what\'s
distributionally fair. And, that\'s going to be the tough part on that.

CHAIRMAN MACK: Yeah. Well, I\'m glad we had an opportunity to have a
little input on the value-added taxes. I think that\'s very helpful. I,
obviously, don\'t draw any conclusions at this point, but I think it was
very helpful to get that input.

MS. GARRETT: Can I just underscore one other thing \--

CHAIRMAN MACK: Sure.

MS. GARRETT: \-- that is, I think, relevant to that?

When some attack of VAT under the money machine argument, they also talk
about the fact that it is invisible, and I just wanted to underscore
that that\'s actually a design issue. It may not be an invisible tax
that can be reflected in the prices of goods, it can be an apparent tax
as well. It may have some effect on the political economy arguments that
Tim and Ed are importantly underscoring.

CHAIRMAN MACK: Yeah, okay, great, great.

I think we\'ve kicked this around enough. We\'ve got one last area to
discuss. A little while ago Jeff went through a process of discussion
about a clean base, and now we are going to go through a discussion
about, well, what do you do, if you\'ve got a clean base, what happens
if you add certain things back in?

The staff has received revenue estimates and distributional analysis
from Treasury, which shows how the clean base structures change when
some of the largest tax expenditures are included, and the staff has
also asked Treasury to make adjustments to the flat tax to make it more
progressive.

So, again, I\'ll turn to you, I guess, Jeff or Rosanne.

MR. KUPFER: Thank you, Senator Mack. You provided an introduction, so
I\'ll move right into the presentation.

The first chart lists the top tax expenditures over the budget window,
or at least five-year budget window. We\'ll just pause on this so people
can see what the top expenditures are.

As you can see, the top one is the health deduction and preferences, and
then they go down from there.

CHAIRMAN MACK: Do we need more time?

MR. KUPFER: Okay, I\'ll read them off for everybody then. I don\'t have
the exact numbers, but the first one is the health deductions and
preferences. The second one is incentives for home ownership. The third
is retirement savings preferences. The fourth is the child credit. The
fifth is charitable contributions. The sixth is the Earned Income Tax
Credit, and then there\'s a number of other ones that go on from there.

What the staff asked Treasury to do was to add the Earned Income Tax
Credit, and then the top five household and business tax expenditures,
back to the broad income tax base that we talked about before, that pure
comprehensive base that we described earlier, where we had those lower
rates.

And so, for the household side, it\'s the five that I just mentioned,
exclusions for employer contributions for health insurance and pensions,
we added that back in, retirement savings preferences, itemized
deduction for mortgage interest, itemized deduction for charitable
contributions, child tax credit, along with the Earned Income Tax
Credit.

On the business side, Treasury added back accelerated depreciation,
rather than economic depreciation which was in the earlier base, oil and
gas preferences, manufacturers deduction, graduated corporate rates, and
the R&E credit.

This chart represents what we saw earlier, which was \-- oh, I\'m sorry,
actually, this chart represents what we saw earlier with the lower rates
when they were all cut by a third, so that the top rate would be 23
percent. When you add back in the expenditures that I just mentioned,
both on the household and on the corporate side, the rates increase in
order to make up that revenue and to be revenue neutral. You\'ll see
that the lowest rate goes back up to 9.7 percent, and the top rate goes
to 34 percent, and that\'s adding back in just those expenditures that I
mentioned.

The single rate, which was 15 percent before would rise to 21 percent.
That\'s what this chart represents.

So, you can see that when you add back in those expenditures, we are
very close to where we are in the current system. The dark blue lines
are the rates in current law, and you see that the light blue line is
the income tax base with those expenditures added back in.

Okay. Let\'s take a look at what the distributional analysis would be
when adding back in those expenditures.

When you add back in the EIC and those top five expenditures, the
distributional burden changes. We will compare that to the broad base
that we saw earlier. The green line, the green bars are what the
distribution was with the broad base, the grey line is what they are
with the tax expenditure. You notice that the burden shifts and that the
highest quintile now pays a higher share of Federal taxes than they did
before, they go from 66 percent to 69.8 percent.

When you do that same exercise with the single rate, the highest
quintile also pays a higher share than before, they go from 61.3 percent
to 64.5 percent. The lowest quintile goes from .8 percent to .4 percent.

CHAIRMAN MACK: And, that\'s showing that 21 percent rate that we saw
earlier, that\'s how the distribution now would flow out.

MR. KUPFER: That\'s correct, we\'d have a 21 percent rate, and we would
have all those expenditures added back in.

CHAIRMAN MACK: Okay.

MR. KUPFER: As opposed to a 15 percent rate earlier with no
expenditures.

CHAIRMAN MACK: Right. Right.

MR. KUPFER: We also thought it would be useful to add the expenditures
back to the Flat Tax base that we saw earlier, and then also to examine
how that would change as well.

So, in line with Ed\'s comments earlier about having a different rate
structure, first we added back in an Earned Income Credit and then
different rate brackets. Treasury picked the three brackets of 15, 25
and 35 percent. They are similar to brackets that we have under current
law. With those brackets, Treasury then set rate thresholds, or rate
amounts that would be revenue neutral, and you can see what those rate
amounts are. Now the 15 percent bracket would be up to \$75,000 joint,
25 percent would be for \$75,000 to \$120,000, and the 35 percent
bracket would be over \$120,000, and those were picked to be revenue
neutral.

We also then added back in the top tax preferences on both the household
and the business side into that modified Flat Tax, which is modified by
having an Earned Income Credit and graduated rates.

And, what you see here is what I described earlier, basically, which is
what the new rate brackets would be with the modified flat tax.

When we add back in the same tax expenditures that I\'ve just described,
and we keep those same income thresholds, the rates, obviously, need to
increase in order to be revenue neutral, and you see here what those
rate increases would be. The bottom rate would go from 15 to 18 percent,
and the top rate would go from 35 to 42 percent, and that\'s to make up
the revenue that would be spent on those various tax expenditures.

We went through the same exercise with the distributional analysis of
those various proposals. Here you see how the distribution changes. As
you would expect, when you vary the rate structure, and when you add
back in the Earned Income Credit, the distribution changes. The highest
quintile pays more in tax than they would under a straight Flat Tax. It
goes from 69 percent share paid by the highest quintile under the
modified flat tax, previously it was 64 percent.

When we add back in those top tax expenditures, the green line you see
the highest bracket pays an even higher share than they paid before,
they pay a 71.7 percent share.

The other thing that we wanted to do was to add back in the \"prebate,\"
which is what the \"Fair Tax\" calls a rebate that they have in their
proposal. What we did earlier was that we ran the replacement sales tax
or the VAT without any type of rebate, which would be designed to
ameliorate any regressive effects of a sales tax or a VAT, and like I
said, this run that we did earlier was different than the actual
proposal that was presented to the Panel, because that proposal did
include a prebate. The prebate is described on the slide. It would be
the tax inclusive retail sales tax rate times the poverty guideline
amount defined by Health and Human Services.

We asked Treasury to provide those rates. The rates need to be higher
than they would be without a prebate, because there is revenue that is
being used to fund the prebate.

The rates that Treasury calculated go from 25 percent to 33 percent for
a tax inclusive basis, and 34 to 49 percent on a tax exclusive basis.
Once again, those rates go from the current level of evasion, assuming a
current level of evasion, to assuming double the current level of
evasion, and that\'s why the range is from 25 percent to 33 percent.

We also asked Treasury to calculate what the distribution would look
like with a sales tax with a prebate, as defined in the last slide, and
as you would expect having a prebate does change the distribution.

The third and fourth quintiles pay more as a share of taxes than they
did before the prebate, and you see as the sort of orange lines those
quintiles are higher than the blue lines, whereas, the first, the second
and the fifth, the highest quintile, all pay less as a share than they
did previously without the prebate.

Senator Mack, that concludes the staff analysis, the staff experiments
that we asked Treasury to run for this hearing.

Thank you.

CHAIRMAN MACK: I think I\'d say thank you for that. I mean, there\'s so
many numbers now that are floating around that it makes it somewhat
difficult.

The one \-- just remind me, with respect to the retail sales tax, we had
an 18 percent rate at one point, the 25 percent is a rate that reflects
what?

MR. KUPFER: The 18 percent range, or the 18 percent rate, which was
based on current evasion levels, represents what one would need to be
revenue neutral using the Fair Tax base, which was a very broad base.

CHAIRMAN MACK: Right, and the 25 was a narrower base, is that it?

MR. KUPFER: No, no, with no prebate at all.

CHAIRMAN MACK: Okay.

MR. KUPFER: In other words, it was just the amount of money needed to
replace the current amount of revenues being collected in our system.

The 25 percent rate \--

CHAIRMAN MACK: Oh, is with the prebate.

MR. KUPFER: \-- is with a prebate. And so, since we need to generate
money to fund that prebate, the overall rate would then need to be
higher to still remain revenue neutral.

CHAIRMAN MACK: Okay, good.

And, the one chart that \-- I mean, I think it really clearly shows the
tradeoff with respect to \"tax expenditures\" was 25, slide 25, which is
the tax rate schedule of a broad income base with top tax expenditures
added back. When you did the clean base you had rates or tax burden that
basically went from, say, 6.6 at the low end to 23 percent at the upper
end, are you all with me?

MR. KUPFER: Yes.

CHAIRMAN MACK: And then, when you add back in the burden goes to \-- or
the tax rate, excuse me, goes to 9.7 percent at the low end and 34
percent.

So, on one hand people think that these various tax expenditures kind of
come to them with no cost to it, and this notion that maybe somebody
else is paying this tax, but the reality is that marginal tax rates, or
statutory tax rates, have gone up and people are paying for it that way.

And, I think it\'s a very, very clear chart about what, in essence, the
cost is. That\'s my observations.

I don\'t know, are there any other thoughts or comments that have been
triggered as a result of this last presentation of adding back in?

Yes, Charles.

MR. ROSSOTTI: Well, I\'d just like to say that, at least in our group,
when you look at these so-called tax expenditures or tax incentives,
especially on the individual side, that are the big ones like incentives
for health insurance and home ownership, you know, I don\'t think it has
to be all or nothing. I don\'t think this purpose of analysis shows it
as an all or nothing, that you either add it back or you put it back,
and that\'s good for the purpose of explaining what the impact is. I
think there are ways that we could think of to, perhaps, still maintain
these to the extent that we \-- especially in our charter, in some of
these cases we\'ve been directed to, but we could maintain them, health
insurance, or health expenditures, home ownership and charities, while
still, perhaps, limiting them in ways that would keep the basic
incentives there for the purposes they were intended.

For example, in home ownership, you know, there\'s already a limitation
as to what the total size of a mortgage is that you could deduct
interest on, but it\'s effectively a million dollars plus \$100,000 for
home equity, you could consider something that would be \-- that\'s well
in excess of what the mortgage is that most people need to buy a single
home, you could consider still having a home ownership incentive and a
home mortgage deduction without having it be quite as large as it is
now.

And, there are similar kinds of things you could think of with respect
to the health benefits.

VICE CHAIRMAN BREAUX: Now, I mean, in health care there\'s no limits.

MR. ROSSOTTI: Yeah, there\'s no limits, right.

VICE CHAIRMAN BREAUX: Regardless of your income, or regardless of how
much is spent, none of it is taxable as income no matter how much you
make. You have a limitation on mortgage deductions, obviously, and it\'s
sort of means-tested in that sense, but on the health care expenditure
there\'s nothing.

CHAIRMAN MACK: Okay.

It may be just the hour, we\'ve been here for a number of hours, I\'m
starting to wind down. I think we\'ve covered our topics pretty well.

We, obviously, have more to \-- a lot more to do, and as we make
decisions with respect to our next public meetings we will make that
known.

And again, I want to thank the staff. You\'ve put a lot of work into
these presentations today, and I want to thank the panel members as
well. Some of you travel long distances to get here and participate in
this, and we appreciate the time and effort that you put into it.

At that, we will conclude our meeting.

Thank you all very much.

(Whereupon, the above-entitled matter was concluded at 1:02 p.m.)